Traditionally, when looking at any market, whether in commodities like corn or stock of companies like Apple, simple supply/demand dynamics can help explain underlying price action. Simply put, if there is a high demand and a low supply of something, the price tends to go up. Rising prices equate to inflation, whereas falling prices result in deflation.
One of the main mandates of the Federal Reserve (the Fed) is to keep prices stable. Although hyperinflation is problematic for the Economy, it is deflation that is their ultimate enemy, causing spiraling and cascading impacts that are hard to control once loose.
Oil is an example of that spiraling and cascading price decline, recently hitting a historic negative price print for West Texas Intermediate (WTI) Crude, meaning that not only was a barrel of oil worthless in the paper trading markets, those holding securities tied to WTI (via Futures Contracts based on the physical market) had to pay buyers in order to sell their positions.
The absolute collapse of energy use globally during the Coronavirus led to a never before seen decline in demand. While demand was collapsing, the supply of oil increased due to the breakdown of OPEC negotiations, leading to an economic anomaly and “double whammy” deflationary scenario in the physical market, with storage facilities nearing capacity.
As factories, travel, commerce and economies around the world have started to open back up over the past few weeks and months, we have started to see demand return and oil use resume, although nowhere close to what it was before. Simultaneously, we are seeing supply decrease with drilling wells being shut, oil companies at risk of default and OPEC coordinating a cut to production. This may lead to another economic anomaly and “double whammy”, but instead on the inflationary side as demand increases suddenly while supply decreases. Like many things, the supply line dynamics of the Oil market is such that re-starting the wells and the production process will take longer than it took to shut them down.
These type of price moves in WTI are a result of many factors, but very little intervention was seen by non-market participants (i.e. government price stabilization efforts). Rather, free market dynamics mostly led the prices down and have also led the recovery, with many investors losing out on each side. These natural market dynamics can lead to self-stabilization in the long-run without the need for intervention.
When looking at the intervention that the Federal Reserve has recently initiated, in the Bond market specifically, we are starting to see anomalies that may lead to greater challenges down the road when the Fed tries to unwind the easing action it has put in place. In order to fight the downward spiral of deflation, the Fed has long become the buyer and lender of last resorts in certain markets.
The ultimate impact of the recent pre-emptive interventions by the Fed, intended to soften the unprecedented economic blow from the Coronavirus and the shut-downs, will not be realized for some time to come. This may lead to more of an imbalance in prices and distortions of the true state of the Economy.
In my next series on this topic, I’ll delve into the Bond market risks that have existed for some time and are now even more exasperated based on the macro-economic supply/demand views.
Thanks for taking the time to read this article and I hope you found it informative. If you have any questions on this topic or would like to discuss further, please feel free to reach out.
Shar Gogerdchi, CFP®