Fed Rate Cuts Can Backfire by Lifting Crude Oil Higher
After Wall Street’s dismal start in 2008, there is a growing unease within the Republican Party that this election year could be one of scanty returns. The highly accurate “January Barometer” states that as goes the stock market in January, so goes the year. Since 1950, the “January Barometer” has a 91.2% accuracy rate. Food and energy prices remain stubbornly high, thanks to a chronically weak US dollar, and is sapping the pocketbooks of the US consumer.
Bernanke’s magic potion for whatever ails the US economy is: Fed rate cuts and massive money injections into the markets, dropped from helicopters and B-52 bombers. The Fed was scheduled to convene on January 30th, but held an emergency meeting after stock markets plunged in Europe and Asia, while Wall Street was closed for a holiday. Bernanke rode to the rescue of the badly shaken stock markets with a 0.75% rate cut to 3.50%, the biggest injection of morphine in 23-years.
But little thought was ever given to the destabilizing impact of big rate cuts on the US dollar, which can unleash hyper-inflation into the US economy, if it goes into free-fall. In the second half of 2007, the Fed’s rate cutting campaign back-fired by igniting an explosive surge in crude oil, grains, and precious metals, which in turn set off a whole new round of global inflation.
“The dollar is a terribly flawed currency. The US is now the biggest debtor nation. What is more terrifying, the US is going deeper into debt by $1 trillion every 15-months. Loose money is not the answer to problems in the United States, and Bernanke is making horrible mistakes. America has given him the printing press, who knows how fast they will run it when we have serious problems,” said famed hedge fund trader, Jimmy Rogers, on October 24th.
The Fed rookies were caught by surprise when global traders turned to “black gold” as a hedge against a weaker US dollar and double-digit money supply growth, the twin engines of inflation in the US economy. With the Dow Jones Industrials already hobbled by worries over $1.8 trillion of toxic sub-prime mortgages and slumping home prices, it was the Global “Oil Shock” that lifted crude oil to $100 per barrel, and ultimately tipped Wall Street into a horrific slide in January.
Until recently, high and rising oil prices didn’t disturb the bullish psychology of global stock market operators. Instead, the spin surrounding soaring oil prices depicted a positive story of strong demand from unprecedented growth in the world economy. Depending on how the adjustment is calculated, $38 a barrel for crude oil in the 1970’s would be worth around $96 to $103/barrel today, and was not viewed as a serious threat for the global economy and lofty stock markets.
But historically, “Oil Shocks” have tipped the global economy into recession. The Arab oil embargo of 1973-74 and the Iranian Revolution of 1978-79 triggered unprecedented increases in oil prices and were associated with worldwide recessions. Most US recessions in the post-World War II era were preceded by sudden spikes in oil prices. And on average, the S&P 500 Index lost 26% of its value during the past 11 recessions since 1945. The Australian stock market has undergone seven brutal corrections since 1960, losing an average of 34 percent.
President Bush went on a high stakes mission to Saudi Arabia to knock the price of “black gold’ lower. Speaking to reporters before his key meeting with Saudi King Abdullah on Jan 15th, Bush said, “When consumers have less purchasing power, it could cause the economy to slow down. I hope OPEC nations put more supply on the market. It would be helpful,” he added.
But Bush appeared to come home empty handed, when influential Qatari Oil Minister Abdullah al-Attiyah said on Jan 16th, “I don’t think the market needs more oil. The recent drop in oil prices shows that there was no shortage of supply. OPEC needs to be cautious ahead of the seasonal drop in consumption in the second quarter and because of a possible US recession, which could weaken demand,” he added.
King Abdullah must walk along a tightrope, balancing his military patron’s request for more oil against Iran’s opposition to further increases in output, which could hurt Tehran’s oil revenue. On Dec 5th, Iran’s President Mahmoud Ahmadinejad scored a big victory when he convinced king Abdullah to join the hawks of OPEC – Iran, Libya, and Venezuela – and hold the cartel’s oil output steady at 27.25 million bpd. Riyadh wants to stay on good terms with an eventual nuclear armed Iran.
“Our position is that demand and supply are balanced and there is no need to increase oil to the market,” said Iranian Oil Minister Gholamhossein Nozari. On Jan 23rd Libya’s oil chief Shokri Ghanem said, “We don’t think the market needs more oil. What we see is the operation of speculations and geopolitics.” Indeed, OPEC’s benchmark crude prices have already tumbled 10% to $84/barrel amid speculation that a global economic downturn might dampen demand for energy.
The Saudi royal family is disturbed by the sudden plunge in the local stock market over the past two weeks. The combined market capitalization of the seven Gulf equity exchanges has fallen by 15% or $170 billion from a week ago. The Saudi Tadawul All-Share Index took the worst hit, losing 21% of its value, while Dubai market indexes in the UAE have seen their shares drop 15%.
Most likely, Riyadh will decide to keep oil prices elevated within a higher target zone to sustain the enormous flow of petro-dollars to the Gulf, and support the stock market by deciding to leave its oil output unchanged at the upcoming Feb 1st OPEC meeting in Vienna. The six Arab oil kingdoms in the Persian Gulf held foreign assets worth about $1.9 trillion at the end of 2006. The stash has probably grown to $2.5 trillion today, and how they invest the funds will have big impacts on the markets.
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