Will Yemen Hurt Markets?

Bombing and a potential invasion of Yemen by a Saudi-led coalition, shocked markets late Wednesday night /early Thursday morning, and that has sent oil prices to multi-week highs. But, while it produces scary headlines, the answer to the question of will Yemen hurt markets due to this military conflict is “not likely.” Well, at least not directly.

By now you know that a Sunni Muslim coalition led by Saudi Arabia is bombing and likely invading Yemen. The reason is because the Sunni government there has basically been overthrown by a Shiite tribe called the Houthi, who are largely backed by Iran.

There are two characteristics of this conflict I need to point out to give it proper context: First, despite the urgency of the headlines, understand that this conflict is not new. Yemen has been basically in a state of civil war since last September, and the capital of Sanaa has largely been in control of the Houthi for months. Second, this is the latest iteration of a decades-long proxy fight between Saudi Arabia & Iran (so Sunnis and Shiites) for control of the region.

I don’t mean to be dismissive of the event, or the likely human tragedy that will unfold, because I am not. However, my job is to tell you the potential market impact, and to answer the question of whether Yemen will hurt markets. And, beyond the temporary concern and spike in oil, there simply won’t be much of one unless one of two things occurs:

Market Disruption 1: Strait of Mandeb closes (very unlikely)

Yemen is actually a very small oil producer, so the risk of a supply shock is not what sent oil higher. Instead, it’s that Yemen is on the eastern edge of the Strait of Mandeb, which is a main thoroughfare for oil exiting the Persian Gulf. Fears naturally have risen that the Houthi may shell tankers entering the strait, which would result in a supply shock—and that’s why the price of oil went higher.

Will Yemen hurt markets?

Will Yemen hurt markets? Brent crude prices surged 4.27% Thursday.

Theoretically this is a possibility, but it’s not likely. Part of the Saudi coalition have already dispatched war ships to the area to ensure no disruption, but also it’s unlikely the Houthi, which control most of the country, are probably receiving whatever meager revenue Yemen gets from oil exports (and they travel through the Strait). Bottom line, it’s something to watch, but the likelihood of this becoming a supply issue is low.

Potential Market Disruption 2: Yemen spirals into a larger Sunni vs. Shiite conflict

The battle for Yemen leads to a larger regional conflict between Shiites (backed by Iran) and Sunnis (backed by Saudi Arabia). This is the general fear everyone has, but again, the likelihood of that happening is small. This is mostly the latest battle in a centuries-old religious and cultural proxy war in the Middle East.

Yemen is having an effect on markets; however, but not directly. You’ll notice yesterday that bonds sold off hard (30 year down 1.3%). The Yemen issue will likely keep oil prices elevated, and that’s going to continue to put upward pressure on inflation indicators (CPI/PCE), which could make the Fed more prone to hiking rates sooner (June or July) than later (September).

In this Fed dominated world, even geopolitical events need to be considered in the context of Fed “lift off.”

So, will Yemen hurt markets? No, but it will contribute to more elevated prices than we’ve seen over the last two months. That could help inflation indicators rise, and make the Fed more prone to raising rates in June—and that’s the real reason we need to watch Yemen.

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Did the Fed End the Commodity Collapse?

The Fed just ended the commodity collapse. Well, maybe not overtly, but the single biggest takeaway from the FOMC meeting last week was that they effectively capped the US dollar rally, and because of that an opportunity may be developing to buy value in the commodities sector.

To be clear, we do not think the Fed is actively trying to engineer a weaker dollar, but they are trying to cap any further rise. And, if that’s the case, then there are several potential investment consequences that stem from that change, as a lot of trades across asset classes and sectors over the past seven months were basically different forms of the “stronger dollar” theme. That means we could see some substantial unwinds in different places.

One of the biggest potential shifts coming could be in the commodity and basic materials complex. And, while too early to be definitive, it’s not unreasonable to say that if the Fed has indeed capped the dollar rally then it may also have ended the commodity collapse.

