Why the Fed’s QE is About to Move Oil Prices
Recently, I talked about how crude was beginning to occupy a position as a store of market value (“Why Oil Is Becoming the New ‘Gold Standard,” May 20, 2013).
The development has been a direct consequence of the flight from holding gold.
That flight may be tapering and a new floor established for the next major spike by the metal. The problem is there is no agreement on which direction that move will be.
These days, a sudden improvement in gold prices may only extend as far as hedge funds and institutional investors covering shorts.
Nonetheless, there is an interesting parallel developing between the plight of gold and oil prices.
The Consequences of Quantitative Easing
It results from what is becoming a popular mantra – Fed policy has resulted in the creation of phantom assets, a curious rise in bond rates despite the continuing central bank buying of U.S. Treasuries and related paper, and the specter of another asset bubble forming.
Now I have several points of issue with the underlying assumptions of this approach. Yet that is not the focus of this OEI.
My focus today involves an unattractive (one of several) consequence of the Fed’s Quantitative Easing (QE) policy.
Despite buybacks, U.S. Treasury prices have been declining, resulting in a rise in yields (interest rates). A number of economists have argued that this will require the Fed to initiate policies supporting bond prices.
That move will almost certainly fuel the fires of inflation. Such concerns have been there all along with QE.
According to an increasingly held approach by some economists, holding rates at 0% for eight consecutive quarters would result in significant inflation anyway. Nobody knows for sure because the current experiment has never been attempted before.
Nevertheless, widening uncertainty about navigating such uncharted waters has discounted the view that QE could ever be a long-term strategy. It may also explain the conflicting statements coming from Fed members over when the bank gets out of the surrogate money business.
Oil Prices and Quantitative Easing
And this brings us back to the potential impact on oil (and gold).
I have made the observation that Fed policies cannot sustain a prolonged non-market-induced growth cycle. One blunt truth results from rising interest rates in the face of QE (especially at the longer end of the curve) – the bond market is expecting higher inflation levels moving forward.
In an interesting column yesterday, Minyanville’s J.W. Jones provided a nice connection. Entitled While the Fed Parties, Gold and Oil Have Left the Building, the piece is based on more detailed analysis done earlier by staff at none other than the Federal Reserve Bank of New York.
Called The Forward Guidance Puzzle, this is a thought-provoking piece.
Jones observes that, “If the printing presses fire up fast and furiously to help put a floor under Treasury bonds (cap rates), what is going to happen to commodity prices such as oil?”
As the article illustrates, a coiled price pattern develops that ultimately will lead to a strong move in price.
The NYMEX futures crude contract closed yesterday above $96 a barrel. According to the “coiled pricing pattern,” that is already in the $96-$98 range that would drive prices up above $110.
Of course, market dynamics could then put on the brakes for a range of reasons. That translates into the “coil” directly or indirectly producing a rapid movement in price.
Here’s the interesting observation: the Fed’s policy actually will intensify that price change, regardless of its direction.
According to Jones’ analysis, “gold futures are also in a basing pattern after selling off sharply… Similar to oil futures, gold futures prices are coiling up as well and could go [in] either direction.”
Once again, the Fed cannot prevent it.
However, combining the concern over consecutive quarters of 0% in the bond market (an assumption of higher inflationary pressures) and the qualities exhibited by both oil and gold prices nicely illustrated by Jones’ charts, would likely result in liquidity rapidly moving into commodities as soon the Fed tries to support bond prices (and restrain bond yields).
A fair amount of that liquidity results from the “quick fix” paper printed for QE. It is not based on the generation of assets or wealth; rather, it results from central intervention.
But there is nonetheless one takeaway. The corner the Fed has painted itself into with QE will require addressing the bond panic.
And that is going to result in higher prices in the energy sector.