Whats Behind the Slide in Oil and Commodities?
On the morning of July 15th, the price of crude oil, the most widely watched commodity in the world, was gyrating in a narrow range, just above $145 /barrel, as dealers in London were position-squaring ahead of the Nymex opening. Just a few days earlier, Iran was conducting war games in the Persian Gulf and threatening to shut down the Strait of Hormuz, if attacked. The world watched a fireworks display of Iranian Shahab-3 missiles that were armed with one ton explosives.
In the background, the global stock markets were entering into bear market territory, having lost $13 trillion of value since their peak set last October. Soaring energy and key raw material costs were squeezing profits of manufacturers, unable to pass the entire cost increases onto consumers, who were themselves getting squeezed by soaring prices for gasoline, food and other basic necessities.
IndyMac Bank, a prolific mortgage specialist, was seized by federal regulators, in the third-largest bank failure in US history. Preferred stock sold by Fannie at $25 /share fell to $14 lifting its yield 13.50-percent. Lehman Brothers' preferred stock plunged to $9.50 /share to yield 20.8%, discounting its eventual demise. General Motors suspended its common stock dividend. Hedge-fund trader George Soros said the global banking turmoil is "the most serious financial crisis of our lifetime."
On July 15th, the Dow Industrials plunged 250-points in the first-hour of trading to an intra-day low of 10,825, extending its losses to 2,400-points, from eight weeks earlier. Where was the US Treasury's "Plunge Protection Team" (PPT) with its magical safety-net, designed to rescue Wall Street during moments of gut wrenching panic? "Helicopter" Ben Bernanke was handcuffed by a weak dollar and gold hovering near $1,000 /oz, and couldn't slash interest rates to rescue the market.
US consumer prices were increasing at a 5% annual clip in June, reflecting the global commodity boom that the Fed's rate cuts had set in motion. Then suddenly, at 10:30 am EST on July 15th, a miracle happened, the Nymex crude oil market began to collapse, plunging $10 per barrel within a span of less than one-hour, to its biggest daily decline in 17-years. What was behind the historic crash in the crude oil market on July 15th that prevented "Black Tuesday" on Wall Street?
A few hours later, at 11:30 pm EST, the Bush administration announced a shift in its foreign policy, and said it would send a high ranking envoy to Geneva, Switzerland to talk with Iran's diplomat directly, about Tehran's nuclear program. As long as the diplomatic game continues, there is less chance of any military action against Iran's nuclear weapons program. At a cost of one round-trip airline ticket to Geneva, Washington engineered a stunning 15% drop in world oil prices.
On July 16th, Nevada Senator Harry Reid fashioned a bill to rein-in speculators in the energy markets, who bet on the price of oil, but don't intend to take physical delivery. "This bill will address the rising cost of gasoline in the short term, and prevent Wall Street traders from gaming oil markets, and insure that American consumers are paying a fair price at the pump," Reid said. The bill would restrict the number of oil futures contracts an individual speculator could control.
Oil prices have tumbled more than $23 a barrel from their all-time high set on July 11th, marking the biggest decline in dollar terms in the market's history. The evaporation of the Iranian "war premium" from the oil market, rescued the Dow Jones Industrials with a "miracle rally" of 800-points, from the brink of Armageddon. But could there be another hero who is responsible for the historic slide in crude oil, besides the backroom cabal at the US State and Treasury departments?
No market travels in a straight line. In the second half of 2006, the crude oil market fell by 35% to as low as $50 /barrel, before hitting bottom in January 2007. Such is the nature of commodity markets, which often fool most people, most of the time. The OPEC cartel was forced to rescue its most precious asset, by slashing oil output one-million bpd in Nov 2006, to put a floor under the "black gold" market.
But perhaps, the real hero behind the latest slide in crude oil is European Central Bank chief Jean "Tricky" Trichet, who has a penchant for fooling most traders, most of the time. The world owes a big debt of gratitude to Trichet and the ECB hawks, for objecting to the reckless strategies of the Federal Reserve, the Bank of Canada and England, who slashed their interest rates in a state of panic, and guided the global economy into the "Stagflation" trap.
Instead, Trichet and the ECB hawks refused to be bullied by politicians into a series of rate cuts, in order to bail-out over-zealous speculators in the Euro-zone stock markets. Instead, the ECB held its repo rate steady at 4% throughout the first-year of the global banking crisis. Then on June 5th, Trichet and the ECB hawks shocked the global markets, by signaling a baby-step rate hike to 4.25%, and guided benchmark German schatz yields to their highest levels in six-years.
If the historic rise in crude oil to $150 /barrel is driven by speculators, as the OPEC cartel and Democrats on Capitol Hill argue, then the world needs a powerful central bank to go against the "Big-Easy" at the US Treasury and the Fed, and the "yen carry" traders at the Bank of Japan, in order to deflate the oil "bubble" with a classic dose of higher interest rates. "The simple fact is that there is nearly $250 billion in America's commodity futures markets that wasn't there just a few years ago," said CFTC commissioner Bart Chilton on July 22nd.
The ECB's surprise rate hike to 4.25% is greasing the skids under the Dow Jones AIG Commodity Index, which has tumbled -15% below its historic high set on July 2nd, including an -18% slide in the agricultural sector. Nymex coal has plunged by $40 /ton. Most importantly, the year-over-year change in the DJ Commodity Index in US$ terms has dropped in half to 20% in just the past two weeks.