In most commodities, the supply/demand dynamic is still negative, but commodities don’t just trade on supply/demand, so consider a few points in the context of the recent historic commodity price collapse:

Coordinated Global Easing May Lead to Stronger Demand

Remember that 24 central banks have cut rates this year, China is aggressively supporting its economy, and now the Fed is more dovish than expected. As we have covered with our “long shippers/tankers” call—Claymore/Delta Global Shipping (SEA)—there is a chance they actually stimulate global growth more so than is currently expected, leading to a potential uptick in global demand for commodities.

Inflation Statistics Should Begin to Rise Quickly if the Dollar Index is Capped

Rising global deflation fear has been driven mainly by plunging oil, and to a lesser extent, by other falling commodity prices. But, we already know that away from commodities, inflation pressures are starting to slowly trend higher. Wage inflation in the US is rising, service sector inflation is running near the Fed’s 2% annual target, and with oil stable (and potentially rallying form here thanks to a capped dollar) there is now upside risk in real inflation and inflation statistics. Rising inflation is good for commodities, and it’s good for materials stocks.

Commodities Have Collapsed

From a valuation standpoint, commodities have already largely priced in a worst-case scenario: No uptick in global demand and a constant dollar headwind. Point being, this is a very shorted and unloved space, so the potential for a rebound is there.

As you know, we look at everything from a risk/reward standpoint. And, given low valuations and a potential positive game changer of a capped US dollar and an uptick in global growth (not to mention how shorted and oversold the commodity complex is) the risk/reward profile for gold particularly, and commodities in general due to the Fed ending the commodity collapse, is starting to look better and better everyday.

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A Dovish FOMC Surprise

Wednesday’s dovish FOMC surprise took the markets by storm, as Fed chair Yellen and company removed the word “patient” from the FOMC statement, but simultaneously “moved the goal posts” out on economic conditions that would result in a rate hike (meaning the jobs market has to get even better than was previously thought and inflation has to accelerate higher).

I said last week one of the Fed’s problems was that it said it was “data dependent” and that the data said a rate hike was necessary. Well, the dovish FOMC surprise was the solving of that problem by changing the “data dependent” requirement to reflect desired lower unemployment and higher inflation.

Of course, there were multiple reasons why this Fed meeting turned into a dovish FOMC surprise. First, “patient” was removed but qualified by saying the Fed needs “further improvement” in the labor market and needs to be “reasonably confident” inflation will move back to 2% target. Going forward, “reasonably confident” is the new “patient” with regards to the wording of the FOMC’s statement.

Second, the dollar wasn’t explicitly mentioned, but the FOMC did note that “export growth has weakened,” which means that they are paying attention to the US dollar strength. Third, the Fed changed from “solid growth” to “economic growth has moderated somewhat” in describing economic activity.

dovish FOMC surprise

The Dow jumped on the dovish FOMC surprise.

Finally, the interest rate “dots” were moved decisively lower, especially with regards to 2015, substantially closing the gap between market expectations and the Fed projections. Bottom line, the majority of Fed Presidents now expect Fed Funds to end 2015 around 0.625%, which is nearly 50 basis points lower than in December, and reflects just two rate hikes.

Additionally, the “longer run” unemployment rate was reduced to 5.0% to 5.2% from the previous 5.2% to 5.5%. (These were perhaps the two biggest reasons the statement amounted to a dovish FOMC surprise.)

The much bigger issue of whether the Fed will hike in June, July or September remains very much unresolved, and more importantly, we still have no clue how markets will react when that happens. So, unless economic data turns decidedly weaker in the near future, we can continue to have the “June/July/September” rate hike debate for the next few months, and that will cause more volatility in stocks.

More broadly, the path to a sustainable rally isn’t through perpetual 0% rates and a dovish Fed, because we all know that at some point (and it can be debated as to whether we are there already) 0% rates will start to do more harm than good.

Bottom line, this was a dovish FOMC surprise, but I do not think it opens the door to materially higher stock prices as the major uncertainty surrounding the Fed remains unresolved.

