The Oil Market: Now and Then
We have included in today’s report a chart that was featured in a Forbes article yesterday regarding the two main influences on the oil market right now: rising US output and OPEC/NOPEC production cuts. At first look, the chart suggests that using hindsight as a gauge, US production lags the rise in rig counts which supports the argument that US production will not rise fast enough to offset the OPEC/NOPEC efforts. But we think that argument is flawed and here is why.
During the last aggressive expansionary phase for US oil production (rising US rig counts/increasing output) which lasted from 2009 to 2014, oil prices were wavering between about $80 and $110/bbl. The correlation between the pace of rig count growth and production growth was rather low as you can see by the difference between the slopes of the two lines in the chart. The likely and simple reason for that low correlation is the fact that there was a lot wild cat drilling, thanks to a surge in industry investment, that turned out to be unsuccessful.
In today’s lower price environment, efficiency is key and exploratory drilling, especially in unconventional areas, is at a minimum while producers focus their time, efforts, and investments on reliable sources of oil with considerably lower lift costs. If this is indeed the case as we believe it is and a good portion of the increasing rig counts that are being reported by BHI are actually DUCs (Drilled but Uncompleted wells) in proven areas, then the relationship between rig counts and production should have a tighter correlation than it did 5-10 years ago.
Bottom line, the fundamental backdrop of the energy market is different right now than it was between 2009 and 2014 and because investment in energy is much lower while the industry remains focused on efficiency, we are more likely to see a tighter correlation between rising rig counts and rising US production which would result in a faster pace of production growth. That in turn would offset the efforts of global producers who are trying to support prices and as a result, leave us in a “lower for longer” oil environment.
Here is a “Stock Market Update” from The Sevens Report: Stocks finally moved Tuesday, as the S&P 500 staged a modest rally following good economic data and well received (but not really positive) political headlines. The S&P 500 rose 0.66%.
Stocks were flat to start Wednesday trade thanks to generally “ok” economic data from Europe (the European and German flash PMIs were light). There were also a lot of earnings reports, but they were the normal gives and takes, and none of the big companies reporting really moved markets beyond their specific sector (JNJ weighed on healthcare, but that’s it).
After the flat open, stocks started moving higher following a strong January flash manufacturing PMI, and the gains accelerated following several political headlines.
First, the Trump/auto company CEOs meeting was uneventful; then Democrats unveiled a $ 1 trillion infrastructure spending bill, and finally the president signed executive orders to reopen negotiations on the Keystone and Dakota Access pipelines. Stocks hit their highs early afternoon, and the S&P 500 made a new fractional all-time high before backing off just a bit into the close.
Stock Market Update: Trading Color
Yesterday was the first big Trump On day in markets since the first few days of 2017, as small caps and cyclicals handily outperformed.
The Russell 2000 rose 1.5%, more than doubling the S&P 500’s performance while cyclical sectors handily outperformed. Banks (KRE), financials (XLF), industrials (XLI) and basic materials (XLB) all rose more than 1%, with the
latter rising nearly 3% on a big DuPont (DD) earnings beat that pushed the Dow higher (they are heavily weighted in XLB, so the strength there was chemicals based, not commodity based).
Outside of DD earnings there weren’t really any big market movers, with the exception of JNJ weighing on the healthcare sector. XLV dropped 0.70% on the JNJ miss, although the weakness was somewhat isolated as the Healthcare Providers ETF (IHF) rose 0.29%.
Most of the remaining SPDRs we track were up about 0.60% (including consumer staples, which traded pretty well), although utilities were only fractionally higher on the rise in bond yields.
Bottom line, none of the political actions mentioned yesterday were surprises, but overall it was a generally business friendly day of headlines from Washington. That, combined with the PMIs, helped stocks rally.
10 Year Treasury: The greenback ended a volatile week little changed as the Dollar Index dropped more than 1% last Tuesday after now-President Trump called it “too strong.” Then a hawkish tone from Yellen on Wednesday, and dovish comments from ECB President Draghi Thursday, helped reverse that initial decline. The Dollar Index ended the week down 0.30%.
The headline volatility around the dollar last week is likely a preview of what’s to come over the next year (it’s going to be a good one for currency brokers) because while the trend in the Dollar Index remains clearly higher, there will be bouts of sharp declines due to politics, economic data, etc. However, at its core, the rising dollar is an economic and interest-rate phenomenon, not a political one.
Turing to bonds, yields were sharply higher last week on a combination of firm inflation data (CPI, Prices Paid indices, Beige Book commentary) and Yellen’s hawkish tone from Wednesday. The 10-year Treasury yield rose 7 basis point while the 30-year yield rose 6 basis point, the first weekly rise since early December.
