Assist FX Research Note: WTI Crude Oil (sample from December 2016)

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Sample Only: Research note issued December 12th, 2016, exactly as it was released:

Macro Theme: Higher Oil on OPEC/non-OPEC Production Cut Implementation Exceeding Expectations with Historic Cooperation
OPEC/non-OPEC petroleum energy producers will continue to cooperate until the crude oil complex balances in the $55-60 WTI range and beyond. The downside risk of prices falling below $48 WTI have been muted dramatically by the recent supply limiting deals struck in Vienna. On the demand front, fiscal policy in the US will be supportive of infrastructure led consumption gains. Increased US shale production “offsets” triggered at higher levels will take the punch out of one way oil spikes above $60 WTI for the time being, setting up a high probability spot WTI range of $48-60 with a supply constrain-propelled magnetic pull toward the higher end of the range.

Catalyst                                                                                                                                               Non-OPEC producers agreed on December 10th in Vienna at the OPEC Secretariat to production cuts of 558k bpd beginning in January of 2017, as well as being subjected to a committee of three OPEC plus two non-OPEC members monitoring implementation of the cuts. We see sentiment leaning strongly to the upside for the crude oil complex. This is expected to persist until crude prices consolidate in the $55-60 per barrel range toward the end of Q1 2017. The agreed upon reductions are 1.2MM bpd by OPEC members plus 558k bpd by non OPEC members, totaling nearly 1.8MM bpd of cuts from a January 2017 baseline.

What Isn’t Priced In?
Skepticism surrounding the effectiveness of production cut implementation is overdone. The main point to consider is that oil producers are cooperating in a way that hasn’t been seen in 15 years. It is their motivation and willingness to act that is important. They will not allow another price collapse to occur simply because they can not afford for this scenario to play out. Saudi Arabia is against the ropes when it comes to public finances. It needs a bridge period of 5 years of stable prices to transition into fully diversified sovereign wealth investments and raise funds with a successful Saudi Aramco partial IPO. Most other producers have been caught off guard by the severity and persistence of oil market declines since mid 2014, bottoming out at 70% declines.

It is less than certain whether these particular deals struck in Vienna will be the catalysts to propel higher and stable prices. What is closer to high conviction certainty is the incentive for struggling oil exporting nations, and in the case of Venezuela, downright desperation, to ensure the bottom doesn’t fall out of the oil market again. This, along with the preliminary concrete steps already taken in the past couple of weeks, leaves us with a high conviction, favorable asymmetric risk long crude oil market setup. It is crucial to act on this conviction on any notable dips below $52.50 in WTI as the higher prices move, the less favorable the asymmetric risk is for this oil producer cooperation theme. Increased US shale production and strong dollar headlines will begin hitting the newswires as we approach $55 and keep prices in a choppy range between $55-60 for the majority of Q1 2017.

Entry and Exit Levels
WTI crude oil is a high conviction buy at $52.50 per barrel with a target of $60 and stop below $48. Downside risks to this call include, primarily, a breakdown in the implementation of production cuts agreed to at the November 30th OPEC meeting and the December 10th OPEC/non-OPEC meeting. Assist FX’s attendance of both OPEC events bolstered the conviction of this trade idea based on renewed confidence in the oil ministers to follow through on the historic agreements in ways previously doubted by skeptics.

Note: all information issued by Assist FX is for informational purposes only. Trading commodity futures or any leveraged financial instrument may carry high risk. Assist FX and any persons representing Assist FX will not be held responsible for your financial decisions. Please use caution managing risk and take responsibility for your own actions.

This is the Most Important Inflation Chart in the World


The most important inflation chart to focus on right now is that of producer prices in China. It provides a depiction of what is happening with prices at the early stages of production in the largest net exporter nation.

China’s producer prices tend to filter into the rest of the world in the form of exported deflationary or inflationary pressures. After remaining deep in negative territory since early 2012 and registering a long string of consecutive contractions, China PPI has turned positive and is moving sharply higher.

It may only be a temporary spike to 7% that plateaus and then falls off as it did in 2011. According to the models I follow, which directly oppose the more traditional models used by many Keynesian economists, consumer price inflation is an input directly responsible for choking off economic gains. You can’t easily make raw commodities cost less but you can often replace labor with automation at a certain breakeven cost point. Thus, wage gains will struggle to keep up with input-cost led inflation, inflicting harmful economic damage when central banks get behind the curve rather than providing additional stimulus from “running the economy hot.”