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Is There a Conspiracy in Gold Prices?

Could there be a conspiracy when it comes to gold prices set forth by the elite metals traders?

On Tuesday, volatility surged in the gold market as futures swiftly dropped more than $10 shortly after the open to fresh, four-month lows. Then, gold prices came roaring back nearly $20 dollars within the same hour. Gold prices finished Tuesday trade down 0.44% in what was expected to be a slow day of trading driven by trader positioning.

The really interesting thing about the action in gold prices Tuesday was that the December 1st low of $1,140.70 was only violated by 1 tick, to $1,140.60. This is interesting because gold prices at $1,140.60 would be a logical place for “sell stop” orders for anyone betting on a “dovish” FOMC with a long gold prices position.

So, basically what happened Tuesday in gold prices is that some heavy hitter gold trader, or some elite group of gold traders, crushed the market into those stops where they were waiting with their own buy orders.

Those buy orders then lifted gold prices futures back up $20 for a hefty profit.

Now, I realize this move in gold prices sounds like a bit of conspiracy theory, and I’m not usually one to harbor such thoughts. In fact, I usually argue against the notion of powerful, behind-the-scenes forces manipulating gold prices, oil prices, or any other kind of prices. What is most-often the case is that markets react to supply and demand, and traders act as a discount mechanism for future gold prices, oil prices, stock prices and every other asset class.

gold prices

Are gold prices the victim of conspiracy?

Yet in the case of gold prices in Tuesday trade, it otherwise wouldn’t make sense for a recent low to be violated by just one tick.

Of course, I can’t prove this theory on gold prices, but what I can say from years of trading experience is that the action in gold prices Tuesday is the reason why the idea of a “rigged market” is common among many investors; journalists such as Michael Lewis, and of course, the non-investor class that’s disposed to consider the whole thing a giant, enigmatic black box full of secrets.

You and I know better, but Tuesday’s move in gold prices certainly seems like a case of a conspiracy in action.

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An FOMC Preview–5 Things to Watch

The Fed is meeting today and tomorrow, and we’ll hear from Janet Yellen and company on Wednesday. Of course, I always like to provide an FOMC preview for you the day before the announcement comes, as I know anyone watching the markets for a living is always busy. So, here is an FOMC preview of the five things to watch in the statement.

1) FOMC Preview–“Patience” removed from the statement. If “patient” is removed, all it means is that a June rate hike is a possibility, not a certainty. Everyone expects “patient” to be removed, but they also expect that the removal of “patient” will be qualified by the Fed in the same way that the removal of “considerable time” was qualified in the December statement. Look for the Fed to say something dovish like needing “certainty” that inflation is moving higher before raising rates. Expectation: “Patient” removed, but qualified.

2) FOMC PreviewUS Dollar or Global Central Banks Policy. The FOMC did not specifically mention dollar strength in January and only made a small acknowledgement of international headwinds. Markets will be looking to see if A) recent US dollar strength is explicitly mentioned, and B) If comments regarding global central bank rate cuts are expanded. If they both occur it’s dovish, if neither occurs it’s very slightly hawkish. Expectation: No mention of US dollar or any expansion of international commentary.

3) FOMC Preview–Economic Activity. FOMC commentary on the US economy in January was very upbeat, and most expect that to be dialed back a bit. The FOMC referred to growth as “solid” in January and the expectation is that it’ll be changed to reflect more modest growth given recent data. Regarding inflation, there is the expectation the FOMC may use a bit more upbeat language, so the net effect of both changes should be minimal. Expectation: Commentary on economic growth is slightly downgraded, while commentary on inflation is slightly upgraded.

4) FOMC Preview–Fed Forecasts and “Dots.” Given recent economic developments, most expect the “dots” regarding future interest rate expectations to be lowered slightly. This is especially true regarding year-end 2015 interest rates, as six Fed Presidents had greater than 1.5% Fed Funds at year-end 2015 (that’s not re-ally possible given June is the earliest possible hike now). Expectation: Small reduction in forecasted year-end interest rate levels, GDP and inflation, but anything more than small changes will be viewed as slightly dovish.

