The crude contagion could cause chaos, crash

On the heels of another massive sell off in crude oil, the US stock market woke up from its slumber.  Instead of the discount in crude oil being priced in as a stimulus, it was seen (perhaps more accurately) as a risk. Crude touched prices that had not been seen since April, 2009.

US equities sold off on higher than average volume, with bonds, gold and silver catching a bid.  The VIX showed fear entering the market and spiked higher, but the rally faded as the day went on.  The US dollar strengthened modestly on the back of a weaker Euro and Yen.

Interest rates on the 10 year bond tested 2.00%, while gold has climbed above $1,200 and stabilized.  Tonight the Nikkei is selling off significantly in Tokyo.

crude oil

Greed may pause to give room for fear to take the reigns.

Markets are decidedly in a risk off mindset.  I suspect that this fear of risk will prevail over the leveraged and crowded long side bullishness that has pushed the US stock market up to record highs with few downdrafts over the last few years.

The fundamental improvements in the US economy have been sluggish, with many corporations buying back their own shares to boost EPS.  There is a dislocation between current perceived valuations and the global economy’s condition.

The crash in crude oil has brought about a serious challenge to many economies of energy producing nations, including the US.  Since 2008 many of the high paying new jobs have been in the energy sector.  Now that oil is down over 50% from its highs, many of these projects are no longer viable and drill rig operations are now at 10 month lows.

us oil and gas rigs jan 5 2015

Energy markets are an indication of economic health.

There is a certain amount of feedback from energy market prices that can be indicative of manufacturing activity, shipping and transportation.  To the extent that supply exceeds demand, prices should diminish until demand returns.  But even with a 50% cut in prices, there still seems to be room for more of a decline.  That is because while demand is diminishing, some oil producers are keeping or increasing supply rather than removing production.  This includes OPEC, Russia and Iraq, who stubbornly churn out more oil as prices lose support.

The perception becomes that a flood of oil is oversupplying the markets, but the reality is that demand has declined to such an extent that softening Chinese manufacturing demand has caused a ripple effect.  Most of the softening demand comes from Europe, China’s largest customer, coming to grips with a wave of economic headwinds.

This new normal, if we are to give it a name, is likely an indication of future global macroecnomic trends.

Global GDP 2015

Deflation strikes Japan and the EU.  Is the US next?

Persistent deflation is becoming a persistent theme.  Bond yields in Germany on 5 year notes hit negative yields.  Japanese bonds have fractional yields.  The US bonds seem to be ebbing lower and lower in interest rates in sympathy of the global deflationary pressures coming home to roost.

Are we going to experience a lost quarter century like Japan?  It seems ever more likely as the similarities are increasingly problematic.  A prescription of debt to solve debt-related problems.  Liquidity injections for structural economic problems show a lack of understanding from central authorities about what is wrong with our economy.

Nikkei stock index

Too much leverage, too many derivatives, too little transparency.

What the world needs now is more clarity about how far stretched the current system has become.  With over 700 trillion dollars of global derivatives, there is such an enormous amount of risk in opaque markets that a significant dislocation could cause another financial collapse.

None of the problems of 2008-2009’s Great Recession have been resolved at home or globally.  Instead the financial players that created the problem have now been given the reigns of the global economy and are leading us down a destructive path towards crisis.

The problems of the world will most likely come home to the US in 2015 and cause a profound impact on our economy and financial markets.  While it may not be apparent yet, I believe that the risks now are much greater than back in 2008-2009 and the ability of monetary authorities to mitigate those risks is impaired by the current and recent aggressive measures.

DerivMkt-BIS-Dec'87-Dec'10

Stay tuned in to the flow of news.  Interesting things may happen sooner than we expect.

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