The coming week’s market movers will answer 4 key questions. There’s also a packed start-of-month calendar.
Six months of nearly uninterrupted rallying in risk assets hit a wall this past week. One reason only but it was significant and its potency is far from exhausted: the budding civil war in Libya, its effects on oil prices, and the fear that the unrest will spread to other oil producers and shut down production elsewhere in the MENA (Mideast North Africa) region.
For those who missed the action last week, here’s a brief recap. Last week markets moved with news on Libya and it’s affects on oil prices.
- During the week of February 14-18, stocks and other risk assets continued to rally even as unrest spread in the MENA area. Oil prices spiked from $80 to $90/ barrel, but that was only due to the risk that the strife might eventually affect oil production. As long as the risk was only theoretical, markets could continue to rally.
- However on Monday the strife spread to Libya, the 8th largest oil producer in the world, 2% of global production
- Oil prices shot 6% higher from $90 to $97/ barrel Monday. Stocks and other risk assets predictably plunged because the cost of nearly everything was now set to rise. As the situation deteriorated through the week, oil prices moved higher, stocks and other risk assets that rise with optimism moved lower.
- Assurances on Friday that OPEC could make up for any shortfall brought a modest pullback in oil Friday, and a corresponding bounce in stocks and other risk assets. It didn’t matter that that Friday’s economic news was quite bad:
lower revised GDP for both the US and UK
rising consumer prices in Japan
Who cared? The key was that oil supplies were stable for now.
Oil ended the week around $100, up well over 9% for the week.
With Libya, the popular uprisings in North Africa and the Middle East have now hit their first a large oil producer. Production was cut by as much as 75% per Italian driller ENI.
Here are the questions:
1. Oil Dictators To Flee Or Not To Flee? That Is The Question
Further turmoil is likely for Libya, but the real risk is whether additional oil producing states will be hit with similar civil strife and production cuts. Watch developments in the MENA region for the answer. Any significant sign of spreading or containment is likely to move markets.
Here are the details for those interested. If not, skip to the next key question.
Hat tip to Unicredit Bank’s excellent treatment of the topic, which you can find at here.
The decline in Libyan crude oil production (1.7 million barrels/day) can be offset by OPEC, which is estimated to have free production capacity of 5.4 million barrels/day (see chart below, red line, click to enlarge).
Chart Courtesy of Unicredit Bank 18 feb27 0333 d
In the short term, therefore, the Libyan shortfall is not the reason for the drastic jump in oil prices.
Rather the catalyst for higher oil is the ongoing political uncertainties (risk premium) and thus the increased need to hedge transactions.
- How long will Libyan production be affected?
- Will a new government require renegotiation of existing contracts?
However the key risk is that the unrest will spread to the larger MENA oil producers (see table below, click to enlarge).Will it? Watch developments in the MENA region for the answer.
Chart Courtesy of Unicredit Bank 19feb 27 0336 d
If the crisis were also to hit these countries, not even OPEC could make up the production losses. The oil price would then probably test its all time highs of July 2008, $147.
Until that risk subsides, oil prices at best stay around current levels.
For the first quarter of 2011 at least, the risk premium will be with us, thus oil should be around $100/barrel at best. It appears probable that the disturbances will continue and likely get worse before things stabilize. While OPEC can replace the loss of Libyan production, this will take time, and their oil is not of the same high quality low sulfur ‘light sweet’ crude as that from Libya.
If unrest shows signs of spreading, there is real risk that oil could revisit its 2008 historic highs of $147.
Risk assets have long been due for a normal 5-10% technical pullback to test support, however Fed and ECB operations have kept risk assets resilient. Still, a breakdown in oil production from a popular revolutionary uprising in the MENA region is beyond the control of the Fed and ECB. It could well be the needed fundamental catalyst capable of overpowering even Fed and ECB, and providing enough risk aversion to power a sustained pullback. The easiest way to play that are assorted short index plays, like S&P 500 short ETFs including SDS, RSW, BXDC, BXDD, SPXU, SH) for playing drop in the SPY.
