Oil slides to $45 per barrel.

* Oil slides to $45 per barrel…
* US data is mixed on Monday.
* Commodity currencies take us on a ride…
* STL Fed on Oil Prices and Inflation…

And Now. Today’s A Pfennig For Your Thoughts.

Frank will get things started off this morning with a ‘road report’ from somewhere in the mountains of Colorado:

August 4th, 2015 – Gypsum Creek Road, CO. Gravity. No not the movie, popular as it was. But Newtonian gravity. It was on my mind a lot Sunday as I joined a stack of friends and others for a 27 mile hike around the Maroon Bells in Colorado on the Four Pass Loop. For me it was a step or thousand too far but I am delighted to say I made it all the way. The route crests four 12,500+ passes and roams through vast valleys covered with wildflowers watered by streams and trickles and waterfalls. Back to gravity, it was on my mind a lot slogging up each of the passes, and then plummeting down. No more on this scale like this for me, but I’ll be back to the high country. Sunday night as I staggered into the house in Aspen I emailed Chris Gaffney to say that there was no way I could write a Pfennig intro and promptly checked out until 9am Monday.

Turning on the computer for the first time since Friday Monday evening I was greeted with, well, a similar picture. The euro shows a 1.09 handle which is where I left it. The message from the bond traders shows a little less confidence in the recovery as the ten-year Treasure has slipped to 2.15%. The stock market actually appears to be a tic or two higher, meaning not much has changed. And gold has slipped a few dollars, forlorn and loveless. Oil prices have slipped a little more showing a combination of supply excess and demand reduction. Is the train running out of coal – hope not.

Back here in this remote valley there is especially little change since the late 1800’s. The creek rushes by as always. The beaver dam taken down a hundred yards downstream was rebuilt overnight. Busy beavers! A major storm just blew through and left a blue sky behind. Sticking the chairs next to the fire for 10 minutes provides a dry place to sit. Areas like this appear to carry on pretty much as is for all time. Agricultural economics change the choice of products, technology makes it easier to complete the task and evaluate the opportunity. But it all carries on. In contrast the airport at Aspen had jets parked 4 deep intertwined in the limited space. Got to get back and get at it. Build value, extract value. Now. The world needs both sides to move forward.

Thanks to Frank for setting things up for me this morning. We never really ‘plan out’ what the theme of each day’s Pfennig will be, but usually we end up on the same page – and this morning the markets are mainly concerned with the drop in oil prices which occurred over the past few days.

US light crude prices fell to just over $45 per barrel in trading on Monday and oil futures hit a six month low as oversupply concerns and weak manufacturing data combined to weigh on commodity prices. The poor manufacturing data out of China which I reported to all of you yesterday was followed up with equally disappointing news concerning US manufacturing. The Institute for Supply Management said its national factory activity index fell to 52.7 last month from a reading of 53.5 in June. Manufacturing accounts for just over 12% of the US economy, so the drop in the ISM number was a bit concerning in spite of it holding above the 50 level. On the positive side of the data, a gauge of new orders rose to a seven month high, while inventories continued to decline.

Adding to worries about the US economy was consumer spending which advanced at its slowest pace in four months in June. Consumer spending accounts for more than two thirds of US economic activity so the .2% rise in June was concerning, especially following a stronger .% increase in May. The combination of a slightly weaker manufacturing sector along with lower consumer spending had the dollar bulls taking cover again Monday morning. But the dollar gained some ground as Monday wore on, with stronger vehicle sales boosting sentiment in the afternoon. Wards Total Vehicle Sales increased to 17.46M in July, better than the 17.2M economists had predicted.

The lower oil prices certainly put pressure on the Russian rouble which fell to a new five month low yesterday. The rouble lost nearly 2% of its value vs. the US$ as Brent crude slipped below $50 per barrel on concerns that Iran would be flooding the market with fresh supplies after sanctions are lifted. Commodity currencies are off to their worst start since the financial crisis of 2008 with the Canadian, Australian, and New Zealand dollars all feeling the pressure of lower commodity prices. The Canadian dollar touched the weakest point in over 11 years vs. the US$ as both the Aussie dollar and kiwi traded near six year lows.

