Oil Weakness May Intensify

Earlier this week, Asian & European markets showed another failure to respond to Mondays 1.4% gains in US equity indices (Dow & S&P), further highlighting the unsustainability of the gains in indices, which had become increasingly dollar-driven (caused by prolonged USD weakness resulting from Fed officials failed attempts to support it) instead of improved economic figures.

Earlier this week, Asian & European markets showed another failure to respond to Mondays 1.4% gains in US equity indices (Dow & S&P), further highlighting the unsustainability of the gains in indices, which had become increasingly dollar-driven (caused by prolonged USD weakness resulting from Fed officials failed attempts to support it) instead of improved economic figures. Indeed, the absence of further improvement in fundamentals (4-month lows in Oct industrial production, slowing core Oct retail sales and 6-month lows in Oct housing starts) underscores the role of USD weakness as the main driver to higher equities.

Yet, while the dollar index hit fresh 15-month lows on Monday at $74.68, oil failed to regain its interim resistance of $80.50 (not even mentioning the year high of $82). Such failure was especially prominent following the higher than expected decline in oil inventory drawdown. Last weeks brief break below $76 underscores the emerging bearishness in the fuel, which suggests a swift renewal of fresh shorts to retest the 75.53, which is the 38% retracement of the rally from the 64.98 low to the 82.06 high. And should the pattern of previous down cycles repeat itself in oil, a steeper decline could be in the woks, likely calling up the 73 handle.

Oils inability to preserve rallies in the face of USD weakness reflects the lack of sustainability of speculative flows to elevate the fuel as real demand falters (shown by 2 consecutive weekly higher than expected builds in oil inventories). The chart below shows a downward drift in the Oil /EURUSD ratio, resulting from a more rapid appreciation in the euro (more rapid depreciation in USD) than an appreciation in the price of oil. Note how this pattern occurs after a rise in the ratio in October, which emerged as a result of a more rapid increase in oil relative to the rise in the euro. Said differently, oil is losing its ability to respond to USD weakness. Thus, any catalyst driving USD strength (stocks correction, Chinese remarks on commodities or less dovish rhetoric from Fed officials), would especially accelerate oil selling.

Oils relative weakness has also been highlighted against equities (S&P500 and Dow), as the equity/oil ratio surged to a 4-week high. Interestingly, US equities have outpaced those in Japan (Dow/Nikkei at highest since Dec 08), UK (Dow/FTSE at 3-month highs). Could relative strength of US equity indices be the product of currency weakness and not much more? We have already raised the S&P500s recurring failure to recover 50% of the decline from the 2007 record high to the 2006 low (1,120). The equivalent 50% retracement for the Dow stands at 10,335, which was broken on Mon, Tues, Wed but has yet to do so for the week (on Friday).

A weekly close below the 10,335 in the Dow, below 1,120 in S&P500 and a confirmed downtrend in oil (close blow $79 and 5th straight weekly lower high), would establish markets fading dynamic for risk appetite. This was already established on the currency side, amid the protracted yen strength. We warned last that yen strength would continue outperforming the much-warned about USD strength by pundits.

Ashraf Laidi is currently chief foreign exchange strategist at CMC Markets, where he oversees the analysis and forecasting functions of G-10 currency pairs as well as decisions and trends of the major global central banks. Laidi is also responsible for education services and informing clients on the essential dynamics underpinning FX markets. His FX analysis has received world-wide wide acclaim for more than a decade, centering on G10 currencies and... More