Oil prices dropped nearly 10 percent following the decision by OPEC not to cut production from current levels of about 30 million barrels per day (equivalent to just under 1/3 of global supply). The oil market has not changed as dramatically as recent price action would imply. Inventories have risen over the past few months, partly due to shale production in the US and elsewhere. As the US became less reliant on imported oil, the likes of Venezuela and Nigeria had to look for alternative markets, increasing global inventories.
As such, the size of the move in oil now goes well beyond a normal inventory correction. There is an element of price discovery here. In addition to the inventory situation, the move in oil prices is related to developments in currency markets. It is curious how the drop in oil coincided almost perfectly with the rise in the dollar index. And global oil demand and supply did not suddenly change dramatically at the end of June 2014. Concerns about German growth, pessimism about China, the correction in US equities as a reaction to an expected Fed policy change along with and the IMF’s concerns about global growth impacted sentiment. Markets have, however exaggerated the real threats to global growth, particularly as they pertain to Chinese and German growth prospects. EM will grow faster next year as will the US. As global growth recovers inventories should decline, which should support oil prices (lower prices stimulate demand and discourage supply).
Why should currencies be part of the oil story? Recall that the world’s largest consensus trade – to be long US dollars – has dominated global currency markets at least since 2011. Over this period, markets have accumulated ever more USD through a series of consensus trades with relatively weak fundamental groundings, but strong emotional appeals. The first trade in this series was the euro zone debt crisis, which involved buying USD against EUR. When ECB President Mario Draghi killed this trade in 2012 it was replaced by “Abenomics I”, which saw the market buy USD against JPY. When this trade ran out of steam the long-dollar trade moved on to EM, where currencies were sold against USD in the so-called Taper Tantrum of 2013. So far, in 2014, the search for something to short against the Dollar became more febrile: In June’s “Tightening Tantrum” the USD was bought against virtually every other currency in the world. This trade then quickly gave way to “Abenomics II” – selling JPY against the USD to front-run portfolio changes in the enormous Japanese government pension fund (GPIF).
Probably because it is becoming increasingly difficult to find currencies that are genuinely expensive relative to the Dollar the long-Dollar trade now appears to have leapt to commodities, which are the closest proxies to currencies. Lower commodity prices will justify further dollar accumulation, particularly against oil currencies. Indeed, it would be unsurprising if the trade did not soon move onto other commodities too. Gold fell sharply after Swiss voters rejected a proposal to boost gold reserves. As we have argued extensively, the accumulation of dollars is building up technical imbalances that are likely to backfire when the US begins to experience inflation. By then, markets are likely to be “limit-long” dollars against...well...almost everything. This is extremely dangerous.
— John Sfakianakis is with Ashmore Group.