In that sense, higher inflation may take care of itself by slowing down growth and threatening to let air out of the massive China credit bubble. Of course, monetary conditions should be tight enough to prevent the type of extreme credit expansion seen in China and elsewhere from happening in the first place. However, we are living in a Keynesian-dominated world of permanent bubble manufacturing after all. But what if the credit bubble doesn’t burst and producer prices keep rising?

If China PPI doesn’t level off very soon and it indeed surpasses 2011 levels, we have ourselves a potential black swan for 2017. Global consumer prices would certainly follow the China PPI trend with or without additional oil price gains (higher oil will only compound the problem). It is too early to know at this stage, but you should be watching the most important inflation chart in the world for further clues as new data is released out of China. We may eventually be headed for an inflationary spike followed by the bursting of the great credit bubble, in which China is at the epicenter.

Market Impacts of Economic Populism and Elevated Debt Levels

The politics of trade protectionism, nationalism, and anti-immigration are the match which will ignite dormant inflationary gasses bubbling underneath the surface after years of short-sighted monetary policy experiments.

Governments have failed for several years to enact meaningful structural reforms that would set economies on a more sustainable path. This is just now beginning to lead to the realization of painful, inflationary solutions. Losses in real wealth and spending power for many advanced economy citizens in the name of “economic competitiveness” and “growing out of debt” are under way. Central banks are somewhat subtly engineering an inflation overshoot as it is implicitly understood that government gridlock, corruption, and incompetence are preventing wiser legislative solutions from coming to fruition. Central banks have been “the only game in town,” as coined by Allianz chief economic advisor, Mohamed El-Erian. In other words, growing out of debt with real growth, innovation, and productivity gains is much less likely at this point than inflating out of it with falling real wages, lower standards of living, and stagflation.

Real average hourly earnings in the US fell by 0.5% in January versus the prior month; nominal wages rose by 0.1% while the BLS CPI-U Consumer Price Index increased by 0.6%. Even excluding energy, nearly any measure of consumer prices leads to a trend of deteriorating real incomes and saving rates going forward. Bank of England Governor Mark Carney has warned of accelerated losses in purchasing power on the way for the United Kingdom.

While the UK’s 20.5% year-over-year manufacturing input price inflation in January was largely inspired by pound sterling depreciation after voting to leave the European Union, the reflation trend is a global phenomenon. Germany, Norway, Sweden, and countless emerging markets including Mexico, China, Chile, Turkey, and Egypt, are experiencing a pace of wholesale (PPI) price increases faster than has been witnessed since at least 2011. PPI increases of this magnitude are generally a leading indicator for CPI to follow suit, though wholesale businesses will absorb a portion of the input cost increases through margin contraction.

I have been warning about building inflation risks for the past couple of years. Contrary to what new Keynesian economic advocates will have you believe with their gravity and logic defying models, there exists a simple mathematical problem of too much debt and not enough productivity to legitimately grow out of it in developed nations with aging demographics.

Prominent demand-side economists such as Larry Summers have been advocating currency debasement, money printing, debt-fueled fiscal stimulus, and interest rate repression continually since the financial crisis. Paul Krugman famously called on then-Fed Chair Alan Greenspan to create a housing bubble in 2002 to replace the .com bubble bust. This cyclical mentality of monetary bubble manufacturing has been blind to the secular economic rot festering underneath those same policies. It has also had unfettered control of the levers within the world’s most powerful central banks for the past 20 years. Financial history books will eventually hold these highly flawed policies and their proponents accountable for doing little other than fueling the next great bubble—the credit bubble. Or, as I alternatively call it, the global QE bubble.

Keynesian economists calling for debt-financed spending, ultra-easy monetary policy, and demand-pull inflation during a period of economic stagnation is nothing new. It isn’t only the usual suspects, however, singing the inflationary gospel now. That is why we are at such a significant inflection point. The populist right is winning political momentum and its policy prescriptions are astoundingly inflationary—border taxes, import tariffs, currency debasement, immigration restrictions limiting the labor market supply, etc.

Economic populism is credited with giving birth to the new political paradigm. Its recent “scalp prizes” were supporters of the UK staying in the European Union and the entire US political establishment. Lines between the traditional political left and right have become blurred in the developed world. Right wing populist candidates are closely vying for power in the least likely places on earth one would expect—the Netherlands (Geert Wilders) and France (Marine Le Pen).

Established politicians and their party infrastructures are more at odds with each other than they have been in decades. Yet, grass roots supporters of what are typically opposing parties have converged as strange bedfellows in supporting several key areas of common ground: reforming global trade rules with the intention of better protecting their own domestic workers, reducing cronyism within big government and big business, decriminalizing marijuana, and protecting civil liberties from government overreach, to name a few.

