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Monday October 31, 2005 - 18:59:38 GMT
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Forex: If It Ain't Oil, It's Interest Rates

Just when the global economy looked ready to be blown off course by hurricane-force headwinds generated mainly by high energy prices, the US and global expansion is facing a weather shift...the headwinds have diminished to gale-force and could fall to small craft warning if oil prices extend the decline of recent weeks. Normally the weather metaphor would be figurative and not literal, but then again markets have learned to be prepared for both interpretations in the wake of the mother of all hurricane seasons. Surely a $50 handle on oil is welcome news for those who have to heat their homes, light their lights and run their factories and offices.

Still an Indian summer late October in the Northeast is no basis for forecasting a warm winter, the greenhouse effect notwithstanding. But just maybe markets did indeed over react in energy markets to weather and supply-demand dynamics. Some of the speculation for sure has been squeezed out in recent weeks and that makes some difference. Energy suppliers in the US are also under the microscope for ringing up record profits...leading Republicans in Congress (Frist) have taken up the call for reining in oil companies on the profit front. Firms may now adjust retail prices with fewer lags when crude prices are in retreat.

Okay so we may have less interest in satellite pictures of the Caribbean basin to see where tropical depressions and hurricanes are headed. But we will have every bit as much interest in the weather report as winter descends on the Northern hemisphere. Thermometers readings replace satellite images as the "currency" of asset markets and economic prognosticators. Not being a meteorologist, I am prone to defer to the Farmers Almanac... But I am also willing to accept that some things can't be known and despite clever modeling I will admit that weather is one the great unknowns.

But for the time being, lower oil means less headwind and stronger growth...even when it is a US-type of stronger growth - resting on unstable ground (structural imbalances). Gee If only I were a televangelist-economista (those who get way too much airtime on TV commenting on how all things economic are great today and greater tomorrow, even greater the day after tomorrow and so on), I would be ready to recommend getting long stocks and real estate...the trade of the current expansion (US stocks clearly less so this year, but global stocks definitely this year).

However, something else has started to unfold with the decline in energy prices in recent weeks that could prove to be the straw that breaks the camel's back. Bond markets are seeing yields rise globally after failing to do so for nearly the entirety of the Fed tightening cycle. While it may be too early to call the bond market conundrum dead, the bond market is looking like its former self. Indeed the rise in yields has unfolded in the face of significant declines (albeit from record highs) in energy prices. Forget second round or pass through effects...we are talking first round effects on GDP (consumption and investment). My point is the rise in yields driven in part by reduced headwinds for the global expansion may have the seeds of a slowdown that heretofore was thought largely a energy problem. Yes, the US consumer is quite vulnerable to rising market rates...the home ATM machine gets gummed up if rising mortgage rates lead to a correction in the US housing market. Okay it may be early in the rise in Treasury yields and fall in energy prices to think the juggernaut of the US consumer (driving global expansion) is at risk. But then again the US savings rate remained negative in September, real income was down the most year over year since the ECI was dragged out and just about everyone thinks real estate prices are softening in the face of rising borrowing costs.

So stocks can celebrate lower energy prices (except energy stocks) a little longer. However, if bond yields keep rising which I think they will, then not even stocks are safe from a welcomed decline in energy prices. In this case lower energy prices could prove to be a Trojan horse unleashing a problematic rise in market rates.

David Gilmore


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