FED Rate Hikes Could Cause Unintended Volatility Shock

[source: Star Tribune]

Last week the Federal Open Market Committee surprised no one when they raised rates 0.25 basis points to increase rates to between 1% and 1.25%.  What did surprise the market, was the revelation that the FED is committed to normalize rates, even if inflation does not meet their target.  This was reiterated this week in a speech by William Dudley, President of the Federal Reserve Bank of New York, who stated he feels the FED needs to raise rates, despite low inflation, to be ready to act if the economy does slow down.

The market has been quick to respond, and nothing was hit harder by a reduction in inflation expectations than commodities.  Gold, since the announcement, is lower by 2.39%, and oil is down -3.18%.  Crude futures have broken their upward trend line and appear poised to test the previous low of $39.56.

While, oil has been under pressure all year, the S&P 500 does not seem to care, as it continues to make all-time highs.  Oil is down 23% year to date, while the S&P is up close to 9%.  In 2016 the opposite was the case.  Then, the market paid very close attention to what oil was doing, especially as it drifted close to 40 dollars a barrel and below. Below $40 a barrel, the market became increasingly worried that there could be a contagion effect.  We had a situation where domestic oil producers’ balance sheets were questioned by the market, followed by a spillover effect to regional banks who owned that debt.  That is the type of financial crisis credit owners fear.  This culminated on February 11, 2016, when oil bottomed out at $26.21.  This dangerously low oil price for shale producers sent the VIX to 28.14, and the S&P to 1829.08. 

The market has been eased with oil over $40 dollars a barrel, a level which shale producers can safely turn a profit, thus eliminating the contagion risk.  Right now, it seems the oil trend-line is breaking, headed lower, while the stock market is still hovering very close to all-time highs. 

[Source: sustg.com]

Saudi Arabia named a new crown prince today; the current King’s 31-year-old son, Prince Mohammed bin Salman, who is openly upset about Iran and Qatar’s actions in Yemen. Oil Bulls point out that rising political tensions in the Middle East, specifically between Saudi Arabia and Qatar, will drive prices higher.  This view may be right; that tensions could be rising and might lead to more state actions.  Bulls point out, that a war between Iran and Saudi Arabia would send Oil skyrocketing.  Today, however, investors seem to think war is unlikely; that there is a different way Saudi Arabia can harm Iran and Qatar.  They can harm them on their balance sheets.  Prince Mohammed could push Saudi Arabia to allow OPEC to lower the price of oil.  Since Saudi Arabia has the lowest break even cost per barrel, lowering the price will hurt Qatar, and Iran significantly more than Saudi Arabia.

[Source: Bloomberg]

Oil is still above the key $40 dollars a barrel technical level, or $39.51 to be exact, and at this point, investors seem confident oil will remain above that level.  Oil could be one supply glut short of being sent back to the 2016 low.  Meanwhile, volatility remains historically low, Today's June settlement was 10.71.  Volatility traders should watch the $39.51 in oil level closely, while being mindful of what happened in February 2016, and the effect it can have on our stock market risk.  

- Joe Tigay