Stock market rally despite oil deal collapse could reinvigorate US dollar at some point

The collapse of the deal to freeze oil output at the Doha meeting on Sunday came as a big surprise to market participants, as major producers such as Russia and Venezuela had invested significant efforts and political capital into it. In the end, it looked like Saudi Arabia was still not on board, as they blamed their foe Iran for not signing up to the deal but this might have been just a pretext for the Saudis to keep the market oversupplied and not let high-cost producers catch their breath by pushing prices higher. In any case, it looked like world oil supply was indeed coming down because of the lower prices, as the rapidly falling rig count in the United States showed. Nevertheless, oil producers such as Russia still appear to be ramping up production. The issue of a production freeze will now be discussed at the June OPEC meeting, although given the low level of cooperation and coordination on display in Doha, expectations are likely to be low.

What was very interesting was the market reaction to these events. US oil futures gapped down by over 5% during Monday’s Asian open, but by Tuesday’s European session start they managed to close the gap by rallying all the way up to the same level they were at prior to the Doha meeting. The recovery in oil prices seemed to help risk assets climb around the world, as many stock indices in the US, Europe and Asia rallied to fresh multi-month highs.

Risk and monetary policy

Risk assets were also helped by Fed speakers that remained supportive of the case for keeping interest rates unchanged for the time being. Indeed, risk assets may be taking heart from the fact that the world’s major central banks are either in easing bias (ECB, BoJ, PBOC) or in roughly neutral mode (Fed, BoE). This has apparently opened the door for many markets to rally and commodity currencies, traditional beneficiaries of positive risk sentiment and rising commodities, also climbed to multi-month highs.

It should be noted however that if the party in financial markets continues and stocks – particularly in the US where the S&P 500 is just 1.5% from an all-time high – continue their advance, it could arm the remaining few hawks within the Federal Reserve with some powerful arguments. Firstly, that the ‘caution’ the Fed is showing with respect to domestic and global economic developments is in sharp contrast with the market’s assessment that the economy and companies are expected to do ok. Secondly, hawks can also argue that it might be loose monetary policy that is at work, helping asset prices rise higher and creating new financial stability risks. Taking precautionary measures with measured rate increases could make more sense now.

To sum up this argument, although the dollar has been an underperformer since the beginning of the year and has fallen further during the past two sessions, more gains by risk assets might start to force the Fed’s hand towards a tightening bias, which could lead to a recovery for the greenback. Therefore, Fed speakers, especially Yellen, Fischer and Dudley, will be followed closely by investors for hints of any change in the outlook.