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Explaining The Big Drop In Oil Prices

Oil

As I’m sure you are aware, over the last week and a half, U.S. stocks have taken a massive hit. The reason we are told, is that the widely followed and frequently indicative forex and Treasury markets are both suggesting that inflation fears are growing. It is understandable if all the potential ramifications of that elude you as inflation was last a real problem back when Reagan was President, but most know that it involves higher prices of goods and commodities. So, logically speaking, inflation fears should be pushing oil higher, right? Wrong.

(Click to enlarge)

As you can see from the above chart for WTI futures (CL), the U.S. benchmark crude contract has instead dropped around ten percent from the highs, following the stock market lower. If you think about it, though, that shouldn’t be a surprise. Stocks, like commodities should also logically trade higher on inflation expectations, but they are collapsing too, so something else must be going on. In fact, it is not one thing, but several things that make this seemingly counterintuitive move perfectly understandable.

First and foremost, what the stock market is reacting to is not the prospect of inflation per se; it is the prospect of the response to the prospect of inflation. Part of the reason that inflation has not really been an issue in the U.S. since the days of big hair and disco is that the Federal Reserve Bank has become a lot better at seeing the warning signs of rising prices and taking preemptive action when they appear. The first part of that action is to increase interest rates, and it is the prospect of that that has markets spooked.

Following a recession of historic proportions, America, indeed the world, has been in a long, drawn out period of recovery, with low but consistent growth encouraged by ultra-low rates. As the U.S. steadies at what looks like full employment, though, and prices start to edge up, we should be coming to the point where the policies that have facilitated that steady growth are gradually reversed. The problem however, as is so often the case, comes from politicians.

The passing of a budget that offers massive spending increases to go alongside the tax bill that blew a huge hole in government revenue makes sense only as a cynical, foolish attempt to grab votes. In case you think that I am making a partisan point here, I am not. The Democrats pushing for even more spending after bleating about deficits as the…




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