Category Archives: economics

The Immediate Impact of the ECB’s QE on the US

From our perspective, the most important and useful part of the Efficient Markets Hypothesis (EMH) is its assumption that asset prices change quickly to reflect the impact of new information upon the future expectations of investors.

So what does the ability of investors to collectively and efficiently absorb and assess new information and to communicate the changes in their outlook through asset prices tell us about what the U.S. Federal Reserve is likely to do with respect to its plans to hike short term interest rates?

Well, if we go by how U.S. stock prices responded after the European Central Bank (ECB) announced its Quantitative Easing (QE) program on 22 January 2015, the immediate assessment of U.S. investors was that the Fed will most likely implement its rate hike plans sooner rather than later. We can see that shift in the sudden change in the trajectory of the S&P 500, where it has gone from following the trajectory associated with an investor focus on 2015-Q4, which is consistent with what had been the growing consensus that the Fed would delay its rate hikes until then, to the nearer-term future associated with a forward-looking focus on 2015-Q2, which investors would now appear to consider to be more likely.

Shift in S&P 500 Stock Prices from 2015-Q4 Trajectory to 2015-Q2 Trajectory on 22 January 2015 following ECB Announcement of QE

That assessment will most likely be confirmed after the Federal Reserve's Open Market Committee concludes a two-day meeting on Wednesday, 28 January 2015 and issues a new policy statement. The Wall Street Journal explains why investor expectations would change in response to the ECB's decision in its schedule of economic news events for the week.

U.S.: 2:00 p.m. EST. Federal Open Market Committee’s monetary policy announcement:

After the ECB’s bombshell news of last week, all eyes now turn to the Fed. If it signals its continued intent to raise rates in the months ahead, this will likely drive even more fund flows into the dollar. How the Fed views that ECB move will be key. If it interprets it as an effective move to restore growth in the eurozone, it will see it as constructive to U.S. growth and likely want to stay the course and move toward higher rates sometime in the last spring or summer. If it instead focuses on the surge in the dollar that has come from the ECB move, it could be inclined toward holding back because of the disinflationary effect of that.

We already know that the Fed pays very close attention to the stock market in weighing their future actions, which we observed previously during their own QE programs. The reaction of the U.S. stock market to the ECB's action to initiate a QE program for the EU is such that the Fed is likely to hike short term interest rates in the US above their current 0-0.25% range by the end of 2015-Q2.

And that will hold until newer information might force the Fed to adapt its plans.

Factoring Global Demand into the Price of Oil

Brent Crude Oil Price Projections - 1987-2040 - Source: AEO2014 EARLY RELEASE OVERVIEW, http://www.eia.gov/forecasts/aeo/er/early_prices.cfm

How much of a change in global oil prices can be attributed to changes in the relative demand for oil? And how much might be attributed to changes in the relative supply of oil?

Those are questions that we've asked and answered before, but now, for the first time, we can finally quantify the extent to which either of these economic factors may be driving the price!

We can do that math now thanks to the work of James Hamilton, who built a model of how much world oil prices change in response to changes in the prices of other commodities - ones that are particularly sensitive to changes in the demand for them: copper, U.S. dollars, and 10-Year Constant Maturity U.S. Treasuries.

Our tool below is built to do that math, with the default values being the values recorded for the week of 4 July 2014 (for the "Previous Values" and for the week of 12 December 2014 (for the "Current Values"), which Hamilton recommends because they smooth out some of the big swings in values that are recorded in the day-to-day data. If you want to do the math for the current day, here is where you can obtain the data for the "Current Values" to replace the default values we've entered in the tool below:

Got all that? Here's the tool....

Value of Global Demand Sensitive Commodities
Input Data Previous Values Current Values
Copper [USD/lb]
Trade Weighted U.S. Dollar Index
Constant Maturity 10-Year U.S. Treasury Yield [%]
Brent Crude Oil - Europe [USD/barrel]

Projected Price of Crude Oil Based on Demand Factors
Estimated Results Values
Expected Price of Brent Crude Oil If Only Affected by Global Demand Factors
Differences from Previous Price of Brent Crude Oil
Estimated Change in Price of Brent Crude Oil Due to Demand Factors
Actual Change in Price of Brent Crude Oil
Percentage of Actual Change in Brent Crude Oil Price Attributable to Demand or Supply Factors
Percentage of Change Attributable to Demand Factors
Percentage of Change Attributable to Supply Factors
If you're reading this article on a site that republishes our RSS news feed, click here to access a working version of this tool!

Using the default data, which applied for the week of 12 December 2014, we find that 42.8%, or $20.29 of the $47.45 per barrel change in Brent crude oil prices following the week of 4 July 2014 can be attributed to a negative change in global demand (from slowing national economies, particularly in Europe and Asia), while 57.2% might be attributed to the relative changes in the supply of crude oil (thanks largely to increases in U.S. oil production.)

And so, just like the recent discovery involving the causality associated with the chicken and egg dilemma, we now know not only whether its changes in demand or supply factors that are mostly driving changes in the price of oil in the world, but can now also determine tow what extent each factor is responsible!


Do Falling Oil Prices Lead to Trickle-Up Economics?

Via e-mail, one of our readers asked some very good questions, which frame the seemingly fortunate economic situation in the U.S. pretty well:

With the falling price of oil, there is a chance to see if “trickle up” economics work as opposed to "trickle down" economics … What is the overall economic impact of lower fuel prices?

