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US uncertainties to take center stage, WTI bounces back
Do not get carried away by oil’s dead cat bounce
After falling as much as 20% in the second half of April, crude oil is making a comeback as the West Texas Intermediate bounced back at around $48 a barrel, up roughly 3% over the week. After the decision of OPEC and its allies to cut supply back in November last year, investors entered into a wait-and-see mode and took their time to assess the effectiveness of the OPEC decision. The market’s enthusiasm was only short-lived but the WTI stabilised at between $48 and $55, during the first quarter at least.
It is quite clear that OPEC is always a trifle late. A few years ago the Cartel, realising that the US shale industry could jeopardise its dominant position in the oil business, tried to nip them in the bud by flooding the market with cheap oil. This move stopped any new investments in upstream exploration and killed the momentum of the US shale industry. However, the move came quite late as North America’s frackers were already too efficient and were able to lower their break-even price well below $50 a barrel.
The problem now, is that OPEC countries are struggling with cheap oil prices, even though their breakeven prices are much lower (around $20 a barrel for Saudi Arabia, for example), as they need a higher price to balance their state budgets. To lift prices, OPEC trimmed production last year and members are currently discussing to extend the cut. Unfortunately for OPEC and its allies, the US shale industry, which does not participate to the cut, is the primary beneficiary of those production cuts. Indeed, the higher the price, the higher the number of profitable US wells.
Against such a backdrop of supply glut and subdued demand, we believe that the recovery in oil prices is quite limited, especially given the current set-up. The cartel has to cut production more aggressively and for longer if it wants to lift prices substantially. Only in the latter case, may we see WTI above $55 a barrel, but again, the primary beneficiary will be the US shale industry.
Focus is back on uncertainties in the US
Just when the President Trump-trade was gaining traction on the congressional passage of the Healthcare bill, new uncertainty threatens to derail the driver. Trump's poor-timing firing of FBI head James Comey has unleased fresh unease within the administration and will challenge his enacting critical pro-growth tax reform. Interestingly, the US and China trade deal reached overnight failed to gather much market positive reaction. At this point markets are unconcerned as volatility continues to contract. However, given the overstretched valuation it would not take much to shift investors’ sentiment bearish.
This trigger and with a pause on scheduled risk events (UK parliamentary elections anticipating a landside Conservative victory and Fed 25bp rate hike fully priced in), sustained low volatility will further push investors into yield chasing, powering the already robust carry trade. We see upside for EM growth outlook above 4.5%, so a bit of support from commodity prices will give EM another strong bound. For today, US economic data will further support USD buying. Recent US data has been surprisingly solid followed by hawkish Fed comments and has pushed US yields higher. Markets expect headline CPI to increase by 0.2% m/m in April, which converts into annual inflation of 2.3%. Excluding energy and food prices, we think core CPI inflation will ease back to 0.2% m/m and annual 2.0% (flowing a fall for -0.1% in March).
We suspect that the reversal of inflation decline will keep pressure on the Fed to hike two or possibly three times in 2017. Given this scenario, we believe the market is still underpriced and should give short-end rates a boost. Higher front-end yield also equates in our mind to earlier discussions on strategies for reducing the Fed balance sheet (indirect tightening).
Retails sales will also be released, after slowing in 1Q February and the March headline fell 0.2% m/m consecutively, driven by weak sales in the auto sector. However, rebound in ISM non-manufacturing indicates that we should see a bounce. We anticipate that April headline retail sales will increase 0.6%. In addition, the markets will get business inventories and University of Michigan consumer sentiment.