Oil continues to drive markets ahead of FOMC

The symbiotic relationship between equity markets and oil prices continued yesterday as after a rocky start to trading saw a slide in oil prices below $30 drag equity markets lower, the lack of follow through saw a semblance of stability return and a sharp recovery back above the $30 level on vague chatter that senior OPEC officials were looking to open a dialogue and put together some form of deal with Russia in an effort to put a floor under prices.

The symbiotic relationship between equity markets and oil prices continued yesterday as after a rocky start to trading saw a slide in oil prices below $30 drag equity markets lower, the lack of follow through saw a semblance of stability return and a sharp recovery back above the $30 level on vague chatter that senior OPEC officials were looking to open a dialogue and put together some form of deal with Russia in an effort to put a floor under prices.

While such a deal remains very much an extremely remote possibility and unlikely to happen quickly, if it happens at all, the fact that it was being touted did introduce an element of caution to proceedings, and saw oil prices return back to earlier peaks seen at the beginning of the week, though a big API inventory build knocked them back down again.

There is also the not insignificant fact that we will be getting the first FOMC rate decision of 2016, which is likely to have seen some reluctance on the part of markets to push the US dollar too much higher.

While no one is expecting a change in rates the Fed statement is likely to be scrutinised very closely for any clues as to whether Fed officials have been rattled by the enormous amounts of volatility seen so far this year, particularly given the enormous gains seen in the US dollar against commodities in general, as well as a host of commodity currencies, in the last month.

The dollar has also been the best performing currency against its G10 peers with the exception of the Japanese yen, a fact that is unlikely to have gone un-noticed by Fed officials, though they have only themselves to blame in this regard.

Persistent talk of three to four rate increases this year, would be a sensible approach if the economy was overheating, but it isn’t, far from it, and if anything the recent approach seems to have all the hallmarks of wishful thinking, particularly given the strength of the US dollar, turmoil in emerging markets, China, tightening credit markets, and turbulence in financial markets. Only a few weeks ago these were being downplayed by Atlanta Fed President Dennis Lockhart in remarks made on January 11th, when he downplayed the potential for any spill over, though to be fair he did say he could revise that view in the event of a prolonged period of uncertainty.

Indeed St. Louis Fed President James Bullard, who coincidentally was one of the more hawkish voices on the committee last year calling for a rise in rates, even though he didn’t have a vote, sounded a note of concern earlier this month about forward looking inflation expectations, which have been declining steadily since last month’s rate increase.

The US 5Y/5Y forward inflation expectations rate is currently down near 7 year lows at 1.56% and down 30 basis points since the beginning of the year, when it was sitting at 1.86%, not exactly the direction you would expect to see at the beginning of a tightening cycle.  The last time inflation expectations were this low the Fed was just about to start its first QE program.

Given this turn of events Bullard’s caution is understandable, probably more so now he has a vote, and while the FOMC are unlikely to want to admit to a policy error there is a strong possibility that we could well see a slight adjustment in tone in the statement and as such see rate rise expectations dialled back. We might also see references to market volatility, potentially tempering the tone of the statement.

The recent volatility seen in financial markets has also helped Gold prices push higher over the past few days to two month highs, in anticipation of a slightly more dovish outlook.  

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