This article is an on-site version of our Unhedged newsletter. Premium subscribers can sign up here to receive the newsletter every weekday. Standard subscribers can upgrade to Premium here or explore all FT newsletters
Good morning. The good news was the bad news after yesterday’s hot retail sales numbers. Yields jumped across the curve, led by long-term yields, and the Nasdaq fell about 2 percent. Oddly, however, the two-year return increased only slightly. What is the long term trying to tell us? We’re trying to find an answer below, but chime in: [email protected] and [email protected].
A flat market
Around March 20, the stock market stopped growing and started moving sideways. This graph goes back to the start of the rally, last October:
What happened on March 20? On the one hand, during a Fed meeting and press conference, during which Jay Powell reassured markets that despite the CPI inflation reports being too hot for January and February, the attitude of the Open Market Committee towards rate cuts was unchanged:
As labor market tensions eased and progress on inflation continued. . . We believe that our policy rate has likely peaked for this tightening cycle and that if the economy generally performs as expected, it will likely be appropriate to begin reversing policy tightening at some point this year. . .
I don’t want to suggest that Powell succeeded in jinxing the market. Rather, his comments perhaps represented extreme optimism. The market, one might have thought on the 20th, would experience full employment, strong economic growth, steady disinflation, rate cuts and perhaps a pony.
Since then, various things have happened suggesting that we may not be living in the best of all possible worlds. On April 1, an inauspicious date, Israel bombed the Iranian consulate in Damascus, which pushed oil, already on the rise, a little higher (see next point). The next day, Tesla, whose membership in Mag Seven was already tenuous, reported sharply declining unit sales. April 10: Another uncomfortably spicy CPI report. On the 12th, JPMorgan Chase, the world’s largest bank, disappointed the market with its loan margin outlook and its shares fell. Then, yesterday, a blistering retail sales report confirmed the idea that the economy was overheating and the market didn’t like that at all.
Note the mix of different kinds of news. It’s not just that higher inflation and a strong economy suggest rate cut expectations need to be rescinded, but the narrative that technology is everything is being undermined (Tesla), higher rates are biting (JPMorgan ) and global distress is finally making its presence felt (Israel-Iran).
However, the stubborn link between inflation, high growth and higher interest rates over a long period of time is clearly the main explanation for market stagnation. It is not just about expectations of rate cuts, which have been falling steadily since January. But after March 20, real and nominal long-term rates, which had been following a sideways trend, began to recover.
For us, this smacks a bit of a regime change: from an ideal world of strong growth, normalizing inflation and falling rates to a world of strong growth, stubborn inflation and rates that remain quite high – and all this, potentially, for a while.
Why oil jumped
Brent crude prices are at $90, up 17 percent this year. For what?
Obviously, people are worried about the Iran-Israel conflict. A fifth of the world’s oil passes through the Strait of Hormuz and, over the past year, Iran’s contribution to global crude supply has increased by 30 percent to 3.3 million barrels per year. day, or about 3 percent of global production. Any disruption to all of this would be detrimental. The fact that this weekend’s missile and drone attacks on Israel produced a negligible reaction to oil prices suggests that some geopolitical risk was already baked into prices. (Analyst estimates of the geopolitical risk premium are around $5 to $10.)
But market fundamentals have been the most important force behind oil’s rise, surprising many energy observers. In January, the International Energy Agency predicted a “substantial surplus” in oil supplies. In March, its forecast changed to a “small deficit”, a conclusion maintained in the IEA’s latest April forecast. Since February, as fundamentals have become clearer, investors have stepped up their long bets on West Texas Intermediate contracts:
How did we get here? First, demand was firmer than expected. The strong macroeconomic situation that Unhedged reported on was not lost on oil traders. The recovery of the global manufacturing sector (see chart below), strong employment in the United States and the first signs of activity in China are boosting energy demand. Since the end of zero Covid, Chinese demand has remained strong and, in percentage terms, Indian demand is expected to grow the fastest this year.
Second, OPEC+ supply cuts have started to take effect. Combined with strong demand making supply cuts more impactful, the cartel agreed in March to extend expiring supply cuts until June. Some say OPEC+ will ease its cuts later this year, citing significant spare capacity and oil prices above many members’ “fiscal breakeven point,” the price that balances petrostate budgets. But Robert Ryan, veteran energy strategist at BCA Research, takes the opposite view: “History says it was a bad bet to take on Saudi Arabia. [To realise their Vision 2030 economic diversification plan] they want Brent crude prices above $90.
Third, other supply disruptions have emerged. Attacks on Houthi ships in the Red Sea have led to increased amounts of oil stuck on ships. Pemex, Mexico’s state-owned oil company, is cutting exports as part of its self-sufficiency efforts. And cold weather in the United States earlier this year knocked out 800,000 barrels per day of production, leading to reduced inventories that have yet to be replenished.
In any commodity market, you have to ask: will high prices cure high prices? In particular, could the increase in oil production in the United States, the main world producer, fill the “small deficit” predicted by the IEA? There are reasons to think this is possible. As Goldman Sachs analysts point out in a recent note, U.S. oil production in the first quarter was held back by several transitory factors, including unseasonably cold weather, normal seasonality and an oversupply of natural gas (which requires hydraulic fracturing companies to hold back).
As these tensions ease, U.S. producers may begin to respond to rising oil prices. Bradley Waddington of Longview Economics says recent US survey data bodes well for producers scaling up:
WTI oil prices are currently $21 above shale producers’ equilibrium price. [ie, the prevailing oil price needed to profitably dig new wells]. That’s up from just $4 at the December low. The widening of this margin should encourage shale producers to reopen the supply taps. . .
These arguments in favor of stronger American production are confirmed by other indicators in the survey. Shale producers’ investment expectations for the next 12 months, for example, have reached high levels. . . Confirming this, the number of American platforms began to increase
Even if Waddington is right, it’s hard to imagine that increased U.S. supply will significantly lower prices. U.S. energy producers remain constrained by investors’ insistence on capital discipline. This was reflected in the number of drilling rigs, which collapsed in 2023 and is only now recovering. U.S. producers have put aside their “genius for destroying capital,” says BCA’s Ryan, and are desperate to maintain their access to the equity and debt markets by generating free cash flow.
The bottom line is that any future geopolitical supply disruptions could hit an oil market that is, at best, delicately balanced, risking tipping the world into an energy shortage. (Ethan Wu)
A good read
According to a study, passively scrolling Twitter is as bad for your subjective well-being as spending time with people is good for it.
FT podcast not covered
Can’t get enough of Unhedged? Listen to our new podcast, hosted by Ethan Wu and Katie Martin, for a 15-minute deep dive into the latest market news and financial headlines, twice a week. Find previous editions of the newsletter here.
Newsletters recommended for you
Swamp Notes — Expert insight on the intersection of money and power in American politics. register here
Due diligence — News from the world of corporate finance. register here