[Posted: 9:30 AM EDT] News flow overnight was rather slow. This is typical of summer. The Senate is working on its version of health care and, no surprise, is dealing with the same problems the House faced—to make the bill palatable to moderates, it fails to garner votes from the hard right. Senate Majority Leader McConnell can only lose two GOP senators to pass the bill and most counts suggest he has four ‘no’ votes. Of course, negotiations continue and there is a chance something might get done. However, we are not convinced that McConnell is all that driven to execute a deal and would much rather move on to tax reform. If this is the case, he will be less likely to use his political capital to pass health care legislation in order to conserve it for tax changes. If the Senate health care bill fails to pass, it might actually be bullish for equities because it would raise hopes of tax changes this year.
The Gulf Cooperation Council (GCC), the representative body for the Arab Peninsula nations, has given Qatar its list of demands. They include closing Al Jazzera, reducing ties to Iran and closing a Turkish military base in the country. The other GCC nations want reparations for unspecified damages inflicted by Qatar over the years. We assume these would include security and social spending costs that came from Qatar’s support of the Muslim Brotherhood. Qatar has indicated it won’t negotiate while under a blockade; the GCC has given Qatar 10 days to comply, although no consequences have been signaled if Qatar doesn’t acquiesce. We would not expect Qatar to comply. Turkey is increasing support and we would expect Iran to do so as well. The Trump administration appears divided, with the president offering support for Saudi Arabia’s hardline position while Secretary of State Tillerson has pushed the parties to end the tensions. Although this issue hasn’t had any real market effects, we are watching for signs of escalation which would be bullish for oil prices.
St. Louis FRB President Bullard made comments yesterday suggesting that the path of interest rate hikes is probably not justified, although he fully supports reducing the balance sheet. Bullard has become something of a renegade on the FOMC, arguing that monetary policy operates in a “paradigm” that keeps rates within a certain range and these rates should stay within that range until the paradigm changes. We believe that monetary policy is at a crossroads of sorts; the FOMC essentially uses the Phillips Curve to formulate policy and it doesn’t necessarily have a good measure of economic slack, a key component of Phillips Curve analysis. Bullard, Kashkari and Evans are questioning the path of rate hikes, which would suggest they believe more slack exists. Currently, Evans and Kashkari are voting members of the committee; next year, none of these three will vote, which may give a more hawkish bias to the FOMC. Of course, by next year, we may have five new governors so the path of policy could change significantly. If Cohn and other establishment figures within the Trump administration are influential in filling current and future vacancies, monetary policy could tighten faster next year.
[Posted: 9:30 AM EDT] Most of the overnight news surrounds the oil market; we have our analysis of the weekly data below and we will offer our views on oil there. We are seeing reports that China is trying to work out a deal with North Korea in which the Kim regime will cease missile tests in return for a smaller U.S. military footprint in South Korea. Of course, China would probably like to see the THAAD installations removed, and the new Moon administration is pushing for lower key military exercises. The problem with this proposal is that such measures have been tried before with little success; the North Koreans have repeatedly violated agreements. China is afraid to press the Kim government too hard, fearing the regime will fail and cause a refugee crisis and perhaps a hostile government on the Yalu River. We remain highly concerned about an escalation to conflict.
U.S. crude oil inventories fell 2.4 mb compared to market expectations of a 1.2 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but they are declining. We also note that, as part of an Obama era agreement, there was a 0.8 mb sale of oil out of the Strategic Petroleum Reserve. This is part of a 17.0 mb sale to partially pay for modernization of the SPR facilities. We note that sales have reached 11.3 mb this year, which likely means we should see these sales end in the coming weeks. International agreements require that OECD nations hold 90 days of imports in storage. Due to falling imports, the current coverage is near 140 days. Taking that into account, the draw would have been 3.2 mb, which is well more than forecast.
As the seasonal chart below shows, inventories are usually well into the seasonal withdrawal period. This year, that process began early. Although the actual level of stockpiles remains quite high, we have seen rather sharp stock declines until the past three weeks. We would expect the draws to increase as the recent rise in imports should fade.
(Source: DOE, CIM)
Based on inventories alone, oil prices are overvalued with the fair value price of $38.35. Meanwhile, the EUR/WTI model generates a fair value of $52.03. Together (which is a more sound methodology), fair value is $47.75, meaning that current prices are well below fair value. Currently, prices are below our expected trading range; we view oil prices as attractive on a short-term trading basis.
