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Schork Oil Outlook: Dollar-Crude Correlations Move

Wednesday, 17 Nov 2010 | 6:16 PM ET

Buy the Rumor, Sell the Fact?

Since the U.S. Fed announced its plan to purchase $600 billion of Treasury bonds (QE2) two weeks ago, the US dollar has rallied 5.3% against the euro. In turn, after a slight decoupling, Nymex crude oil has plunged 7.4% (peak-to-trough) over the last four sessions. More importantly, bond yields have surged as investors have dumped U.S. government debt.

This is potentially troublesome, given that the whole point of QE2 is to drive bond yields lower. Thus, it appears that the market bought up the Fed’s well-telegraphed rumor and is now selling the fact.

To wit, from mid-September through the Fed’s FOMC meeting on November 04th the yield on the 7-year Treasury note dropped by 393 bps to 1.72% and the 10-year yield dropped by 232 bps to 2.49%.

Since then the 7 and 10-Yr yields have bounced back by 381 and 351 bps to 2.10% and 2.84% respectively. The greenback has thus benefited from the unexpected rise in yields, along with concerns over what Ireland could mean for the euro.

The short-term correlation between the dollar and crude oil has narrowed, but the longer term (120-day) has strengthened.

As such, should the dollar continue to rise, then the odds of seeing >$90 oil before we see <$80 oil lengthen considerably. Oil bulls also have to navigate the possibility of rate increase in China to stem inflation there. Last week China’s CPI rose to 4.4% in October (two-year high). As illustrated in today’s issue of The Schork Report, there is an apparent strong positive relationship between the pace of inflation in China and the value of oil.

In other words, as China — a country whose average living standard greatly lags advanced economies — moves to tame inflation, its ability and/or willingness to subsidize U.S. investors in commodity ETFs falls dramatically.

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Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.

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