Market Opinion
Foreign Exchange
Tough Times For Greenspan
Last week we asked whether the rising oil price would make us reconsider our view of the US economy continued strong growth with mild inflation pressures. The question is all the more poignant this week, in light of the tragic and devastating effects of Hurricane Katrina. Our thoughts are with all those affected.
Then, in our article Living With High Oil Prices, we emphasised the resilience of the US economy something which we still believe and alluded to a potential adjustment in economic activity should energy costs rise further or stay high for a sustained period of time. Now, of course, following the severe disruption to both US oil refining capacity and to the infrastructure network of the Mississippi region, the economic adjustment could be that much larger.
Thus far, the US consumer has been earning enough money to cope with high oil prices. Disposable income increased by around US$440bn y-o-y in July, where as spending on energy rose by US$62bn, just 14.0% of the increase in disposable income. If this trend continues, the US consumer may prove even more resilient than previously assumed, allowing US growth to bounce after what will surely be an inevitable dip.
Of course, much depends on how quickly infrastructure can be repaired and oil refineries return to full operational status, and therefore, importantly, whether the price of gasoline at the pump can ease from its current high level. Reports last week estimated that should gasoline stay at or above US$3.50 per gallon for around two months, real GDP in Q405 would fall to 2.0%. In fairness, this is not unrealistic.
As such, Mr Greenspan is in a potentially tight spot. Recent comments revealed the FOMC in hawkish mode, worried about elevated asset prices and any increase in inflation expectations, which suggests more rate hikes to come. Now, however, the Fed Chairman may well be re-thinking his position. The markets, of course, have their own view, and they are reflecting a more pessimistic outlook for the economy. March eurodollar futures, previously implying an interest rate of 4.40% - almost 100bps over current Fed funds are now implying a rate of 4.00%, only another two hikes of 25bps by the start of Q206. The yield on the 10-year bond has dropped to 4.00%, while the dollar has fallen through the key 1.2500 level against the euro.
Yet, as we wrote last week, just as we are confident about the resilience of the US economy, so we are reasonably confident in the flexibility of the Fed. Mr Greenspan will be paying just as much attention to any oil-induced slowdown in economic activity as to inflationary pressures, eager to keep US growth on a solid footing. At the moment, the odds are in favour of a pause in the tightening cycle, although a clearer picture will emerge over the coming weeks. Against this backdrop, EUR/USD has acted as we assumed last week, breaking up through 1.2350 to the key 1.2500 area. The move through 1.2500 sets up a rally towards the 1.2700-1.2800 area. Furthermore, medium-term portfolio flows have turned EUR/USD positive, an additional sign of continued euro strength. However, if EUR/USD were to slide back through 1.2500, and more importantly 1.2460, then a short-term fall to 1.2350 cannot be ruled out. Key trendline support exists all the way back at 1.2220.
Yet, as the International Energy Agency (IEA) stated over the weekend, the lack of refinery capacity in the US could, in the extreme, turn into a global crisis, not just limiting itself to the US. In any case, while high oil prices are clearly a problem for the US, they are hardly a stroll in the park for the euroland, or indeed the UK economy. Western Europe will grow by 1.3% at best this year, and is very much at risk from a prolonged period of high energy costs. As such, while the risk for further dollar weakness over the coming weeks remains, the euro will not have things all its own way in the medium-term. That long-term head and shoulders pattern on the monthly chart is really taking shape.
As for oil prices, the short-term sell-off to which we alluded last week may actually now be starting to happen, despite Hurricane Katrina. News that the US government is releasing oil from its strategic reserves and that the IEA is to release 2 million barrels per day over a 30-day period from its emergency reserves which also include refined products - has capped prices for now. We expect further downside this week. However, key support for front month Brent exists in the US$61.00-62.00/b area, with major trendline support at US$56.00/b. That said, we only expect a short-term decline at this point. Prices will stay high in general, with the risk of spikes higher still very much in place. Indeed, with demand remaining strong, especially from places such as India and China, supply side effects whether they be strikes in Nigeria or Venezuela, geopolitical tensions in Iraq and Iran, or hurricanes in the Gulf of Mexico become that much more acute. Anyway, heres our favourite statistic only 0.7% of the Chinese population own a motor car.
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