Oil weakness may intensify

Earlier this week, Asian & European markets showed another failure to respond to Monday’s 1.4% gains in U.S. equity indices (Dow & S&P), further highlighting the unsustainability of the gains in indices, which had become increasingly dollar-driven (caused by prolonged USD weakness resulting from Fed officials failed attempts to support it) instead of improved economic figures. Indeed, the absence of further improvement in fundamentals (four-month lows in October industrial production, slowing core October retail sales and six-month lows in October housing starts) underscores the role of USD weakness as the main driver to higher equities.

Yet, while the dollar index hit fresh 15-month lows on Monday at $74.68, oil failed to regain its interim resistance of $80.50 (not even mentioning the year high of $82). Such failure was especially prominent following the higher than expected decline in oil inventory drawdown. Last week's brief break below $76 underscores the emerging bearishness in the fuel, which suggests a swift renewal of fresh shorts to retest the 75.53, which is the 38% retracement of the rally from the 64.98 low to the 82.06 high. And should the pattern of previous down cycles repeat itself in oil, a steeper decline could be in the woks, likely calling up the 73 handle.

Oil's inability to preserve rallies in the face of USD weakness reflects the lack of sustainability of speculative flows to elevate the fuel as real demand falters (shown by two consecutive weekly higher than expected builds in oil inventories). There is a downward drift in the Oil /EURUSD ratio, resulting from a more rapid appreciation in the euro (more rapid depreciation in USD) than an appreciation in the price of oil. Note how this pattern occurs after a rise in the ratio in October, which emerged as a result of a more rapid increase in oil relative to the rise in the euro. Said differently, oil is losing its ability to respond to USD weakness. Thus, any catalyst driving USD strength (stocks correction, Chinese remarks on commodities or less dovish rhetoric from Fed officials), would especially accelerate oil selling.

Oil's relative weakness has also been highlighted against equities (S&P500 and Dow), as the equity/oil ratio surged to a four-week high. Interestingly, U.S. equities have outpaced those in Japan (Dow/Nikkei at highest since Dec 08), UK (Dow/FTSE at three-month highs). Could relative strength of U.S. equity indexes be the product of currency weakness and not much more? We have already raised the S&P 500's recurring failure to recover 50% of the decline from the 2007 record high to the 2006 low (1,120). The equivalent 50% retracement for the Dow stands at 10,335, which was broken on Monday, Tuesday and Wednesday but has yet to do so for the week (on Friday).

A weekly close below the 10,335 in the Dow, below 1,120 in S&P 500 and a confirmed downtrend in oil (close blow $79 and fifth straight weekly lower high), would establish markets fading dynamic for risk appetite. This was already established on the currency side, amid the protracted yen strength. We warned last that yen strength would continue outperforming the much-talked-about-USD strength by pundits. Deepening weakness in oil and equities would help stabilize USD (instead of propping any major rally beyond 7%), but JPY will continue to show the greater rebound.

About the Author

Ashraf Laidi is chief global strategist at City Index-FX Solutions and author of “Currency Trading & Intermarket Analysis.” His Intermarket Insight appears daily on AshrafLaidi.com.

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