(Source: Bloomberg)
This chart shows the nearest WTI futures price. We have drawn a box between $45 and $55 per barrel. Note that nearly all prices have fallen within this range since early October. This range has developed because OPEC’s cuts are being offset by rising U.S., Canadian and Brazilian output, leaving a mostly balanced market. As the chart shows, prices at this level have been attractive entry points. Of course, the risk is that we are seeing a downside breakout but we view further weakness as unlikely without strong evidence of OPEC cheating. Thus, a recovery should develop in the coming weeks. If we are correct, we should see two patterns develop. First, the market will need to stop declining on bullish news. Second, in the commitment of traders’ data, we will need to see a sharp decline in the number of speculative long positions.
Most of the time, oil markets trade in ranges because the market has a cartel structure. A cartel usually keeps some production idle to bolster the price. This excess capacity can be brought on line if prices rise, so the net effect is stabilization. On the other hand, the media hates trading ranges; they simply aren’t news. Thus, there is a tendency for reporters to talk up the breakout. That’s why most of the talk is bullish near the tops and the talk is bearish at the bottom of ranges. Current prices are well below fair value and we expect prices to stabilize in the coming weeks.
MSCI opens up for China: The index producer has been reluctant to add domestic shares of Chinese companies due to numerous concerns, including capital controls, lack of accounting transparency, etc. This is something of a big deal, but also not. Chinese shares are already in the MSCI EM indices; in fact, China currently represents 28.6% of the index. However, the companies in this share of the index are internationally traded and generally follow Western accounting rules. The domestic “A-shares” will only add 0.7% of new Chinese shares to the index. So, in actual money terms, it’s not a huge deal. However, it is another signal, similar to the CNY’s inclusion in SDRs, that China is joining the major economies on an equal scale.
GOP holds two seats: In the sixth Georgia Congressional district, Karen Handel, a veteran Republican politician, fended off a well-funded[1] young Democrat named Jon Ossoff. Given that the GOP has held this seat for four decades, this was the expected outcome and the win wasn’t huge—Handel won 51.9% to 48.1%. Meanwhile, in South Carolina, Republican Ralph Norman defeated Democrat Archie Parnell 51.1% to 47.9%, holding the seat vacated by Mick Mulvaney. The win was narrower than his predecessor’s 20-point margin but still a comfortable win. Although the president remains a divisive figure, these two elections suggest that discomfort with the president probably isn’t enough to change control of Congress. The problem for the Democrat Party is a path to increase popularity. The leadership, tied closely to parts of Wall Street and Silicon Valley, wants to run as center-left technocrats. The rest of the party wants to go hard left, becoming a “Corbyn/Sanders” party. We believe the broader issue is that we are seeing a restructuring of the coalitions that form both parties and therefore navigating the landscape will become increasingly difficult.
A Saudi shakeup: Saudi King Salman announced that Crown Prince Nayef was demoted and he has elevated his son, former Deputy Crown Prince Salman, to crown prince. Nayef will also lose his important power base of interior minister; this ministry oversees domestic security and counter-terrorism and was the base of power for the late King Abdallah. The new interior minister will be Prince Abdulaziz bin Saud bin Nayef, a nephew of the ousted crown prince. The decision was apparently approved by 31 of the 34 members of the Allegiance Council, which oversees succession.
