Justified worries about the health of the Chinese economy were succeeded by the sanguine view on how the US will perform in the coming month. The reassurance was provided by the chair of the Federal Reserve, Jay Powell, who used the annual central bankers’ symposium in Jackson Hole, Wyoming as a platform to describe the state of the US economy before providing his strongest hint yet at the impending lowering of the cost of borrowing.

Until Friday afternoon, however, the oil market spent most of the week predominantly in hell before making a quick turnaround and ascend towards heaven. Dispiriting Chinese economic and oil data was the chief reason for Brent toying with its recent trough of $75.05/bbl reached at the beginning of August. A truly encouraging weekly report on US oil inventories was casually swept aside on Wednesday as further insult was added to injury in the form of the preliminary estimate of US non-farm payrolls benchmark revision covering the twelve months up to March 2024.
It was US job data that had intensified the selling pressure mid-week, and it was the Fed chair’s constructive prognosis on the US labour market that made amends two days later. The main message was that ‘the upside risks to inflation have diminished, and the downside risks to unemployment have increased’. Reining in inflation has, so far, been successful, and incoming data on consumer prices, and the job market will define the pace and the extent of the rate cuts. The US central bank is in a good position to fulfil its dual mandate of ensuring price stability and a strong job market.

The reaction to the speech was one of optimism and a growing belief in a ‘soft landing’. The S&P 500 index rose 1.15% and settled a smidge under the all-time high closing price level on July 16. Bonds rallied and yields fell, whilst the dollar weakened. Its index against six major currencies closed at its cheapest level since the end of last year. Oil duly shared the prevailing enthusiasm, and the malaise experienced just a few days earlier was long forgotten.
The CME FedWatch tool now fully prices in a rate cut at the September FOMC meeting. There is a 71.5% chance that borrowing costs will decline by 0.25% and a 28.5% chance that it will be double that. In any case, the Fed will follow in the footsteps of the European Central Bank and the Bank of England. They decreased key deposit rates in June and August respectively although it is not entirely clear if more cuts will follow; again, such moves are data-dependent.
In the words of Jay Powell, the increase in consumer prices in the last two years was the function of ‘an extraordinary collision between overheated and temporarily distorted demand and constrained supply’; in layman’s terms the recovery from the health crisis and the economic consequences of Russia’s war against Ukraine. Just by looking at how inflation played out over the last two years in major economies, one will conclude that the speed and the level of restrictive monetary policies were surgically accurate. In the last two years, US inflation has fallen from 9.1% to 2.9%, in the euro zone it has retreated from 10.6% to 2.6%, and in the UK from 11.1% the 2.2%. The time has become ripe to start lowering borrowing costs in major economic centres.

With that in mind, investors will surely start contemplating the potential effect a Fed rate cut could have on the US economy and the prices of assorted asset classes. The next challenge for the central bank is to ensure that rate cuts will not reignite inflationary pressure. If it manages to achieve this then, at least in theory, consumer and business spending and borrowing ought to grow boosting economic expansion and employment. The interest rate gap between the US and other economies will narrow and this could put further downward pressure on the dollar. A cheap greenback is a welcome development for emerging economies that need to finance their debt in USD and should spur oil demand, both in the physical and in the paper markets. On the other hand, past data suggests rate cuts do not entail a protracted stock market rally, therefore the yawning chasm that currently exists between equities and oil could start narrowing – provided that all the other parts of the equation remain constant.

The Heat is Back on

These parts, however, are moving, and sometimes with unpredictable speed. The geopolitical temperature has risen once again, both in the Near East and in the eastern part of Europe. Over the weekend there was a heavy exchange of fire between Israel and Hezbollah as the conflict continued to escalate. It is something that will keep the geopolitical risk premium at an elevated level and make any possible truce between the warring parties increasingly implausible, notwithstanding the mandatory US optimism. A massive ariel Russian bombardment of targets across Ukraine allegedly aimed at critical energy infrastructure added to the anxiety.

Further support was provided from South America. In Colombia, five attacks were carried out on two pipelines by leftist guerillas although it is noteworthy that exports have not been affected, so far. The final nail in the bear’s coffin came from the troubled North African OPEC member, Libya. The internationally recognized government in the western part of the country has been trying to replace the governor of the central bank, the guardian of the country’s oil revenue. This attempt has reportedly led to the shutdown of almost the total oil production, which is concentrated on the eastern part of the country ruled by the warlord, Khalifa Hafter.

The forthcoming US rate cuts, and the unabated tension all over the world that could and does have an adverse impact on oil production and exports have sent oil prices significantly higher over the past three days. The lowering of the borrowing costs has seemingly helped re-enforce the $75/bbl floor basis Brent, where prices bounced impressively off last week. Supply concerns surrounding oil-prodcuing regions, on the other hand, tend to provide temporary price support unless output is meaningfully impacted, consequently, it will probably not be long before the focus shifts back to the underlying supply-demand oil balance effectively capping any attempt to send prices spiralling out of control.

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