Daily Comment (July 20, 2016)
by Bill O’Grady and Kaisa Stucke
[Posted: 9:30 AM EDT] Market commentary is starting to suggest that the FOMC may be heading toward a rate hike later this year. Since the Brexit event is now behind us and the U.S. economy has stabilized, if the Fed wants to return to a tightening mode, it could. However, the markets themselves don’t believe it is going to occur. The fed funds futures market doesn’t signal a greater than 50% probability of a rate increase until the March 2017 meeting and, even then, the odds are only 53.1%. By next June, the odds reach 64.3%. If the FOMC moves more quickly, this would come as a surprise to the financial markets. If sentiment toward tightening increases, we would expect some weakness to emerge in equities. Fixed income would likely experience a flattening yield curve and the dollar would probably rally, which would be bearish for commodities. We doubt the FOMC moves rates this year. The level of political turmoil is high, the economy isn’t robust and inflation remains contained. However, the lack of policy consensus on the FOMC does suggest that a return to a more hawkish rhetoric from the U.S. central bank would not be a shock.
Reuters is reporting that a survey of Chinese sales managers confirms the economy is growing but suggests the growth rate is only about 50% of the official rate. The Sales Manager Index for July came in at 51.7, up from 51.6; the group that conducts the survey, World Economics, suggests that China is growing around 3.3% based on its data.
The WSJ is reporting that Saudi Arabia is drawing down inventories in order to meet domestic demand. The kingdom estimates its maximum production capacity at 12.5 mbpd and current production is pegged at 10.3 mbpd. There is some controversy surrounding the capacity number. This level is not verified by outside sources so there is some doubt the kingdom can actually achieve this level of production. In addition, there is some question as to why Saudi Arabia doesn’t just raise output to meet domestic demand and maintain export levels. Reports suggest it would need to raise output by 0.3 mbpd to meet domestic demand, but it is possible the kingdom fears that an increase of that magnitude would signal a renewed market share war and send prices lower. Another possibility is that the marginal production is more expensive than the cost of the oil in storage, thus it’s a decision based on relative costs. It should be noted that Saudi Arabian oil inventories are 289 mb, down from 324 mb from last October. There is still ample oil in storage, so there is little chance that the Saudis will allow global supplies to tighten due to the lack of storage. Overall, we still believe the guiding principle of Saudi oil policy is market share and the decision to boost output or use inventories is probably more a function of relative cost. On the other hand, the behavior suggests the kingdom is comfortable with current prices.