US President Donald Trump has lashed out concerning a too-strong dollar and flirted with altering a decades-long US strong dollar policy. France Presidential Candidate Marine Le Pen wants to leave the euro currency bloc, take control of the central bank, kick out the immigrants, and print money to fund social spending; and this is coming from someone widely considered to be of the political right wing. What could possibly go wrong? This has not gone unnoticed in the FX market or the French bond market. I’m afraid we haven’t seen anything yet, however.

These inflationary macro trends will continue to surprise many, even if Le Pen is not victorious in the France elections this year. The easy monetary policy leanings of the establishment-left and nationalistic fiscal policies of the populist-right are in alignment. They are both clamoring for a wave of higher consumer prices to erroneously “fix” structural problems of high debt and low labor productivity. It is completely illogical and will only have the opposite effect, but that is beside the point.

I sensed a stronger populist undertone than given credit by the press before the UK referendum to leave the EU and before the US presidential election. My base case doesn’t currently have Marine Le Pen winning the France presidency this year, but there is little room for error in the upcoming election season in Europe. Economic populism is here to stay due to the alignment of interests between grass roots supporters of opposing parties against political elites in general.

Punishing the globalist-minded political elites who have presided over declines in living standards for middle and working class Average Joes throughout the developed world is no longer exclusive property of the hard left. The populist right wants to make its dent in the elites’ armor as well. The result of anti-elite political sentiment will have profound impacts on financial markets for the next several years and some of these impacts are relatively predictable.

Behind the tire marks of the new anti-elite political paradigm exists a trail of how we got here. Gross mismanagement of government budgets globally and the inability of labor to share in the economic gains created during the previous period of high productivity have contributed to a deep structural hole that might prove too deep to escape with a “healthy” type of growth. This is especially the case given the drop off in productivity in recent years and aging demographics. It has also created outrage amongst the masses who feel duped for trying to play by the same rules the elite class gamed in order to gain even more wealth; ie, the carried interest deduction allowing billionaire money managers to pay lower tax rates than electricians.

The current hot topic of “low productivity” is often lazily discussed as if it is the reason real wages have been stagnant (or falling) for decades. Low productivity is more of a post-Great Financial Crisis phenomenon probably caused by a misalignment of corporate incentives. With Zero Interest Rate Policy (ZIRP) and central bank quantitative easing (QE) flooding the capital markets with fresh cash, why invest in new equipment to improve worker productivity when you can simply borrow for a negligible cost and use the cash to immediately fund common stock buybacks, dividends, and M&A? Excessively easy monetary policy distorted market dynamics and reduced incentives to increase productivity. Additionally, governments used the temporary benefits of monetary stimulus as cover to avoid taking more unpopular measures to improve their structural situations.

A decade of global central bank activism paired with several dysfunctional governments did not permanently address very many structural issues. What it did is limit the immediate severity of the 2008/2009 financial crisis, inflate asset prices to bubble territory, boost employment mainly for lower paying service sector jobs, and change the composition of the next recession to an inflationary debt reset rather than a deflationary bankruptcy-based debt reset, thus destroying responsible savers to the benefit of debtors.

What kind of a market environment will persist in a political climate of economic populism combined with excessive global debt? Real wages will take a beating initially, as will fixed income markets. Equity indices will be tugged higher on the illusion of inflated corporate earnings and then yanked lower after resulting interest rate spikes. FX rates will have multiple “Brexit-esque” caliber events, causing pockets of illiquidity and displacements in rates. A targeted Chinese yuan devaluation of 15% or more within 1-2 years is likely as one prime example. Any implementation of border taxes or tariffs designed to protect domestic workers will likely be met with retaliatory actions that will greatly harm those same workers, unless the new trade rules are negotiated and agreed upon by both sides. Bilateral trade deal negotiations and politics could be the chief drivers of global markets for the next five years in the same way monetary policy divergences drove markets in the past five years.

The best case scenario is governments use a period of unsustainable increases in budgets and financing costs over the coming years as political cover to get leaner, more efficient, and more responsive to the needs of their citizens (hopefully this doesn’t cause readers to erupt into spontaneous laughter). In a glass-half-full world, wages will eventually catch up to price increases. Those who are unemployed, retired, renting their primary residence, net savers, or whose incomes are not closely tied to actual inflation will feel like they were on the wrong side of a crash. It probably won’t be a traditional nominal price crash so much as a crash in real terms; however, there could be flashes of both.

