Paging the plunge protection team

Published at 15:56 7 Jun 2019 by . Last edited 11:18 22 Aug 2019.

A dramatic 20% fall in crude prices since 1 May is conjuring memories of Q4 18’s liquidity-induced risk assets crash and bringing recession fears to the surface. But this time around, while crude has been capitulating, equities have not. In fact, the divergence between crude and equities is almost as stark as that between flat price and timespreads. While there are clear signs of an economic slowdown, the mix of data coming in suggest that the US is not yet in recession. But that hasn’t stopped many from searching for ways to make data and events fit a narrative that suits them.

For example, while many point to the sudden drop in distillate demand as proof of a looming recession, we find that almost all of this drop is concentrated in PADD 2 and it is mainly due to flooding in the Midwest and the resulting hit to corn planting efforts, among other things (more on this below). Moreover, strong trucking and intermodal data suggest that there are pockets of strength that don’t chime with collapsing demand.

But if the demand signals are mixed, the supply signals are not, despite the collapse in flat price. This is visible in the continued strength in physical Gulf Coast grade differentials, and every grade is backward, which is not indicative of an oversupply, US crude builds notwithstanding. Finally, even as oil volatility has spiked in the last week, equity and FX vol is relatively subdued. For now, the world isn’t falling apart.

Fig 1: Crude ($/b) vs S&P Index Fig 2: Equity vs oil volatility indices
Source: Bloomberg, Energy Aspects Source: Bloomberg, CBOE, Energy Aspects

“The economy is in a really good place”
A number of high-profile banks (but not Goldman Sachs) have now slashed their rate forecasts for the rest of the year (some calling for three cuts by year-end) amid trade war and recession fears. With equities wobbling, the market has been bleating for the Fed to confirm that it ‘gets it’, with some even suggesting that, like in 1998, the Fed should pre-emptively cut interest rates to stave off a potential threat (back then it was the Russian debt crisis). A month ago, Fed Chairman Jerome Powell played down speculation of a rate cut this summer. Since then, sentiment has shifted decidedly weaker and the futures market is now pricing in a 25% probability of a cut in June and 75% for a cut by 31 July.

Unlike in May, Fed officials haven’t expressly pushed back against market pricing on rate cuts in recent days. Both Bullard and Evans gave comments at the start of the week that were decidedly dovish, with Bullard openly calling for a rate cut. Bullard, a perma-dove, was expected to call for a cut. But Evans, a traditional hawk, also suggested that the persistent inflation shortfalls might require an explicit adjustment in the reaction function of the Fed. Though on the surface this may not seem particularly dovish—and in fact his comments were presented by the press as a ‘hawkish’ counter to Bullard—in reality, relative to his traditional views, his comments were actually quite dovish (Evans in Q4 18 was still calling for three rate hikes in 2019).

This message was reinforced in Chicago where a slew of Fed officials gathered for a research conference this week. Both Clarida and Powell reassured the market the Fed would move faster than it has in the past to shore up growth should signs of impending weakness begin to emerge—an important reassurance given the fiasco of December 2018, when the Fed hiked rates as the market was melting down. But significantly, Fed officials also reinforced the message they did not want to react prematurely to events that could change quickly.

To some extent, the market wants the Fed to pre-empt any pitfalls that could emerge this summer. But the market may be jumping the gun on pricing in a June rate cut, as it appears there would need to be a material deterioration in the economy before the Fed would pull the trigger. There are those at the Fed who believe that market signals are valid signals of future economic conditions—many put a lot of focus in FX markets, for example, more so than the equity market. But right now, volatility is just not sounding the kind of alarm bells that would mobilise the plunge protection squad. Risks are rising, but the alarm bells are not yet ringing at the Fed, which is not nearly as dovish as the broader market. With volatility across FX and equity markets generally in check, the Fed is not yet panicking.

Fig 3: FX vs Treasury volatility indices Fig 4: Fed rate probability for Sep meeting
Source: Bloomberg, Energy Aspects Source: CME, Energy Aspects

But just because the Fed won’t cut imminently, it could still signal intent to assuage a market that remains concerned about the Fed’s reaction function. For example, the current dot plot still has a hike in 2020. It’s fairly safe to assume this will come out. Moreover, Powell can use the June meeting press conference to address market concerns, potentially saying that a cut was discussed at the June meeting. This would show that the Fed’s base case is that it no longer needs to be restrictive. It would also show that it is firmly in neutral (as opposed to “at the lower end of the range consistent with neutral”). And while not a prerequisite, it would be the next logical step before moving from neutral to accommodative if required.

