Oil upside limited

China’s ratings cut

As expected, Moody’s has downgraded China’s sovereign credit rating to A1 from Aa3 with revised outlook stable. According to Moody’s, the cut was due to growing leverage and the fact indirect liabilities will be pressured as economic growth decelerates. However, the upgrade to a stable outlook indicates that at A1, the risks are balanced.

China's Ministry of Finance was quick to reject Moody’s assessment on the grounds that local government and SOE debt should not be considered obligations of the federal government. Markets will be watching the S&P rating for a probable reaction as China still has an AA- credit rating and negative watch. While the credit rating cuts failed to hurt China's stock markets, AUD headed lower following industrial commodities weakness and risk in China.

In our view the probability of a full blown collapse is low considering their ability to control capital flows. However, today's rating move is another warning shot from the markets that pace of credit growth and sustainably of debt is worrying. It is uncertain whether China authorities have the nerve to tighten further at the risk of damaging already weak economic growth.

Oil upside limited

OPEC's meeting tomorrow is expected to see a 9-month extension to the production cut agreement. We suspect that much of the production cuts are already priced in as WTI climbed from $44 to $51.60 since 5th May. Clearly a no-extension result would deliver an asymmetrical negative reaction, while an unexpected deeper cut would send oil higher.

With expectations elevated and further crude price gains unlikely, watch for oil sensitive currencies RUB, CAD and NOK to fall back. In addition, the US budget proposed to sell 270 million barrels of oil from the Strategic Petroleum Reserves over the next 10 years. Traders will be watching US crude inventories today. Given our negative oil outlook (past production cuts deals have only had a transitory positive effect on prices) and a more optimistic view on EU inflation, we would trade long EURNOK.