Italy's central bank chief Lorenzo Bini Smaghi explained on July 22nd, "This teaches a lesson to those who wanted the ECB to follow the expansionary course taken by the Fed. If the ECB had cut rates, today we would also have a much higher inflation rate. European citizens would have been the first ones to pay for such a mistake. You need to fight back immediately against inflation," he said.
ECB chief Trichet wasn't afraid to engineer a decline in the Euro-zone stock markets, in order to stamp out inflation psychology. "Through the wealth effect, asset prices have an influence on demand, and therefore on future consumer prices.So asset prices are taken into account by central banks," he explained on July 17th. Furthermore, Trichet rejects the Fed's practice of ignoring food and energy prices. "We do not consider core inflation as a good predictor of future inflation," he said.
So far, the ECB's rate hike to 4.25% has managed to put a lid on the gold market, and helped to deflate North Sea Brent by 14% in euro terms. Commodity traders dumped corn and soybean contracts, which are linked to the energy markets, thru the bio-fuel connection. The speculative shakeout in agriculture and energy markets eased inflation pressures, and ignited a rally in the European Banking Index, rebounding +20% above its panic bottom lows set on July 15th.
German investor confidence had plummeted to a record low, after Germany's DAX Index lost 7% in the first half of July, and 23% this year. There have been several false bottoms in the DAX that have snared bargain hunters into bear market traps. But the latest rebound in the Euro-zone stock markets is based on sounder footing, with renewed hopes for "price stability" set in motion by the ECB.
However, Trichet was asked on July 18th, if the worst of the global banking crisis was over, "We are experiencing a very significant market correction with episodes of turbulence, high volatility and hectic market behavior. It is an ongoing process. The risks to growth are on the downside, including the very significant financial market correction, the possible further increases in oil and commodity prices, and the possible unwinding of global financial imbalances," he warned.
The ECB's surprise rate hike is widely seen as a one-off event with the Euro-zone economy is showing signs of fatigue. Industrial output in Germany and France plunged -2.6% in May, the biggest monthly fall since 1992, and Italy's contracted by 1.4 percent. The Spanish economy could slip into a recession in the second half, after a housing bust pushed-up the jobless rate to 9.9% in May, the highest in the Euro zone. Still, "price stability" is the only needle in the ECB's compass, and if a wage-price spiral takes hold in Europe, Trichet has vowed to hike rates again.
The ECB cannot handle all the heavy lifting of interest rates that is necessary to tame the powerful "Commodity Super Cycle" over the longer-term. There are signs of a rebellion within the Bernanke Fed, led by Dallas Fed chief Richard Fisher, and joined by Minneapolis's Gary Stern, and Philly Fed chief Charles Plosser, who are calling for a baby-step rate hike to 2.25%, at the next Fed meeting in August.
"Real interest rates are negative, and can't stay there indefinitely. We've got price pressures clearly throughout the economy. Ultimately, rates are going to have to go up, and the only question is the timing. It's important that we act before inflation expectations become unhinged. We need to reverse course. I anticipate the reversal will need to be started sooner rather than later," warned Philly Fed's Plosser.
"The Fed cannot wait until financial and housing markets stabilize before raising interest rates," said Minneapolis Fed chief Gary Stern on July 18th. "Headline inflation is clearly too high, and could feed through to core prices," he warned. The hawkish remarks by the Fed rebels spooked the US Treasury market, and yields on the 2-year note jumped a quarter-point to 2.75%, but are still far below the inflation rate.
Combined with Trichet's hawkish outbursts last week, the gold market lost its nerve, and surrendered $50 to $920 /oz. Crude oil slumped to $124. Clearly, a trade-off between a half-point Fed rate hike and the 15% slide in commodity markets is a deal worth taking for US central bankers. But the Fed rebels are in the minority amid a flock of doves at the Bernanke Fed, who dare not lift interest rates, while the US economy is losing jobs and home prices are falling ahead of an election.
The rebels at the Bernanke Fed talk tough about fighting inflation, in order to keep gold bugs off balance, but eventually, their rhetoric dissipates into thin air. However, the Bank of Brazil has joined the ECB's sound-money crusade, and is acting aggressively to tackle inflation in Latin America's largest economy, The BoB hiked its overnight Selic rate 75-basis points to 13% on July 23rd, and futures markets in Sao Paulo are projecting another half-point increase to 13.50% by year's end.
The Bank of Brazil is the world's top inflation fighter, and has guided its currency, the real, 16% higher against the US dollar from a year ago. As a result, the Dow Jones Commodity Index is only 4% higher than a year ago, in local currency terms. "Having stable prices is the best path to economic growth," said Henrique Meirelles, Brazil's central banker. "It is important that the central bank take timely measures so that the country can continue in its course of growth with low inflation," he said.
Backed by the central bank's massive build-up of foreign exchange reserves, the Brazilian real has become a top-flight currency to own, and might start to attract the interest of sovereign wealth funds. However, the ballistic Brazilian Bovespa Index is sliding into bear market territory, weakened by the downturn in global commodity markets and the central bank's tighter monetary policy.
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