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Central Bank Action Could Send Oil Higher

Nick Cunningham

Faced with an economic slowdown, the European Central Bank indicated on Thursday that it was planning for an interest rate cut for the first time in more than three years. U.S. equities sold off on the news.

The ECB also hinted that it may restart large-scale asset purchases later this year, hoping to provide a jolt to the Eurozone’s flagging economy.

Next week, the U.S. Federal Reserve is widely expected to cut interest rates by either 25 or 50 basis points, although analysts see the smaller cut as more likely. It will be the first rate cut in a decade, and arguably provides evidence that the central bank tightened a bit too quickly last year.

“We see evidence that the global economy is in a slow-growth mode with weakness in Europe, Japan and emerging markets,” Terry Sandven, chief equity strategist at U.S. Bank Wealth Management, told the Wall Street Journal. “That provides support for central banks around the world to continue with a dovish easing policy.”

The economic outlook “is getting worse and worse,” Draghi said at a press conference on Thursday. “Basically we don’t like what we see on the inflation front.”

At the same time, the rate cut from the ECB puts more pressure on the Fed. Currencies are all interconnected, so as a rate cut pushes down the euro, the U.S. Fed will come under pressure to cut as well so as not to see the dollar gain too much relative to the euro. President Trump even recently acknowledged the dovish moves by Mario Draghi, the head of the ECB. “What Europe did with Draghi, is they’re forcing money in,” Trump said in June. “We’re doing the opposite.” He then added: “We should have Draghi instead of our Fed person.”

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A series of other rate cuts have been seen around the world, including in Indonesia, India and Malaysia. Morgan Stanley says that additional rate cuts will continue into 2020, and the shift in outlook from the Fed and the ECB provide central banks around the world with more room to maneuver.

Rate cuts on currencies and commodities can be interpreted in different ways. On the one hand, they are a sign of economic concern, and the dip in U.S. equities on Thursday is evidence of that. Draghi was clear that he was worried even though he said that the odds of a recession are low.

On the other hand, rate cuts can provide monetary stimulus, juicing the economy. As central banks try to outcompete and keep pace with one another, the whole of the global economy begins to see looser conditions. For oil, the effect tends to be bullish, particularly when the U.S. Fed cuts rates. Oil is priced in dollars, so as monetary easing from the Fed weakens the dollar, it makes oil more affordable around the world. The result is higher demand and upward pressure on oil prices. 

However, monetary stimulus only works insofar as it provides a boost to the real economy. Manufacturing data has been poor around the world. On Wednesday, Caterpillar reported disappointing figures, as did some rail companies, and investors took the bad news as a proxy for weak industrial demand. Auto sales have been weak around the world. It’s unclear if small rate reductions will be enough to reverse this trend.

Worryingly, should an economic recession actually hit, central banks – particularly the ECB – have little firepower left to call upon.

The news is not all bad. Durable goods orders rose by an unexpectedly strong 2 percent in June, assuaging fears of a slowdown in the United States. Also, corporate earnings from the second quarter are coming out now, and so far the results have exceeded expectations.

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The pace of oil demand growth will be greatly influenced by the trajectory of interest rates and economic growth.

The latest oil data from the EIA was a bit clouded by the Hurricane Barry, which shut in roughly 1 mb/d of oil production in the Gulf of Mexico for a period of days. The EIA’s weekly figures showed a 700,000-bpd decline in production last week, and crude stocks fell by a massive 11 million barrels as a result. The decline in stocks would normally be a signal of strong demand, but traders are not sure whether the declines will continue after production fully resumes following the storm.

“Despite the bullish supply-side fundamentals and geopolitics that support oil prices, it seems that the market needs a positive economic catalyst to move appreciably higher,” Harry Tchilinguirian, global oil strategist at BNP, told Reuters.

By Nick Cunningham of Oilprice.com

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