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Oil prices are only one sign of Central Bank market manipulation gone bad

We live in unprecedented times. Never in our history have global central bankers moved in such a coordinated fashion for so long a period of time in what appears to be a vane attempt to control market forces. They have employed all manner of economic stimulus, from quantitative easing programs to near zero-interest rate policies, to bring our global economy back from the dead zone, only to create a massively coiled financial spring that could unleash its fury at any moment.

To paraphrase an oft-heard phrase heard during presidential election years, “It’s all about market forces, stupid!” We learned long ago in Economics 101 that a freely acting market is the most efficient means of allocating scarce resources among producers and apportioning scarce goods and services among consumers. Every instance, where mankind has attempted to manipulate this efficient utility principle, has typically yielded favorable initial results, soon followed by economic mayhem that can take years to reconcile.

One supreme example of this scenario transpired in January of this year, when Swiss central bankers removed the Euro-peg for the Swiss Franc. It had been put in place years previously for well-intended purposes. The financial earthquake and subsequent tsunami rocked the foreign exchange market, causing billions in unexpected damages and forcing numerous bankruptcies across the globe, both on a corporate and on an individual level. Currency pegs never achieve their purposes without a major price to be paid further down the road. At some point, Chinese officials will also learn this lesson.

The extraordinary measures taken after the Great Recession by the worldwide central banking community were supposed to be temporary in nature. The fear of rampant inflation was the largest concern, but it never took place. What did take place when free credit hit the streets was a rush to buy stocks and bonds, preferably offshore where returns were higher. Overseas markets began to bubble over, literally. Liquidity increased, egged on by the banking community, which chose to trade in this global casino on its own behalf. Shades of 2008 began to appear on the horizon.

Easy credit terms were designed to revive small and medium-sized enterprises, the arenas where job creation can approach light speed, if given the right rocket fuel. Banks, however, preferred to avoid the risk, and regulators agreed. Bloated balance sheets, filled with toxic mortgage-backed assets, still existed. Regulatory reserve requirements were not relaxed to favor more risk, and so, the attention of commercial and investment banks favored their internal trading departments. Risk/return ratios in these areas could ostensibly be controlled, as long as interest rates remained low and growth was gradual.

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What are the possible signs that easy credit has woven a web of future woe?

We are now nearly eight years into uncharted territory. Our compass is broken, and our maps are blurry at best. Analysts have searched far and wide for comparable instances in history that could serve as guideposts for next steps, but these efforts have been illusory. We do know, however, that credit has flowed freely without market forces to guide its allocation, a direct affront of the most basic of economic principles. We witnessed the first crack in the dam when the Swiss France Euro-peg was lifted. You only have to look around to see several other examples that represent increased pressure about to be released. Here are just a few prime warning signs:

  • A major gasp was heard when the Shanghai Composite Index began its 40 percent or so plunge a few months back. Asset bubbles in Chinese real estate were already well known, but the run up in equity values occurred after officials tried to manipulate the system to open up liquidity. Free credit rushed into stocks until the inflated bubble could take no more. There was no massive liquidity crunch, as feared. The world shuddered, but most analysts agreed that the pain was confined to China and was just one more example of the experimentation that was transpiring in the Middle Kingdom;
  • Behind the opaque Chinese screen, however, major infrastructure projects had come to a screeching halt. After building tons of new roads, airports, apartment buildings, and shopping malls, no one came. The Chinese “Field of Dreams” did not materialize. Perhaps, declining demand in the West was the root cause or, better yet, easy credit allocation had been allowed to flow into areas that it should not have. In any event, oversupply was the result, which also happens to result when market forces do not participate in the allocation processes. Consequently, global commodity producers have gone into death spirals. Developing countries have seen ephemeral capital disappear like snow in the desert. Several major mining interests continue to produce, another result of easy credit, but their argument is that oversupply is temporary, a predictable stage in the business cycle. Experts say not;
  • Investors are now overly concerned about equity valuations of major corporations in developed economies. Finding undiscovered value is now more difficult than ever. Price/Earning ratios are peaking, and the debate is on as to whether we are in the middle or the end of a business cycle. Experts believe the Fed will step up to the plate this week and finally begin the arduous task of interest-rate normalization. Liftoff is near. Excess funds are flowing to cash or departing debt-heavy industries. Surprisingly enough, capital has flowed back into housing starts and real estate valuations. A new bubble is beginning to form. Where are today’s “safe havens”?
  • Lastly, the major headline-getter today has to be oil prices. $50 per barrel was supposed to be the new low, then $45, and now the market has dipped below $40. The global energy market is often called the “Mother of all markets”, simply because it is the largest industrial market on the planet. Easy credit has wreaked enormous damage in this sector, as well. Young car drivers around the world may be rejoicing at how far their gas money takes them today, but economists are perplexed. The road ahead is murky. It is easy to claim that supplies are up and that increased demand will have its day, but easy credit allocations have distorted basic industry dynamics that may take years to correct. Everyone will be impacted. There is no escape.