So, while we would not expect to see a rate cut at the next meeting, we should expect to hear the phrase “the economy is in a really good place” a lot over the coming weeks. Both Clarida and Daly said it last week, and certainly the Beige Book reinforced that as well. This is probably going to be the new code word for ‘on hold’, but increasingly we feel that that is exactly where the Fed is right now.

The Fed is facing a stern test of their communication prowess in the coming two weeks, given how they really botched it in December 2018. They certainly don’t want to find themselves again in a position where they have to grudgingly become more dovish to backstop markets. It should now be clear that the Fed has no tolerance to allow deflation or even disinflation to become ingrained in the market again. But the Fed is also acutely aware that, of all the central banks, it is really the only one with any ammo left, and that perhaps it may want to save some for the bigger challenges ahead regardless of recent signs of economic pressure. So it may still take some time to bring the Fed to where the market currently is. Ultimately, whatever the Fed chooses to do, we still believe that the most important catalyst for markets and staving off deflation is to weaken the dollar. Whether the Fed chooses traditional rate cuts or something more exotic (i.e. unconventional policy), the goal must be to weaken the dollar. Without a weak dollar, the Fed will fail in its attempts to reflate the economy, given that most everything that is traded is priced in dollars.

Meanwhile, in a classic TV drama, President Donald Trump is keeping the world in limbo about whether he will soon double down on the trade war with China or call a truce. Great expectations are being built for another dinner like in Buenos Aires last November between Xi and Trump when they meet at the G20 in Osaka later this month. Markets continue to price and act as if a grand bargain is in the making. However, it is important to remember that Buenos Aires was nothing more than a tactical pause. There may be little that can prevent a slide toward a protracted and high-stakes competition between the US and China that has little to do with trade. At this point, the best that can be hoped for at Osaka is yet another tactical pause that allows discussions to resume. But that is a far cry from a grand bargain. In our opinion, markets continue to ignore the potential risk for a deep escalation with China.

Has the US position on Iran softened?
There has been some confusion over Secretary of State Pompeo’s recent declaration that the US had “no preconditions” for holding negotiations with Iran. This in no way implies that the US was softening its position. Rather, this was merely a statement of fact. The US is willing to sit with Iran. But, that does not mean that it has softened any of the 12 demands announced a year ago regarding what it would take to “normalise” relations with Iran. Think of it this way: the US was merely stating that it has no preconditions to negotiate Iran’s adherence to the 12 points.

That being said, it is clear that things had gotten too hot too fast over the course of the last month. A handful of analysts inside the Department of Defense had a freakout session over some Iranian movements that they deemed to be overtly offensive in nature but subsequently turned out to be defensive. But of course, in the meantime, the US had repositioned troops, deployed assets and escalated the rhetoric between the US and Iran. Quickly. But this is not at all what President Trump wants.

Backchannel surfing
It is clear to us that US backchannels are being mobilised to reach out to the Iranian regime, as Donald Trump clearly wants to talk, and it is within this context that Pompeo’s “no preconditions” comment should be taken. There are now three legitimate backchannels for sending the specific message that Donald Trump would like to talk. The first came through the Swiss, though it remains unclear whether they have agreed to act as a conduit for the president. The Omanis are a traditional backchannel for both the Israelis and the US, and they have also been mobilised. And on 12-13 June, Japanese Prime Minister Shinzo Abe is set to go to Iran, where he is expected to meet Supreme Leader Ayatollah Ali Khamenei and President Hassan Rouhani. Our understanding is that Abe will be carrying a personal message from President Trumpand will encourage Iran to talk to the US and may even make an offer for Rouhani to attend the G20 meeting in Osaka later this month.

Let’s be clear—what is happening now is little more than pre-negotiations about the potential for real negotiations. Iran has explicitly said that negotiating was a non-starter so long as economic sanctions remained in place. Thus, at a minimum, the US would have to be willing to be flexible on its sanctions policy. Then other things could be explored like a possible prisoner release, or perhaps even some set of limited waivers to buyers of Iranian crude (for China and/or India), or the US could agree to turn a blind eye to some oil cargoes (though that becomes even trickier as companies would have to go on their good faith that they wouldn’t be prosecuted…yeah right). And Iran might have to offer some concessions on some parts of its nuclear programme that it has restarted since the US imposed sanctions. None of this has been determined, and to be honest nothing has even been offered. However, these are the contours of what an agreement to negotiate might look like. All of these are possible, but only if Iran and the US truly want to sit around a table. That is not yet clear.