This decision has three elements of risk. First, CP Salman is very young and has conducted an aggressive foreign policy. He has managed the war in Yemen and is a hardliner with Iran. His appointment to next in line for the throne suggests that Saudi foreign policy will likely become increasingly bellicose. Second, the king’s appointment of his son as successor raises the problem of primogeniture. The founder of Saudi Arabia, Ibn Saud, unified most of the Arabian Peninsula through war and marriage. At the time of his death, he reportedly had at least 44 sons, 22 wives and four known prominent concubines. His successor was his oldest son, Saud, who proved to be a feckless spendthrift and was ousted in a royal coup. Ibn Saud never made it completely clear how he wanted succession to occur. By appointing his oldest son, if the kingdom had followed primogeniture, Saud could have then selected his oldest son, leaving 43 sons of Ibn Saud out of kingly succession. The ouster of Saud instead created a system where the kingship would transfer to the sons of Ibn Saud. Although there are some available (albeit elderly) sons of Saud remaining, the royal family has agreed that the time has come for the grandsons of Ibn Saud to take control. That was the reason Nayef was made crown prince.[2] By selecting his son as the next crown prince, Salman has introduced the precedent of primogeniture. According to reports, the Allegiance Council considers this appointment as a “one-off” but, now that it has occurred, the precedent of the next king selecting one of his sons is in place. If such an event occurs, the potential for a civil war of sorts within the royal family increases. Third, why now? It is quite possible that the king’s health is failing and he wanted to open the path of the throne to his favorite son before he died. King Salman is old (81 years) and there have been unconfirmed reports he suffers from dementia. If Salman passes soon, his controversial decision to elevate his son could become contentious.[3]
A century with Argentina: The South American country recently sold $2.75 bn of 100-year bonds with a coupon of 7.125%, giving it an annual yield of 7.9%. It had a bid/cover ratio of 3.5x. On the surface, this bond sale is amazing. Argentina has defaulted eight times since its independence in 1816. However, the risks may not be as large as they seem. First, the duration on a 100-year bond isn’t significantly different from a 30-year bond. There will be very little principal paid for years. Second, given the high coupon, an initial investor recoups his investment in about 12 years. So, as long as Argentina doesn’t default during that time, an investor should at least get paid back the initial stake. On the downside, it is dollar-denominated paper, which almost guarantees the bonds will face default at some point in the next century. However, we doubt any of today’s buyers care; they are simply looking for a high coupon. This is one of the problems that comes with low policy rates; investors become tempted by debt that carries a higher yield with a high probability of default.
[Posted: 9:30 AM EDT] There were five news items worth noting overnight:
Carney goes dovish: Last week, the BOE voted to keep policy steady but had three dissenters. In a speech today, BOE Governor Carney focused on the economic problems that could be triggered by Brexit and suggested it wasn’t time to raise rates. The GBP fell on his comments. Britain is rapidly heading to a point where it will be forced to decide which policy problem it will address—inflation or weak growth? A Dutch economist, Jan Tinbergen, suggested that policymakers need to have an equal number of tools for an equal number of problems. In other words, if a nation faces weak growth and rising inflation, it needs to address each problem with separate policies. Usually, in this case, the ideal policy mix would be to use fiscal policy to address weak growth and tighter monetary policy to deal with inflation. Given the political turmoil in the U.K., the BOE is likely on its own. Thus, it must decide if it will raise rates to deal with inflation or keep rates low to support the economy. Carney indicated his choice would be the latter and so the GBP is falling this morning. It isn’t clear whether the rest of the Monetary Policy Committee will go along with this sentiment.
More Fed hawks than doves: Boston FRB President Rosengren, who has been a reliable dove over the years, gave a fairly hawkish speech in Europe this morning. He is suggesting that easy monetary policy could be leading to inflated asset markets and, if so, the Fed should raise rates to prevent excessive valuations and the potential market risk such valuations might bring. Although other FOMC members have made such statements in the past (Jeremy Stein, most notably), such views are not predominant among members because it smacks of setting policy based on asset markets. Although theoretically defensible, such positions are fraught with political risk. Alan Greenspan briefly touched this “third rail” once, with his famous speech in 1996 when he coined the phrase “irrational exuberance.” He faced severe criticism on the idea that the Fed would raise rates because equity valuations were “too high.” Although we don’t expect Rosengren’s views to sway policy, he is joining others on the FOMC who hold more hawkish views on expectations of higher inflation. In the end, regardless of viewpoint, the outcome is tighter policy. We note that NY FRB President Dudley made hawkish comments yesterday as well. By the way, the WSJ has an article today about the FOMC’s poor record on soft landings.[1]
Special election in Georgia: The state of Georgia is holding a special election to fill the Congressional seat of Tom Price. This is usually a safe GOP seat (the party has held it for nearly four decades), but the race between Democrat Jon Ossoff and Republican Karen Handel is close. The Democrats have poured money into this race, suggesting it is a referendum on the Trump administration. In fact, this has become the most expensive Congressional race in U.S. history.[2] Ossoff has eschewed the Sanders platform, running as a centrist; it should be noted that Trump narrowly won what is usually a reliable GOP state. If Ossoff wins, the establishment Democrats will use it to argue that the Sanders/Warren wing doesn’t win elections. If Handel wins, the hard left will argue that the Democratic centrists can’t win. Our view is that there will probably be few takeaways regardless of the outcome, although the pundits will try to use the election as a harbinger for 2018.
Otto Warmbier dies: The UVA student who was recently incarcerated by North Korea died yesterday. Our condolences and prayers go out to his family. We are in the middle of a two-part examination of the possibilities for war with North Korea. His passing won’t necessarily increase the odds for war but it does reduce the chances of any sort of negotiated settlement and that, by itself, could lead us into a conflict.
