The Daily Prophet: Bears Are Running Wild in Oil Markets

Connecting the dots in global markets.

The oil market is breaking, and the implications are far reaching. Crude entered its first bear market since August as concern over a global supply glut worse. West Texas Intermediate, the U.S. benchmark, fell more than 20 percent from its highest close this year as futures settled at $43.23 a barrel in New York. That's down from $54.45 on Feb. 23.

It appears that not even OPEC can do anything to alleviate the oversupply amid news that Libya is pumping the most in four years and that shale drillers are staging the longest drilling ramp-up on record, according to Bloomberg News' Meenal Vamburkar. While end users such as consumers can rejoice, the collapse in oil and related prices are damping already low inflation expectations. But if inflation is low, then employers are under less pressure to raise wages, which could ultimately hurt consumers. That's boosting demand for bonds, as traders add to bets that major central banks will need to continue easy money policies for longer. The losers are the many emerging markets dependent on high prices for oil and commodities for revenue, notably Russia. U.S. stocks fell the most in a month, led lower by energy shares.

Wednesday will be key for the market as the Energy Information Administration releases key weekly supply data. The latest Bloomberg survey shows expectations that U.S. crude inventories probably shrank by 1.2 million barrels last week, after production climbed to 9.33 million barrels a day through June 9, near the highest since August 2015. “The market’s in a game of chicken with OPEC and with Saudi Arabia in particular,” said John Kilduff, a partner at Again Capital LLC, a New York-based hedge fund. “Unless and until they respond, we’re going to continue to grind lower.”

EUPHORIA IN THE BOND MARKETS
Bond traders are convinced that low oil is here to stay. The difference in yields between five-year U.S. inflation-linked government notes and conventional notes, or what traders expect the rate of inflation to be over the life of the securities, has collapsed to 1.56 percentage points, compared with about 2 percent as recently as early March. The Fed's goal is to get the inflation rate to 2 percent. Want more proof? The so-called yield curve, or the gap between two- and 30-year Treasury bond shrank to 1.39 percentage points Tuesday, the least since 2007. The yield on the benchmark 10-year Treasury note has fallen to 2.16 percent from this year's high of 2.63 percent in March, and could drop below 2 percent, according to bank of America strategists. They also see oil risks trending below $40 a barrel. Bond markets worldwide have had a surprisingly strong year so far, with the Bloomberg Barclays Global Aggregate Index up 4.44 percent through Monday. Remember when everybody said get out of bonds because the election of Donald Trump would usher in a period of debt and deficit spending to finance growth?

THE RUBLE IS CRASHING
The ruble just had its worst back-to-back days since February 2016, falling 5.68 percent, as the drop in oil and broadened U.S. sanctions took a toll. Russian stocks entered a bear market last week after the U.S. Senate voted overwhelmingly to expand penalties against Russia. Following the downing of a Syrian government jet on Sunday, Russia threatened to treat U.S. warplanes as targets in response. “The ruble is facing a perfect storm,” Dmitri Petrov, a trader at Nomura International in London, told Bloomberg News' Ksenia Galouchko. “The return of geopolitical tensions and strengthening of U.S. sanctions added to the earlier weakness driven by falling oil.” Russia’s eurobonds due in May 2026 fell, lifting the yield nine basis points to 4.16 percent, the highest level since April. At least Russian consumers are happy. Retail sales and real wages topped forecasts and unemployment fell to the lowest in eight months, the Federal Statistics Service said on Tuesday in a sign of consumer revival in an economy trying to gain momentum after almost two years of contraction. 

SMALL IS BEAUTIFUL AGAIN
The violent rotation gripping U.S. equities has chased professional investors back into small-cap stocks. In just two weeks, hedge fund positioning in Russell 2000 Index mini futures went from the most bearish in six years to the most bullish in four months, according to Bloomberg News' Lu Wang. It’s the biggest about-face on record based on Commodity Futures Trading Commission data compiled by Bloomberg that goes back to 1994. While the reason for the flip-flop is hard to pinpoint, it’s mirroring a larger reallocation across U.S. stocks that has sent bank shares up in seven of the last nine days and lifted other sectors that rose in the aftermath of Trump’s election. Financial firms dominate the small-cap universe, making up almost a third of the Russell 2000 Index, almost twice the share in the S&P 500. Another driver is the narrowing of credit spreads, an indication of financial magnanimity that bodes well for smaller companies whose leverage is near all-time highs, according to Bank of America.

THE WIDOW MAKER CLAIMS MORE VICTIMS
It's been proven time and time again that it doesn't pay to bet against Japan. For at least a decade, some very high-profile investors have placed large sums betting that the nation's world-leading debt-to-GDP ratio of 235 percent would cause the economy to crash spectacularly. That hasn't happened, and many investors have taken to calling bets against Japan the "widow maker" trade. The latest example can be seen in the stock market, where foreigners have dumped $27 billion of the country’s equities since the start of 2016 even as the Nikkei 225 Stock Average soars toward its highest level in more than two decades. While they were initially right to sell as the benchmark fell to a 20-month low in June 2016, they’ve been slow to return, according to Bloomberg News' Min Jeong Lee. Strategists say overseas investors, who made big profits plowing money into Japanese equities in Prime Minister Shinzo Abe’s early years, have been more enamored recently by markets in places such as Europe, where valuations are attractive and political risk has receded. A Bank of America Merrill-Lynch survey published this month showed global fund managers cut their allocations to Tokyo shares.

TEA LEAVES
Trump son-in-law and designated chief for Mideast diplomacy Jared Kushner arrives in Israel Wednesday to broker peace talks, and investors may be shocked by what they see. No, not the likely sight of Kushner, Israeli Prime Minister Benjamin Netanyahu and Palestinian Authority President Mahmoud Abbas all standing together, but rather the performance of Israel's economy and currency. Israel is on a roll. Its economy grew more than twice as fast as the rest of the developed world in 2016 and is projected to beat its peers for the next three years, according to Bloomberg News' Yaacov Benmeleh. The shekel is one of the world's best performing currencies this year, appreciating 8.22 percent. Things are so good that Yoel Naveh, the Finance Ministry’s chief economist, warned earlier this month that the 9 percent growth in household credit last year made him think of the U.S. subprime crisis.

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