The Fed sends in the repo men

Prepared by Jeff Halley, Senior market Analyst

U.S. overnight funding rates competed for headline space with oil and today’s FOMC rate decision, with the Federal Reserve dusting off its procedures manuals to conduct its first overnight repo operations in 9 years. Overnight funding rates had spiked to almost 10% yesterday following another oil-induced jump on Monday with the Fed having to add over $53 billion in liquidity via overnight repos with another $75 billion on standby today.

The various conspiracy theories floating around as to the cause of the spike ranged from payment of tax receipts due this week to treasury short-term paper issuance to finance the government’s burgeoning budget deficit. The Financial Times speculated that the Saudi’s could be liquidating short-term U.S. dollar assets to cover the country’s running costs while oil production was offline.

It is probably another headache the Federal Reserve didn’t need ahead of perhaps the most important FOMC rate decision of the year. The Fed faces a delicate balancing act as U.S. data continues to outperform (industrial production recovered overnight), but the trade war exacerbates the world economic slowdown. Throw in a militant U.S. President who believes rates should be zero now and the chances of severe conflict in the Middle East disrupting energy supplies, and it starts to look like a thankless job. Rather like my wife asking your opinion on the new haircut that you hadn’t noticed. You know it’s a trap with no correct answer, but you have to walk into it all the same.

A rate cute of 25 bps at 0200 SGT tomorrow, is universally regarded as a done deal by global markets. What will be closely watched is the press conference 30 minutes later, where we will gain more clarity as to whether the Fed has moved to an explicit easing bias. The FOMC members’ “dot plots” of future rate expectations I feel, will be marked down meaningfully. The likelihood of a shift from neutral to easing will high as the FOMC will not be able to ignore the storm cloud around the rest of the world that must eventually start raining on the United States.

An easing bias should see a fall in the U.S. dollar, but I suspect it will be an aberration in the medium term. The U.S. rates are still the highest in the G-10 by some distance and domestic data is still a shining light when compared to its counterparts around the world. Throw in some geopolitical risk, and the reasons to be short dollars in the medium to long-term appear to become tenuous.

Oil prices continued to be the Caligula’s of volatility, falling by over 5% overnight, as Reuters reported that Saudi Arabia had restored 50% of the lost production from the Abqaiq processing facility. The comments, by the Saudi Oil Minister, went on to say the country would be back to almost full capacity by the end of September, an impressive achievement in my opinion.

What hasn’t been said is how future attacks will be prevented there or elsewhere on their oil infrastructure. The spectre of military retaliation still looms over any accused of the attacks and for these reasons, intra-day volatility aside, a risk premium of a few per cent will remain built into oil’s pricing.

Equities

Wall Street posted gains overnight as oil prices fell and the street looked ahead to a probable easing by the Federal Reserve this evening. The S&P 500 rose 0.25%, the Nasdaq rose 0.40%, and the Dow Jones rose 0.12%.

Bullish urges in Asia will be tempered though as Saudi Arabia’s defence ministry announced it will hold a press conference today. It will present evidence of Iran’s alleged involvement in the weekend attacks according to State TV.

The Nikkei and ASX are flat in early trading as the spectre of military escalation across the Straits of Hormuz lurks. Asia will likely adopt a hide and seek strategy today, as Middle East risks balance a probable flurry of rate cuts over the next two days.

Currencies

The U.S. dollar fell overnight as Treasury yields slipped ahead of a likely Fed easing tonight and despite the squeeze in overnight dollar funding rates. The dollar index eased 0.37% to 98.24, with Euro and GBP notable gainers on better German data and receding Brexit fears.

Both AUD and NZD have edged lower against the dollar following the Saudi defence ministry announcement reflecting their risk proxy status. The threat of accusations aimed at Iran for the weekend’s Saudi Arabia attacks will likely see the U.S. dollar strengthen slightly in Asia given the region hosts the most of the world’s largest oil importers.

Oil

Another wild ride overnight as news that over 50% of the Abqaiq complex’s production had been restored sent Brent and WTI tumbling. Brent crude fell 6% to $64.25 a barrel and WTI dropped 5% to $58.75 a barrel.

Both contracts are, somewhat surprisingly, flat in Asia today. I would have expected a more heated reaction to the Saudi Defence Ministry press conference. Oil traders should be alert to headlines from it though during the session, as they have the potential to seriously ratchet up the tension in the region which is unlikely to be bearish for prices.

Oil is trading on event-driven headlines and will likely stay that way for some time, ignoring fundamentals like the higher than expected API Crude Inventories last night. Monday’s highs in Brent at $70.00 a barrel and WTI at $62.50 a barrel are near-term technical resistance.

Gold

Gold finished the day flat overnight at $1501.00 an ounce. An impending Fed rate cut was offset by falling oil prices, leaving gold marooned in no-man’s land. That situation will not last, however.  The Saudi’s appear to be gearing up to accuse Iran officially, and with an impending rate cut today from the FOMC, the balance of probabilities seems to indicate gold has room to move higher.

Gold’s critical support continues to be at $1480.00, followed by $1450.00 an ounce. Technical resistance is at $1412.00 and $1424.00 an ounce.

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