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Crude Realities for Foreign Exchange - Global Exchanges

FICC Podcasts June 29, 2021
FICC Podcasts June 29, 2021

 

On today's episode, we discuss the first half of 2021's most shocking financial price move and its implications for FX


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi, welcome to episode 13 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson. In this week's episode, my co-host Stephen Gallo and I will be discussing the first half of the year's most shocking financial price move and its implications for FX both now and for the second half of the year. The title for this episode is Crude Realities for Foreign Exchange.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's cohost.

Stephen Gallo:

In each weekly podcasts like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

We strive to make this show as interactive as possible. So don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Stephen Gallo:

Greg, here we are. We're basically at the halfway point of 2021. So it's probably a good time to take stock and just look at what we've seen year to date. Let me tell you what in my mind are the key things that stand out. First of all, we had that move in longer term yields, particularly US yields early on in the year, but that has since retraced, it's come back down. When I think about the equity market, equity markets are up a good deal. We've got in local currency terms, the EUROSTOXX up about 15%, the US is up around 10 to 12%. The MSCI World is up 12%. What about you? What do you think stands out?

Greg Anderson:

Before answering with what stands out, let me start with what doesn't stand out. Unfortunately, for us and probably for the vast majority of our listeners, FX does not stand out. We've had the big yield move you mentioned, a decent sized equity move, but in FX, the US dollar is up a boring 1.6%. And in G10 FX, nothing has moved more than 7% against the dollar. Usually on a half year, we get something in G10 that has moved at least 10%. Now let me answer your original question. What stands out even more than the equity and rates moves is the commodity move. The Bloomberg Commodity Index is up 20% year to date. And while that moves started with base metals and things like lumber have gotten all the popular press. What really stands out is the move in oil. And just as an example, the Bloomberg Commodity Energy Component has generated a total return of 45% at the half year point.

Stephen Gallo:

Yeah, I think you nailed it, Greg. Oil is basically the star of the show and it looks to me like it's fast becoming an even bigger star. Here's the point I want to make. And then I want to turn it back over to you to get a response. When we talk about the global reflation trade, we often talk about the influence that central banks have on asset prices. We're not necessarily talking about goods price inflation, or services inflation, although we could be mentioning that, but typically speaking, the reflationary trade or the global reflation trade has to do with the influence that central banks have over asset prices, including sometimes commodities. But this move in oil to me seems different. There's a fundamental story here that is acting in support of the oil price, and it looks like it could continue. I mean, would you basically agree with that and also agree with my comments about how oil is different from the reflation trade?

Greg Anderson:

I don't know if you can hear me rolling my eyes about the reflation trade. It's not my favorite topic. I would just say this. Yes. Global QE has clearly got to be part of the reason why equities and commodities are rising. But I agree with you that it can't explain the quote unquote excess return of oil. That has got to be something more fundamental, something that ties back to supply and demand rather than what the hot trade is for the speculative, herd.

Stephen Gallo:

Right, Greg, those are all fair points. So obviously expectations have been built into the oil market of some type of an increase in production from OPEC Plus this week, but perhaps not enough to alleviate the supply demand and balance for the rest of the year. Especially, as European demand continues to bounce back, air travel picks up, and we move further into the summer driving season in the US. Of course, we'll see what OPEC Plus do on Thursday. But I also, I guess, because of the green agenda, prices are reacting to future constraints on supply too. So there are elements here of a structural move in the price of oil, right?

Greg Anderson:

I think you're right, Stephen. I think a lot of the oil move is structural. You mentioned the renewed global emphasis on green energy and it's noteworthy. I also think that just the exciting technology of electric vehicles and what they can do is becoming fully realized by markets. This will dampen future investment in oil exploration and production.

Stephen Gallo:

Right, Greg. Interesting. So do you have any hard numbers on that?

Greg Anderson:

Great question, Stephen. I think, where you get the best hard data is for the US. So in early 2020, the US had demand of 19 to 20 million barrels per day of oil. Its production of oil was 13 million barrels a day. And then production of finished products for export was the equivalent about seven million barrels a day. So the bottom line, US had excess production of about a half million barrels per day, and was a net exporter. In the initial six months of the pandemic, US demand dropped to about 15 million barrels a day and production and this is both crude plus product, dropped to about 17 million. So in other words, the excess supply became worse. But over the first half of this year, we've seen that completely flip. US production is still where it was back in December of 2020, but demand has come back all the way to where it is now, 95% of what it was pre pandemic.

Greg Anderson:

So now the balance is that the US has excess demand for crude of about a million and a half barrels per day. And this means that US needs to go out and buy this from producers in the middle east and elsewhere. So suddenly Chinese buyers face competition from US buyers. And that wasn't the case for the two years or so prior to the pandemic.

