In late 2013 throughout 2014 we have been contrarian stating that a longer term rise in interest rates above 3% in the 10 year Treasury was unlikely and that rates should keep falling. In sync with this call our forecast for all Oil rallies over $100 to be sold over the same period has logically coincided with a renewed deflationary fear. The usual suspects of lower demand – due to European austerity, global stagnation and US fuel efficiency – and larger supply thanks to US fracking – have enabled the vast majority of forecasters to miss the lower Oil price and lower interest rate trends that persist.
Short term we expect this trend to continue into the week of January 22nd. This is when markets expect significant European monetary stimulus by the central bank (ECB). The odds favor the markets being disappointed upon this announcement, but until then we would expect continued selling of Euros and energy products as well as most commodities and a higher Dollar. Stocks have some minor risk should Junk Bonds move to new lows as expected. If Oil breaks to new lows under $53/barrel and reaches 50 or lower then stocks will correct in unison.
A powerful rally in Oil and interest rates will remain difficult to generate in 2015 not just because of a slow global economy. Sharply falling Oil and deflation tend to engender a virtuous cycle. Not only has the US reached another record Oil production level in December, but major producers such as Russia and Iraq have already increased production to multi-decade highs despite falling prices because they need the money. OPEC typically maintains or increases supply as well when prices fall and continue to pump above their 30 Million/barrel quota. Thus the only wild cards to play to create higher interest rates and Oil prices are a reduction in high marginal cost US fracking and a monetary induced economic rebound in Europe/China/Japan. All these, “if” they occur, take time and for now they are all trending the other direction. Sure our frackers have already reduced their spending and idled some rigs, but sunk costs will maintain much of their lofty production levels in 2015. If the Saudis want to knock out US fracking for a few years then they had better be prepared to keep prices low for a couple years, otherwise our Oil investments will just ramp right back up to new heights. The Saudis are forecasting a $38 Billion budget shortfall in 2015 assuming a lofty average Oil price of $75. Should prices average $50 then their deficit would be $50 Billion which would be the comparative US equivalent of an annual deficit of $1 Trillion. Ouch! Unless Europe can demonstrate surprising uptrends in economic growth we would expect low Oil prices and low interest rates to remain a fixture.
Of course eventually low prices cure low prices as cheap energy creates a huge tax cut boost to the US and the world while low interest rates provide cheap credit and a boom in mergers and acquisitions, IPO’s and eventually consumer spending. One year from now we should also witness US unemployment well under 5% and possibly testing a near record 4% rates in 2 years. Unemployment rate downtrends often remain steady until recessions arrive, and with about 1.5 to 2% labor demand growth rates and only 0.5% labor supply growth, we think people will be shocked by how low we can go. Wages will have to rise and elevated levels of immigration and greater labor participation rates will occur. We have not quite entered the Goldilocks phase of this 6 year recovery, but over the next 3 years we may find our temperature gauge is just about right.
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