By Phil Flynn
The bonds are back and were going to be in trouble! Rising yields may yield to fear as the Japanese stock market starts to melt down. Japan's central bank just did not get the fact that it was the massive stimulus that was giving their markets some semblance of hope. Now with the Fed threatening to taper bond purchases, taking away an important flood of cash from emerging market and a scary World Bank forecast it is clear that Japan’s economic woes are clear for all to see. That may force the dollar back down and yields higher as turmoil in global markets may force the Fed to reassess the timing of the taper.
The World Bank lowered the world growth forecast down to 2.2% down from 2.4%. That comes as it is being reported that the dollar is moving in the best lockstep position with stocks since the days of the financial crisis began.
Yesterday crude reacted to a bearish report by the Energy Information agency by trying to rally. Warnings that crude supply could tighten by the International Energy Agency also gave bulls reasons for hope, yet OPEC is warning of potential threats to the oil market's balance and reported an increase in its own output in May. North Sea problems and geopolitical risk has kept Brent Crude solid. The Wall Street Journal is also reporting on how important the Fed is to the price of oil. The WSJ says that "There is a shadow looming over oil prices in the shape of a big tank — and a big central bank. At around 394 million barrels, U.S. commercial stocks of crude oil, excluding the strategic petroleum reserve, are hovering around their highest levels since the early 1980s. In part, that reflects the shale-led surge in U.S. supply, with domestic production outpacing imports in late May for the first time since January 1997. In its latest monthly report, issued Wednesday, the International Energy Agency forecast U.S. output would top 10 million barrels a day on average this year, up 23% in just two years.
Meanwhile, domestic demand is sluggish. The IEA expects it to average slightly less than 18.6 million barrels a day this year, down for the third year in a row. The trend of Americans buying more fuel-efficient cars and driving less is holding down consumption. Back in 2005, Americans burned almost 21 million barrels a day. But another factor keeping inventories high has nothing to do with roughnecks or commuters. It emanates from Washington. Refiners and oil marketing and trading firms keep stocks on hand to ensure they can supply customers. Low interest rates, facilitated by the Federal Reserve's policy of quantitative easing, make it cheaper to finance those inventories. Indeed, those low rates can make it very profitable to buy oil, store it and lock in a margin by selling futures.
Energy economist Phil Verleger estimates that with short-term interest rates around 0.25% — roughly in line with Libor — the financing cost of holding stocks today is around two cents a barrel every month. Right now, three-month oil futures trade at about a 30 cents a barrel premium to the spot price. On that basis, assuming 90% leverage, an investor could buy oil and sell it three months forward, earning a 2.5% return after costs. That might not sound like much. But it is five times the yield on the three-month U.S. Treasury and a no-brainer for a trader at an oil firm with access to storage capacity. But the trade is getting squeezed over time. Back in February, the spread was around $1 a barrel, implying a return over three months of almost 10%. While spot prices have held pretty steady over the past few years, futures further forward have been slipping, likely reflecting rising expectations for U.S. supply and acceptance that the global economy's recovery will be a gradual, drawn-out affair. The upshot is that, with bond yields rising as the end of quantitative easing becomes a more realistic prospect, profits on the carry trade are likely to shrink further. The same trade described above at current spreads but with a 1% financing cost earns a return over three months of less than 0.7%. As this squeeze becomes more apparent, it can become self-fulfilling as those holding inventories sell them in the expectation that futures will decline further. That liquidation adds further pressure to prices as it increases available supply. Say 50 million barrels were liquidated over the second half of the year, which would simply bring U.S. inventories down to around their five-year average. That would amount to almost 274,000 barrels a day. To put that in perspective, it equates to about a third of the IEA's expectation for global oil-demand growth this year. The past few weeks have seen yields rise globally as bond investors raise their expectations of the Fed taking its foot off the gas. Oil investors won't be immune."
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