Divergence between the market and the Fed is a serious problem

Outlook:

We are about to revisit the economics of cartels in real time. A forest of trees has been sacrificed on this topic, with wild fear of OPEC during the 1970’s giving way to snarky snipes at the inability of OPEC to enforce quotas. Both aspects of the OPEC cartel are true and useful. The Qatari and Venezuelan oil ministers will meet with Iran tomorrow to try to bring Iran into line with an output freeze, but this is entirely against Iranian self-interest.

Even if Iran pretends to agree at some level short of 1 million bdp, everyone will have an eagle eye out for cheating. In OPEC, somebody is always cheating. Non-OPEC producers don’t give a toss what OPEC says, anyway, and today that includes the US and Canada as non-trivial producers. In fact, if OPEC is going to freeze at January levels, that allows analysts to figure out a more accurate break-even level. And a freeze does nothing to reduce the vast over-supply already sitting in depots and tankers eve-rywhere. As long as over-supply is so vast, we can’t expect a freeze at an over-supply level to cut into inventory by much. It could take years for the over-supply to get cut down to the size where any specific price has the power to move the market.

That’s just the economics. It doesn’t consider that the Saudis are unhappy with Russia over Syria and actually fighting outright against Iran in several places, including Yemen.

All the same, global markets will cheer in the end if the freeze does indeed lead to a stabilization of oil prices within a narrower band. Up to now, volatility was open-ended. Analysts could write of $20 oil with impunity, and so could those speaking of $100. A more well-defined high-low oil price range will serve as a tranquilizer to equity markets overly correlated with oil prices, one of those great market mys-teries that never did make much sense. After all, cheap energy costs are a bigger boon to consumers than they are a negative for producers, and yet equity indices for several months followed oil prices slavishly.

The only explanation is that falling oil prices imply slower growth and possibly recession. We can’t ex-pect the obsession with oil prices to go away, but the output freeze, if it succeeds without too much cheating, should allow the fear of recession to fade—especially since global demand is, in fact, rising. We are still left with worries about European bank balance sheets, whatever Mr. Draghi says. El-Erian writes in a Bloomberg op-ed. Energy, junk bonds and FX have seen “eye-popping price overshoots and contagion. And each has yet to regain its footing.” We better get something else for the banks. “Should the banking sector become unhinged, the flow of funds to companies and households would slow, and international trade financing would be more expensive and less accessible. It also would further restrict the already limited appetite of broker-dealers to alter their balance-sheet inventory to accommodate in-vestors seeking to reposition their portfolios.

“The trouble with banks, though notable, has been containable so far. But should it evolve into a much sharper downturn, there could be serious consequences for a slowing global economy and for financial markets that have generally had a lousy start to the year. Those are risks that the global economy and markets can ill afford at the moment.”

Something else the world can ill-afford would be a presidential election so tight that it would take a Supreme Court ruling, as we had in 2000. The court came down on the side of Bush with the help of the now-dead Justice Scalia. The Republicans want the president to give up his right and duty under Article 2 to keep the Supreme Court at nine justices.

They even say they will refuse to confirm any and all candidates the president proposes, a dereliction of the Senate’s duty. The politics are easy enough to understand and so are the historical precedents—plenty of justices have been confirmed in the last year of a president’s tenure (the Republicans are lying about that). If the 2016 election is so close that it would take the Supreme Court to settle it and the court is deadlocked four to four, as would happen unless we get that 9th justice, the US rule book literally does not have another option. The founders never saw it coming that Senators could be so petty and self-ish. Scalia himself would not approve.

It’s too soon to predict the effect of a more stable oil price on the FX market. We dislike the supposed inverse correction of falling oil with a rising dollar and vice versa, not only because it’s economically irrational and often not true, but also because it ignores other factors, including energy supply and de-mand and the overall robustness of the US and other economies. Still, if oil prices start rising in a less volatile and more normal manner, many players will expect the dollar to retreat—a self-fulfilling proph-ecy.

Also, if prices stabilize and at somewhat higher levels because of the freeze, the Fed has a slightly less lame leg to stand on when it comes to predicting higher inflation and thus justification not only for the Dec hike but upcoming ones, too. This is not reflected in Fed funds futures just yet and may get over-looked as we digest the minutes tomorrow, but the minutes will truly be out of date this time. At a guess, the fixed income gang will decline to consider that the freeze really does mean higher oil prices and thus an end to deflationary influences. Again, the divergence between the market and the Fed is a serious problem. But one Fed worry may be about to go away—the too-strong dollar.