Saudi Navy captures three Iranian Republican Guard Corp troops: The Saudi Navy captured three IRGC members in the Persian Gulf Friday. The Saudis claim the three were manning a vessel loaded with explosives and headed toward a Saudi offshore oil rig. The Iranians claim they were civilian fishermen and claim that the Saudis killed one of the Iranians. We don’t know who is telling the truth here but it is part of a broader trend of rising tensions in the region. So far, oil prices are clearly unconcerned about these tensions but that position is probably underestimating the potential for supply disruption.
Tensions with North Korea have been escalating in recent months. The regime has tested numerous missiles and claims to be capable of building nuclear warheads, which, combined with an intercontinental ballistic missile (ICBM), would make the Hermit Kingdom a direct threat to the U.S. Such a situation is intolerable to the U.S., and thus there is rising concern about an American military response.
In Part I of this report, we will recap the Korean War, focusing on the lessons learned by all sides of the conflict. We will discuss North Korea’s political development through the postwar period and the fall of communism. This examination will frame North Korea’s geopolitical situation. The next step will be to analyze U.S. policy with North Korea and why these policies have failed to change the regime’s behavior.
In Part II, we will use this backdrop to discuss what a war on the peninsula would look like, including the military goals of the U.S. and North Korea. This analysis will include the military assets that are in place and the signals being sent by the U.S. that military action is under consideration. War isn’t the only outcome; stronger sanctions and a blockade are possible, and the chances of success and likelihood of implementation will be considered. As always, we will conclude with market ramifications.
[Posted: 9:30 AM EDT] Global equity markets are rising this morning, although the weekend news was mixed. Here’s a recap:
Macron dominates in France: Emmanuel Macron, the recently elected president of France, solidified his new government with a solid win, capturing 350 of the 577 seats in the National Assembly. For a party that didn’t exist before the election, this was a remarkable achievement. The center-right held 135 seats, representing the opposition. The Socialists, who had a majority in the previous government, were reduced to a mere 45 seats. The National Front, led by Le Pen, won only eight seats while the far-left won 17 seats. It should be noted that the turnout was very low; it isn’t clear if the turnout dropped because voters saw Macron’s win as inevitable and decided to stay away from the polls, or if they were in despair that a good outcome was not possible. Macron describes his policies as “muscular centrism,” but they look to us like neo-conservative. He is pushing deregulation and lower taxes. Although such policies are on shaky ground around the world, France never really had a Thatcher-Reagan revolution and so having one now would not be unusual for France. Still, we suspect the low turnout reflects more of a rejection of politics in general and, if that is the case, Macron may face more opposition than this vote would indicate.
Syrian warplane shot down: A U.S. F-18 shot down a Syrian military jet that was bombing rebel positions. These rebels have U.S. support. Russia indicated this morning that it would now treat U.S. aircraft in the region as hostile. There has been a concerted effort by the U.S. and Russia to avoid air confrontation but, as IS continues to wither, the war is now shifting away from IS onto the ultimate fate of the Syrian regime. We note that Iran fired missiles into Syria over the weekend to attack IS in retaliation for the recent terror attack. We are seeing a clear escalation in this region which is a concern and points to the rising likelihood of a broader conflict.
Apparent terrorism in London: Yesterday, what appeared to be a terror attack occurred in London, this time directed against Muslims. A vehicle drove into a crowd leaving a mosque. These attacks serve to further undermine the PM just as talks begin with the EU over Brexit.
Chinese regulators tout commodities: The China Securities Regulatory Commission indicated it will loosen limits on how much commodity exposure commercial banks, insurance companies and pension funds can have. It isn’t completely obvious why this policy is being proposed but it may be as simple as trying to distract investors from Chinese property markets. The commission did indicate it wants to see deeper futures markets; perhaps the increased investment exposure would develop those markets but we doubt investment firms would offer a two-way trade. We will continue to closely monitor commodity markets to see if Chinese flows show up in any meaningful way.
Vancouver real estate woes: Canadian financial regulators are taking a much closer look at residential lending practices as it appears loose collateral rules may be part of the lending boom. There are reports that some loans may have been made against collateral in China, which would be rather problematic to seize in case of default. Canada avoided a real estate crisis in 2008 but it may be facing one now.[1]
Where millionaires flee: New World Wealth, a market research firm, has published its most recent report which offers some insight into capital flight. In 2016, the top five nations with the most fleeing millionaires were France, China, Brazil, India and Turkey. The favorite destinations for this capital flight were Australia, the U.S., Canada, the UAE and New Zealand.[2] As global tensions rise, we could see more capital flight in the future.
