PlainLanguagePlace.com  -  August, 2006 Update

Oil Prices, Interest Rates and Possible Stock Market Downturn.

The stock market is coming under pressure right now and a move to a defensive position might be a good idea.  I’ll explain the reasons for this view below.  But first defensive stocks are those companies that are not affected by the economy too much.  Proctor & Gamble (PG) is an example because they sell household staples and you still have to clean your house good economy or bad.  Having some bonds that pay interest is also a good place to park some cash.  Finally having some ready cash in the money market would be handy to pick up some stock bargains if some really bad news hits the wires.  A dramatic event in the Middle East / Iraq or a major oil supply disruption could trigger some panic selling thereby creating some bargain prices for solid companies.

The pressure being felt by the stock market is coming from high interest rates, high oil prices and a slowing housing market.  To say it in a simpler way, the economy is slowing down.  The housing market is declining from the higher interest rates.  When rates were very low families were re-financing their mortgages and keeping some cash from the transaction.  This added billions of added consumer spending power and now that is drying up.

Oil Prices

Oil and gasoline are hitting record levels again and that has a definite effect on the economy and the stock market.  On Monday, August 7th crude oil was trading at $77.00 per barrel up a $2.24 for the day and just cents away from the record high price.  The closure of Alaskan pipelines by British Petroleum (BP) due to pipe corrosion is the major factor right now.  Alaskan oil represents 8% of total U.S. oil production.  Plus the president of Iran is predicting $100 per barrel of oil in the near future due to the Middle Eastern wars.  The only good news for energy consumers lately is the lack of hurricanes in the U.S. so far this year.  The wars and the world political situation add approximately $30 to $40 to the price of a barrel of oil.  If you own oil stocks world peace would certainly be very costly to you.

Interest Rates

The pressure from interest rates is coming from the Federal Reserve mostly.  The Fed finally announced a halt in raising interest rates after more than 2 years of steady quarter point increases.  Finally!  But based on the stock market performance on Tuesday, August 8^th when the announcement was made the halt was too late.  The market believes the Fed overshot.  It raised rates too high. Raising rates is just like putting the brakes on the economy.  Put the brakes on too much and you stall the economy and it could slip into a recession.  The verdict is still out, but the down stock market on Tuesday shows an economic slowdown is predicted.  The stock market should have been rallying on news of the Fed not raising interest rates.

The basic thing to know about interest rates is that the Fed raises rates to slow the economy and lowers rates to stimulate the economy.  Sounds fairly simple but almost always the Fed overshoots and raises rates too far or lowers them too much.  However it’s not that simple though.  When the Fed raises or lowers rates it takes 3 to 6 months for the change to be felt in the economy.  Therefore we still have six more months of the brakes being applied and we are already going pretty slow.  The stock market is not happy about that.

A Good Interest Rate Indicator

The eurodollar is an excellent indicator of the future direction of interest rates.  Eurodollars are merely U.S. dollars deposited in foreign banks.  Any bank in the world, not just Europe as the name implies.  Eurodollars are a huge pool of cash measured in the trillions of dollars.  They are called a “currency without a country” because they are outside the regulatory reach of the U.S. government.  Eurodollars are also where China keeps the billions of trade surplus money they have with the United States.  It is because of this currency without a country feature that makes Eurodollars a good indicator.  They don’t have the “noise” of banking regulations to deal with.

Therefore the eurodollar futures contract is one of the best indicators of what the world thinks interest rates will do.  This contract is now showing a fall in rates at the end of 2006.  If the futures market is predicting lower rates, it is just like saying that the market thinks the economy will slow down.  The stock market is not happy about this either.

Wrap Up

So has the Fed slowed the economy to a stop?  It will take 4 to 6 months to be sure.  However the biggest unknown is the price of oil and the wars.  A solution to either one would cause a powerful stock market rally.  But neither seems likely this August. 

If the price of crude oil reaches $100 per barrel that will translate into gasoline pump prices being in the $4 to $5 per gallon range.  This would be a heavy drag on the economy along with the high interest rates.  So I believe a defensive position is in order until at least October or November.

Be careful out there.

Ken Mueller