Why You Should Be Wary About the Oil Price Heading Higher

abstract 3d illustration of oil barrel and dollar sign

Our central banking overlords and puppeteers clearly love this…

The Dow Jones Industrial index jumped another 0.8% overnight as the market grows increasingly comfortable with the Fed raising interest rates in the coming months.

At least that’s the latest narrative to grip markets. Here it is nicely wrapped up by Bloomberg:

Don’t fear the Fed is the new mantra for global markets.

U.S stocks rose to their highest level in almost a month amid mounting investor optimism that the world economy can withstand higher interest rates from the Federal Reserve.

Behind all the noise though, here’s what you need to know. The driving force behind the market’s recent rise is the rally in bank stocks. Banks like the prospect of higher interest rates because it allows them to earn higher margins on their traditional lending activities.

You can see this in the performance of the Philadelphia Bank Index below. Overnight, the index closed at its highest level for 2016.

Source: Market Analyst

Click to enlarge

The prospect of higher rates is due to renewed optimism about the US economy. Recent data showed the US housing market continued to recover. This seemed to take the market by surprise.

Readers of Cycles, Trends and Forecasts are well aware of the ongoing recovery. They know that there is a long way to go before US real estate blows another gasket.

But that doesn’t mean an interest rate rise is a done deal for June. In a sign of the need to hedge their bets, St Louis Fed President James Bullard said overnight that a June rise was ‘not set in stone.

Perhaps he was concerned with data showing the huge US services sector slowed during May. The reading for the Markit US purchasing managers index (PMI) came in at 51.2, down from 52.8 in April, and well down on the average reading for 2015 of 56.

A reading over 50 denotes expansion, so these numbers tell you that, while the US services industry continues to grow, it is doing so at a slower rate.

In other words, there are quite a few cross currents in the US economy right now. Just because the market is all fired up about a June rate rise doesn’t mean it will happen. In fact, the narrative can turn quickly, depending on the data release.

The other important piece of the jigsaw puzzle is oil. The rally from the lows of early 2016 continues; this is also providing support to the market.

As you can see in the chart below, the price of Brent crude nearly hit US$50 per barrel last week. The rally from the low of nearly US$28 per barrel in January this year has taken a lot of pressure off the global financial system.

Source: Market Analyst

Click to enlarge

The rout in the oil price threatened to turn a huge amount of debt ‘bad’. That was a big threat to the stability of the global banking system. Now the oil price rally has taken that pressure off.

What’s surprising is to see oil rally in the face of a strengthening US dollar. Connecting the dots, the prospect of an interest rate rise boosts the US dollar, which should put pressure on non-dollar assets like oil.

But oil has shrugged it off. Whether it can continue to do so is another question. As far as I can tell, there hasn’t been much of a change to the fundamental story. That is, there is still plenty of supply around.

Not surprisingly, the culprit for the persistent rally relates to positioning in the futures market. Check out the chart below, from Saxo Bank. It shows the oil market position of ‘managed money’ — mostly hedge funds.

There are two things to take note of. Since late 2015, hedge funds increased their bullish bets (blue line rising) and decreased their bearish bets (red line falling).

The result of this is that the ‘net long’ position (bullish minus bearish bets) is now the highest it has been since at least 2011. Given the abundant supply still in the market, that is a little concerning.

Source: Bloomberg, Saxo Bank

Click to enlarge

In Brent crude, the ratio of longs to shorts is 16:1!

The oil market has had a great rally, but it is now very stretched. I’d be wary of a decent pullback from here.

Unfortunately for Australia, one commodity that hasn’t proved anywhere near as resilient is iron ore. It’s coming back down to Earth fast.

Qingdao port prices fell another 1.2% yesterday, to US$50.40 per tonne. 12-month futures are at US$37/tonne. The iron ore stocks don’t seem to care though. They’re trading in line with the general bullishness of the market.

When I say general bullishness, what I really mean is indiscriminate bullishness. It’s hard to argue that the outlook for earnings is particularly good, yet stock prices are rising strongly.

Perhaps the combination of lower rates in Australia, and higher rates in the US, is the perfect combination for Aussie stocks? Or perhaps the market has just lost its head for the time being.

We’ll know more shortly. The ASX 200 is trading right on 5400 points this morning. As I’ve pointed out before, this is a crucial level for the market. A close above here will be a positive, pointing to more gains for stocks.

Let’s see whether the market remains strong into the afternoon. More on that tomorrow…


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

Leave a Reply

Be the First to Comment!

Notify of

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au