On The Energy Cliff's Early Warning Signal
The XLE closed yesterday at 63 - only a buck above the June 1 lows. For the year, XLE is now down a whopping 8 bucks. And of course oil, which started the year at 103 and peaked at 110, has dropped to 78. Jefferies David Zervos offers some critical insight into the energy sector bloodbath in the last few months, which of course begs the question - what in the world is going on? Shouldn't all this accomodative policy by the Fed, ECB, SNB, BoE and BOJ be sending commodities to the moon? The BoJ has been implementing additional QE, the Swiss have been printing francs at a breakneck pace to hold the peg, the BoE just announced the ECTRF (Extended Collateral Term Repo Facility), and Ben just extended the twist for 6 more months. Of course the ECB, as always, has been behind the easy money curve - but all signals point to some action in July: an MRO cut, a depo cut and some relaxation of the collateral lending rules. Maybe we even get another LTRO. So back to the original question; if the worlds' central banks are so easy, why is energy collapsing? And how can gold be unchanged YTD?
[ZH - As an aside - Oil priced in ounces of gold has slipped back to an important level here]
The answer is straightforward - central banks are NOT being accomodative enough. These downward trends in the energy and commodity complex should be a warning sign to anyone with a "price stability" mandate. There is a hefty disinflation trend developing and given the amount of debt in the system - and the weakness of global aggregate demand - any signs of significant disinflation should be cause for grave concern. We cannot mix a lot of debt with a lot of deflation - that will be the end of us!! That is Irving Fisher 101!
And while it may not be "common wisdom" to assert that our global central banks are being too tight, the proof is in the prices. A large sustained drop in energy costs at this stage of the reflationary game is VERY unsettling. It is the surest sign that monetary policy is too tight!
That said, I suspect it will not take much for us to see further action. US headline inflation has a one handle and is falling fast. Europe and UK are most likely in recession. And Japan still has deflation. The central banks have "talked the talk" when it comes to accomodation, but they have not "walked the walk". However, when push comes to shove in this post 2008 world, they always come through.
So while this move in the energy complex is unwelcome news on the reflation front, it does have two important positive side effects. First, as alluded to above, it lowers the bar for more accomodation to support a reflationary recovery. And Second, it has positive supply side effects. Cheaper energy will give a boost to consumer and (non XLE) business sentiment. The supply side implications for this energy drop are very supportive for the growth side of the reflationary equation, particularly in the US. But the positives on the supply side will hardly outweigh the negatives on debt/deflation side given the size of the debts.
For now we should look at this energy cliff as an early warning sign for stress in the system. And as such we should expect the usual central bank backstopping to come out in force if this trend picks up material steam! Its the same old story, reflation or bust - and I'm still betting the central bankers deliver the former! Good luck trading!