Goldman Wrong on Rates, Zero Hedge Wrong on Oil As Deflationary Side of Biflation Begins Its Ascendancy

When the cup is empty, you can only pretend it’s full for so long.  So it is with the capital base of the United States.

Before the collapse in the share prices of Citigroup and BofA in 2007-8, along with those of so many other financial companies, the stocks began underperforming the general market in 2006, implying that smart money knew that there was less “there” there in their capital bases than the companies were saying.

The beneficiaries of this destruction of capital were bond bulls.

I suspect the same thing is happening now, perhaps in an “echo” fashion.  One look at BofA’s stock chart tells the story.  It’s an ugly double rollover pattern.  (Citi’s is worse.)

Markit, similarly, shows a recent collapse in its “CMBX” indices of commercial real estate securities prices.

Similarly, when oil pushed past $100/barrel in the last expansion, that signaled the onset of recession.  While momentum and exaggerated stories of peak oil pushed the price much higher, the drop to under $35 demonstrated that prices much over $100 were bubble prices.

Given how little aggregate wage growth has occurred the past few years in the main oil-using parts of the world, meaning the US, Western Europe, and Japan, we can assume that oil prices, which have been at or over $100/bbl for months now considering Brent prices as well as West Texas Intermediate prices, have been doing their usual thing to oil-importing economies.

In the past, that decline in industrial activity has typically been associated with declines in Treasury yields, as the corrective action of declining oil prices is in fact disinflationary.  In 2008, the financial collapse was so severe that there was actually a brief period of deflation.  The result was zero short term interest rates, which over time have a gravitational effect on 5 and 10 year bond yields as it becomes evident that ZIRP is here to stay.  In that context, I view Goldman as probably getting it wrong on rates:

Goldman Sachs says in a note today that 10-year Treasury yields, trading recently at 3.022%, have stabilized around 3% on both sides of the Atlantic and below the bank’s measures of “fair value”. . . Goldman sticks with its year-end call of a 3.75% yield on the 10-year, even as some other major banks have cut their yield calls. (WSJ)

I think that 2.25% is more likely than 3.75%, not that I am assigning a 50+% probability to such an extreme downward movement in rates by year end or ever again.  But between the two, I’ve taken the “under” by converting cash yielding nothing into Treasurys of 8-30 years duration.  (I blogged on this last week in Rolling Down the Yield Curve.)

In the same pro-inflation vein, Zero Hedge has not one but two pro-oil price surge posts up today (LINK, LINK; boldface added by me).

The worst nightmare of crude bears has just come true:

  • OPEC secretary general says OPEC unable to reach consensus to boost production
  • OPEC delegate says OPEC has no consensus for agreement
  • OPEC president says some in OPEC believed should have had production increase, other said more time needed to assess
  • OPEC secretary general says OPEC spare capacity down to 4-4.5MBPD after Libya

What I think more likely is that demand will surprise on the downside, that Libyan oil production will not be shut in forever, that oil is in secular decline vs. renewable energy and possibly natural gas, and that non-OPEC production will grow substantially.  Thus when I look at the charts, I see $80 oil as a first downside target in a global industrial slowdown, with $60-70 not a stretch at all.  That 4-4.5 M barrel per day spare capacity might end up becoming gigantic as new production comes on line as global industrial businesses retrench.

After all, it was only the middle of the last decade that international oil companies were using $20 as their go-no go cut point for decisions on developing new fields.  $80 would still be a quadrupling and $60 still a tripling from there.  And of course these downside targets I have put forth could both be achieved and could easily be followed by strong new highs to and above $200/bbl in the next correlated economic expansion accompanied by yet another acceleration of global money-printing.

Investors and traders may want to get ready for at least a mini-rerun of the 2007-8 cycle.  In this scenario, gold will be pressured, but industrial commodities will be much more pressured, and silver will be intermediate in its price movement.  In such a situation, capital will be trapped and the path of least resistance will be purchasing of bonds farther out the yield curve at yet higher prices (lower yields), encouraged by the gigantic powers of the State.

We are now begun our fourth decade of declining bond rates.  The longest such cycle in US history is 36 years.  With record low short-term rates due to persist until at least 2012, who knows if this bond bull market will not also become the longest, and thus have a number of years, and a number of basis points, of life left before it ends?

Japan, anyone?


6 comments to Goldman Wrong on Rates, Zero Hedge Wrong on Oil As Deflationary Side of Biflation Begins Its Ascendancy

  • LarryS

    It appears that you have discounted a rebuilding Japan as a total non-factor in your analysis.

