Are Oil Prices a Sign of Things to Come?

SPY ETF

SPY ETF

S&P 500 futures reversed all of yesterday’s losses to close the day up 15 handles. The dollar resumed its ascent against both the Euro and the Yen today. The ECB meets this Thursday in their new headquarters in Frankfurt, and few expect Draghi to adopt a hawkish stance while Europe is still perilously close to entering a deflationary spiral. This has combined with the ending of QE in the US to be very positive for the dollar:

Euro FX Futures

Euro FX Futures

Dollar strength spilled over again into the energy markets, pushing down the price of oil again. With its reliance on energy exports, Russia has seen its currency hit hard by the falling price of oil.

USO Oil ETF

USO Oil ETF

Whether or not this will provide a boost to the world economy is an open question. Normally falling energy prices benefit the economy in aggregate. However, this recent crash in oil may be a sign of a massive slowdown in the world economy. Energy prices should rise in a booming economy as industry competes for scarce resources. When the economy slows down, firms respond to that by slowing down production and thus their energy consumption. The last time the price of oil fell this fast was 2008 during the height of the subprime crisis. 

The question becomes how long can stock markets exist in a state of cognitive dissonance? Supposedly rational investors are presented with massive headwinds to the global economy:

  • Europe is mired in a deflationary spiral with interest rates at zero for years to come. Their banks primary business model is to hoard ECB LTRO cash or use it to buy peripheral debt; they fail to lend to the wider economy. Germany is obsessed with austerity and would rather destroy the Euro then bail out the profligate periphery (which lets be honest includes France at this point).
  • China is in the middle of crashing. People know this already. They assume that stimulus will always be nearby. The outcome that scares them is the so called “hard landing” where authorities lose control of the situation. China’s export juggernaut relies on energy and is usually the marginal buyer for Oil. A crashing price of oil implies crashing industrial production out of China. Last months PMI was at an 8-month low
  • Continued East-West belligerence over the eastern Ukraine. As a combination of financial sanctions and a falling oil price squeeze Russia’s finances, who can tell exactly how this saga will unfold.
  • A collection of assorted risks from Iran to the South China sea
  • A winding down of QE and rising short term rates expected from the Federal Reserve

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