Last week, the Federal Reserve published its Financial Accounts of the United States report, more commonly called the “Flow of Funds” data. The report offers a plethora of insights into the economy. This week we want to examine the household debt situation.
In Q1, household debt reached $15.1 trillion, up 3.4% from the previous year.
Although the growth in liabilities is positive for consumption, note that the current growth rate is well below the 9.8% average from 1946 through 2006. As we will show below, deleveraging continues but the pace has slowed dramatically. Still, part of the reason for sluggish growth is that households are simply not borrowing as quickly as what we have seen in the postwar period.
As noted, deleveraging has continued but the pace has slowed to a crawl.
Household debt (non-profit debt is not meaningful) is down to 78.2% of GDP after peaking at 97.7%. It is virtually impossible to determine the “correct” or sustainable level of debt, but a solid case can be made that any reading above 60% is probably not manageable over the long run. Of course, there are three ways this ratio can decline, falling levels of debt, rising real GDP relative to debt or rising inflation relative to debt. The lack of inflation has probably prevented an even larger drop in this ratio.
Low interest rates have reduced the servicing costs.
This chart shows household debt service costs as a percentage of after-tax income. Debt service costs rose steadily from 1993 into 2007. The combination of falling interest rates and the level of debt has led to a sharp drop in debt service costs. At these levels of debt service, one would expect that households would be encouraged to expand their debt levels. However, the “hangover” from the debt crisis has not yet diminished.
As long as households are reluctant to borrow, economic growth will remain slow and inflation low. This combination should lead to moderate policy tightening from the FOMC and an extended business cycle. If borrowing were to increase, these conditions might change but, for the foreseeable future, we expect borrowing to remain sluggish and economic growth to remain weak as well.
[Posted: 9:30 AM EDT] After a choppy week, financial and commodity markets are rather quiet this morning. There were a couple of news items of note. The BOJ, as anticipated, left policy unchanged. The vote was 7-2, with the two dissenters calling for tighter policy. However, the two outliers, Takahide Kiuchi and Takehiro Sato, will be leaving the BOJ board after this meeting and will be replaced by allies of Governor Kuroda. Thus, the governor will face less internal pressure to begin withdrawing stimulus. The news is modestly bearish for the JPY.
Greece has avoided default by reaching an agreement with its international creditors. The country will receive €8.5 bn in bailout aid, allowing it to make €7.0 bn in debt repayments. The primary sticking point was the IMF. The international lender wants European creditors to give Greece debt relief. German leaders are loath to do this, especially with elections looming in the fall. The IMF formally joined the agreement and will contribute €2.0 bn in new loans. However, the IMF won’t actually disburse the funds until the EU develops a plan for debt relief. Germany wants IMF participation for two reasons. First, the Merkel government fears that the EU won’t hold Greece to austerity, and second, the IMF gives the bailout/austerity package an international imprimatur.
In the wake of the FOMC meeting, the deferred Eurodollar futures market was essentially unchanged. This chart below shows the current pricing for three-month LIBOR in two years. After the election, the implied rate jumped to levels not seen since 2011 on expectations of fiscal expansion. However, as those expectations erode, we are seeing expected yields decline. The fed funds rate implied from the Eurodollar futures suggests only one more rate hike. The dots plot clearly suggests that policymakers expect to raise rates more than the market expects so there is a danger that policy may become too tight and trigger a recession.
[Posted: 9:30 AM EDT] There were three items dominating the overnight news. First, the shooting at the GOP baseball practice yesterday continues to reverberate. We will have more to say about this event in the future but it is further evidence of deep divisions within American society that show no signs of improving. Second, the BOE followed script and held policy steady. However, the vote was 5-3, with the dissenters calling for rate hikes. The strength of dissent caught the markets by surprise; the GBP rallied off its lows (the dollar has been stronger today) and Gilt yields jumped. Financial markets in Britain have been leaning toward rate cuts. The high level of dissent suggests that cuts will be difficult. Third, we are seeing further fallout from yesterday’s FOMC meeting; the dollar is up, gold and equities are lower and Treasury yields, which fell yesterday, are recovering a bit this morning.