2. Will The ECB Feed Or Bleed Rate Hike Expectations?
The rally of the EURUSD and other EUR pairs over past 7 weeks has been mostly due to speculation that the ECB had become more likely to raise interest rates, especially compared to the Fed, due to its concern over rising inflation. That question will be answered at the Thursday March 3rd the ECB press conference. If ECB President Trichet appears more in favor of rate hikes the EUR will likely rally to test 1.4000. Per Kathy Lien of fx360.com:
If the central bank President joins the chorus of hawkish central bankers, it will send a very clear message to investors that the ECB is actively thinking about raising interest rates, which could renew the rally in the euro. The key is to watch for the word “vigilance.” If Trichet uses this word in his press conference – it would be perceived as a major step towards a rate hike which would be positive for the euro.
If Trichet sounds more cautious, expect a pullback to test support around 1.3450, or even lower if MENA region turmoil continues to feed risk aversion. Our take? Regardless of hawkish comments earlier this week from ECB officials or whatever Trichet hints at, policy makers will usually prefer inflation over relapse into recession and soaring unemployment under their watch. When pushed, the EU officials have consistently chosen to avoid risking a PIIGS default and jettisoned their reputed hard money attitudes. Thus, until the PIIGS restructure or default threat is resolved, we don’t see rate hikes coming.
We won’t know if there is any real progress on the PIIGS until the mid-March EU summit, but it’s unlikely that will produce the reforms and expanded aid needed. Why? If the past is any guide, just as last year at this time, coming German elections will likely prevent Germany from providing the needed cooperation & funding as German officials play to their voters. Only after we get another crisis to provide the needed political cover (“Ve had no choice, no bailout, alle ist kaput”) will German officials commit more funding (relevant ETFs: FXE, EUO) .
3. Will US Jobs Reports Provide Hope For The USD?
Markets believe the Fed will be among the last of the central banks to raise interest rates, and recent poor economic data and mild inflation has confirmed that impression. The Fed will not want to raise rates until jobs and spending improve. This coming Friday’s Non Farms Payrolls (NFP) and Unemployment rate reports provide the next chance for new optimism about the US recovery and rate increases that might support the USD (relevant ETFs: UUP, UDN)and stop the EURUSD rally (relevant ETFs: FXE, EUO).
The EURUSD is nearing multiyear highs despite a growing list of nations needing aid and no clear sign that it’s coming soon. Also expectations for USD rate increases are very low right now. That means the USD could get a bounce on even mildly good news. So if US jobs gain anything close to the forecasted 176K jobs (vs. the 36K for January), that could well be the excuse the USD needs, especially if more trouble in the MENA region and/or an ECB rate increase disappointment makes the EURUSD look overpriced.
4. Will Irish Elections, German Politicking, New EU Bank Stress Tests, Or Rising PIIGS Bond Yields Scare Markets?
Irish voters are expected to elect a government with a mandate to cut Ireland’s debt. The EU is firmly opposed to any losses for bondholders, though it’s believed the new government may settle for a reduction in the rates it’s paying as a compromise, given Ireland’s need for EU help. But whether any is coming may depend on German cooperation to fund a chunk of it, which is unlikely in the weeks before a German election. Will that spark a confrontation with the newly elected government with its own voters to consider?
The EU is due to announce a new round of bank stress tests, with this one supposedly aimed at actually testing bank stability. The last test this past summer was mostly a PR show aimed at restoring confidence after last spring’s string of to-little-to-late bailout packages so undermined confidence that even the final $1 trillion package wasn’t enough, as PIIGS borrowing costs soon continued their march higher.
Will this one inspire or undermine confidence?
This past week, while markets were transfixed on Libya, those PIIGS bond yields kept moving higher. At some point this will raise red flags. Will this be the week? Plenty of PIIGS debt issues in the coming weeks.
DISCLOSURE & DISCLAIMER: AUTHOR SHORT THE EUR FOR PERSONAL PORTFOLIO. THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY AND NOT TO BE CONSTRUED AS SPECIFIC TRADING ADVICE. RESPONSIBILITY FOR TRADE DECISIONS IS SOLELY WITH THE READER