Does this week's price action herald an end to the "risk on/risk off" relationship between oil and equity prices?
Chances are you’ve heard about “the great decoupling.” This phrase has been in vogue for some years now. It describes the belief that emerging markets will break away, or “decouple,” from the aging West in terms of long-term economic results.
It used to be that emerging markets were tightly linked, or “coupled,” to the West in that, when a Western country sneezed, the emergings would catch cold (or pneumonia, depending on the severity of the transmission).
On Monday of this week, something curious happened. The market responded vigorously to positive consumer data points in both the U.S. and Asia. Equities both foreign and domestic went into bullish breakout mode.
But crude oil did not.
“Rally Monday” passed up the oil market this week. West Texas Intermediate (still the benchmark for crude) was flat and, lo, even down noticeably on a day when other risk assets surged.
The “Other” Great Decoupling
Putting aside Asia’s ability (or lack thereof) to escape from the West’s economic gravitational pull, there is another “great decoupling” in store that gets far less press.
As with emerging markets, it is one that will have to take place sooner or later. It is the severing of the bizarrely strong price relationship between oil and stocks.
For the past good while, market conditions have been defined in terms of “risk on” or “risk off.” Commenters at the Financial Times and in other places used these binary terms to describe the way all risky assets seemed to be synchronized, flying high or falling low in the same breath. (During the summer of 2009, your editor wrote to Macro Trader members of a “Mr. Miyagi market,” comparing “risk on/risk off” to the sensei’s inscrutable “wax on/wax off” instructions in The Karate Kid.)
The rise in the price of crude oil became part of the “risk on” side of the market, as commodity prices and equity prices acted as one. Even though higher oil prices are hard on the U.S. economy (and the Chinese one too for that matter), a surging crude price was seen by bulls as confirmation that all was right with the world.
It almost got to where you could watch one instrument, like the S&P 500, and guess how oil had done that week based on its performance. Or vice versa. The coupling was so tight as to be downright creepy to those of us who did not think it normal, or healthy, for a mob of risk assets to exhibit the bulk solidarity of a roving motorcycle gang. But no one cared.
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Stimulated No More (Complications Return)
In retrospect, the mandate was fairly clear for the majority of 2009. Buy the stuff that’s going up in price as the tidal wave of government money sweeps all before it.
Things are no longer quite so clear. China is now facing serious inflation pressures, including the possibility of labor shortages. Even in the United States, the Financial Times reports, a shortage of skilled manufacturing labor is threatening to restrict production capacity of manufactured goods.
That’s inflationary too, bettering the odds that both Beijing and Washington will have to get more aggressive in withdrawing credit – and jacking up interest rates. Stimulus monies are being withdrawn, and interest rates at or near zero have only one direction to travel.
The U.S. dollar, still in a sturdy uptrend as of this writing, is another factor no longer so cut and dry for the “risk on” side of the ledger. As the U.S. economy shows more relative robusticity than Europe’s – not to mention a functioning monetary union on this side of the pond – the euro gets dumped. This, too, complicates things.
At some point in the (possibly near) future, we are going to get back to more “normal” asset markets in respect to some stuff going up as other stuff goes down. This will be a big shift from the stimulus-deluge-fueled “risk on/risk off” game in which the majority of all speculative assets surf the same wave. Crude oil’s head-scratching weakness on Monday is evidence that such a day draws closer.
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