Oil may bottom out around $50, but only after it sees $40

Outlook:

Today’s ends the last full week of the year, if that means anything. It seems as though every year brings thinner and thinner markets around Christmas and year-end. As a result, markets are jittery. What we mean by “jittery” is that second or third-tier data can have an outsized effect, or first-tier data can have none. Today we get the Atlanta Fed business inflation expectations and the Kansas City Fed manufacturing survey. Yawn or freak-out? Probably nothing here. Last-minute end-of-week and perhaps end-of-year positioning will count for a lot more. We can look at charts to see what’s overbought or oversold and guess at corrective countermoves, but “guess” is the important word.

Whatever happens to oil prices and in Russia over the next week or two, we see two developments coming down the road like a 10-ton truck. The first is that it ain’t over for oil. The bottom may end up being $50 but to get there, it has to try $40 first. This is just the way market prices work, especially in a market as flighty as oil. The FX market is a bastion of sanity and reasonableness compared to oil, and we don’t even have supply and demand data.
Expected volatility in oil, including to the downside, means Russia and other emerging markets are well and truly in the soup. Russia has it worse because sanctions exclude it from Western markets. Russian companies are calculated to have about $600 billion in external debt, according to the FT, and the Russian parliament just passed a bill raising bank capital to help these companies wean themselves off dollar debt that cannot be rolled over due to sanctions. Gazprom will probably be okay—it earns dollars, but not every debtor companies has dollar earnings. Russian companies are like the Hungarian households that took a Swiss franc-denominated mortgage—without a Plan B.

The BIS is alarmed, to say the least. The FT writes “According to BIS data, there are some $2.6tn of outstanding international debt securities from emerging market borrowers, three quarters of which are issued in dollars. A significant slice of this is being serviced by revenues earned in domestic currencies, the BIS believes, although it is not clear precisely how much. In addition, international banks have extended some $3.1tn hard currency loans to emerging market borrowers, with a particularly stark increase in places such as China.

“This means, somewhat remarkably, that corporate leverage in regions such as Asia is considerably higher today, relative to gross domestic product, than it was before the 1998 Asian financial crisis, as Frederic Neumann of HSBC notes. What is even more alarming is that these numbers might understate the risk since many emerging market companies have been using offshore vehicles to raise funds — and those flows are not well tracked.”
US rates (and possibly UK rates) do not actually have to rise on official central bank policy action in order for these debts to be forced into default. It will be enough for creditors to dump the borrowers and decline to renew, exactly what is starting to happen in Russia. We don’t know if we will get another 1998 or maybe a 2008, but the flying stock markets should not distract us from the potential calamity in EMs. Again, US yields possibly down to 1.25-1.35%, removing dollar support.

Happy holidays. We will return Monday, Dec 29 for three days. The votes from Readers are in—nobody wants reports next week. So we will take the week off.