Stephen Gallo:

Some really interesting comments you made there and your last comments suggest to me that there could be even more upward pressure on oil prices from the international picture. That's really interesting and important to watch I think. Now Greg, I just want to swing back and talk about the global reflation trade one more time, even though I know that you despise this topic. So based on what you said, the hard data you've provided, if there is a fundamental story that is supportive of crude oil, then in my opinion, we're less likely to see a steep drop in crude as we move closer to the point where central banks like the Fed begin to slow the pace of monetary easing. But it seems to me like we're setting up for a really interesting second half of the year, if the bullish price action in crude persists. Because you're going to have these fairly dovish central bankers effectively playing a game of chicken with the oil price and inflation rates. I really hope they can hold their nerve. But I guess that's more of a concern for equity markets than the oil price.

Greg Anderson:

Yep. Rising oil prices put dovish central bankers in a tough spot for sure. But central banker 101 for that topic teaches that you look through as Bernanke once put it, increases in inflation caused by oil. I would expect central bankers to generally communicate that's their intention in the second half of the year. So I'm not convinced that a differentiation in central banker reaction functions will create much FX volatility in the second half of the year. But look, it doesn't mean that FX won't get oil induced volatility. Oil price swings often cause FX volatility without central bankers acting as the middleman. There can be profound impact on FX flows for countries where oil is either the biggest import or the biggest export.

Stephen Gallo:

Yeah, Greg. So what I've done is I've taken a cursory look at the FX returns in Q2. And when you look at the G10 space, a Q2 to date, you don't really see a massive bifurcation between the performance or the returns of oil importing currencies, and oil exporting currencies. I mean, year to date, it's a slightly different picture because the Canadian dollar and also, I think Norway, they're amongst the best performing G10 currencies. But even as oil has continued to move up in Q2, we haven't really seen the gap between oil importing currencies and oil exporting currencies really increase. So I guess there's scope for this to happen in Q3 if we continue to see this bullish price action in oil.

Greg Anderson:

Your point about a lack of bifurcation between exporters and importers is an important one. Yes, the CAD yen cross has moved about 9%, but if markets are fully priced in this oil move, I would think we'd see a similar size move in crosses like, oh, say ruble Korea. But it's not there. It seems to me that the FX market has been so surprised by, and maybe skeptical of the oil move that it hasn't priced in oil in the 70s, let alone oil higher than the 70s. Except in yen anyway, which is the biggest mover in half one in FX, down about 7%. And maybe that minus 7% is appropriate given the fact that oil prices this high flipped Japan trade surplus into a trade deficit. But why haven't other oil importer currencies reacted to the same extent?

Stephen Gallo:

Well, funnily enough, Greg, I have the same question and you know what intrigues me? What intrigues me is that the Euro has outperformed the yen in the first half of the year, not by 0.5% or so, but by a pretty large 4%. So Euro yen has rallied year to date, including a 1% rally in Q2. Now oil imports, as a share of GDP for Japan are slightly bigger than for the Euro area. I think oil imports for the Euro area works out to something like a half a percent of GDP, is a little bit bigger for Japan, but not miles bigger. So the Euro area, yes is a massive oil importer. And when you add up oil imports for the top three or four largest, most industrial Euro area economy, it's basically second to China. So I would think that if the oil price does stay around 70 or continues to rally, I would think that Euro, yen should face a bit more headwind in terms of its ability to rally.

Greg Anderson:

Come on Stephen, your soft peddling with your line about headwinds against the move higher on Euro yen. Really you have a stronger view than that, don't you?

Stephen Gallo:

All right. Fine Greg, you win. Yeah. I think Euro yen at these levels, doesn't make sense. It should be lower if the price of crude stays bid and the ECB doesn't react hawkishly. Yes. Given what they've been saying and what they've been doing with their monetary policy stance, if oil holds up yeah, I think Euro yen should be lower.

Greg Anderson:

And Stephen, let me just throw in there for you, Swiss yen and Swedish yen as exchange rates that probably ought to adjust lower if oil prices just to stay where they are.

Stephen Gallo:

Yeah, Greg, if Euro yen moves lower it should drag the European complex generally down with it. So there would be scope, I think for Swiss yen and Swedish yen to move lower. And plus they both have relatively dovish central banks too, that are guarded against currency appreciation. And I think what we'll do there is we'll wrap this episode up. Episode 13 of Global Exchanges. As always, we want to thank our listeners for tuning in. Please join us next time for Global Exchanges, episode 14.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:

We'd Love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO, Nesbitt Burns Incorporated, and BMO Capital Markets Corporation. Together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Not withstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell, or to buy, or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or suggestion that any investment or strategy referenced here in maybe suitable for you.

Speaker 3:

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Speaker 3:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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