In this excerpt from The Macro Show, Hedgeye Senior Macro analyst Darius Dale discusses the recent reflation rally and provides critical context about why we remain bearish.
Oil prices have experienced a moderate rally over the past two months since the production freeze proposal was unveiled in Doha on February 16 by Qatar, Russia, Saudi Arabia and Venezuela. So they will try to do it again on Sunday with about a dozen other producers attending the meeting.
One hitch: Saudi Arabia agreed to a production freeze only if all other producers agreed to participate, including and most especially Iran.
Today, Iran's oil ministry released a statement saying the Iranian oil minister will not attend the Doha meeting but will instead send a delegation "to explain situation of Iran" that "it cannot join the plan to stabilize oil prices."
That is why Saudi Arabia's oil minister, when asked this week by a reporter about the freeze, he replied, "forget about it." Saudi Arabia's Crown Prince also very publicly declared in an extensive Bloomberg News interview that the Kingdom would not freeze production unless Iran did as well. We believe there is no chance Saudi Arabia reverses its position and agrees to freeze production on Sunday.
The freeze would only be meaningful with Iran's participation, which is the only producer capable of ramping up production. But Iran has made it clear that it won't participate and even freeze proponents now concede that any agreement will exclude Iran. Therefore, despite the freeze marketing, there is no control over production.
OPEC and Russia are currently producing near-record amounts of crude. OPEC members Qatar, UAE, Iraq, Nigeria and Ecuador are at maximum production; Saudi Arabia, Kuwait and Angola are at near maximum production. Therefore, a freeze will only continue the supply glut and add to record crude inventories.
What we do expect to see in Doha is great public relations: positive talk about cooperation to stabilize oil prices. With a June 2 OPEC meeting just 45 days away, we suspect many speculators will be swayed by the Doha public relations. But we are highly skeptical that any meaningful agreement will be reached or that it changes the outlook for oil markets.
So what is the goal of the freeze talks? You may recall that in a March 29 note to clients, we said the goal of the production freeze proposal is to establish an artificial price floor. Our assessment was confirmed on Thursday by an invitation letter to oil ministers sent by Qatar's oil minister. The letter dated March 23 said the freeze proposal "has changed the sentiment of the oil market" and "has put a floor under the oil price." The letter was obtained by Bloomberg news under a Freedom of Information request to Norway's petroleum ministry.
June OPEC Meeting - Don't Expect a Production Cut
In a little more than a month after the freeze meeting on April 17, OPEC will meet for its regularly scheduled meeting on June 2 in Vienna. Many observers point to cooperation on the freeze as setting the predicate for action at the OPEC meeting. We see it differently.
We are not expecting any change in production from OPEC at the next regularly scheduled meeting in June . We maintain our investment thesis that Saudi Arabia believes its market share policy is winning. Therefore, it's still too soon for a production cut that only serves to throw a lifeline to U.S. shale and other non-OPEC producers to increase production. The next meeting of any consequence will be the year-end OPEC meeting in December when there may be the first serious consideration of a production change. However, it is still too early to forecast any policy changes. We would expect the picture to be clearer in late summer after non-OPEC production declines are evident.
Below is a brief excerpt from our Potomac Research Group colleague and Chief Political Strategist JT Taylor's Morning Bullets sent to institutional clients each morning. For more information on how you can access our institutional research please email email@example.com.
We never said the Democratic primary and corresponding debates were going to be a picnic in the park, but we never thought it would get this ugly. From opening salvos on qualifications/judgement to be president, Wall St. banks and the minimum wage to the Iraqi war, guns and Israel, Hillary Clinton and Bernie Sanders came out swinging and the punches continued throughout night.
On debate points, the edge may go to Sanders, but he was unable to land the knockout blow he desperately needs to overtake her lead in the delegate race - and the trajectory of the race continues in her favor only to be cemented by a win in NY next week. Clinton and Sanders clearly don't like each other and their contest hasn't reached the level of vitriol that we've seen on the Republican side - but the recent downturn in tenor may make unity harder to attain in Philly this summer.
Senator Marco Rubio won 172 bound delegates before suspending his campaign in March, but with the growing possibility of an open convention, he's making to bid to hold onto them for at least the first ballot, in an attempt to go to Cleveland with some leverage in tow.
It appears most of these delegates will be bound to him, but at least 34 are up for grabs - setting the stage for another behind-the-scenes battle for them. Will Donald Trump be ready this time around?
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Takeaway: With JP Morgan's results out this week, the business-to-business shift between brokers and exchanges becomes more transparent.
With the largest Capital Markets operation reporting results this week, JP Morgan's numbers continue to relay the business-to-business (B2B) shift in both bond and equity markets. With capital hamstrung by Financial Crisis era regulation, and fixed income desks running tight as a drum, brokerage activity continues to shift over into the exchange traded derivative markets. JPM's FICC or fixed income trading results hit $3.5 billion in revenue in 1Q16, down 13% year-over-year. Conversely, the daily reporting of CME Group's bond volumes finished at 8.2 million contracts per day in 1Q, up +9% from last year. On a revenue basis, CME's results are actually a little stronger, with fixed income rate per contract up +2% year-over-year. The shift in equities is more balanced, with JPM's equity trading revenues up +6% y-o-y according to their latest report. CME's stock volumes however still outflank the big brokerage desk with futures and options volume up +9% y-o-y for the forthcoming quarterly report on April 28th.
