Iraq concerns causing energy prices to fluctuate

The eyes of the world continue to focus on developments in Iraq, with the key proxy around a civil war being brent prices.

Oil pump
Source: Bloomberg

Judging by the modest falls in the front-month brent contract, the fact that the US are looking to send a small, yet targeted force into the region has appeased some, although the situation is extremely fluid and the prospect of higher energy prices is still something that could feasibly occur over the coming weeks.

Naturally one hopes that the army can contain ISIS to the largely Sunni region in the North, however if that fails to materialise and it appears that energy prices could really spike then it’s worth looking at central banks that focus more closely on headline inflation, as opposed to core inflation. The ECB would be the one to focus on straight away, given Brent prices make up around 15% of its inflation basket, so the EUR could find support on grounds energy will lift inflation going forward. Of course this is the worst possible type of inflation, especially when the economy is likely to grow around 1% this fiscal year and at a time when European banks are about to borrow ultra-cheap funds from the ECB to extend to households and SMEs.

It’s also worth looking at the increasing correlation between gold and brent; which makes a lot of sense as traders would want to hedge geo-political risks by buying precious metals. Still, the metal failed to clear the April downtrend resistance yesterday at $1287 and this level seems fairly important given it is also where the 55 and 200-day moving average converge.

US inflation in focus

On the topic of inflation, in trade today we get US May CPI, with core expected to tick up 10 basis points to 1.9% year-on-year. This would represent the highest level since March 2013 and while the Fed prefers to focus on PCE (personal consumption expenditure) the market will still put much emphasis on this print. US long end treasuries caught a modest bid yesterday and it’s hard to see significant upside in yields (selling) until we work through the rising Iraqi tensions and clarity resumes.

Perhaps one of the more interesting concepts being spoken about today has been around the view that the Fed may impose exit fees on bond funds. In my opinion this throws further weight behind the view that Fed are looking more closely at its exit strategies and trying to mitigate as many risks as possibly that could a be a by-product of its actions. One of the key issues in this week’s FOMC meet will be around a further discussion on re-investing the proceeds from maturing mortgage-backed securities, something Bill Dudley floated recently. Keeping the Fed’s balance sheet constant, while they raise rates, would in theory limit the selling seen in the bond market, however if they also offset this with exit fees it could provide a more managed environment . Of course it could have unforeseen ramifications as well.

In other parts of the world, Asia has seen mixed trade today, with a slight bid in USD/JPY and the Nikkei, while the ASX 200 and the China CSI 300 has pulled back a touch.

Lower foreign direct investment in China

There seems a constant barrage of news out of China at present, some positive and some less so, but it is clear equities remain range bound. This seems the best way to think and trade around China right now (unless you focus on steel and iron ore), with property prices (as measured by SOUFUN) easing 0.32% in May, adding to yesterday’s housing starts decline. Foreign direct investment was announced today, printing $8.6 billion in May, a fall of 6.7% on the year. It was also a 0.1% fall on the month, but given weakening of the RMB and sideways moves in the local equity market it’s understandable why China saw lower levels of foreign investment. Still, the Chinese market seems lower today as a result of the FDI print.

Australia has been an interesting market today and traders will be watching Royal Dutch Shell on open given its partial liquidation of its 23.1% holding in Woodside.  Many in the market could learn something from Shell in the art of buying low and selling high, but that is exactly what has happened and they have taken full advantage of Woodside’s recent share price gain. In saying that, we will have to wait for the reaction in Woodside’s stock tomorrow, but investors will like the 6% EPS accretion, while at the same time maintaining the 80% payout ratio (despite using its own cash and debt facilities). Most importantly they have created a more market-friendly structure, doing so in an orderly manner.

Europe should open on the firmer foot, with US futures gravitating slightly higher during Asian trade, in-line with moves in the Nikkei. On the data front traders will be keen to look out for improvement in the ZEW survey; while US inflation could affect the USD and longer dated treasuries.

On a currency level we haven’t seen much of a bid in sterling, despite traders hearing from David Miles (an external member of the MPC) that he would vote for an increase before his term ends in 11 months (source The Times). UK CPI will presumably be the bigger short-term driver, with traders expecting a slight decline in CPI to 1.7%.

EUR/GBP has been one of the macro crowd favourites for short positions of late, but I feel selling rallies is the way to go here given the oversold conditions. On the hourly chart it looks prudent to potentially work offers just under the 38.2% retracement of the recent sell-off at 0.8030, placing a stop loss at 0.8105 for a move to the 0.7800 level over the coming weeks.

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