A lot of questions have been asked by economists wondering at what price will oil cause a recession. Secondly, they've been asking at what level interest rates will hinder economic growth. The consensus seems to believe that $150 and $200 oil are where we should find some resistance in the markets. Concerning rates, it is felt that anything higher than 5% would spell recession. These questions are surfacing because the underlying fear is that quantitative easing (QE) 2.0 is inflationary and will eventually come back to bite this rally in the butt. That fear is multiplied two fold should the economy fail to reach a self-sustaining economic activity level without the assistance of QE. There's a word for that situation: stagflation.
William Dudley, the New York Fed president and vice chairman of the FOMC, gave some important insights into the Fed's thinking and plans for the next few months in a speech he made to the NYU Stern School of Business earlier on February 28th.
Although there is uncertainty over the timing and speed of the labor market recovery, I do expect that payroll employment growth will increase considerably more rapidly in the coming months. We should welcome this. A substantial pickup is needed. Even if we were to generate growth of 300,000 jobs per month, we would still likely have considerable slack in the labor market at the end of 2012…
We also have to be careful not to be overly optimistic about the growth outlook. The coast is not completely clear—the healing process in the aftermath of the crisis takes time and there are still several areas of vulnerability and weakness. In particular, housing activity remains unusually weak and home prices have begun to soften again in many parts of the country.
State and local government finances remain under stress, and this is likely to lead to further fiscal consolidation and job losses in this sector that will offset at least a part of the federal fiscal stimulus.
And we cannot rule out the possibility of further shocks from abroad, whether in the form of stress in sovereign debt markets or geopolitical events. Higher oil prices act as a tax on disposable income, and the situation in the Middle East remains uncertain and dynamic. Also, we cannot ignore the risks stemming from the longer-term fiscal challenges that we face in the United States.
Essentially, Dudley gave many reasons why we don't expect quantitative easing to go away for a long time. With the structural, economic problems we face (such as cheaper labor overseas, spending programs the state and federal government will not cut, a work force that will not adapt to future trends) there are many reasons why the Federal Reserve will likely continue to pump liquidity into the markets.
So going back to the original questions posed by economists, if QE will continue to increase monetary inflation by increasing supply, and revolution in the Middle East will cause crisis pricing in resources, what price level will halt this market's 2-year run? Technically speaking, the market will tell us at which point by looking at the price of oil as it diverges from stock prices. As the economy has shifted towards recovery over the past two years, oil has had a positive correlation with the S&P 500 – that is to say, they go up together at the same time. Let's consider what happened to this relationship as oil and stocks rose in 2007 versus how they diverged in 2008.
In the next chart below, we have the S&P 500 in the upper window, WTIC oil in the middle, and then we have the relative strength ratio (the WTIC oil price divided by the S&P 500 price) to follow the rates of change for both. In 2007 when we follow the rate of change relationship between the two, we find that oil continued to accelerate as the S&P began to decelerate around October 2007. The price of oil at that time was near /barrel. It would be ridiculous for me to say that oil caused the top in the stock market, because there were a billion other reasons that were causing growth concerns for the economy at the time; however, the relationship is there such that when the S&P 500's rate of change slowed and oil continued to accelerate, the relative strength ratio between the two broke out that month as highlighted by the vertical red bar through the chart.
Looking at that same relationship today, neither the S&P 500 has decelerated nor has oil accelerated enough to break the existing 1:1 relationship (highlighted by the blue box between 2009 and 2011. That's to say that consumers are a lot more comfortable with -0 oil than they were in 2007 based on this relationship alone. This concept is better explained in an interview Warren Buffet did on March 2nd with CNBC:
If you have something valuable to offer even if the dollar gets worth less, you will retain earning power that's commensurate with purchasing power…In the year since I've—was born the dollar has depreciated 94%. I mean, it's 16-for-1 in terms of inflation. But if you owned Coca-Cola in 1930, you've still done pretty well. Or if you owned a lot of good business in 1930. Because they have the ability to extract real earnings in terms of what they deliver to people. And your doctor is able to charge 16 times as much as in 1930 because his services are still as valuable. So, as the currency gets worth less, it does not make—it does not penalize the service or the good that is really needed by other people. The world adapts.
As oil prices have risen, so has the stock market (coca-cola) such that the American (through private finances, employer 401k plans, or government 403B plans) that is invested in the market has "done pretty well", as Buffet would say. By that very relationship, they're able to cope with 0 oil as long as other financial assets are going up to compensate. It's when an October 2007 happens and those other financial assets decelerate that we'll need to worry about the price of oil and other commodity prices.
My brother, Chris Puplava, showed this relationship using scatter plot analysis. For every x-point of oil from to 0 in 2007, he referenced the price of the S&P 500. So whenever oil was at , a point was made for what the closing price was for oil. Here were his results showed that somewhere in the lower s for oil, the S&P 500 began to decelerate to create a dome top. As oil continued higher, the price of the S&P 500 fell. He later shows in a 2010 to present chart, that at 0 oil, the S&P 500 has begun to decelerate. If the S&P 500 can resolve its recent concern over the Middle East to reach new highs, we will see this curve pushed further to the right. We still need some more data for it to be definitive, but again, this is a relationship we're paying close attention to.
Concerning interest rates, 5 percent is what the 10-year Treasury note was at the time the S&P 500 rolled over in 2007. So that's the bull's-eye on the dart board economists are shooting for when they estimate a rate that will cause the market to roll over again. Historically speaking, 5% interest rates are low; however, 20 years ago, homeowners had 20% or more equity in their home and 30-year fixed rate mortgages. It would by folly to make an exact comparison, but there is a definite shock and amazement I hear from home investors much older than I, when they announce the rate they refinanced 300k mortgage on their 0k Californian home. It wasn't too long ago they remember rates near 10%. Price is relative!
Summary
So on the radar, the price of oil, interest rates, and the dollar are bleeping across our macro screens. It's too early to tell at what price oil or what interest rate will hold back this bull market in equities. Despite the recent pullback in the S&P 500 versus oil, it hasn't been enough of a change to warrant a clear inflection point as we had in October of 2007. Time will tell.
Recently, the U.S. dollar has taken a different turn than was anticipated. Usually, during times of economic or foreign crisis (as of now in the Middle East and last summer in Europe) the U.S. dollar has found a bid under it as support. The Middle East crisis marks the first time in a long time that has no longer been the case. Instead, we find silver is the number one, go-to spot for investors worried about the Middle east. Below is a table of precious metal prices and other currencies versus the U.S. dollar. Very few are down versus the dollar over the past month. Numbers are on a percent change basis and sorted by the one-month column.
Source: Bloomberg