5) FOMC Preview–Bottom Line: Given the economic data since Thursday (disappointing retail sales, IP, Empire Manufacturing) the expectation seems to now be for a slightly “dovish” meeting, considering yesterday’s rally. So, there is some risk of disappointment now for stocks if the FOMC isn’t as dovish as expected.

FOMC preview

FOMC preview point–watch the VIX

Bigger picture, the million dollar question facing the market is when the Fed will start to raise rates. And while the hope is that we get more clarity on that point, it’s not likely to happen and uncertainty around Fed rate “lift off” will continue to be a general headwind on stocks—and contribute to continued volatility.

Look for the FOMC and Yellen to stress that they are “data dependent,” which will unfortunately lead to more data-driven swings like we saw Thursday through yesterday. So, baring a shock from the Fed tomorrow, we can all continue to expect more volatility going forward.

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The Real Jobs Report Takeaway

The two major takeaways from the economic data last week, and by economic data I really mean the February jobs report, as it was all that really mattered are: 1) The word “patient” is almost certainly going to be removed from the March FOMC statement, and 2) The chance of a June rate hike is now much more likely (but still not absolute consensus) thanks to that “hotter” jobs report.

Stepping back, here is the main problem the market is facing right now: The Fed has spent the last year telling the market it will be “data dependent,” thinking it would be taken as “dovish” in that the Fed wouldn’t raise rates too soon or too fast. Yet given the February jobs report, and the fact that along with the jobs report the data is better than anyone thought it would be (looking over the last few quarters), and the data is saying an interest rate hike is warranted sooner rather than later, which is in conflict with the Fed’s “dovish” leanings.

Looking at last week’s jobs report, it was obviously “hawkish” but not for the reason I expected. The wage data, which was the key sub-index in the jobs report, was actually a touch soft, rising 0.1% and 2.0% yoy (down from 2.2% in January). But, the rest of the jobs report was so strong that it cancelled out the soft wages.

The overall jobs report showed there were 295k new adds vs. (E) 230k, while the unemployment rate dropped to 5.5% (new low for the recovery) and the U-6 unemployment rate fell to 11% (also a new low for the recovery). This came despite concerns about the negative influence of port shutdowns and refinery strikes. Bottom line, it’s another strong jobs report, and clearly adds to the chances of a June hike.

Part of the reason the sluggish wage number in the jobs report didn’t have more of a “dovish” influence is because other broad-based measures of inflation have shown signs of bottoming. And, that continued last week with the core PCE Price Index (the Fed preferred measure of inflation), which rose 0.4% month/month (vs. expectations of 0.3%) while the year over year increase was flat from January at 1.3% (most expected it to decline).

And, with oil stabilizing (for the most part) other inflation indicators should continue to bottom, and as such won’t be a dovish influence on the Fed.

Bottom line: The February jobs report was hawkish, and clearly adds to the chances of a June rate hike “surprise.”

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A February Jobs Report Preview

As has been the case in the jobs report over the past couple of months, the wage and unemployment number will be just as important—if not more important—than the headline jobs report figure. The official estimate is for the February jobs report to come in at 230,000 jobs added. With tomorrow’s jobs report, the major area of concern for markets is that a “too hot” wage figure pulls forward expected Fed rate hikes to June. A June hike is not priced into markets, so if that happens, expect potentially material declines in stocks, commodities and bonds.

The “Too Hot” Scenario

> 2.2% yoy wage increase. Wages are again the most important metric in this jobs report. In the January jobs report the yoy wage increase rose to 2.2%, and if that number moves above 2.2% expect the market consensus for Fed rate “lift off” to move to June, and again that is not priced into markets here.

< 5.5% Unemployment Rate, ≤ 11.0% U-6 Unemployment Rate. With all the recent discussion of “NAIRU” (Non-Accelerating Inflation Rate of Unemployment) the unemployment rate in the jobs report may be taking a back seat as a Fed indicator. But, if we get a sub 5% UE rate that is combined with a sub-11% U-6 unemployment rate (which measures underemployment also), then pressure from this jobs report will rise on the Fed to hike in June.