Going forward, depending on economic data, it looks like this counter-trend rally in a greater bond decline is coming to an end, and we are watching 2.60% in the 10-year yield specifically. If that level is broken, then we could see a potentially sharp acceleration in Treasury yields, and stocks will definitely start to notice if/when the 10 year approaches 3%. Economic data needs to continue to accelerate for stocks to weather that type of a rise in yields.
The key number to watch this week is the flash manufacturing PMI out tomorrow. As stated, that number needs to remain firm for general market psyche, because we’re likely to encounter at least temporary disappointment on the fiscal stimulus front in the next few weeks (as is typical in Washington).
Beyond the flash global PMIs, Durable Goods and Q1 GDP are the two next most important numbers. Durable goods will offer the latest insight into business spending, which needs to continue to accelerate. GDP won’t mean much from a market standpoint but the media will cover it, and anything north of 3% will be taken as a positive (although a number that high is unlikely). For all the optimism over future growth, right now the economy is still stuck in 2%ish annual growth mode, just like we’ve been for the last several years.
Finally, Existing Home Sales comes Tuesday, and as we mentioned last week, it’s critical to the economy that the housing recovery doesn’t get derailed by higher rates. Last week’s Housing Starts data was mixed, so focus will remain on the December data, as that was the first full month of consistently higher rates.
Bottom line, the key here is acceleration in the data. Better economic growth and hope of fiscal stimulus has powered stocks higher, but the latter will likely get delayed due to regular Washington shenanigans. To counter that, growth needs to continue to accelerate.
The dollar index fell into a key support level yesterday as the market remained in “Trump-Off” mode. If support just above 100 is violated, dollar index futures could quickly fall back to the uptrend line pictured above, near 98.00
Donald Trump and British PM Teresa May were the two major influences on the currency markets yesterday, as Trump’s comments to the WSJ over the weekend about the dollar being too strong, combined with May’s Brexit address being slightly less hardline than feared, caused a big drop in the greenback. Meanwhile, the pound surged nearly 3% (it’s best day since ’08). The Dollar Index closed down 0.75%.
Starting with the biggest mover on the day, the pound hit fresh multi-decade lows over the weekend on fears of PM May taking a hard line in her Brexit address (the pound briefly broke through 1.20 late Sunday). But in her comments yesterday, May said that while she will seek a clean break from the EU, any final deal will be put to a vote before Parliament.
It was the last point that ignited the pound rally, because while the news of the vote isn’t exactly positive (it will still be a “hard Brexit”) it does introduce some sort of moderating force and influence into the negotiations. And, since it was unexpected, it caused one massive short-covering rally.
Going forward, do we think today’s news marks the low in the pound?
No, not unless US economy rolls over. That’s because Brexit will be a consistent headwind on the pound for quarters and years (May said she will begin a two-year negotiation with the EU in late March). Unless you are a nimble traders, we certainly would not want to be long the pound, as we don’t think this is the start of any material rally (again, absent any rollover in the US data).
Turning to the US, Trump’s comments about the dollar being too strong over the weekend and “killing” US manufacturing hit the currency. As a result of those comments, all other major currencies were universally stronger vs. the buck. The euro and yen rose 0.80% each while the Aussie rose 1% and the loonie rose 0.60%. Nothing particularly positive occurred with those currencies, they were simply reacting to dollar weakness.
Going forward, at this point I don’t see Trump’s comments as necessarily dollar negative, and for one simple reason. If he accomplishes his goals of tax cuts, infrastructure spending and deregulation, the Fed will hike interest rates much more aggressively than is currency expected, as inflation will accelerate—and that will be demonstrably dollar positive despite what Trump says.
Near term, clearly the momentum is downward, and the dollar is testing support at 100.24. A close below that level likely opens up a run at, and through, par, with truly firm support resting in the high 90s.
Turning to Treasuries, they also traded Trump Off yesterday, in part due to the uncertainty of Trump’s comments (generally though, he didn’t say anything Treasury positive), and the 30 year rose 0.60% while the 10 year rose 0.35%. The 10 year hit a fractional two-month intraday high while yields on both bonds hovered near two-month lows.
Much like the dollar, we don’t see the recent Trump Off rally in bonds as longer-term violation of the new downtrend. Again, that’s based on the simple fact that if growth accelerates, so will inflation, and the Fed will have to hike rates faster than is expected—and that will power bond yields higher.
Near term, clearly we are seeing consolidation. If today’s CPI is light, and the Philly Fed is light later this week, and if Yellen is dovish in her comments, then we could see the 10-year yield test 2.30%. Longer term, unless we see a big reversal in economic growth, this counter-trend rally in bonds remains an opportunity to get more defensive via shorter duration bonds, inflation-linked bonds (VTIP) or inverse bond ETFs.
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