Daily Note – Pouring petrol on the fire

Oil fieldSummary

United States: Inflation pressures mount

United States: FOMC preview

United Kingdom: Headline CPI takes a dive in May

Eurozone: German Business Expectations slide in June

Good morning,

Iraq oil supply remains a concern as Russia shuts off gas supplies to Ukraine

Fighting continues to rage in Iraq. The major news is that Iraq’s largest oil refinery in Baiji was shut down yesterday, with the evacuation of all foreign staff as insurgents moved in to surround the refinery. The refinery in Baiji, one of only three in the country, processes all of the oil produced in the north of the country. This represents 25% of the nation’s total output. The fate of this major asset is up in the air and if the jihadist force comes out on top, they will surely use it to further fund their operations as they have done with captured Syrian oilfields.

Figure 1: The situation in Iraq

Chart 1 18 June

With the UN condemning mass executions and other “war crimes” being carried out by Isis, the crisis seems more and more like a repeat of the sectarian bloodbath in 2006.

However, one silver lining may be the chance for the West to improve relations with Iran. The deep-rooted distrust between Iran and the West may be beginning to fade. William Hague has announced that the British embassy in Tehran – on Bobby Sands Avenue – will be reopened!

Also, we are seeing prospects of greater understanding and even possible military cooperation between the seemingly mortal enemies, Iran and the US.

But this scares Saudi Arabia the other big power in the region.

While oil seems to be one of the focal points of the Iraq crisis, as is always the case in the Middle East, natural gas is heightening tensions in Ukraine as Russian giant, Gazprom turned off gas supplies to their Western neighbor.

In a continuation of the mind-games and mixed messages, Russia’s state-owned Gazprom accuses Kiev of failure to pay its huge debts (which is true), while the Russian ambassador to the UN, Vitaly Churkin, is proposing a new resolution calling for humanitarian aid, national dialogue and a ceasefire between Ukrainian forces and Pro-Moscow separatists.

The Russians are accusing Kiev of trying to “blackmail” Russia into giving them lower prices, while Ukraine’s Prime Minister, Arseniy Yatsenyuk, believes it is part of a “general Russian plan to destroy Ukraine”.

Put simply, this is the summer of discontent. For markets, 2014 has been the year of geo-political risk and this is going to continue. I believe the chances of a civil war in Ukraine are higher than many think, with huge implications for grain prices worldwide, just at the time that US inflation is, as we expected, ticking upward sharply.

United States: Inflation pressures mount

Table 1 18 June

In the US, headline CPI increased 0.4% in May (vs. consensus +0.2%). Prices were boosted in part by gains in food (+0.5%) and energy (+0.9%) prices.

Headline CPI has hit an 18-month high in the US (see chart below). As we have talked about a number of times in recent days, various inputs to inflation from food prices (cattle) to energy prices (crude oil) have risen in recent months.

Figure 2: United States Headline CPI YoY %

Chart 2 18 June

I suspect if real wages slip, as they have done, w0rkers in a reasonably tight labour market will get higher wages in the months ahead (see chart below).

Figure 3: United States – Real Wages YoY %

Chart 3 18 June

Elsewhere in the US housing starts fell 6.5% in May (vs. consensus of a fall of 3.9%). Despite all the negativity in recent months around housing in the US, both permits and housing starts (see chart below) remain in an uptrend. Yesterday, we saw the homebuilder’s sentiment index pickup as well, as lower mortgage rates helped buyer confidence.

Figure 4: United States Housing Starts MoM “000”

Chart 4 18 June

United States: FOMC preview

Until the inflation release, the market had very little reason to tune into today’s FOMC decision but suddenly there is an inflation story to cling to. What’s especially important in the Fed’s mind is that the rise in yesterday’s inflation data was broad based and not driven by a single factor.

The US dollar continues to extend gains after the higher-than-expected numbers, and a nod from the Fed toward inflation would drive it higher.

The hawks will be emboldened after this data and traders will be focused on inflation comments in the statement and Yellen’s press conference. Even if there isn’t a grand headline a la Mark Carney from last week, the market could spin any kind of inflation comment in a hawkish direction.

Trading Conditions

We remain very bearish on US fixed income looking for higher rates. We are short US 5 Year note looking for rates to move through the 1.80% mark in the next few weeks. (see chart below)

Figure 5: United States 5 Year Yield %

Chart 5 18 June

The real yield on the 5 year note is negative and this is unsustainable. See below.

Figure 6: United States 5 Year Note Real Yield %

Chart 6 18 June

United Kingdom: Headline CPI takes a dive in May

Table 2 18 JuneHeadline CPI inflation fell in May and with continued strength in the GBP, we might see inflation fall into the autumn – meaning no rate rise. Let’s wait and see.

In contrast, UK house prices continue to surge in April (see chart below).

The UK may turn out to have lower general inflation and very much higher house price increases. A major headache for Carney.

Figure 7: United Kingdom Headline CPI & House Prices YoY %

Chart 7 18 June

Eurozone: German Business Expectations slide in June

Table 3 18 JuneFinally, German business expectations are slumping back. While the ZEW number out yesterday is not as important as the IFO number out early next week, it would suggest that the German economy may have peaked for the year, as headwinds from a stronger Euro and the geo-political tension in Ukraine erode confidence.

Figure 8: German Business Expectations

Chart 8 18 June

Portfolio: Waiting for the FOMC

Table 4 18 June

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