Crude’s crash could cause conviction crisis

Oil prices haven’t been this low since 2009. Energy stocks are collapsing, credit markets are rattled and the commodities complex is capitulating.

What does it all mean?

Commodities, and especially energy, are a barometer of global economic health.  The current reading indicates we are heading in to a serious storm.

China’s exports have been dropping, which shows curbed demand from Europe and the United States.  Thus, demonstrating that the consumption-driven global economy is struggling.

Where do we go from here?

It’s quite possible that a global recession is the next leg down.  We’re already seeing signs in the economies of the Euro zone, Japan, Canada, Brazil, Russia and others that a soft landing may not be in the cards.

How does one protect their capital?

Conventional financial investments tend to get bludgeoned during recessions.  This is because risk adversity grows and investors convert stocks in to bonds, cash and other assets that are perceived to be ‘safe havens.’

My inclination is that gold, silver, the Japanese Yen and Treasury bills will see a supportive bid in 2016.  The US dollar and equity markets will likely see a corrective pullback, if not a larger decline.

Commodities crash below 2002 lows

Prices of commodities tend to reflect underlying global economic health. With the recent crash below 2002 lows (as priced by the Bloomberg Commodity Index), concerns are mounting that the world is headed toward recession.


Dwindling demand deepens downside

China’s days of double digit GDP growth appear to be on pause, if not over. The lower demand from China and other countries, combined with the ramp up on commodity production during the global growth boom that China led has created elasticity.

The greater slack has then lent itself to lower prices due to the combination of greater supply and lower demand.  A problem which seems to have no short term resolution on the horizon.

Gold may be closing in on a bear market bottom

As we approach extremes in bearish sentiment, the number of gold ounces promised per contract (on the Comex at least), relative strength and the dollar rallies on the promise of a tightening cycle — I think it’s important to take a moment and reflect.

Interest rates make a bad situation worse for debtors

The US government currently spends over 6% (about $250 billion per year) of its budget on interest alone.  If interest rates were to normalize this figure would swell significantly.  So the idea of a tightening cycle being a possibility without a significant (and deflationary) reduction in government spending is unlikely.  Even if spending were to be decreased, it would not be in time to reduce the deficit or debt burden.

Further, liabilities in the private sector are explodingStudent loans, car loans, credit card debt, mortgages and debt-driven share buybacks are all at unprecedented levels.  This is further evidence that the system at large is far too debt-dependent to move to a higher rate structure without a significant rise in insolvencies.

Leverage and volatility don’t mix well

Lest we forget the interest rate complex at large.  The biggest swath of derivatives in the world, hundreds of trillions of dollars of leveraged OTC instruments, are tied directly to it.  To give you an idea of its scale, the amount of interest derivative products alone dwarf the global GDP by nearly 7 fold.

Large moves in short periods of time render leveraged trades insolvent due to the trade turning against them.  If one is borrowing $9 for every $1 they put in to a trade, then if the trade goes against them by 10% they are wiped out.  More than 10% and they owe more than the $1 they put down.

This is precisely the risk present in the world of derivatives.  The only difference is the leverage is much, much higher than 10 to 1.

Another problem is that in a tightening environment that’s unilaterally led by the US central bank (when other central banks do not follow), deflationary shock waves may proliferate throughout the global financial system and wreak havoc on interest rate derivatives markets, emerging equity and bond markets, US corporate debt and ultimately global financial markets as a whole.

Sensitive markets showing stress

Corporate bonds are beginning to sell off. Emerging markets have been in a funk for some time as they were once the beneficiaries of QE.

Given the level of medicine applied, one would expect the patient (the global economy) to have either rebounded or died of an overdose. Neither has happened, but markets are essentially in the eye of the storm.  The troubles past are gathering speed again at a remarkable pace behind the scenes.

Consequences are continuing to climb

This time around it is not just the financial system at risk, it is many governments of the world and many of their respective central banks that risk insolvency.  We are witnessing the biggest bubble that has ever been blown in history.

No wonder there is so much effort in preserving such a bubble.  The result of its end is a mind blowing problem.  And that’s precisely why the rate normalization cannot happen.  We may see a push higher by 25-50 basis points.

Policy road fork ahead

Such a hike, however, will in all likelihood pale in comparison to how the Fed manages its maturing balance sheet of bonds.  A new round of QE-like activity will likely emerge as those funds that mature are put to use to purchase longer dated bonds to re-stimulate debt markets in a variant of operation twist.

As equity markets finalize what appears to be their ultimate topping formation, I assume that we will witness another sharp move downward.  The Federal Reserve appears to be more sensitive to the gyrations of financial markets than the economy at large.  As a result it will likely pause and possibly even reverse in to this new variant of operation twist.

Ultimately this is bullish for gold

I believe we will have already formed the bottom in precious metals and begin to see a resurgence in prices once the stock market has topped and the Federal Reserve is no longer willing to tighten.  Whether the gold price tests the $1,000 level is still on the table, but I don’t see much further downside from here based on these assumptions.

US dollar strength knocking commodities down

An unusually strong jobs report, which saw seniors take the lion’s share of the new jobs, caused an enormous continuation of the recent US dollar rally.  The move knocked commodities down, causing the entire complex to shudder.

This strength is predicated on a forthcoming Federal Reserve rate hike in December. The same rate hike that has been put off for almost a year by policy makers that talk a lot, but do very little.

If the past is any indication of how this current trend will play out, most of the strength in US dollar rallies (and conversely, commodity weakness) happen before the first rate hike.

If that’s true, we may be through the worst of the US dollar rally — assuming the Fed actually hikes in December.  If not, or if the dollar continues its ferocious path higher, there will be significant headwinds for US corporate multinational earnings as well as the entire commodity complex.

Inflection point in S&P 500 reached

We’re not out of the woods.  If anything the latest rally’s staying power is about to be tested. Given how heavy the chart looks, I am inclined to think the path of least resistance remains lower.

Only if the S&P 500 can make a new high and close above it on a weekly basis would I be convinced that a meaningful low has been put in.


Alternatively, if the market breaks below 1,800 on the S&P 500, look out below.  That will confirm a massive head and shoulders topping pattern which could lead the market as low as 1,000 in the intermediate term.

Stay on your toes.  There’s a lot of momentum chasers looking for the next major break.  They will push prices around (up or down) in an exaggerated manner.

The Fed has zero credibility until it raises rates

A lot of hot air, but no substance. That’s what’s been emanating out of the mouths of Federal Reserve officials over the two years about the direction of interest rates — with no follow through of taking rates higher.

As a result the Fed has no more credibility left.  When Fed officials talked about moving rates in the past markets would move with their chatter.

Not so much recently.  Market participants are squelching out the talk and waiting for the Fed to walk the walk.