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The Worm Has Begun to Turn

fixed-income-market-worm-turning.jpgI am not getting too excited about this morning’s employment numbers, most notably the Year-over-Year (YoY) Average Hourly Earnings increase of 2.5% (2.2% was expected). We need a few consecutive months of this kind of growth to get to the point where we can say there’s real wage inflation. The U.S. Dollar (USD) is rallying and bonds are selling off of this morning’s data.

I think that price action will be short lived. I’d rather focus on two more important developments over the last couple of weeks. The first is the Federal Reserve inspired weakening of the USD, and the second is the potential bottoming process for crude oil.

This Wednesday, Federal Reserve Bank of New York President William Dudley said this in response to the growing turmoil in global financial markets, as well as the rather weak domestic and global economic data that has been coming in since the beginning of 2016:

“One thing I think we can say with more confidence is that financial conditions are considerably tighter than they were at the time of the December meeting.”

That is a very big statement, in my opinion. Words are important with the Fed, and anything that follows the word “considerable” is very important. We could say that the market had led the Fed to thinking about abandoning its policy normalization in 2016. However, as I have said in the past, it is not enough for the market to “take the Fed off the table.” The only thing that really takes the Fed off the table is the Fed itself.

With statements like President Dudley’s, as well as weak domestic and global economic date coming in pretty much all of 2016, the USD finally started to weaken enough to take some pressure off beleaguered commodity prices and commodity-based currencies like the Canadian Dollar, which strengthened approximately 2.3% for the week.

As far as crude oil is concerned, there’s sort of an “Axis of Evil” battering the commodity. First, the massive supply glut; second, cooling global demand; and third, the rapid appreciation of the USD. While the USD is probably the weakest of the three “evil doers,” its recent depreciation has been the first bit of good news for crude, since…. well, a long time!

A favorite fixed income strategist of mine, Chris Ahrens, had a very interesting point earlier this week with regard to the potential bottoming process forming in crude. Mr. Ahrens points to January 20 where the S&P got to an intraday low of 1,812 as potentially the point where Saudi Arabia looked into the abyss, and perhaps began the thought process of stepping back from their production strategy to pump their rivals (notably the U.S. fracking industry) into oblivion. The Saudis are beginning to suffer a massive feedback loop. Their production strategy has not just been losing massive amounts of oil revenue, needed to sustain peace in the Kingdom; they have also been suffering increasing losses in their vast holdings of risk assets. Here is what Mr. Ahrens had to say on the subject:

“Last week's price action in risk assets approached the precipice, however, and looked down into the potential abyss - the point at which consideration had to be given to the impact of a market collapse on the broader economy and the ramifications for growth. Additionally, the absolute value of risk assets, the potential draw in the event of a crash, have negative portfolio implications for the Saudis as well as the investor community at large.

It would be ignorant to believe that, given the Federal Reserve’s encouragement, the reserve managers at the Saudi Arabian Monetary Authority haven’t made significant investments in risk assets to complement their traditional purchases of Treasuries.

At some price point, therefore, it would seem logical that the team managing the oil strategy would have talked to the team managing the international reserves, and it would have dawned on them that the oil strategy had reached the point where the ramifications were becoming increasingly harmful to their own self-interest. Their actions were reaching the point where they were putting their petro-customer base at risk, as well as foreshortening the time frame in which they could sustain themselves. There is a price point which is low enough to put the fracking interests on their back heel while at the same time “maximizing” Saudi returns – a “minimal maximum” price, if you will, which is not $0/bbl.”

I think this statement is very important. When a commodity has fallen so dramatically, breaking through what was perceived a bottom multiple times, it becomes difficult to even imagine the true bottom. When that mindset takes hold, it is a natural response for the investment community to curl up in a ball and hide underneath their desks. The visualization of a bottom, even if that bottom is in the high $20s per barrel, is important.

I still believe that risk assets have a tremendous amount of pain to take in 2016. However, I think we are starting to see some important signs that we may no longer be staring into the abyss. To quote Winston Churchill, “This is not end. It is not even the beginning of the end. But it is perhaps, the end of the beginning.”

Member SIPC & FINRA. Advisory services offered throughSWBC Investment Company, a Registered Investment Advisor.

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