Exactly what is going on behind the scenes with oil prices and the so-called glut?

According to the LA Times, the price for a barrel of U.S. crude slumped last week to $35, “the lowest price since early 2009.” Goldman Sachs had already sent shockwaves through the markets last September, when they forecasted a $20 bottom: “The oil market is even more oversupplied than we had expected and we now forecast this surplus to persist in 2016.” It was just one year ago that oil traded at $70 per barrel, after having fallen from over $100. What exactly is going on with crude and demand for it?

After the glory days of the nineties, oil prices have ratcheted up severely before falling off a cliff in 2014, as depicted in the chart below:

Chart

Industry experts in the know, after ignoring the recent recessionary spike, summarize the industry as changed forever by one single word: “Shale”. Current prices are actually the same as in the nineties, once adjustments for inflation have been made, but supply and demand dynamics are now dependent on many more variables. U.S. shale and gas producers have prospered, and, despite OPEC’s attempt to drive them out of business with ever-lower prices, OPEC members must also fund national economies or face political unrest in their respective regions.

At its recent meeting in Vienna, OPEC members decided to continue current production levels and allow for Iranian interests to increase in 2016 when sanctions are lifted. Their strategy has created what have been termed the new “Walking Dead Zombies” of the oil industry, high-cost shale producers that are hanging on by their fingernails with just enough cash flow to pay the interest on their enormous debt loads. Although rigs have declined by two-thirds, more than 1,000 in number, new technology will allow these rigs to be turned back on within a month, something that will happen as soon as oil prices rise above a more normal level like $50 a barrel.

The waiting game is now on in full force, but expert opinions as to timing differ across the map. Analysts are trying to use pre-shale analytical methods to follow inventories and gauge when demand might resume its position of strength. Is 2016 the year that a reversal occurs? Will oil prices hit $100 once again in 2018? Or, are we in for a new round of pain and deflation?

It is not just an oil problem. Natural gas, copper, and a host of other commodities have taken big hits on the deflationary curve, with only a small portion related to the strengthening of the U.S. Dollar. Inflation has also been stuck in neutral, as shown below:

Chart

Are there not consumer benefits to be had due to commodities tanking in price?

Another cardinal economic rule is that, if consumers get pricing discounts in one sector, then they will spend this largesse in some other sector. Gasoline prices have been falling for over a year, but the expected increase in retail spending on other items has never materialized. The subtitle for a recent article in The Wall Street Journal addressed this seeming anomaly: “Experts expected the drop in gasoline and oil prices would jolt spending by U.S. consumers and businesses. It hasn’t turned out that way.”

Once again, a chart is worth a thousand words:

Chart

Year-over-Year changes in retail spending have been declining since July of 2011. Gains posted for November were relatively modest, hitting levels that resemble those before the last two recessions. The positive “bump” from low gasoline prices has not materialized. The problem is that Americans are still deep in debt. Studies show that a meager 25% of the benefit of low gas prices went for other goods and services. The remaining 75% went into savings and to pay down debt.

Concluding Remarks

Once again, we are in unprecedented times. The Fed is about to embark this week on interest-rate normalization, when the global economic picture is cloudy at best. The foolish attempt to manipulate market forces since 2008 has enabled a number of mal-investment practices across the globe that can only come back to haunt us in the years ahead. At some point, you can expect a short squeeze in oil to beat the band, but timing will be everything in that trade. Stay cautious!

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.


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