  • LarryS: I’m expecting a global industrial downturn in the aggregate. Japan will rebuild, and that fact will increase demand, but even that extra demand will be at least partially offset by the ongoing loss of some of its industrial production. I’m also thinking that as a major oil importer, the US will be one of the major beneficiaries of this slowdown relative to other countries. US GDP would be less affected by such an occurrence than that of countries for which manufacturing was a larger percent of GDP.

  • Paul


    I do not see your blogs on your site anymore. Why is that?

    You mentioned in your thought process that you do not buy into the theory of peak oil at the current time. I am a subscriber to Chris Martenson’s blog and he provides a fairly compelling analysis that the Saudi’s so not have much more capacity than thie current 8.5 MM barrels. This is not to say that they could not increase production over the next 10 years with massive capital spending. It’s just that the world does not have as much spare capacity as stated and is more suseptible to demand growing faster than new reserves are being brought to production. Renewables will take much longer than most people think. I am in the biofuels industry and have a good understanding of the dynamics.

    Your thoughts appreciated. I enjoy your analysis and always seek a range of differing opinons. In the end, I make my own mind up by considering a range of views.


  • Paul: I have been having some interoperability issues between posting on this site, which uses WordPress, and mine, which uses Blogger. WordPress offers greater graphing and charting capabilities, which are sorely lacking in Blogger. Please check both sites for a bit longer.

    Re peak oil, here’s what I said above:

    “Similarly, when oil pushed past $100/barrel in the last expansion, that signaled the onset of recession. While momentum and exaggerated stories of peak oil pushed the price much higher, the drop to under $35 demonstrated that prices much over $100 were bubble prices.”

    I do think that that was an accurate statement. It took exaggeration of peak oil concepts to get buyers to buy oil over $120 in 2008. (Distribution from strong to weak hands.) Whether peak oil and gas, collectively, is as important a concept and as imminent as Mr. Martenson thinks is unclear. Unconventional techniques, if they can be done safely, are quite promising. I just read that Israel’s Leviathan field may contain almost as much hydrocarbon reserves as Saudi Arabia is said to have.

  • i


    Peak oil is subtle. It’s best understood not as a simple quantity of oil (There’s a lot), but as energy return and price. Put simply, aggregate energy return on oil has been declining markedly since the 60s, while price has been increasing. When oil prices are high enough, and energy return is low enough, we’re done with oil as a major player in the energy picture.

    This is a problem. Oil adds 160 exajoules of energy to civilization each year, more or less. Nothing, not natural gas, coal or nuclear energy can replace that quantity of energy at a price and energy return that would make these alternatives a viable substitute. A quick quantitative analysis can be found here:

    Not that we *won’t* pursue alternative. We will and with increasing desperation and disregard for the consequences. It just won’t matter much. We’ll become a power poor civilization and frankly, a lot of us won’t make it through the end of the 21st century. While we have enough conventional oil reserves for 40 years – perhaps 50 with unconventional sources, however, it’s not like a milkshake where we are all sipping from straws until the glass is empty while singing Kumbayah. Declining supplies will shake markets, increase prices and cause political instability as it slowly dawns on the leaders of the world that they can’t transport food or fight wars or even defend their borders without *cheap* oil and lots of it. Oil nationalism (i.e. hoarding) will probably cause more shortages than any actual shortage of liquid hydrocarbons.

    I’d like to believe that magic techno-capitalists will ride in and save us, but unfortunately, oil extraction technology, while advancing, is like any other. It has hit the point of diminishing returns. Frakking is a wonderful thing, but it’s not a miracle. It costs more and can reduce net energy return.

    I wish I was more hopeful about this, but I have yet to see an argument regarding the end of peak oil that I can’t knock down fairly easily.

  • DoctoRx

    i: You and Paul may have forgotten more about peak oil than I ever knew.
    All I said about it is that (IMO) the price of oil was levitated to unreasonably high levels in 2008 in part because of exaggerations about the imminent advent and severity of peak oil. I wasn’t trying to opine in either direction about the reality or not of that issue longer term. Remember Goldman and $200 oil in 2008? Perhaps LOL now, but people were jumping into oil and oil stocks on that basis.
    IMHO my market sense is that the odds favor lower market prices for oil in the months ahead. (It should go w/o saying that major supply disruptions such as could emanate major unrest in Saudi Arabia or Iran remain perpetual possibilities that could override the economic trends that I foresee for the months ahead.)
    I am basically arguing w the POV that Mr. Dudley just took, which is that economic growth will pick up in Q3 and Q4. I am taking the “under”.