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The oil price was the big mover last week. Brent crude fell through some major levels including $100, $95 and it even tested the air below $90 for a while. Three things weighed on the oil price: 1, weak economic data out of China, Germany and the US fuelling concern about the future for world demand 2, the on-going Eurozone crisis and the spike higher in Spanish bond yields 3, the Fed voting against more QE at last week's FOMC meeting and instead extending Operation Twist by a fairly meagre $270 billion.
There are various opinions of where oil will go next. Some believe it is oversold and there is a lot of technical evidence to back this up. The daily Relative-Strength-Index was in oversold territory below $90 per barrel. Added to this the price has fallen well below its daily moving averages and the base of the Ichimoku cloud, suggesting that $90 could be a temporary low and Brent crude be due to some light respite. However, while the outcome of the Eurozone crisis remains cloudy and the prospect of a major global recession caused by a disorderly breakdown of the currency bloc remains on the table it's hard to see how the oil price can rally.
Brent crude oil, daily chart: after sharp falls it is starting to look oversold:
Instead, the break-down in the relationship between oil and US stocks remains more interesting in my view. Oil and stocks tend to move closely together, but in the last 6 weeks the oil price has been tumbling while stocks have been consolidating. But could the fall in oil be a warning sign for the stock markets?
Brent crude oil and the SPX 500 (normalised to show how the two move together)
Source: Bloomberg and Forex.com
Typically commodity and bond markets move first while stocks lag. This is because commodity prices denote inflation/ deflation, this causes changes to central bank policy which affects the bond markets, and the stock market is sensitive to changes in interest rates. The decline in oil prices and the sharp drop in US Treasury yields suggest two things: 1, a deflationary force threatens to take hold of the markets and 2, the commodity and bond markets are worried about a sharp slowdown in growth hence oil prices have declined and so have yields. The Fed reiterated its commitment to keeping rates low through to 2014 at its meeting last week. Low rates are usually good for stocks, however, not when they are caused by deflation (which is bad for companies, as it puts consumers off spending in the hope of even lower prices later on). Thus, could 1,360 be the high in the SPX 500? That is one possibility. Right now the US stock index has a nice range framed by the 100 and 200-day moving averages between 1,295 on the downside and 1,360 on the upside. The outcome of this week's EU summit is critical for the future direction of stocks. If the outcome is deemed positive (the EU authorities agree on fiscal and political union) then we could see risk rally hard, if it is disappointing and doesn't agree on any of these things then we could see risk assets sell off sharply, including stocks, which opens the way to a severe decline back to the 1,100 low we saw back in the September last year. In the lead up to the meeting, we expect this range in the SPX 500 to persist.
SPX 500: daily chart
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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