Federal Reserve & Interest Rates

The stock market is rallying on the heels of falling oil prices, which are at their lowest levels since the beginning of May.  Despite the conflict that erupted between Russia and Georgia that threatens oil pipelines, oil continues it’s free fall, retreating nearly $35 from it’s July high.

“It’s become clear that demand is cratering, which is making it hard to rally,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts. “It’s hard to imagine that the market will shrug off the potential loss of 1 million barrels a day of pretty good quality crude but that appears to be the case.”

Oil producers have long stated that the natural price of oil should be around the $80 a barrel mark.  Heavy speculation and a falling dollar pushed oil above $100 at the start of the year and close to $150 by mid July.

Demand is falling across the globe so unless there are significant disruptions to supply, the price of oil could continue to fall.  There is no question that oil is the leader of the commodities market and it’s slide is having a spillover effect on the rest of the market.

Traders are leaving the commodities market in droves and pumping some of that money back into the stock market, fueling a rally that some experts feel could last a few weeks.  The bubble is bursting for commodities in general and it looks like the Fed was correct when it predicted that inflation pressures would ease as global demand cooled.

The stock market is taking advantage with it’s largest weekly gain since April.  So far, shipping and transportation companies are benefiting the most from falling fuel prices.

Although the decline in the price of oil is getting most of the attention, commodities have been retreating across the board for the last two weeks.

“People have gotten very worried about demand for commodities because of this global meltdown,” said Michael K. Smith, president of T&K Futures & Options in Port St. Lucie, Florida. “If all these major economies are going to slow down, people think that’s really bad news.” 

When the dollar started it’s free fall last year and inflation started to rear it’s ugly head, we saw large amounts of institutional money pouring into the commodities market.  Commodities were one of the few outlets for investors that provided decent returns with the bond, stock and housing markets all in decline.

So much money went into these markets over such a short period of time, a speculative bubble couldn’t help but form.  Unfortunately with the economic troubles that began in this country slowly spreading around the globe, that bubble is starting to burst.

On one hand it seems as if some of the inflationary pressures are starting to abate, which is the good news.  On the other hand, the reasons for this is not because conditions are improving in this country but that the rest of the world is falling to our level.

For example the dollar has been gaining in exchange markets recently but instead of thinking of the dollar as growing in strength, it’s more like foreign currencies are weakening with their respective economies.  Consider that interest rates in the U.S. are comparatively lower than much of the world, which serves to drive down demand for dollars.

If commodities continue their fall, it would allow the Fed to maintain interest rates at their current level and allow more time for financial markets to recover.

As expected, the Federal Reserve didn’t make any changes to interest rates at this month’s Open Market Committee meetings.  In it’s news release, it cited weak credit markets though it is still concerned with the threat of inflation.

Economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

Financial markets remain fragile as more writedowns are expected and mortgage markets continue to deteriorate.  It is looking increasingly likely Freddie Mac may be forced to use the government’s rescue plan sooner than expected, having reported large second quarter losses this week.

The good news is that oil prices have continued to fall this week and have shed about $30 from it’s high in mid July.  Increased output from Saudi Arabia and decreased global demand from slowing economies have finally made a dent on oil’s meteoric rise over the past year.

Only a single member of the Open Market Committee, Richard W. Fisher, voted to raise the Federal Funds rate this month.  If oil prices can stay around this level it would take a lot of pressure off the Fed to raise rates and give more time for financial markets to stabilize.