> 300k Job Adds. There is the expectation we’ll see continued moderation in the jobs report in terms of adds from the end of last year, but if we see a print of another 300k then that will be taken as hawkish by the market and we could see stocks sell-off.

jobs report

The February jobs report could pull stocks off of their all-time highs.

The “Just Right” Scenario

Basically anything under the “too hot” scenario levels in this jobs report would be considered “just right” and the market should broadly yawn in response.

The “Too Cold” Scenario

< 2.0% yoy wage increase. There really isn’t much of a chance of a “too cold” scenario in the February jobs report, unless we see yoy wage increases drop below 2%, because even if there is a big miss on the headline jobs report it will be ignored as a one off.

The bottom line in the February jobs report is that almost all the risk going into the print is to the downside for stocks, as any surprise will be a hawkish one. Remember, a bad jobs report (say under 175,000) won’t be bullish for stocks, because no one wants soft data and more easing from the Fed.

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Falling Rig Count Does Not Mean Less Oil

Rig count reductions are the big reason cited by many oil analysts for a supposed coming contraction in oil supply. Yet over the past two days earnings from two energy companies offered anecdotal insight into why I am skeptical of the theory that rig count reductions will ease the growing oil supply glut. On Tuesday, oil giant BHP Billiton Limited (BHP) said it would reduce its US shale drilling rig count to 16 from 26, nearly a 30% reduction.

However, that reduction in rig count would not impact 2015 financial year production guidance. BHP said expected shale liquids volumes (shale oil and NGLs) to rise by approximately 50% in the period—despite the falling rig count.

Then Wednesday, Chesapeake Energy Corporation (CHK) said they were slashing capex for 2015 and reducing their rig count to the lowest level since 2001. The rig count will fall to between 35-45, down from an average rig count of 64 in 2014.

Yet despite these rig count cuts, production growth still is expected to increase by 3%-5%.

I realize this is a sample of only two companies, but they help make my point that energy company share prices (especially Exploration and Production companies) live and die by production growth—not rig count.

rig count

Will a falling rig count put upward pressure oil prices?

It’s pretty simple: E&Ps need to show growth by either 1) producing more of their commodity to boost revenues, or 2) selling current production at a higher price. Obviously, #2 isn’t happening, so unless these energy companies want to see their stocks annihilated, they have to show some incremental production growth even with a falling rig count.

Shutting in production to try and support the price of your commodity is something that these companies simply will not do (nor should they). So, again, the declining rig count isn’t quite the bullish indicator that everyone thinks it is.

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Are Oil Prices Rolling Back, And is That Bad for Stocks?

The market was focused on Greece last week, and because of that traders basically ignored the more-than-3% weekly decline in oil prices (the biggest decline in nearly a month). Yet, as we originally pointed out in late November/early December, oil prices and the Dollar Index remain the near-term drivers of stocks, and it’s no coincidence that the bottom in stock prices in January came two days after the bottom in oil prices (1/29 bottom in oil prices, 2/2 bottom in the S&P 500).

The main fundamental catalyst for the recent rebound in oil prices (aside from last week) has been the plunging rig count and the reduction in exploratory capex from oil producers. And, I totally acknowledge those are bullish influences longer term for oil prices. Yet the key question now is whether the price action for oil is 1) a bottom or 2) a large oversold bounce in a still downward trending market. I am leaning towards #2, because that’s what the fundamentals and technicals are starting to point to.

The way I see it, there are three bearish influences on oil prices right now.

Oil prices

Oil: Support at $48 is now key to determining whether this is a bottom or just an oversold bounce in a still downward trending market.

Bearish Oil Prices Influence #1: Inventories

We know that US inventories are at 80-year highs. Some of that recent build has been because of the refinery strikes (so, less demand to refine raw crude). The refineries participating in the strikes account for 13% of refined product production. But, if we look at the weekend inventory data, it’s not like we’ve seen a huge collapse in production from levels earlier this year. So, inventories at an 80-year high is bearish for oil prices.