Ultimately, the same forces that have always been responsible for real wage increases and higher standards of living still hold true: high productivity, broadly enjoyed technological innovations that lower costs without displacing too many workers, and a peacetime dividend enjoyed during times of no major war conflicts. Does it seem like we are headed toward this scenario?

Remember this: when someone tells you the surest path to economic prosperity involves devaluing your savings, lowering your real wages, and paying down old debt with new debt—run away and call the police—someone is trying to rob you.

Bond Markets Are Sending a Message: No Free Ride for Trade Protectionism and Reflation

It’s all fun and games until everyone tries to sell their government bonds at the same time.

Markets have only begun seriously thinking about what the impacts of a more nationalistic, populist, reflationary economic climate might look like should the same political forces which caused the UK to vote itself out of the European Union and Donald Trump to become the 45th US President materialize into concrete legislative action. One notable impact is a significantly higher cost of financing debt for governments, corporations, and consumers. Marine Le Pen, leader of the National Front party in France and major contender in the upcoming French presidential elections, has a plan to Make France Great Again too. It is a much more pronounced version of Trump-onomics in its aim to protect domestic industry, restrict immigration, and tighten the reigns of its own sovereign control. Le Pen wants France to leave the shared euro currency bloc and introduce a “new French franc” within 6 months of her taking over the highest political office in France. She plans to finance her plans by taking control of the central bank and printing money to fund at least 5% of the government. This is also known as “helicopter money.”

Who in the right mind would want to lend France money with plans like that? Not enough people to keep a bid under the French bond market it seems. Make no mistake – Le Pen is still a long shot for President. She is expected to win the first round of the election taking place on the 23rd of April but handily lose a runoff election to Emmanuel Macron likely to take place on the 7th of May–so say the professional pollsters who have gotten nearly everything wrong in the past two years. Therein lies the problem. Markets are starting to worry. Take a look below at what has happened recently to the France-Germany 10y government bond spread. The higher the spread, the more investors are fleeing French bonds and jumping head first into the relative safety of German bunds. One has to wonder, however, about the wisdom of owning either at this juncture. My base case assumption does not anticipate a Le Pen Presidential victory in France but we will see higher bond yields globally regardless in the next 12-18 months, driven by a new paradigm of populist politics.


Do Words Trump the Data? Probably Not Yet

“Our companies can’t compete with them now because our currency is too strong. And it’s killing us,” Trump told The Journal, referring to competition from China.

The Trump Administration wants to make America great again by transforming it into a manufacturing powerhouse like it was in the Post War glory days. Buy America, hire America. That’s not so bad really. Most Americans are generally on board with this patriotic slogan as long as its implications stop there. But then Mr. Trump takes things a step further with nonsense about the “strong dollar killing us.” By “us,” he means the 13% of the US economy reliant upon goods exports (as opposed to the other 87% more reliant upon domestic services and consumption). Mr. Trump surely isn’t referring to the more than 97% of Americans whose incomes are gained in dollars and whose spending power declines when the dollar’s does.

It is true that, in the near term, sharp increases in the dollar’s value can cause financial instability as foreign debtors struggle to pay back loans denominated in a strengthening currency relative to their own. It also causes the perception of lower US multinational corporate earnings as a portion of overseas earnings in relatively weaker currencies get converted back into stronger dollars at a lower nominal value on the income statement. This is as much a perception as anything because the same relatively stronger dollars that make foreign earnings look lower also have more purchasing power to lower future costs in those same regions.

In the medium to long term, there is absolutely no doubt that a strong domestic currency is in the interest of not just the citizens sharing it, but real GDP as well. Inflation tends to be lower, real incomes tend to be higher, and overall well-being tends to be notably higher in countries with strong currencies and low inflation. This fact has also been the stance of the United States Treasury for several decades. Is Mr. Trump challenging this stance or is he simply using fighting words to get in front of China (or others potentially) before it might need to devalue the yuan? Does he want to be able to say “told you so” if and when the yuan gets devalued with the intention of gaining enough political capital to impose tariffs against China? Who knows. It isn’t heartening that Mr. Trump doesn’t seem to understand how China is actually burning through currency reserves to prop up the value of its currency rather than hold it down as he alleges.

It comes down to this: will market sentiment return to favoring the dollar when US economic data surpasses expectations or have Trump Administration words materially damaged the perception of the long standing King Dollar policy in a way that it outweighs the data? Assist FX sees a continuation of data dependent sentiment for the dollar unless the Trump Administration makes an official move to target “currency manipulation” of trading partners using an executive order or proposed legislation. Markets are hyper-sensitive to Trump Administration commentary right now given all of the actions taken already in the first couple of weeks of its existence but the data will eventually move back into the driver’s seat.