Global equities and currencies may be stuck in low volatility mode, but oil, gold and US inflation data have been rare pockets of volatility, and thus the subject of intense scrutiny by otherwise bored traders and financial writers. What this volatility means, and what it doesn't.
The following is a partial summary of the conclusions from the fxempire.com weekly analysts' meeting in which we cover the top lessons for the coming week and beyond.
Oil Prices: How High & Ramifications
Energy in general has been trending higher all year. Ukraine tensions started it, and now expanding fighting in Iraq adds another potential threat to supply, as that fighting threatens to spread to Iraq's Southern oil producing region.
The note references two tables from Columbia University's Center on Global Energy Policy showing how disruptive fighting in the South could be. The first compares proven reserves in the North versus the South.
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Reserves become irrelevant if Iraq loses its sole remaining functioning export terminal, which is also in the South.
The second table compares exports emanating from the southern port of Basrah with those out of the northern terminal at Kirkuk before and after Kirkuk was shut down (after a key pipeline to Turkey came under attack, so Kirkuk is now gone and Basrah is now the only port from which Iraq can export oil.
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The note concludes:
If the conflict migrates to the South, an unlikely but possible worst case scenario in which all production is lost, oil prices could spike to $160 a barrel.
Immediate risks to production appear limited, meaning that oil prices remain around $110/bbl.
On Consumer Spending
Unfortunately, analysts noted last week that the crude price increase that's occurred is expected to send U.S. gas prices to a six-year high of $3.652 this summer.
There is debate over long that will last and how much it will matter. Michael Santoli believes that $4.25/gallon is the red line at which consumer spending would start to suffer.
Professor James Hamilton is an expert on the relationship between energy and the US economy. He has a useful calculator (that shows the relationship between oil and gasoline prices) that translates into ~$137/barrel for Brent crude, and $4/gallon suggests $127/barrel (hat tip to Jeff Miller for that fine source).
On Global Markets
Of course markets are forward looking, so it's anyone's guess how far south the fighting has to travel before speculators start driving up oil prices and risk asset markets like stocks start pricing in the damage of this added tax that carries no corresponding benefit from added government spending or reduced debt service expense.
Gold: Bottoming On USD, EUR Weakness From Central Banks Policies, Rising Oil
Oil isn't the only hot market. Gold was a big winner last week, and has been trending higher since December. In the past three weeks it's risen almost 6%, driven by both new Fed and ECB dovishness as well as rising oil prices.
Unlike most other liquid globally traded instruments, or commodities, gold does not fit neatly into either the risk or safe-haven asset category, because it does not consistently rise or fall with risk appetite. Most of the time gold is best characterized as neither of these, but rather as a "currency hedge," rising or falling with the perceived value of the most widely traded currencies, especially the USD, and to a lesser extent, the EUR. Without getting to technical, gold also tends to rise with rising inflation risk, which is related to, but not necessarily the same thing as, currency weakness.
New ECB easing as well as Fed signals that rates will stay lower for longer are seen as dilutive for their respective currencies. Oil is priced in dollars, so rising oil is usually bearish for the USD (except for times of great fear that drive investors into safe-havens like the USD).
Oil And Gold: Moving In Synch Since Mid-2013
Weekly Charts For Gold (Top), Oil (Bottom) August 2012 To Present
Key: 10 Week EMA Dark Blue, 20 WEEK EMA Yellow, 50 WEEK EMA Red, 100 WEEK EMA Light Blue, 200 WEEK EMA Violet, DOUBLE BOLLINGER BANDS: Normal 2 Standard Deviations Green, 1 Standard Deviation Orange.
08 Jun. 22 17.16
Key Points To Note:
They've been basically moving in sync since mid-2013, both recording double bottoms from mid-2013 to December 2013, trending higher since then, and accelerating upwards in recent weeks on the effects of EUR and USD weakness as well as rising oil prices (for gold) driven by turmoil in energy exporting areas like Ukraine and Iraq.
Inflation Debate: Don't Base Investment Decisions On Short Term Inflation Data
Taken together, the rise in oil and gold matter most to the extent that they may signal rising inflation. These days, inflation matters mostly for investors insofar as it influences sentiment on the biggest market driver of all, central bank policy.
Boring, low volatility markets have the financial media searching for something to write about, and recent signs of rising inflation have been a hot topic, because in theory they should influence sentiment on Fed policy and perhaps increase volatility and thus give traders and financial writers something to do and justify their jobs.
For now, we advise ignoring suggestions that coming inflation means accelerated tightening for the Fed.
The Fed has made clear that it will only change policy based on longer term trends, not monthly inflation data, which Yellen dismissed last week as too volatile to take seriously.
My man Jeff Miller, king of the weekly US market previewers on seekingalpha.com and elsewhere, has a great summary at the end of his weekly market preview of the specific reasons why you should not anticipate any changes in Fed policy based on rising inflation data over the coming weeks or next few months. The most important are:
- The Fed will tolerate inflation over its 2% target for a while
- It believes many metrics overstate inflation
- It doesn't consider food and energy prices as much as consumers do, both because these are volatile and because the causes of higher food and energy prices are beyond the influence of Fed policy.
- Again, the Fed is cautious and will not tighten due to inflation unless it sees dangerous long term trends forming. Periodic but monthly price spikes that don't form a trend of rising prices won't raise Fed inflation concerns.
Higher oil prices will soon be felt on the consumer level, though it's unlikely they'll impact growth yet. If fighting in Iraq even threatens the southern region, however, there is a chance of much higher prices. That said, whoever is in charge will want oil exports restored ASAP.
Oil and gold are moving in sync, probably reflecting concerns about currency values or coming inflation as that is the primary driver of gold.
Rising short term inflation is unlikely to influence Fed policy. Even if inflation does establish a long term uptrend, inflation is only one factor that in Fed policy considerations. It could well tolerate higher inflation if it believes low rates continue to support job growth.
Disclosure/Disclaimer: the above is for informational purposes only, responsibility for all trading or investing decisions lies solely with the reader.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.