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Know your enemy: the energy sector selloff

The global macro dynamics from the beginning of a Fed rate hiking cycle are slowly playing out across the world.

Oil
Source: Bloomberg

In the direct wake of the decision, we have seen some dramatic moves in central bank policy with Taiwan cutting its benchmark interest rate, Hong Kong and Mexico both hiking rates, and Argentina removing currency controls and devaluing the peso by 30% (although less Fed-related). After yesterday’s initial bout of buoyancy in equity markets, Asian markets look to be about to spit the dummy today. Equity markets are beginning to know their enemy – the continued selloff in energy prices.

The Fed decision has clearly had no effect on the ongoing world of pain that oil prices find themselves in. The blowout in US oil inventories on Wednesday and the slow pick up of refinery capacity utilisation continued to weigh on prices as they declined a further 1.9%. The HYG and JNK high yield ETFs both lost 1.1% last night as well.

The implications of further energy price declines are clearly putting the brakes on equities at the moment. The Fed were happy to look through the ongoing weakness in inflation and hike rates on Wednesday. Janet Yellen was keen to emphasise at the press conference that she and the committee had confidence that inflation would increase towards their target of 2%. Yet the dissonance created by the 5% selloff in WTI that day did cast a pall over these optimistic inflation forecasts.

At the current juncture any sustained uplift in oil prices does not seem likely until we begin to see consistent declines in oil inventories. Crude storage has not yet reached capacity and with contango at such dramatic levels, there is little incentive to sell into the spot market. A wave of defaults and bankruptcies in the energy sector still looks likely to come, and these concerns are certainly weighing on markets. The spectre of the collapse of Continental Illinois bank in 1984 during that energy price crash still hangs heavy in these markets. As the GFC proved, the inter-connectedness of the contemporary financial system means that even if a wave of defaults occurs in seemingly speculative portions of the market, it has the capacity to spillover into systemically important institutions. Concerns over future counter-party risks are significantly contributing to the global costs of capital and adding new uncertainty to markets even after the Fed has finally begun the rate hiking cycle.

What has been somewhat surprising is the surging US dollar in the wake of the Fed’s rate hike decision given that markets had largely fully priced it in 1-2 months out. The DXY dollar index surged 1.4% overnight to 99.2, its biggest one-day gain since 22 October, and it looks well on its way to go above 100 again before the year is out. It gained against all of the G10 currencies overnight. The Aussie dollar’s pre-Fed levity looks well and truly over. The ongoing collapse in energy and industrial commodity prices is clearly taking its toll on the Aussie as it lost 1.5% overnight. However, it did bounce sharply off the US$0.71 line, but if this US dollar rally continues the Aussie dollar plumbing its sub-US$0.70 late-September lows would not be out of the question.

 

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