The FOMC did as expected, raising rates by 25 bps. The comments about the economy remain upbeat but the lack of inflation was noted. The big news was that the balance sheet reduction is expected to start later this year, perhaps as soon as September. At some point this year, which remains unspecified, the Fed will begin allowing the balance sheet to decline by $10 bn per month, increasing by the same amount every three months until it reaches a maximum decline rate of $50 bn per month within five quarters. There will be a 60/40 split on Treasury and mortgages, respectively. We do have concerns about the balance sheet; in theory, since most of QE has been sitting innocuously on commercial bank balance sheets, removing it shouldn’t be a big deal. In reality, we simply don’t know how the market will react. If the behavior is symmetrical, it should “double down” on the idea that the Fed is tightening policy. There was one dissenter, Minneapolis FRB President Kashkari, who wanted to maintain the current rate.
Here are some relevant charts:
(Source: Bloomberg)
This shows the dispersion of the dots chart. The green line plots the median from yesterday’s meeting, while the gray shows the previous meeting. There wasn’t any change for the next two years but a modest decline in 2019. The median does suggest a 2.25% peak rate for next year, with only one more hike forecast this year and at least three hikes would be scheduled for next year. The market doesn’t expect this pace of hikes.
Here is our average dots chart:
The most recent dot is in red. The average suggests very little change in projections from the FOMC. The history of the dots chart is one of a steady decline in projections. However, for the past several quarters, there has been a stabilization of expectations, suggesting the FOMC is becoming comfortable with its policy path.
With the release of the CPI data and yesterday’s FOMC action, we can upgrade the Mankiw Rule models. The dip in the core CPI rate (see below) did affect the Mankiw Rule model results.
The Mankiw Rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative. Mankiw’s model is a variation of the Taylor Rule. The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy. Potential GDP cannot be directly observed, only estimated. To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack. We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.
Using the unemployment rate, the neutral rate is now 3.08%. Using the employment/population ratio, the neutral rate is 0.75%. Using involuntary part-time employment, the neutral rate is 2.31%. Using wage growth for non-supervisory workers, the neutral rate is 1.08%. The labor data is mixed, with the employment/population ratio falling and wage growth stagnant, while the unemployment rate fell and involuntary part-time employment was steady. The drop in core CPI has led to lower Mankiw neutral rate estimates across the board.
To a great extent, the issue for policymakers remains the proper measure of slack. The danger for the financial markets is if the proper measure is wage growth or the employment/population ratio but policymakers believe slack is best measured by involuntary part-time employment or the unemployment rate. If that is their measure, policymakers will likely overtighten and prompt a recession. For the past couple of years, this issue has been mostly academic. Regardless of the measurement of slack, policy was generally accommodative. Now, using either wage growth or the employment/population ratio, monetary policy has achieved neutrality. If rates are raised as projected by the dots chart, assuming no change in inflation, the policy rate will reach a level consistent with tight policy with another two rate increases. Thus, we are now entering a more dangerous period for the economy where a policy mistake will matter.
U.S. crude oil inventories fell 1.7 mb compared to market expectations of a 2.3 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but they are declining. We also note that, as part of an Obama era agreement, there was a 0.4 mb sale of oil out of the Strategic Petroleum Reserve. This is part of a $375.4 mm sale (or 8.0 mb) done, in part, to pay for modernization of the SPR facilities. International agreements require that OECD nations hold 90 days of imports in storage. Due to falling imports, the current coverage is near 140 days. Taking that into account, the draw would have been 2.1 mb, which is near forecast.
As the seasonal chart below shows, inventories are usually well into the seasonal withdrawal period. This year, that process began early. Although the actual level of stockpiles remains quite high, we have seen rather sharp stock declines until the past two weeks. We would expect the draws to increase as the recent rise in imports should fade.
(Source: DOE, CIM)
Based on inventories alone, oil prices are overvalued with the fair value price of $37.65. Meanwhile, the EUR/WTI model generates a fair value of $52.56. Together (which is a more sound methodology), fair value is $48.00, meaning that current prices are well below fair value. Currently, prices are below our expected trading range; we view oil prices as attractive on a short-term trading basis.
(Source: Bloomberg)
This chart shows the nearest WTI futures price. We have drawn a box between $45 and $55 per barrel. Note that since early October, nearly all prices fall within this range. This range has developed because OPEC’s cuts are being offset by rising U.S., Canadian and Brazilian output, leaving a mostly balanced market. As the chart shows, prices at this level have been attractive entry points. Of course, the risk is that we are seeing a downside breakout but we view further weakness as unlikely without strong evidence of OPEC cheating. Thus, a recovery should develop in the coming weeks.
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