Swing Low Sweet Interest Rates

There are a lot of emotions that affect the market during financial events concerning a company or the overall economy. We have seen Q2 earnings reports slam energy stock prices as oil revenue dropped significantly. Weekly, production data from the Energy Information Administration throws support behind bears or bulls depending on a change of 100,000 barrels a day in either direction. Volatility can make the markets scary for investors especially when the effects are so real, but that only magnifies the issue as traders, learning from the past, react to the next event like that crowd did the last time. Ask anyone involved in the oil market, and they'll tell you the masters of this form of financial avarice, OPEC. The oil cartel constantly takes advantage of production quotas and Middle Eastern conflicts to win them higher revenues. The markets so far this week have been acting in the same way (although, the Fed doesn't have skin in the game nor attempts to manipulate prices like OPEC). Adjustments and readjustments have caused further volatility up until today when the FOMC board finally emerged with a verdict. Rate hikes will have to wait until October's meeting. What does that mean for the economy? Yellen commented multiple times in her press conference that the economy needed to strengthen before rates would be successful. While there was a lot of Fed speak surrounding her projections, at the base of the report Yellen showed confident in a labor market that decreased 0.3% points since May but appeared discouraged about the low rates of inflation, also about 0.3%, as a result of low energy prices and a strengthening dollar hurting exports. Projections up to 2017 see inflation under the 2% target rate as crude oil prices will take time to recover as well as a weakening of the USD. As for the labor market, the Fed will hope that the continuation of low-interest rates will continue to eat away at excess unemployment while attempting to heat up monetary growth. In response to the Federal Reserves decision, stocks rallied with the Dow Jones, S&P500, and NASDAQ showing bullish sentiment behind the decision. The gains, though, appeared unsustainable as trading continued as if unmoved rate hikes were expected. The Dow ended down -0.39% after the bump from the Fed report which put the high for today around +1.5%. The financial sector leads the losses today producing the highest percentage decline at -0.65%. Even though the markets finished bearish, there were a total of 1,866 advancing stocks as opposed to 1,201 receding. Most investors would attribute that to a confusing day on Wall Street with positive sentiment from rate holds mixing with negative feelings concerning the economy. Today's trading psychology in the overall market seemed to be reflected in crude oil future's trading. WTI showed lateral movement with a meager -0.19%. On the other hand, the international benchmark dropped a full percentage point, spreading the gap with a reaction to weakened global demand. Both the NYSE Arca Oil Index and the S&P 500 Energy Sector dropped less that -0.10% showing a very neutral day on the market. Crude oil ETFs showed a larger loss perhaps hinting at a bearish wave to come. With the discussion of interest rates continued into the end of the year, I'd like to look back at the reaction of crude oil to interest rate increases in the past. When interest rates are raised, oil investors will be left to decide which way sentiment will take prices, either up, down, or lateral.

Above is the chart showing historical changes of the Federal Funds Rate. I have highlighted four time periods where rate hikes were consistent and made a major change to the macroeconomic environment. They are as follows:

• 1.25% June 30, 2004 to 5.25% June 29,2006
• 3.25% February 4, 1994 to 6.00% February 1, 1995
• 6.50% Late January 1988 to 9.75% February 24, 1989
• 4.75% November 26, 1976 to 20.00% December 1980

So we know that the macroeconomic trend during these periods was defined by a tightening of the money supply which typically hurts stocks and decrease demand for commodities. If we were in a period with higher inflation, commodities might be affected by a weaker dollar as far as monetary concerns go, but the deflationary environment would be especially susceptible to further dollar strengthening. Interest rate increases would see a continuation of the trend of dollar strength, thus, hurting foreign demand and exports for commodities, especially prospects for crude oil price. Nevertheless, the periods which rates were increased typically had a higher rate of inflation like (but not as extreme as) hyperinflation in the 1970's. Looking at WTI price movement during these periods, we may (or may not) be able to decipher similarities. Due to data limitations, we will focus on 1994-1995 and 2004-2006 charts.

 

Both of these charts are plotted over the same amount of time (approximately a month) so that we can accurately compare the shape of the graphs which actually show a lot of similarities. Both charts show significant amounts of growth after rates are increased. The increase occurred despite moderate momentum technicals. Both the RSI and MACD indicators sit around the midpoint of their scales which usually denotes a trading segment in the chart's shape. Instead, technicals quickly point to an overbought market which seems to be the reason for a short sell-off after the initial increase. The technical indicators probably operate in this way because the benchmark's traders are responding to the event of rates being raised. Here, in the first six months, we'll see a speculative bubble form from the sentiment surrounding monetary action. Both indicators fall immediately at the sign of excessive buying and continue into a lateral trading segment. In 1996, the lateral movement will hover around the 200-day average, but the 2006 movement shows a slightly more bullish market. Either way, the rate increases both produced initial bullish gains with either a bullish crossover from the two moving averages (1996) or a maintenance of an upward short trend extending beyond the long-term (2006). What comes after is perhaps most important because it shows us that a trend is probably not going to last the full year. As for WTI trends that could crop up during the next interest rate hikes, the first six months will produce a lot of volume back trading (either bullish or bearish) that will seem like a legitimate move. Unless the Federal Reserve waits for inflation to resurface at their target level, my projection would be a bearish trend that tests support levels established in the weeks following the rate increases. But after that, the market will succumb to some lateral movement that will yield to the sentiment surrounding fundamental issues because the 2015 period of crude oil trading is distinctly defined by a supply glut. Numerically, I'd predict $55 to $60 a barrel prices going into a rate hike with a bearish trend dropping prices to $46 to $48. Lateral movement will depend more on fundamentals, but with production cuts already occurring, I could see the WTI benchmark hovering around $60 to $65 going into 2017. If a supply glut continues into the next year, a realistic estimate might be around $55 to $58. It might also be important to monitor the gap between Brent and WTI crude futures as Congress begins to repeal a ban on exports. Obviously, there are many events that we could factor in (such as a last ditch effort to retain market share from OPEC), but including too many variables can fog insight. At the same time, ignoring those possibilities produces a rigid model of normative economics relying on ceterus paribus too much to determine the future. Instead, these ideas can be used as a general guide on how to think about interest rates and crude oil interactions that may be relevant in the future.