Diary of a Financier

Oil breakout: A potential gusher

In Capital Markets on Fri 14 Jun 2013 at 17:52

I expect to use a little more cash to buy some of the Oil ETF ($USO) on Monday, so I wanted to aggregate all my notes on it herein.

I had watched Crude’s ($CL_F) chart simmer for months now:

@RomeoFayette: $CL_F ($90.89) let’s see which way it breaks: LT symmet wedge (since 5/2010) nearing trendline sppt <$90; indicatrs all ambiguous.
$USO $XLE
April 12, 2013

@RomeoFayette: $CL_F watch for importnt breakout/dwn: daily LT symm wedge is ambivlnt given weekly/monthly charts.
$USO
May 26, 2013

Oil based nicely over the past couple weeks, forming a daily, short term Head & Shoulders bottom complete with bull divergence. From that setup, $CL_F broke through neckline resistance to close the trading week:

CL_F daily- H&S bottom w bull divergence

CL_F daily- H&S bottom w bull divergence

In addition, you can zoom out and see that this action was a small part of an even more momentus breakout today. When Oil stretched as high as $98.48, it passed above trendline resistance of its long term symmetrical wedge:

CL_F weekly- LT symmetrical wedge breakout

CL_F weekly- LT symmetrical wedge breakout

Since USO gapped up at the open, I want to wait and see how it trades next week—whether or not it will fill down to resistance cum support—before committing to a position. As expected in a classic symmetrical wedge, the weekly chart above shows no bullish/bearish bias in its indicators. The daily fractal tipped its hand though, offering the aforementioned inverted H&S and bull divergence as upside hints.

~~~~

It gets deeper than that though. I just dropped a comment as an update to one of my earlier entries, which post had asserted that the Fed’s tapering talk was rhetoric aimed expressly at talking-down asset values. Like a private-sector spokesman for the FOMC, The Wall Street Journal released a late-day piece yesterday affirming that very assertion, and Calculated Risk tried to talk some sense into Fed-watching sheeples thereafter:

John Hilsenrath (WSJ, 2013.06.13):
“Fed likely to push back on market expectations of rate increase… [after tapering chatter] appears to have investors second-guessing the Fed’s broader commitment to keeping rates low. This is exactly what the Fed doesn’t want… It’s a point Chairman Ben Bernanke has sought to emphasize before. The Fed, he said in his March press conference and again at testimony to Congress last month, expects a ‘considerable’ amount of time to pass between ending the bond-buying program and raising short-term rates.”

Also, as Bill McBride (Calculated Risk) points out:
“A few years ago, market expectations at each point were that the Fed was going to raise rates in six months – always six months, and that incorrect expectation was one of the reasons the Fed worked to improve their communications and eventually added a statement in January 2012 about keeping rates low until at least 2014. They revised their statement again and added thresholds for raising rates. It is pretty clear the Fed Funds rate will be low for a considerable time, and market expectations appear wrong again.

In a highly correlated rush between this May and June, global assets (from stocks to bonds, from the US to emerging markets) corrected in response to that “tapering” talk. As if smitten with its powers, the Fed decided that investors had suffered enough trauma for one week/month/year and decided to rescind any hint of immediate tightening. Via Mr. Hilsenrath, Ben Bernanke gave the market the “all clear,” then he took a sip of brandy while basked in the aura of his awesome puppeteering. Markets rallied around him.

Aside from noting Pavlov’s dogs and the reemergence of risk-on, I turn to inflation expectations in anticipation of a reaction. Perhaps a sign of rising economic growth expectations, TIPS yields had just peeked above zero for the first time since YE2011, but nominal Treasury yields has risen even faster. That combination sent implied inflation expectations even lower: 5y5y forward inflation breakevens fell below that important 2.5% threshold that the Fed would like to uphold. In fact, they’ve now dipped all the way to 2.36%, a borderline deflationary low as far as the FOMC has been concerned. Since the Fed has backed down from tapering again, the Pavlovian response would have 5y5y bounce from these lowly levels.

Rising inflation will not necessarily make or break a long trade in Oil, but I’d prefer to have it on my side. As I’ve discussed before and you can see in the accompanying chart, 5y5y inflation expectations and WTI Oil normally have a strong, positive relationship, but that historical correlation has gotten muddied post-crisis, due to fundamentals’ trump.

That’s the risk in an energy trade today: the macro supply/demand dynamics may be [are] extremely imbalanced. Although, I’d have to say that despite the broad-based commodity corrections, emerging market slowdown, and US hydrocarbon oversupply, Oil prices have really hung in there—merely consolidating for the past5y5y vs Oil- including correlation 2½ years.

Further, Oil’s correlation with inflation has turned northward after those years in negative territory, so I suspect USO will ride 5y5y’s coattails higher. The chart at your right shows a low-frequency, 300-day rolling correlation curve for the two inputs. The 10-year trailing correlation clocks in around 0.46, and a higher-frequency, 12-month rolling reading showed a strong, positive 0.58 correlation before SPX started catching-down with other assets at the end of May.

This all bodes well for a long $USO trade.

–Romeo (hattip chessNwine)

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  1. […] culpa: I previously took his mention of “rising rates” as synecdoche for QE + ZIRP, yet my re-read suggests […]

  2. […] is around 0.89 vs 0.76 benchmark; sigma 1.39 vs 0.82 benchmark. I’m really poaching $FXCM and $USO for entry points here.  The Regional Bank ETF ($KRE) may also be a candidate after it’s […]

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