Bearish Oil Prices Influence #2: Falling Rig Counts Don’t Mean Less Production

I’ve talked about this for the last month, but if we use natural gas as a potential blueprint, it shows us that reduced rig count and capex budgets don’t result in less production. Since April 2011, the natural gas rig count dropped from 885 to 289 as of last week’s report, yet during that same period natural gas production rose over 20% to 2.37MMcf from 1.9MMcf. Point being, while the sticker shock of the rig declines was substantial, it doesn’t necessarily mean we’re going to see less production. Oh, and over that same time period (April 2011 to last Friday) natural gas prices dropped 38%!

Bearish Oil Prices Influence #3: Market Structure

I don’t want to get too much in the weeds here, but contango (the difference between front month crude and back month crude) is widening. Markets in contango are usually in a downtrend, and that point is further exemplified when the contango is widening like it has been in WTI crude oil prices recently.

Technically speaking, the recent countertrend rally has run out of steam as the uptrend line was broken late last week. And, although that is not outright bearish, at the very least it suggests that oil prices will remain suppressed in range-bound trade between $45 and $55 with a bias to the downside over the medium term, as the primary trend is a bearish one.

Guessing the near-term direction of oil prices is a loser’s game, but we get paid for opinions here, and the fundamentals and technicals imply this rally in crude may just be one, massive, oversold bounce.

If oil prices close below $48/barrel, that will likely result in a test of the recent lows at $43.58.

This is important, because we believe oil prices are still a leading indicator for the stock market, and if oil rolls over form here, stocks very well could decline along with it.

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Gold Prices Volatile, Copper Prices Shine

As was the case with most of the financial markets Wednesday, commodities’ traders were largely focused on the release of the FOMC minutes. The general reading on the back and forth inside the Fed was rather “dovish,” primarily because FOMC officials seemed particularly focused on wanting to make sure the economic recovery was truly “sticking” before they raise interest rates. The Fed’s release had an immediate effect on gold prices, both before and after the actual minutes came out. Meanwhile, copper prices were heavily influenced by what has been one of the biggest influences on the market today, Greece and its deal with the Eurogroup.

Gold prices were the big story in the commodities space yesterday, as futures collapsed through $1,200/oz. to a six-week low as traders positioned for a potentially “hawkish” FOMC announcement. But, upon the “dovish” release, there was an algo-driven, short-covering rally that took gold prices back to flat, and comfortably above the closely watched $1,200 level. The rally in gold prices continued overnight as gold prices now are sitting just under $1,220 per ounce.

Yesterday’s rally in gold prices was mostly an algo-driven short-covering rally and fundamentally, the case remains bearish for gold prices. Looking at the near term, futures did become oversold ahead of the Fed minutes, so a bounce back/consolidation rally may be ahead of us. However, such a move in gold prices should be seen as a selling opportunity once the short covering subsides.

Gold Prices

Meanwhile, copper prices, the benchmark industrial commodity, rallied 1.41% Wednesday, making some bullish technical progress on the charts as optimism surrounding Greece helped support the market.

The Eurozone is the second-largest consumer of the industrial metal after China, so progress in the Greek/EU negotiations that ultimately leads to a better EU economy (without the overhang of Greek uncertainty) is an underlying bullish influence for copper prices.

Technically speaking, copper prices closed at the highest level since January 16, and was able to break back through a nearly three-month old downtrend resistance line. The technical “progress” is obviously near-term bullish, and could see futures rally to as high as a broad resistance band between $2.75 and $2.85.

However, Europe will remain in focus, and if the Greece-EU deal deteriorates (which will increase the threat of EU “contagion”), then copper prices likely will come back under pressure.

The bottom line here is that volatile gold prices and shiny copper prices have largely been news-driven events. Now the question is what will happen once the news is in, and once traders turn back to fundamentals and technicals when making buy and sell decisions.

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