The Big Elephant In The Room: Oil

Markets

US equities were little changed Monday, S&P flat. US rates sold off, 2yrs up 18bps to 2.12%, 10yrs up 15bps to 2.3% (highest since May 2019) after Powell hinted at >25bp hike increments. Oil up 7.7% amid growing political and public support for an EU-wide ban on Russian oil purchases

There has been a lot of debate as to why risk sentiment has been so resilient amidst severe global macro risks. The war in Ukraine is far from over; flattening yields are signaling increasing recession risks as central banks are getting more hawkish, and globalization is broadly retreating as firms and governments are re-shoring supply chains. A moderately toxic cocktail by any standard. 

But we might be seeing an upbeat mix of the previously very successful "buy-the-dip" or TINA ("there-is-no-alternative") mindset and recognizing that the US economy remains robust. And unlike the 1970s oil price spike when OPEC cut production and restricted exports, the US is not facing a lack of supply, only higher oil prices. So to a degree, the US is much better positioned and insulated to weather the oil price storm.

So now I guess the question is, at what point will hawkish central bank policy dent that sentient?

I sense that the Fed might well deliver 50bp hikes in both May and June as policymakers recognize it will be tough to get inflation down without higher unemployment. So as long as multiple 50bp hikes remain on the FOMC agenda, stock markets could remain nervous.

Oil

Attacks by Houthi rebels over the weekend on Saudi energy infrastructure added to an already high geopolitical risk premium in oil, with supply concerns in the Middle East compounding concerns related to current and future Russia sanctions.

Adding fuel (jet) to the oil price rally, Hong Kong was lifting COVID restrictions. Starting from Apr. 1, Hong Kong will lift the ban on countries like the US and UK. Also, the city will stop classifying overseas regions into different risk categories. This move could be an essential step for China to gradually cede its COVID Zero policy.

Meanwhile, the big elephant in the room is US President Biden, joining the NATO meeting and EU Summit this Thursday in Europe. Sanctioning Russian oil is likely to be a topic of the meeting's agenda. 

Forex

This week opened with USD generally trading bid. On the back of a hawkish Fed Chair, the OIS market was pricing in 43bp for May now, 73% probability for a 50bp hike. I expect it to go to over 90% if not 100%. And with Powell suggesting the Fed will hike by more than 25 bp if needed, I suspect traders will start to price in back to back 50 bp hike, especially with oil prices doing another moonshot threatening to trigger hyperinflation.

Last week the ECB announced an accelerated tapering of APP net purchases in Q2 and a conditional expectation that APP net purchases will end in Q3. The ECB has taken a step closer to exit with this new guidance; whether the ECB walks through the exit and raises policy rates before year-end depends on the data.

The commodity price spike following Russia's invasion of Ukraine did not occur in a vacuum, but underscored energy prices rising from late last year.

G10 currencies have followed the "terms of trade script," energy importers underperforming exporters fairly linearly during this period. 

EUR 

With no progress on peace talks, reports are circulating that the EU is setting the table for a Russian oil embargo. Higher energy prices will hugely harm the EU economy and damage the euro without a comprehensive backup energy plan. That said, it's unlikely the EU is going into this blindfolded and contingency plans are in place to offset higher energy prices.

Also, Central Banks will continue to tighten policy regardless of their relative energy exposure. The ECB moved further along by accelerating the pace of QE tapering two weeks ago despite sizeable downside revisions to regional activity projections. With optionality and data dependence now taking over from forwarding guidance, the Bank has quickly realized that the low inflation regime may be a thing of the past.

CHF

The Swiss National Bank's weekly sight deposits were up to some CHF800 mn and roughly CHF3.2 bn over the last two weeks as EUR/CHF briefly dropped below parity. 

The SNB likely hit the alarm bell speed of Swiss appreciation below parity and stopped it, but I don't think they will try to weaken the franc at current levels. A stronger franc helps keep price pressures under control. The main reason is inflation which could push towards 3% if oil makes further gains above $115.

CAD 

CAD's underperformance relative to oil exacerbates the inflation problem and unties the BoC's hands, with markets now pricing in a 50% probability of a 50bp hike in April. This should keep hikes front-loaded, raising the chances of long CAD finally starting to deliver a much better performance than of late. Provided the "risk-on" channel remains supported, USD/CAD could soon be testing 1.2500.