All focus over the past couple of weeks have been on the equity markets as the Covid-19 situation continues to unfold.  In the background we’ve had extreme turmoil in the oil markets.  We thought it may be worthwhile to see if the price action in the oil market can be used to see whether we’ve seen a top in the US dollar.

Let’s start with equity markets.

One measure of the outlook for the global economy are the equity markets.  Whilst all equity indices have experienced significant declines, we will focus on the world’s largest economy as our benchmark.  The Dow Jones Industrial Average is shown in chart 2 below.  As can be seen prices have declined markedly, although not by as great a percentage as during the Global Financial Crisis (GFX).  One question is: have we seen the end of the sell off in equity prices?

Chart 2: Dow Jones Industrial Average (2007 – Present)

Let’s have a look at the oil market and see if it can tell us anything?  Oil prices have always served as a barometer of economic output, as global growth expectations naturally result in a higher oil price as the market expects oil consumption to increase with increased demand from factories, aviation, and auto use. This time around in addition to oil price having fallen due to a bleak economic outlook, we have a battle for market share between Russia and Saudi Arabia which resulted in a significant drop in oil prices (Chart 1).  In pure dollar terms, the oil sell-off during the GFC was far worse than today, but given we started at a much lower price point in this crisis, the percentage drop is of more interest, and shows that they are very similar. (note: most people assume that there is a zero bound to oil prices, but is that true?  Maybe not.  A discussion for another day perhaps)

Chart 1: Crude Oil (2008 to Present)

In order to try to filter out the impact of the price wars, we look instead at what’s known as Contango.  That is, what is the ratio of the price of the contract dated one year from now, and that of the nearest oil contract?  This gives us a sense of what the market expects in the longer-term versus the near-term.  A high ratio means that buyers are willing to lock in a far higher price for a future barrel of oil than the price that they can buy it at now.  Why would they be willing to do that? A) actual consumers of oil will do so because current storage costs are too high, or there is no storage available and B) speculators believe that oil prices will rally over the next twelve months and therefore they will enjoy capital appreciation of the long-term contract. Chart 3 below shows this contango.  We have now hit the highest ratio of the far-term contract to the near-term contract that has ever been seen. 

Chart 3: 1-year Oil contract divided by the near-term contract

What can history tell us, if anything, about the likely move in equities, based on the price action in the oil contango?  Charts 4 & 5 below shows the Oil Contango (blue) and the Dow Jones Industrial Average (orange) during the GFC, and thus far in the Covid-19 crisis, respectively.  In Chart 4 we can see that the oil contango peaked in mid-January, 2009 but the Dow didn’t bottom out until mid-March, almost a full month later.  We have spiked in the oil contango now, so perhaps equities, if they follow the same pattern as during the GFC, have not yet seen the bottom? 

If this is the case, then we can assume that we have also not yet seen the high in the USD, as the dollar has been highly correlated to the equity markets since the outbreak of the crisis in the US.

Bottom line: the volatility and the rally of the USD may not be over just yet

Chart 4: Oil Contango (blue) vs DJIA (orange), 2007 -2009
Chart 5:  Oil Contango (blue) vs DJIA (orange), 2018 – 2020
Chart 6: US Dollar Index (purple) vs DJIA (orange)

Author: John Glover