In July, we speculated that the stock market would make Janet Yellen’s decision to hike interest rates extremely difficult. Since the crisis, the Fed has been sensitive to market volatility and it seemed like officials were committing to a hike just when stocks looked to have topped. That turned out to be wrong. Stocks look wobbly once again, but they’re still within shouting distance of all-time highs as Yellen prepares to raise rates next week. Having said that, the prediction wasn’t that far off – it was just the wrong asset class. Instead of stocks, oil is cratering at the worst possible time for the Fed and it’s probably even scarier than if equities were declining.To be clear, Yellen will definitely move ahead with a hike next Thursday. She saw what happens when central banks mislead markets last week. Even though “lower for longer” would (in theory) be stimulative, further delay would be a major stain on the Fed’s credibility. Labor markets have been strong enough to withstand a hike for some time, it’s been inflation expectations that have held them back. Now, economists at nearly every central bank and strategists at Goldman Sachs, JPMorgan, Morgan Stanley, UBS, Royal Bank of Canada, Société Générale and BNP Paribas are all predicting higher inflation in 2016.
They’re all so confident because the drag on Y/Y CPI from oil becomes less severe due to the base effect. At this time last year, crude was down -42% Y/Y. Today, oil is down -35% Y/Y. There are very few strategists anticipating oil to fall lower because their models say it shouldn’t happen. USD should mean-revert, producers are going bankrupt, shutting down oil rigs and US production is starting to slow. And yet, oil decisively broke below $40 a barrel this week, dealing a huge blow to those forecasting a CPI rise next year.
Ostensibly oil is under pressure because OPEC can’t agree on anything. Prices started falling after last year’s big OPEC meeting when Saudi Arabia voted to secure market share and keep pumping at max capacity. It backfired in a big way, but now they want to double-down again this year. Except that the supply picture has been known for months, and this OPEC news was hardly surprising. Instead, the market could be taking the startling lack of demand into consideration. PMI/ISM in the world’s two largest economies and oil consumers showed outright contraction in November. Europe is growing, but not nearly fast enough to offset that decline.
Remember, in June 2008 it was the ECB hiking rates just as oil peaked that sealed the deal for a financial meltdown. Obviously conditions are much different this time around, but Fed officials should be extremely worried about the oil market. Granted CFTC positioning is already fairly negative and it could get squeezed higher any day, but oil below $30 would throw a major kink into those vaunted econometric models. Looking at the chart, $30 oil is a distinct possibility, especially if USD continues to creep higher. The Fed’s press conference on December 17 could easily end up being a non-event, but oil’s continuing weakness sets the stage for a messy 2016.
The Cup & Handle Fund is up around +5.0% YTD, and +7.0% Y/Y. In mid-November we starting allocating more to some relative value bets, hoping to avoid trading noise into year-end, and they’ve worked out fairly well. PnL has stayed steady through some decent moves in the stock market, to which we hope to remain uncorrelated. Our December letter went out on Monday, and it’s starting to trickle higher today. Hopefully it can keep powering higher. If you’d like to start receiving these letters click here.
With that I give you this week's letter:
As always, if you have any questions or comments or just want to vent, please send me an email at email@example.com.
Until next time, tread lightly out there,
Managing Editor – Cup & Handle Macro