Again, for Iran, there is a hard and fast requirement that some economic sanctions be lifted or at least meaningfully eased, allowing some crude exports to flow, as a precondition for talks. As one DC based source noted to us recently , “if the Iranians had to choose between being at zero [crude exports] and talking, versus not talking, then they would prefer not talking while reassessing tactics, which of course becomes a far riskier outcome”.

While the official public Iranian position is that there is nothing to discuss with the US, it is possible that the Iranians can take a page out of the North Korean playbook. Some sources in the US administration believe that Rouhani has received a green light to explore discussions with the US with the only goals being: a) to stall until the US elections in 2020; and b) to try to keep a minimum baseline of exports going. We would be cautious about inferring anything from the announcement of talks between the US and Iran, as both participants would see talks as a means to very different ends.

The Outlook
Brent: The divergence between spreads and flat price continues, for even as prompt crudes spreads rallied on the week, crude flat price proceeded to shed $4.00 . For all the consternation and hand wringing over worries of an oversupplied market as US crude inventories rise, Brent timespreads and Atlantic basin differentials continue to tell a story of tightness. Moreover, while margins are weak, they are not incentivising widespread crude run cuts. Forties differentials have continued to rally. Urals differentials have eased as contamination problems continue, and buyers are not interested in the grade but this in turn in boosting Brent spreads further.

WTI: The crude market was pounded lower this week by an unabashedly bearish set of inventory data, which caught more than a few off-guard. While the trend has been one of stock builds over the last two months, the degree of the one-week build was shocking. Though the release covered a period including the Memorial Day holiday, which can sometimes lead to quirky data, the 22 mb total petroleum build overwhelms any potential clerical errors that might have occurred. More importantly though, for the fourth straight week, the weekly adjustment factor came in over 0.8 mb/d, and it has averaged close to 0.55 mb/d since the last week of March. That translates into roughly 40 mb of oil over that period that is unaccounted for. It is hard to have confidence in the data when there is such a big fudge factor. But this last week’s build means that since mid-March, total petroleum stocks in the US have surged by 85 mb, putting them within spitting distance of the 2016/17 highs. Nearly half of that build is in other oils, but the trend is hard to deny. But again, given what we know about the trajectory for both inventories and exports over the course of March and April, the one thing we struggle to reconcile is that US crude stocks were building, and exports were falling at a time when Brent spreads were in extreme backwardation, and USGC domestic grades were rallying. That begs the question: why? It is quite possible that there is a statistical anomaly that is corrupting the data (and the EIA has acknowledged this as a possibility and will investigate), or it could be that what is being built in inventory is too light for the market.

Products: With oil prices falling and product stocks building, the fears that the economy is falling into recession are rising. One look at the distillate demand chart below only reinforces that view. But even here there are some interesting trends to glean. Despite the extreme weakness in distillate demand, total US product demand is roughly steady to last year, with both jet and gasoline demand moderately higher y/y. Moreover, trucking tonnage has rebounded after a dramatic fall at the end of Q4 18 and looks like it is back on its normal upswing. Intermodal data also corroborate that transportation and delivery trucking demand remain robust. And while rig counts have stopped rising they have materially fallen either. So, if it isn’t specifically the economy, then what is driving distillate demand weaker?

Fig 5: ATA truck tonnage index SA  Fig 6: US distillate demand, mb/d
Source: ATA, Energy Aspects Source: EIA, Energy Aspects

Interestingly, nearly all of the demand weakness is concentrated in PADD 2. A large part of the builds seen recently has been linked to flooding in the Midwest, cutting demand and corn planting. Corn planting increased to 67% complete for the week ending 2 June, up by 9 ppts from last week, but still well below the five-year average of 96%. The last time planting has been anywhere near this far behind was in 1981, when 87% of corn planting had been completed. This impact doesn’t go away when the weather normalises as, in addition to planting, the harvest also contributes to a significant portion of distillate demand. If something isn’t planted, it can’t be harvested, so the flooding effect is likely to linger into the autumn. But it does suggest that the weakness is localised for now, and it is not clear if the flooding may boost demand later as various regions recover and rebuild from damage sustained from the flooding. The demand trajectories in the US may not be fantastic, but they are not nearly as bad as the headlines suggest either.

Fig 7: PADD 2 distillate demand, mb/d Fig 8: US Dist demand ex PADD 2, mb/d
Source: EIA, Energy Aspects Source: EIA, Energy Aspects

Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)

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