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The theme of heightened two-way volatility in financial markets has not disappointed this week, with choppy price action in oil driving market sentiment and fueling risk appetite.   The sideways price action in hydrocarbon market has allowed global equities to heal, with the defense of the $25 level in WTI easing concern a further deterioration in price is imminent, and the calls for $10-$20 are fading from participants’ short-term memory.   While we continue to believe oil south of $30 level provides long-term value, we also recognize that a bottoming process can take some time to carve out, and that the short-term fundamentals are still not constructive to a sustained recovery in black gold.   It is likely that moves below $30 will allow those to further trim their short position and fuel speculative rumors that production cuts may materialize thus leaving the risk/reward proposition for fast money and speculative investors skewed to the downside; however, it is unlikely that in the near term the supply and demand dynamics of the oil market find an equilibrium, and as such there is limited upside potential for the hydrocarbon market short-term.   With the global demand picture remaining weak as China muddles through a transitional phase of sustainable growth, it will be the supply side that has the greatest chance of adjusting to new market dynamics, yet the lag from declining production in the US shale market will take some time to materialize due to rig shut-downs and closures in an over-leveraged sector that will continue to shutter operations as oil remains depressed.   Later this morning we will get the Energy Information Administration’s report on crude oil inventories from the previous week, and investors will be closing watching to see if the build is materially different from what analysts are expecting.   A bigger than expected build in inventories will keep an offer tone permeating through the hydrocarbon market, where at the time of writing, front month WTI is heading into the low-$30s.

While the effect of the EIA’s report will drive price action in oil this morning (and by extension risk appetite and equity performance), investors will also be keenly focused on the FOMC rate decision this afternoon, ready to decipher any changes in tone or language from the Fed in order to glean clues as to the potential path interest rates will follow in 2016.   It is hard for investors to get any less optimistic about the interest rate trajectory in the United States this year, with the Fed Funds futures pricing in close to zero chance the Fed hikes rates in March, and factors in only one hike over the course of 2016, whereas the Fed has forecasted an increase of 25bps at roughly every second meeting.   The language around the international situation and what consistently low energy prices means for the Fed’s inflation target will be forefront on investors’ minds, though in our opinion the pendulum of expectations has swung too far to the dovish spectrum heading into the announcement, and while it is likely the Fed will mention the need to be cautious given the turbulence in capital markets and the downward pressure on oil prices, they won’t say anything to rule out a rate hike in March.   While the dollar index has been ebbing lower towards the bottom end of the upward trend channel, with the balance of risks ahead of the FOMC decision today, in our view there is a higher probability from a more optimistic than forecast statement that alleviates the offer tone on the big dollar.

Further reading:

Get the most predictable currency pairs list

Fed decision: hard to keep it balanced – 4 scenarios