It was just a couple weeks ago that the Fed was out reassuring investors that stimulus measures would stay in place for the foreseeable future, interest rates would remain low, etcetera, etcetera.
I noted at the time how investor confidence was the key to economic recovery, and that Bernanke & Co. were well aware that stock prices need to remain stable, and that investors have made money. And an expectations to make more money in stocks keeps them investing and spending. But it’s more than that.
I have also observed that it’s critical for banks that their own stock prices remain strong. This is because they still have toxic assets on their books and their capital base is supported by strong equity valuations. This has been one of the main thrusts of all stimulus efforts – to put banks in a position where they can earn their way back to health.
If stock prices decline, then banks are suddenly placed in a much more precarious situation in regards to loan-loss reserves and balance sheet strength. This, in turn, will cause banks to lend less and really slow down the economic recovery process.
So it is significant that the Fed is already experimenting with how stimulus policies will be reversed…
*****I wrote on Monday that the Fed was testing “reverse repurchase agreements” where the Fed entices a bank to buy assets off its balance sheet, with the promise that the Fed will buy them back at a later date. This action serves to temporarily soak up some of the excess liquidity in the system. It’s basically a test to see if banks are able to stand on their own and continue to lend.   
The Fed will wrap up its first test of reverse repurchase agreements tomorrow. And in my opinion, this is why the stock markets have been somewhat stagnant and the Dow Industrials has been unable to break above 10,500.
Don’t be fooled into thinking that the U.S. economy is ready to be removed from government life support. It isn’t. In fact, the economy and the stock market has only come as far as they have because of government stimulus. And the very hint that Bernanke is considering how to remove stimulus is weighing on stock prices.
Of course, Bernanke has to remove stimulus at some point. And it is wise to test some of his planned actions and also prepare the markets for the inevitable. But that doesn’t mean it’s going to be easy, or smooth.
*****Perhaps the one positive point about the removal of stimulus policies is that the U.S. will be among the last countries to do so. Australia has already started hiking interest rates. And the European Central Bank is announcing the end of some of its emergency loan programs.
*****Deutsche Bank is out with its oil forecast for 2010. It believes reduced demand will keep oil prices at an average of $65 a barrel in 2010. The banks analysts believe that demand in the U.S. has peaked and that greater “oil efficiency” around the world will mean that demand will not rise much.
The term “oil efficiency” basically means that we get more use out of every gallon of oil. Like with higher MPG cars. We might drive just as many miles, but we use less gas to do so. That clearly makes sense. But there are also many assumptions included in Deutsche Banks’ theory.
One is that rising Chinese demand for oil will not continue on its current path because Chinese growth at current levels is not sustainable. Personally, I’m very hesitant to say that China can’t keep growing at an astounding pace. As we know, China can continue to support its economic growth for quite some time simply by deploying its foreign currency reserves. It doesn’t have to go into debt to support its economy like the U.S. does.
Also, let’s not forget that at some point, domestic demand in China will pick up and China’s economy can begin to transition away from its export orientation. When this happens, China’s growth becomes self-sustaining, the standard of living rises and you can bet that means oil demand will rise.
As it happens, there is an important catalyst for domestic demand in China we can watch for. Right now, China has a ridiculously high savings rate – around 39%. That’s because China has no social security type of retirement plan. It’s up to individuals to prepare for retirement. At some point, China’s government will implement some form of social security. And that may be the key that unlocks domestic demand in China because it will mean that Chinese citizens can spend more money.
*****Deutsche Bank also makes a huge error by citing statistics from the International Energy Association (IEA). The IEA has been sending out some very conflicting conclusions about oil supply and demand.
In 2005, U.S. oil demand was 21 million barrels a day. There was about 1 million barrels a day spare capacity for the world. Now that U.S. demand has dropped to 19 million barrels a day, overall global supply has 4 million barrels a day of spare capacity.  
The problem is that oil production outside of OPEC is falling, too. For instance, Mexico’s Cantarell Field has lost 1.5 million barrels a day of production in the last three years.
Overall, the chart of non-OPEC oil production looks like this:
It pretty clearly peaked in 2004 and has been in decline since. Now, is there any reason to believe that OPEC will keep current production levels steady in the face of falling demand and prices? I think not. I expect OPEC will seek to keep oil in the $80 range at the very least. And the fact that non-OPEC production simply can’t rise puts OPEC in an even stronger position.
I’d love for Deutsche Banks’ benign estimates to be correct. But I don’t think they are.
Published by Wyatt Investment Research at