But this morning we are seeing a bit of a bounce back by the commodity currencies, led by the Aussie dollar which is firming up after Australia’s central bank changed its policy statement. The RBA dropped a long used reference in its post policy meeting statement which referenced a further decline of the currency being necessary. The markets are taking that to mean the Aussie dollar has reached a level which the RBA is now happy with, so further policy moves aimed at reducing its value won’t happen. The commodity currencies were also helped by a small bounce back in the price of crude oil, as traders in Europe took advantage of the precipitous drop over the past few days.

After spending last week attending a resource conference, the overriding message I have regarding these low prices is that many see them as great values. Time and again I heard resource experts explain that the best time to invest in the markets is when they are near their lows. The real question is how much lower can they go? Unfortunately I don’t have a good answer for that one.

Then there was this. I subscribe to research put out by our St. Louis Federal Reserve, and enjoy reading the opinions and views of our pretty vocal Fed head James Bullard. In the latest issue of ‘The Regional Economist’ I spotted an article which seems apropos for today’s Pfennig: “Oil Prices and Inflation Expectations: Is There a Link?

As the title suggests, the authors of this piece give a quick recap of oil prices and inflation expectations and point out two distinct trends. “First, up to the financial crisis in 2008, we observe a gradual increase in oil prices without large changes in breakeven inflation expectations. Second, since the financial crisis, the two series seem to move in tandem. In fact, the correlation of the two series up to December 2007 was 0.54, while it was 0.75 afterward.3 Also, the figure suggests a break in the mean level of inflation expectations, which falls from about 2.28 percent before the financial crisis to roughly 1.79 percent afterward. It is interesting to note that the correlation between the two variables from January 2003 to April 2015 is only 0.13. The contrast between this low correlation and the high correlation found in the two sub periods discussed above is likely explained by the break in the mean of inflation expectations.”

The paper is pretty technical, but the authors reach two conclusions which I thought were interesting: “that the average level of inflation expectations seems to have decreased after the financial crisis. The fact that the correlation between inflation expectations and oil price was low when measured over the full 2003-2015 period but high in the three sub periods identified in the table suggests that the level shift in inflation expectations after the financial crisis is unrelated to oil price shocks.

Second, only the correlation of oil-specific demand shocks and inflation expectations is large and positive across all sub periods considered in the table. This contrasts with the behavior of the other two correlations. Further, this correlation has increased in recent sub periods. The table, thus, suggests the need to further investigate the nature of oil-specific demand shocks.4”

In layman’s terms, investor’s inflation expectations were lowered following the financial crisis (a bit surprising given the amount of liquidity global central banks have created in response to this crisis). And finally, following the financial crisis the demand shocks which have caused oil prices to drop have had a very close tie to lower inflation expectations. Investors apparently have begun to equate lower current oil prices with lower inflation expectations; perhaps because both are the result of lower global growth.

You can read the entire article by clicking here: https://www.stlouisfed.org/publications/regional-economist/july-2015/oil-prices-and-inflation-expectations-is-there-a-link

To recap, Oil prices hit a six month low on demand concerns and supply news out of Iran. US data was mixed, with the morning data pointing to a weaker US recovery but then the afternoon vehicle sales numbers putting traders in a better mood. The commodity currencies took us on a ride as oil bounced back a bit and the RBA took the ‘currency is too high’ message out of their policy statement. And we ended todays Pfennig with a piece from the St. Louis Fed concerning oil and inflation expectations.

Currencies today 8/4/15. American Style: A$ .7397, kiwi .6589, C$ .7616, euro 1.0969, sterling 1.5609, Swiss $1.0302. European Style: rand 12.655, krone 8.2129, SEK 8.6159, forint 281.07, zloty 3.7865, koruna 24.65, RUB 62.9075, yen 123.97, sing 1.377, HKD 7.7531, INR 63.717, China 6.1177, pesos 16.142, BRL 3.4728, Dollar Index 97.397, Oil $45.76, 10-year 2.1748%, Silver $14.55, Platinum $950.75, Palladium $594.50, and Gold. $1,090.06

That’s it for today. I’ve had a struggle with the computer this morning, and had to end up pulling my computer off of the ‘normal’ network in order to get this finished up and sent out. So things are running a little later than usual but I got it out! I hope you all have a terrific Tuesday and thanks for reading the Pfennig.

Chris Gaffney, CFA
EverBank World Markets