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This Week on Wall Street
**Crude intentions, more scary rhetoric from Iran and a new high on the 10 year. Although the trading week is shortened due to the observance of Good Friday, there was no lack of action.
Crude oil made a strong move higher this week as fears over troubles with Iran just won’t go away. While fear often moves markets, there needs to be an underlying fundamental factor that will indeed verify these movements on fear. And the fundamental factor involved with the movement in crude (on this fear over Iran) is indeed a supply/demand issue… quite fundamental.
With Iran nearing the UN imposed deadline to halt their enrichment program (April 30th), the likelihood of sanctions being forced upon them grows. From Iran’s point of view, sanctions may not be as damaging as we believe them to be… in fact, sanctions may damage the global economy more than that of Iran… I’ll explain in a moment.
Iran has been collecting oil dollars at record rates over the past few years as oil rose from $20 per barrel to its current levels. This extra influx of cash has allowed the nation to stockpile weapons, foodstuffs, medicines and payoff dollars (for certain United Nations officials). In short, they’ve been preparing for this… and they’re ready.
This week, Iran announced it had successfully enriched uranium (albeit only to about 3.5%) at one of its facilities. The announcement alarmed the world and confirmed that Iran has no plans of halting their program by the deadline. The country said they would push ahead with plans of further enrichment to the point where at least power generation levels are reached, but more likely to a grade that is suitable for nuclear weapon production.
This announcement sent shock waves through the oil market and through the pentagon. Iran’s in the power position here. If sanctions are imposed, the nation has the ability to retaliate without war by pulling its share of the global crude supply off the market. Iran has about 10% of the world’s known crude oil reserves. Pulling this supply off the market will create massive shortages, skyrocketing prices and a fall in global economic output.
With the supply/demand equation already in a very tight balance (production of crude is near full capacity), a removal of just 2 million barrels per day (Iran pumps about 4 million barrels per day) from the global market will cause a shock (think Katrina)… and Iran, the US, Europe and Asia know this.
This leaves us in a pickle. We have to act on this or face the possibility of a rogue nation acquiring nuclear technology. Diplomacy is not working. Their clear defiance of the UN mandate showed us that they do not care what we, or the world think… that leaves us with few options… all of which will increase the price of crude.
At the market: Crude oil continued its march to $70 per barrel this week and is showing no weakness, except for the occasional technical pullback. Having moved through $65.50 in late march (the resistance line as shown in the chart below-middle line), crude established a new support zone which now looks to be at $66 per barrel.
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Even though a report on Wednesday showed that oil supplies jumped to an eight month high, crude is drifting higher on that supply shock concern. The chart shows where resistance sits (top line: the highs established during this past hurricane season—note, the above chart shows the hurricane spike in December to January and not during the actual events as this current chart was months in the future). This resistance, if broken, could easily become a support area with the possibility of $80 crude very real.
Current support for crude, the center line, is on an upward slope and is around $66 per barrel with longer term support being the bottom line near $62. Should this Iranian crisis cool off, crude will likely grade back down near the bottom support line until the supply/demand equation sets new prices. But for now, stay long until at least $70.15 then hold. If crude moves above $70.85, continue buying. If a drop in prices occurs, sell and short down to $66. More on crude next week.
This week, the yield on the 10 year note rose to near four year highs, surpassing 5%, foreshadowing rising costs for mortgages and corporate bonds. The action in the 10 year has equity investors concerned that the Fed may need to continue to raise rates as the market is predicting better economic news ahead.
Paul McCulley, managing director at PIMCO said “this (5%) is a very important level… how far will it go above 5? I don’t know. Markets have a tendency to overshoot.”
The problem with the 10 year yield moving higher is simple. It’s anticipating higher rates to come and is adjusting ahead of future perceived news. The 10 year is telling us that the Fed will continue to raise benchmark rates to slim cash in the market and a slowdown in equities is expected as borrowing costs increase.
But, as Mr. McCulley insinuated, the 10 year yield may be a bit overextended and the likelihood of buyers entering the market has grown. Buying the 10 year will push the yield lower as price and yield move inversely to one another. At this current level, buying the 10 year looks to be a very good bet.
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Ben Bernanke has said that energy prices are not significantly affecting inflation so stocks seem to be able to absorb high energy prices, yet the 10 year is telling us that inflation is going to be hitting the market in a big way and stocks may fall. How can this be?... who’s right?
Well, it seems that the 10 year may be right this time. Bond traders feel that the jobs market, which has gotten very tight and looks to tighten further, may cause wage inflation. Personal income has risen and jobs creation is still high. This means that with more people working, and workers earning more, prices for goods should increase as more dollars chase the same amount of product… inflation.
However, a rise in consumer spending should lead to more industrial production to keep up with demand (industry can adjust to the market faster than inflationary pressures appear)… which should wipe out the worries over wage inflationary pressure… if it appears at all. So this brings us to our conclusion on the 10 year… it’s wrong! Buy the 10 year when the yield touches 5.2%… the yield is going to fall, and the price is going to rise. We are expecting more Fed rate hikes at this point, but we feel a neutral level (that which neither hinders nor helps the economy) is 5.25%. Until next week…
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