Crude oil prices plunged by 7% in two sessions as Saudi Arabia and Russia confirmed that they would release 1 million barrels a day in the wet barrel markets. Speculative froth in the oil futures markets vanished, to be replaced by a new trading calculus based on the realities of supply and demand – as well as the unknowable (and unquantifiable!) arc of geopolitics. A market that was in panic due to the loss of Venezuelan output and President Trump’s withdrawal from the JCPOA Iran nuclear deal has just concluded that there is no supply shortage and the shale wildcatters of the Permian Basin, Marcellus and the Bakken ensure that US output will continue to rise. The sharp rise in the US dollar against the Euro, emerging market currencies and industrial commodities also suggests a deflationary chill whose ominous implications must be missed by the Powell FOMC as it positions for the seventh rate rise since December 2015.
The geopolitical risk premium that spiked after May 12 has compressed as oil traders realise that a catastrophic new war in the Levant is not imminent. Unlike Teddy Roosevelt, Trump waves a big stick while definitely not speaking softly and the art of the deal is embedded in this surreal White House, not Sun Tzu’s art of war. True, US sanctions will hit Iran oil exports but, like the loss of Venezuela output, this will be offset by higher production in other oil provinces. Once again, the nemesis of an oil bull run is higher out in the US and some non-OPEC producers like Mexico, Columbia and Azerbaijan.
Saudi Arabia, despite the Aramco IPO and the most expansionary State Budget in the history of the Kingdom, has no wish to trigger a global recession that would eviscerate oil demand. Russia, sanctioned and demonized in Washington and the chancelleries of Europe for the annexation of Crimea, the military interventions in Ukraine and Syria, cyber-espionage in the US Presidential election, the attempted poisoning of FSB renegade spy Sergei Skripal, also desperately wants rapprochement between the Kremlin and the EU. Both the princes of the House of Saud and the siloviki/oligarchs of the Kremlin have no interest in an oil shock that could trigger a US/Europe recession and wreck havoc in the emerging markets.
Thanks to the Saudi brokered OPEC and Russian (Ropec?) oil deal in 2016, the global glut is gone and the crude oil market has balanced. Iraqi and US oil output will surge in the months ahead to offset tight global inventories. This means crude oil prices could well fall to $56 – 60 on Brent. At this price point, Saudi Arabia will not seek to restrain OPEC output and US shale oil output would not be uneconomic. This price reflects fundamental macro realities, not hedge fund speculative mania.
After such a violent trend reversal on credible fundamental news (Saudi/Russian output curve eases to offset the loss of Iran/Venezuelan exports) means the world’s “paper oil” speculators, who trade 1.5 billion barrels a day or 15 times the crude stored in supertankers and onshore terminals, will go short oil. This will precipitate consistent selling. The Trump White House wants lower gasoline prices in the US the summer driving season that began on Memorial Day weekend and in an autumn whose endgame is a Congressional midterm election. Trump’s strong support for Saudi Arabia’s national security interests in the Arab world is also a factor behind Riyadh’s policy U-turn on supply cuts. After all, Tweeter-in-Chief attached OPEC for “artificially” raising oil prices. It is no coincidence that a Saudi-Russian (Al Falih-Novak) plan to raise output was unveiled to the world at the St. Petersburg economic conference, Putin’s Davos on the Neva! The fact that they did not wait for the next OPEC-Russian summit in Vienna on June 22 demonstrates the priority Moscow and Riyadh place to their new shift in oil policy.
The 10% fall in Deutsche Bank last week means the German mega bank is the next systemic risk in the financial markets. The Fed has branded Deutsche’s US subsidiary as troubled and its shares have fallen 42% in 2018, more than even Italy’s battered banks. I will never forget that the collapse of Lehman Brothers coincided with a $100 plunge in the price of crude oil. Will the autumn of 2018 be a ghastly replay of the autumn of 2008, when the lights went out in global finance?
Currencies – The contrarian bullish case for Canadian dollar
The Canadian dollar was the natural victim of King Dollar, the recent decline in oil prices, the money markets softness on interest rate expectations from the Bank of Canada and a surprise GDP miss. However, the real shocker of the week was the Trump White House’s decision to impose tariffs on steel and aluminium imports from the EU, Canada and Mexico – and Ottawa’s decision to retaliate against American metal imports. It is a farce that the Commerce Department has used national security as the smokescreen to impose sanctions against one of America’s oldest, closes allies. This suggests a near term agreement on NAFTA is not on the horizon, though disagreements on a “sunset clause” does not necessarily preclude a final deal. Yet it is undeniable that the tone of Ottawa – Washington trade diplomacy has deteriorated and the loonie’s cost of protection in the foreign exchange options market has risen. The blowout 223,000 May nonfarm payrolls data will pressure the Canadian dollar as June FOMC rate hike is certain. Yet I am convinced that the Canadian dollar is undervalued in the 1.30 – 1.32 range. Why?
One, rate expectations have softened excessively in the past month. Though the Bank of Canada was on hold at its interest rate conclave, there is no doubt that Ottawa can and will shadow the Yellen Fed’s monetary tightening over time.
Two, Planet Forex has priced in a dire endgame to the NAFTA trade talks in Washington. Yet Justin Trudeau and Foreign Affairs Minister Freeland have offered significant trade concessions to Trump and a NAFTA deal can and will happen. This will trigger a global buying wave in the Canadian dollar.
Three, the significant improvement in Canada’s terms of trade in 2018 is not reflected in current levels. The last MFR projects $60 West Texas and $40 Western Canada select, well below current levels. Lumber and soft commodities prices also contribute to better Canadian terms of trade. This fact alone suggests no premature central banking ease in Canada, a factor that will reinforce a bullish tone to the Canadian dollar.
Four, Canadian money market forwards imply only one rate hike in September. Yet this makes no sense given the momentum in domestic economic growth data, positive smoke signals from NAFTA and resilient, even strong domestic data driven by commodities markets. Two rate hikes until December seem far more likely, a scenario that is bullish for the loonie. La Bella Italia is always a wild card for investors and central bankers, but I believe domestic data, NAFTA, housing and terms of trade will be the main factors that will influence the Bank of Canada’s strategic rate setting calculus.
Five, Chicago futures speculative positioning data reinforces my cautious optimism. The downtrend line from the 1.46 lows in mid-2016 suggests the Canadian dollar faces technical support at the 1.30 – 1.32 levels.
Six, Governor Poloz has made it clear that his main policy focus is his 2% inflation target, not the violent mood swings of Club Med politics. The Bank of Canada statement was unambiguous that “higher interest rates will be warranted to keep inflation near target”. The Canadian central bank noted its 2% GDP growth forecast and pointed to the gasoline price driven rise in inflation above 2%. It does not surprise me that the implied probability of a July 11 rate hike by the Bank of Canada has risen from 53% to 75% after the Ottawa central bank conceded that the economy has outperformed in all sectors apart from housing relative to its earlier expectations. I find it significant that events in Turkey, Argentina or global equities did not preclude a hawkish Bank of Canada statement. This is bullish the loonie.