Daily Commentary

MarketMinder’s View: We bring you this longish piece to correct a small, widely held misconception … and because it is an interesting discussion overall. Fed head nominee Kevin Warsh, whose path got clearer when the Justice Department dropped its investigation into outgoing Fed head Jerome Powell Friday morning, thinks it will be beneficial to shrink the Fed’s balance sheet—further reducing the mass of long-term Treasury bonds and mortgage-backed securities it bought under “quantitative easing” after 2008’s financial crisis and during COVID lockdowns. He argues doing so will enable the Fed to cut rates. The article presents this as a tricky conundrum, noting markets freaked when the Fed (according to some) moved too fast. This is where the misperception comes in: Markets didn’t wobble because long rates rose. Rising long rates steepen the yield curve, which promotes more lending and growth. Cutting rates aggressively alongside this would risk turbocharging lending and overheating the economy. Low short rates don’t offset high long rates. They work together to widen banks’ net interest margins. The real reason markets wobbled is what the article spends its final half discussing: a drop in interbank liquidity as reserves held at the Fed dropped (the Fed’s assets and liabilities match, so when it lets assets roll off its balance sheet, there is a corresponding drop in reserves). Shrinking the Fed’s balance sheet thus requires some adjustment in how banks manage short-term liquidity. The article discusses ways this might happen, but the main takeaway is the process is probably long and deliberative, sapping surprise power. No one wants a liquidity crunch. The solution will probably be rather operational and boring, like the Fed’s move to resume transacting in short-term Treasury bills a few months back—returning to its traditional means of managing liquidity with lower reserves. There is some attention on the Fed’s interest payments on reserve balances, but the Fed adopted this policy to put a floor under the fed-funds rate 20 years ago after long-running difficulties keeping market-set rates in line with its target when liquidity was higher. So keep an eye out, but we don’t view this as an action item for now.

MarketMinder’s View: “The S&P Global Flash Eurozone Composite Purchasing Managers’ Index [PMI] fell to 48.6 in April from March’s 50.7, far below expectations in a Reuters poll for a more modest dip to 50.1. That was beneath the 50.0 mark separating growth from contraction. ... An index covering the bloc’s dominant services industry sank to 47.4 from 50.2, far below a median prediction in the Reuters poll for a gentler slide to 49.8. Demand for services fell at the sharpest rate since October 2023. The new business index came in at 46.3 compared to 48.6 last month.” No doubt fear of energy shortages and higher prices is affecting demand to a degree, particularly services—the Continent’s main driver—hence the bleak outlook presented here. But it is important to discern between fundamental headwinds and sentiment. The US and UK face the same higher oil and gas prices, yet both nations’ flash services PMIs rose well above 50, per FactSet. For investors, it is important to view the whole picture globally and locally. While the eurozone’s composite flash PMI weakened with services, manufacturing was a surprise bright spot, rising to 52.2 from March’s 51.6. That improvement happened alongside these same fears, in a much more energy-intensive sector. Though the article paints that in a negative light with “soaring production costs” leading to “financial markets pricing nearly four rate hikes by the European Central Bank [ECB] this year, starting June,” not everything is as dire as it seems. Yes, services account for more than 70% of eurozone GDP (per Eurostat), but PMIs measure only growth’s breadth—not its magnitude. Per S&P Global, the eurozone composite PMI was lower in 2022 and 2023, suffering the effects of Russia’s Ukraine invasion—yet neither of those years saw regional recession. Dips below 50 aren’t automatically contractionary as a minority of firms expanding can still outweigh the majority seeing slight shrinkage. As for potential rate hikes, we see them as a false fear with eurozone M3 money supply growth tame and broad inflation unlikely to run away (unlike 2022). That doesn’t mean the ECB can’t make mistakes and contract credit unnecessarily, but this is far from given. Steep rate hike expectations seem more like investors fighting the last war, and the eurozone’s steep yield curve gives policymakers some wiggle room. And per the ECB, lending is rising at a steady clip, a bit over 3% y/y this year, which should continue fueling economic growth. Meanwhile, future-focused markets are aware of all this and seemingly looking further ahead to that growth, which we think is why stocks appear to be moving on, short-term volatility notwithstanding.

MarketMinder’s View: The titular “wrong oil price” is the global benchmark Brent crude oil futures price, which has trailed the “Brent Dated” since the war in Iran began—the price one would actually pay for oil loaded onto a tanker right now. Usually they track closely, but the divergence since war broke out allegedly means the real-world oil shortage is worse than the futures market appreciates and that those who focus on futures prices have their head in the sand. We agree the divergence is interesting, but we don’t think it shows underappreciated risks stocks or oil futures have somehow overlooked. For one, the higher Dated price doesn’t mean everyone taking delivery of oil today is paying that higher price. Refiners use futures contracts to hedge against future price movement, so many taking delivery now should be paying lower prices locked in months ago. That futures prices are lower than the Dated price now is the market’s way of signaling oil shortages shouldn’t be as bad as feared, which isn’t a bad shout when you consider the Middle East’s pipeline workarounds and producers elsewhere (America, Argentina, etc.) ramping up. (Those workarounds, which push some 5 - 7 million barrels of oil to ports outside the Strait, also suggest the amount of oil off the market isn’t as big as depicted herein.) The higher Dated price isn’t even necessarily a bad thing, as it motivates producers to get supply where it is needed most. If Asian nations are willing to pay up for needed oil now, that is an incentive for oil exporters along the Atlantic coast to undertake longer shipping routes to get it there. Note, too, that the divergence has narrowed sharply from about $35 per barrel on April 7 to about $9 yesterday, per the chart in the article. That strikes us as evidence the market is already adjusting rapidly. Lastly, while we don’t dismiss the real hardship some small developing markets are facing as governments ration fuel to combat hoarding and prospective shortages, the fact remains that the global economy is much less energy-intensive than it used to be. Far higher prices than today’s didn’t render recession in the early 2010s, for instance, and inflation since then means much of today’s elevated prices (whether futures or Dated) are a money illusion. We think there remains ample surprise power for positive surprise to rally stocks.