The Daily Prophet: Oil May Hold Key to Global Financial Markets

Connecting the dots in global markets.

Inflationary or recessionary? The age-old debate over whether rising energy costs add to price pressures or act as a drag on the economy is likely to heat up again with oil surging and gasoline rising to the highest since 2015 -- ignoring the ephemeral spike in late August after Hurricanes Harvey and Irma.

Regardless of which way you lean, know that traders haven't been this bullish on oil since 2014, when it was selling for $105 a barrel, or more than 50 percent above the current price of $67 a barrel. That's seen in West Texas Intermediate crude's so-called call skew, which measures how much more investors are willing to pay for calls than for puts, according to Bloomberg News' David Marino. Rather than a strengthening global economy, geopolitics is the main driver of energy markets at the moment. Oil futures in New York jumped 2 percent on Wednesday as Saudi Arabia, the world’s biggest oil exporter, intercepted a missile attack over its capital just hours after President Donald Trump warned U.S. missiles may strike Syria soon.

Energy markets rallied even though a U.S. government report showed expanding domestic oil inventories, according to Bloomberg News' Jessica Summers. “The geopolitical risk has jacked the market up to three-year highs. This is the first day in a long time that the direction of the crude market and the direction of the stock market have diverged,” said Thomas Finlon, director of Energy Analytics Group LLC in Wellington, Florida. The correlation “stops with heightened geopolitical risk.”

For the second day in a row, the U.S. government's auction of bonds failed to generate any excitement among investors. A class of bidders that includes foreign central banks bought a paltry 53.2 percent of the $21 billion in 10-year notes offered, the least since November 2016. The drop in demand comes amid rising speculation that foreign investors may be pushing back against U.S. policies and fiscal largesse by allocating less of their money to American financial assets. If true, the pullback could force the government to offer higher yields to generate sufficient demand at its auctions, making it more expensive to finance the ballooning budget deficit. Of course, one auction does not make a trend, but this one does come a day after dealers were stuck with 40.9 percent of the $30 billion in three-year notes auctioned by the Treasury, the highest percentage since September. On average, investors have been placing about $2.75 in bids for every $1 of debt offered by the government, the least since 2009, according to data compiled by Bloomberg.

The Bloomberg Dollar Index briefly snapped a three-day decline, its longest slump in two months, after minutes of the Federal Reserve's last monetary policy meeting showed that officials were leaning toward a slightly faster pace of interest-rate increases. The minutes show the Fed was more confident in the growth outlook and in hitting its inflation target. Alas, the dollar's gains couldn't hold as no one was ready to call the start of a long-awaited rebound in the greenback, which has depreciated about 11 percent against a basket of major currencies since the start of last year. If the temporary bounce wasn't enough to dampen whatever little animal spirits the dollar bulls may have had, the strategists at BNP Paribas were out with a report declaring that any hawkish leanings for the dollar are already priced into the currency. U.S. economic data are "no longer broadly and consistently beating market expectations, as it had been at the start of this year," the strategists said.

It's earnings season eve, and this quarter investors may want to pay closer attention to corporate debt levels. The huge surge in Libor rates and corporate bond borrowing costs likely means companies, most of which have loaded up on debt in recent years, will be reporting higher interest expense ratios. Already, the equity strategists at Bloomberg Intelligence say they are noticing that stock performance is starting to correlate strongly with corporate balance sheet health as well as profitability. Over the past year, stocks of S&P 500 Index members with higher cash ratios outperformed low-ratio counterparts, with an average monthly return differential of 0.8 percentage point between the top quintile and the lowest of five bottom quintiles. Also, stocks of companies with higher net debt ratios relative to both cash flow and market capitalization underperformed lower-debt counterparts, with average monthly return differentials of 1.1 percentage points. Defensive sectors have the lowest cash and highest debt percentages, and are thus disadvantaged when investors focus on balance sheets, the strategists wrote in a research note.

The superlatives are starting to line up for Colombia's peso: biggest one-day gain since November 2016, strongest level since 2015 and best-performing currency in the world this year. The peso has appreciated from about 3,100 to the dollar in July to about 2,720 on Wednesday, and the strategists at Citigroup see it gaining to 2,700 or beyind. "The peso should benefit from increased flow as long as oil stays resilient," Citigroup strategists Dirk Willer and Kenneth Lam wrote in a research report dated April 10. Also, the currency seems to be benefiting from the steep selloff in Russia's ruble brought on by new U.S.-led sanctions, leaving Colombia's peso "as the only oil expression" among emerging-market currencies, according to the Citigroup strategists. They also note that the peso is one of the cheapest currencies in emerging markets as measured by its current real effective exchange rate relative to long-term averages. "A cheap valuation may help the market be more at ease with spot plumbing new lows since mid-2015," they wrote.

After the European Central Bank's last monetary policy meeting on March 8, President Mario Draghi unexpectedly dropped a pledge to ramp up bond buying if the economy deteriorated. He said a turnaround in the economic outlook had given the ECB confidence to change a key part of its monetary-policy guidance. Draghi said it was a unanimous decision. Maybe so, but investors will get a look at what the discussion among policy makers was like when the ECB releases the minutes from the meeting on Thursday. Euro zone bonds have largely rallied since the meeting on the back of softer-than-forecast economic data, but that could change if the notes reveal genuine consensus among policy makers.

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