Weekly Activity Wrap Up
Cash equity volume kept pace with last week's strength, coming in at 7.0 billion shares traded per day and keeping the 2Q16TD average daily volume (ADV) at that same level, +10% higher than one year ago in 2Q15. Additionally, volume of futures traded through CME and ICE picked up the pace week over week, rising to 18.2 million contracts traded per day and bringing the 2Q16TD ADV to 17.9 million, +2% higher than the year-ago quarter. Furthermore, CME's open interest currently tallies 112.9 million contracts, +24% higher than the 91.3 million pending at the end of 2015. This compares to ICE's OI growth of just +5.1% since the beginning of the year. Lastly, options volume was stronger week over week, rising to 16.1 million, but the 2Q16TD ADV remains -2% lower Y/Y at 15.0 million.
U.S. Cash Equity Detail
U.S. cash equities trading came in at 7.0 billion shares per day this week, bringing the 2Q16TD ADV to 7.0 billion. That marks +10% Y/Y growth. The market share battle for volume is mixed. The New York Stock Exchange/ICE is taking a 25% share of second-quarter volume, which is +80 bps higher Y/Y, while NASDAQ is taking a 17% share, -178 bps lower than one year ago.
U.S. Options Detail
U.S. options activity came in at a 16.1 million ADV this week, bringing the 2Q16TD average to 15.0 million, a -2% Y/Y contraction. In the market share battle amongst venues, although NYSE/ICE's share jumped week over week and its 18% share of 2Q16TD volume is +92 bps higher Y/Y, it has been trending downwards recently. Additionally, CBOE's 24% market share of 2Q16TD is down -309 bps Y/Y. Meanwhile, NASDAQ is doing well in the first two week of 2Q16, taking a 22% share, +70 bps higher than one year ago. BATS has also been taking share from the competing exchanges, up to an 11% share from 10% a year ago. Finally, ISE/Deutsche, which experienced market share growth through 1Q16, has stagnated recently at 15%, which is -103 bps lower than 2Q15.
U.S. Futures Detail
13.7 million futures contracts per day traded through CME Group this week, bringing the 2Q16TD ADV to 13.5 million, +1% higher Y/Y. Additionally, CME open interest, the most important beacon of forward activity, currently sits at 112.9 million CME contracts pending, good for +24% growth over the 91.3 million pending at the end of 4Q15, an expansion from last week's +20%.
Contracts traded through ICE came in at 4.5 million per day this week, bringing the 2Q16TD ADV to 4.4 million, a +2% Y/Y expansion. ICE open interest this week tallied 66.7 million contracts, a +5% expansion versus the 63.7 million contracts open at the end of 4Q15 and an improvement from last week's +3%.
Monthly Historical View
Monthly activity levels give a broader perspective of exchange based trends. As volatility levels, measured by the VIX, MOVE, and FX Vol should rise to normal levels after the drastic compression this cycle, we expect all marketplaces to experience higher activity levels.
Please let us know of any questions,
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
The week concludes with a made-up data dump out of everyone’s favorite communist economy. Chinese GDP growth allegedly ticked down -10bps to 6.7% YoY in Q1 and the quarter allegedly ended on a positive note with Retail Sales, Industrial Production, Fixed Assets Investment, Money Supply and Total Social Financing growth all accelerating sequentially in March. Here's a brief summary:
- March industrial production in China was +6.8%, which was better than consensus and a sequential increase from February.
- March retail sales were also better than expected at +10.7% year-over-year.
- The truly blow out number was on government spending. For the month, fiscal spending was up 20.1% year-over-year!
While we’ve been right on our call for both the Chinese economy and Chinese yuan to avoid falling off a cliff over the intermediate-to-long term, a lot of the reprieve in Chinese capital outflows and slowing growth on the mainland has been perpetuated by a reversal of the trend of depreciation in the PBoC’s yuan fixing.
But now that the U.S. dollar appears to making a series of higher-lows vs. peer currencies, we expect a meaningful increase in pressure on the CNY and CNH from here. That should propagate another bout of global deflation fears over the next 3-6 months.
Takeaway: While oil prices bounce back and forth on oil production "freeze" talks, we think the dollar will strengthen pushing Oil prices lower.
Since the February lows, oil has rallied massively. Why? Look at the U.S. dollar. The CRB index of commodities has a 30-day inverse correlation of -0.88 vs. the US Dollar.
So where do we go from here?
Our Macro team elaborates on this point in a note sent to subscribers earlier this morning:
"Whether it’s output cut rumors into this weekend’s meeting or declining U.S. production, the “bottom is in” headlines are at the top of commodities feeds from every major news source with WTI +40% in the last 3 months.
However, looking at contract positioning shorts, a crowded consensus short positioning has been washed out (crude, nat. gas, gold, silver positioning all registering z-scores >1x on a TTM basis) with money betting on a continued decline in the U.S. dollar.
A supply side floor argument is a fundamental story, but not a catalyst, and we would reiterate that the credit risk priced into commodity leveraged fixed income is considered all but gone in market-price terms."
In other words, look for dollar strength pushing crude prices lower.
While we're at it, a quick note on commodity-leveraged credit risk...
On The Macro Show this morning, Hedgeye Senior Macro analyst Darius Dale points out that U.S. high-yield bond issuance is down -53% year-over-year in 2016.
Yikes! Certainly not a vote of confidence.
Meanwhile, as Hedgeye Macro analyst Ben Ryan pointed out in "The Unintended Consequences Of ZIRP On Commodities" earlier this year:
"Using a sample of 34 different producers in 4 different sub-sectors, commodity producer debt as a % of corporate credit outstanding has multiplied ~2.5x in 10 years. This group’s aggregate debt level is up ~5x in 10 years. The chart below shows the jump in commodity producer debt as a share of aggregate corporate debt levels."
The critical question to ask yourself... How much longer can it last?
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