You can be forgiven for thinking that a falling oil price would be a positive impact on market sentiment and to all intents and purposes, it is. In both the US and the UK around three quarters of the economy is consumer driven. An oil price cut acts like a pseudo tax cut for consumers who spend a significant proportion of their income on petrol. However when any major financial market plummets to the degree that oil has done in recent months, sentiment becomes wary. The oil price is once again chief on the list of concerns for investors as 2015 begins with the glass half empty.
The problem with the price of oil falling to such low levels is that there has been a significant investment in the US in recent years to take advantage of the shale boom. With interest rates at record lows, cheap loans have been used to drive this growth, but producers would have been doing their sums on being able to sell oil for at least $100. The price of West Texas Intermediate oil fell to less than half that amount yesterday and producers have a big problem. Shale oil has been a major driver of US growth and the improvement in employment numbers. That means that the industry could be impacted by uneconomic production which could lead to loan default, increasing unemployment and dampening growth prospects.
Furthermore, with the low price of oil, it could also result in an increase in supply as producers (not only in the US but also around the world) increase production because they are getting less for a barrel of oil. Already we are seeing Russian supplies at record levels. If oil supply show little sign of dropping, the price will remain under significant downside pressure. For WTI there is no real support until $43.80 and ultimately the 2009 lows around $33.50. For Brent Crude the support comes in at $47.25 and $39.35.
So what does this mean for the markets? Well there is increased fear and fear leads to increased demand for downside protection from fund managers. This is hence why the VIX Index of S&P 500 options volatility has spiked strongly higher (up 25% in just 3 days), however gauges of volatility for other indices such as the DAX and FTSE 100 have also spiked higher. The charts below show how there is a strongly negative correlation between the performance of the indices and volatility.
The other interesting observation I have made is that in the past week the US Dollar Index has decoupled from the correlation with the US 10 year yield. This means that US Treasuries and the US dollar are both rallying together. This is something that has not really been seen since mid-October. Will this divergence continue, or does this mean that the Dollar Index is due a retracement again? The euro briefly threatened to find support early this morning, before the selling pressure took hold once more. The price of Dollar/Yen is also toying with the support around 119 and could easily be set for a move back towards 118.00. For now the Dollar Index is resisting the recent trends (early October and early December) of corrections when the market “fear” takes hold. It will be interesting to see how long this can last for.