It seems the lower price of oil may be with us long enough to test the “trickle up” theory. I use the term "trickle up" because this is not the result of government Keynesian policies that narrowly focus the economic shift. Everyone, rich and poor, is being given a choice on how to reallocate their money now that fuel costs are a lower percentage of their expenses. [ assuming the government doesn’t find a way to take the extra $ back with new taxes ]

Many assume that if Wall Street is taking a hit due to the impact of low oil prices, the country is taking a hit … perhaps the stock market is only a short term indicator of national economic health at the top of the economic chain. If this is the case, stock prices only provide a short term “trickle down” view of the state of the US economy. What if “trickle up” is a longer term economic phenomenon that works outside the cycle time of the market? What indicators show the impact of extra money in every individuals pocket? Are there any short term “trickle up” indicators?

Here is the response we provided back on 5 January 2015, which we've modified since by either expanding our comments to quote things we had only linked before, or [making some correction in grammar or spelling], or adding links to news articles that hadn't yet been written:

[We] think the key to determining if there is such a trickle-up effect is to recognize that there are different cycles at work, which aren't necessarily synchronized with each other. For instance, if they were, then Lance Roberts' take on the economic impact of falling oil prices would be correct:

In the financial markets and economics it is a common occurrence that the media and commentators will latch on to a statement that supports a cognitive bias and then repeat that statement until it is a universally accepted truth.

When such a statement becomes universally accepted and unquestioned, well, that is when I begin to question it.

One of those statements has been in regards to plunging oil prices. The majority of analysts and economists have been ratcheting up expectations for the economy and the markets on the back of lower energy costs. The argument is that lower oil prices lead to lower gasoline prices that give consumers more money to spend. The argument seems to be entirely logical since we know that roughly 80% of households in America effectively live paycheck-to-paycheck meaning they will spend, rather than save, any extra disposable income.

[...]

The problem is that the economy is a ZERO-SUM game and gasoline prices are an excellent example of the mainstream fallacy of lower oil prices.

[...]

The obvious ramification of the plunge in oil prices is that eventually the loss of revenue will lead to cuts in production, declines in capital expenditure plans (which comprises almost 1/4th of all capex expenditures in the S&P 500), freezes and/or reductions in employment, and declines in revenue and profitability.

The majority of the jobs "created" since the financial crisis have been lower wage paying jobs in retail, healthcare and other service sectors of the economy. Conversely, the jobs created within the energy space are some of the highest wage paying opportunities available in engineering, technology, accounting, legal, etc. In fact, each job created in energy related areas has had a "ripple effect" of creating 2.8 jobs elsewhere in the economy from piping to coatings, trucking and transportation, restaurants and retail.

Simply put, lower oil and gasoline prices may have a bigger detraction on the economy that the "savings" provided to consumers.

Newton's third law of motion states:

"For every action there is an equal and opposite reaction."

In any economy, nothing works in isolation. For every dollar increase that occurs in one part of the economy, there is a dollars' worth of reduction somewhere else."

But the thing is that there is extra money coming into the economy because significant income (jobs) has/is not yet being lost in the oil industry. That "extra" money has provided a small, stimulative burst where increased economic activity in other sectors [of the economy] (such as restaurants, to name one industry that immediately benefited from the oil price decline in 2014), produce more income (growth) through a "trickle-up" effect, which is a big reason why the U.S. economy did so well in 2014-Q3 and Q4.

Perhaps the biggest question going into 2015 is how long that dynamic can play out. We would anticipate that the stock market will be especially rocky as oil industry-related companies begin to cull their dividends in greater numbers, which will be offset to the degree that firms in other industries might boost theirs. There are other dynamics that play into that, but from the core fundamentals that drive stock prices, that's the main aspect to which we're paying close attention at this time.

Water Trickling from Faucet - Source: ready.gov

Today, we're finding out that dynamic is just about played out, which we're seeing investors recognize through falling stock prices, falling yields for long term U.S. Treasuries, and falling commodity prices.

Worse, the fourth quarter of 2014 is turning out to not have been anywhere near as good as expected. Retail sales plunged in December, while the falling oil prices promise to dent economic activity in the states that have led the U.S. economic recovery following the December 2007-June 2009 recession.

That trickle up effect was sure nice while it lasted!

So far, there haven't been any major dividend cuts outside of just a few oil industry-related companies, so U.S. stock prices have instead been tracking along with investors' expectations for the timing of the Federal Reserve's planned hiking of short term interest rates.

Which is to say that they've risen whenever the news indicates that things are going well enough for the Fed to hike those rates by the end of the second quarter of 2014, and have fallen whenever the news is such that it becomes more likely that the Fed will delay its rate hikes to later quarters in 2015. At present, stock prices, as represented by the S&P 500, are consistent with investors betting on the Fed delaying its plan to hike rates until the fourth quarter of 2015.

Those temporal shifts in investor expectations account for the S&P 500's rocky ride so far in 2015 - at this point, there has been very little change in the amount of dividends expected to be paid out in each quarter of the current year. The only thing that would be worse would be for U.S. companies to respond to the increasing revenue distress they are facing by cutting their dividends, because that would fundamentally change the likely trajectories that stock prices will follow to the downside.

And then, it could be 2008 all over again as everyone waits on pins and needles for the next bad news to drop.

But unless and until that situation actually develops, investors will most likely focus on the world's central banks for their responses to the growing risks of global recession, which means that the market's rocky ride will continue. For now, anyway.