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Breaking News:

Oil Stabilizes On Small Crude Draw

Ride The Rally But Practice Caution

If the last few weeks in the commodity markets have proved one thing it is that the strongest fundamental influence on pricing in those markets is the relative strength of the dollar. The inverse nature of that relationship is ably demonstrated by three simple six month charts, for the dollar index, gold, and oil.

(Click to enlarge)

Figure 1: Dollar index 6 Month chart



As you can see the dollar spent the last quarter of last year rising, while both gold and oil fell. By February, however, as the dollar topped out and turned, both gold and oil began to recover. Those moves in the dollar were largely in response to market expectations regarding the Fed’s actions.

Late last year it became clear that the Fed wished to “normalize” interest rates by returning to a gradual program of rate increases as soon as they thought the market could bear it. Given the fact that Japan and the ECB, along with several others were still trying to combat sluggish growth by racing to the bottom in currency terms that led to dollar strength.

By the end of January, however, as the U.S. and global stock markets fell dramatically, the Fed began to show signs of wobbling. Conventional wisdom shifted and there was a growing belief that they would not follow through with the program and may not raise rates this month as had previously been assumed. When the Fed’s (in)decision was announced on Wednesday it became clear that that was the case and the dollar dropped further, putting upward pressure on commodities in general.

Not only did the Fed delay the expected rate hike, but the infamous “dots”, the FOMC’s predictions of future hikes, were amended to indicate that only a couple of such moves were expected this year. The stock market celebrated, finally pushing into positive territory for the year, and oil climbed with it.

It is clear, then, that those looking for direction in the energy markets over the next few months must become Fed watchers, and base their actions on what FOMC members say over the coming weeks. The problem is that, as this week’s decision showed, the central banks view can change quickly and seems to be largely dependent on stock market sentiment and moves.

Now that the stock market has recovered, then, can we expect the Fed to flip-flop once again and return to gradually increasing rates? I would love to be able to give a definitive answer to that, but now that monetary policy seems to be reacting to global rather than domestic economic conditions and to the whims of traders it is a hard call to make. I suspect that an immediate re-reversal would be somewhat embarrassing, so we can expect some degree of consistency for a few weeks at least.

If that is the case, then the upward momentum in oil could continue for a while. Sooner or later, though, the hard facts of supply and demand have to come back into play, regardless of what the dollar does. The simple truth is that, even if OPEC does manage to freeze production at current levels without Iran, supply is currently outstripping demand. Unless the renewed flood of liquidity from global central banks has an immediate stimulative effect, therefore, these levels look unsustainable.

In the meantime, though, upward momentum is strong and the belief that the Fed has done a complete 180 degree turn is adding fuel to that fire. The best strategy for oil investors in those circumstances would seem to be to cautiously ride that wave, but to keep a wary eye out for a turn around. That could come as the result of the Fed pronouncements becoming a little more hawkish or as the result of another admission from OPEC that actual cuts in production are not on the cards. Either way, when oil does turn the correction is likely to be sharp, so caution is advised for now.





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