When OPEC, a group of fifteen

Producers, all gathered in Wien

Nobody assumed

The meeting was doomed

To failure, t’was quite unforeseen

Alas, for the group overall

The UAE prince had the gall

To strongly demand

Their quota expand

The Saudis, though, wouldn’t play ball

The big story this morning revolves around the failure to agree, by OPEC+, on new production quotas going forward.  While expansion of output was on the agenda as each member was keen to take advantage of the rising price of crude and its products, it seems the UAE demanded a much larger share of the increase than the Saudis wanted to give.  Ordinarily, this type of horse trading takes place in the background as OPEC likes to show its unity, but for some reason, this particular situation burst into plain sight.  Undoubtedly there are many underlying issues between Saudi Arabia and the UAE, but right now, this is the one that matters.  The result has been that oil continues to rise sharply, up another 1.75% this morning taking the gains this year to nearly 60%.  As is frequently the case in a bullish commodity market, the price curve is in steep backwardation, with the front month contracts being significantly more expensive than the outer months.  This is an indication of a lack of short-term supply, something borne out by the continued drawdown of reserves in storage.

What makes this situation so interesting is the fact that the dollar has not fallen sharply while the price of oil has risen.  Historically, rising commodity prices go hand in hand with a weaker dollar, at least versus its counterpart currencies, but that is not really the case this time.  Thus, for those nations that import oil, their local costs have increased more than proportionally as the lack of dollar weakness means it costs much more local currency to procure each barrel.  For instance, since the start of 2021, the Japanese yen has weakened 6.8% and the Swiss franc has fallen 4.1% while oil’s price has soared.  Neither of these nations produces a drop of oil, so their energy costs have climbed substantially.  In the emerging markets, TRY (-14.1%), ARS (-12.2%), PEN (-8.0%) and THB (-7.0%) are the worst performers this year, none of whom have a significant oil industry and all of whom rely on imports for the bulk of their usage.  A weaker currency and higher oil prices are very damaging to those economies.

The question at hand is whether or not this internecine spat will end soon, with some sort of compromise, or if the UAE will stand its ground under increasing pressure.  One thing to consider is that the US shale producers are not likely to come to the market’s rescue in the near term, if ever, as it appears that even at these prices, the capital flowing into the sector to increase production has not expanded, and if anything, given the green initiatives and demands to stop funding fossil fuel production, is likely to decrease.  We may be approaching a scenario where the US, which continues to pump about 11 million barrels/day, will find itself in very good stead relative to many other developed nations that import a higher percentage of their energy needs.  Arguably, this will help the dollar, which means that for some countries, things are only going to get tougher.

As an aside, there is another commodity that has been performing pretty well despite the dollar’s strength, gold.  Here, too, history has shown that a rising dollar price of gold is highly correlated with a weaker dollar on the foreign exchange markets.  But that is not the current situation, as after a very short-term drop in the wake of the FOMC meeting’s alleged hawkishness, gold has rebounded while the dollar has retained virtually all of its gains from the same meeting.  My sense is that there are larger underlying changes in market perception, one of which is that inflation expectations are becoming embedded.

Of course, that is not evident in the bond market, where Treasury yields remain in their downtrend that began in early May in the wake of the massively disappointing NFP report that month.  Since then, yields have fallen more than 20 basis points and show no sign of slowing down.  Oddly, if the market was pricing in a tapering by the Fed, I would have anticipated bond yields to rise somewhat, so this is simply another conundrum in the market right now.  

Turning to the overnight session, one might argue we are looking at a very modest risk-off session.  Equity markets have been desultory with Asia (Nikkei +0.15%, Hang Seng -0.25%, Shanghai -0.1%) not showing much activity while European bourses (DAX -0.4%, CAC -0.3%, FTSE 100 -0.15%) are a bit softer.  Arguably, the European markets have responded to much weaker than expected German data with Factory Orders falling -3.7% ad the ZEW Expectations Survey falling to 63.3, well below the expected 75.2 reading.  Questions about whether or not the global economy has peaked are starting to be asked as stimulus measures fade away.  By the way, US futures are essentially unchanged at this hour.

While today’s Treasury movement has been nil, we are seeing yields decline across Europe with Bunds (-1.5bps), OATs (1.9bps) and Gilts (-1.1bps) all seeing a bit of demand on the back of waning risk appetite.  Remember, too, that the inflation impulse in Europe remains far less substantial than that in the US.

Aside from oil (+1.75%) and gold (+0.8%), the rest of the commodity bloc is also pretty firm this morning with Copper (+1.5%) and Iron ore (+1.6%) leading the base metals higher.

Finally, in the FX market, the best way to describe things would be mixed.  The RBA met last night and was more hawkish than anticipated.  They not only indicated they were going to reduce the amount of QE purchases when the current program comes up for renewal, but they appear to be ending YCC as well, explaining that they would not be supporting the November 2024 bonds when they become the 3-year maturity.  Not surprisingly, we saw AUD (+0.6%) rally, which dragged NZD (+0.8%) up even more as traders speculate the RBNZ is going to raise rates as well.  Away from that, though, the bulk of the G10 bloc was softer led by NOK (-0.55%), which given oil’s continued rise makes little sense.  At this point, I will chalk it up to trading technicals as I see no strong rationale.  As to the rest of the bloc, modest declines are the name of the game.

Emerging markets have also seen similar mixed price action with ZAR (+0.25%) the leading gainer on the back of gold’s strength while HUF (-0.65%) is the laggard as the market awaits comments from the central bank regarding its green policy ideas.  The next weakest currency in this bloc is PHP (-0.5%) as the central bank confirmed it would not be reducing stimulus until it had further confidence the economy there would be picking up.

On the data front, there are only a few releases due although we do see the FOMC Minutes tomorrow.

Today	ISM Services	63.5
Wednesday	JOLTs Job Applications	9313K
	FOMC Minutes
Thursday	Initial Claims	350K
	Continuing Claims	3325K

Source: Bloomberg

Aside from this limited information, we hear from just one Fed speaker tomorrow.  Perhaps the market will have the opportunity to make up its own mind about where things are going to go.

At this point, the Fed narrative remains that inflation is transitory and that they will continue to support the economy going forward.  However, there is a group of FOMC members who clearly believe that it is time to cut back on QE.  That will be the major discussion for the next several months, to taper or not, and if so, how quickly it will occur.  My view continues to be that the core of the Fed is not nearly prepared to taper QE purchases as they know that the ongoing expansion of Federal debt will require the Fed to remain an active part of the market lest things get more concerning for bond traders.

As to the dollar, it remains in its trading range having reached the top of that range last week.  I would not be surprised to see a bit of dollar weakness overall, if for no other reason than the dollar is likely to slip back toward the middle of its range.

Good luck and stay safe

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