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Trader's Corner
This week’s Trader’s Corner looks at the selloff in commodities and equities that followed the Federal Reserve meeting on Tuesday and Wednesday.
The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy. The Federal Reserve is the nation’s central bank. Monetary policy is the process by which the Federal Reserve controls the supply of money in the U.S. economy.
The Federal Reserve has a dual mandate of keeping inflation in check at around 2 percent annually and unemployment low, ideally less than 6 percent. Generally those are opposing goals, causing the Fed to play the ultimate balancing act.
The Federal Reserve controls three tools of monetary policy:
1. Open market operations – The purchase and sale of securities in the open market.
2. The discount rate – The interest rate charged to the commercial bank and other depository institutions on loans they receive from their regional Federal Reserve Banks’ lending facility – the discount window. The Federal Reserve Banks (FRB) offers three discount window programs to depository institutions: primary credit, secondary credit and seasonal credit. The primary credit rate is what the FRB charges to sound institutions for short-term (often just overnight) money. The primary credit rate is generally referred to when quoting the Fed’s interest rate. FRBs have been holding a primary credit rate of zero, essentially providing the money institutions need without charging interest on the money.
3. Reserve requirements – The amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Since 2008, the FRBs have been paying interest on required and excess deposits by member banks.
The seven-member board of governors of the Federal Reserve controls the discount rate and the reserve requirements. The Federal Open Market Committee (FOMC) controls the open market operations. The FOMC is made up of 12 members – the seven members of the board of governors, the president of the Federal Reserve Bank of New York and presidents of four of the remaining 11 FRBs. All 12 of the presidents of the Federal Reserve Banks sit on the board, but only five are eligible to vote on policy decisions at any given time. The 11 FRBs other than New York are divided into four groups, and members of those groups rotate as the voting members for that group. Ben Bernanke is the head of the board of governors and chairman of the FOMC.
The official policy statement and comments by Bernanke following last week’s FOMC meeting have had a huge impact on commodities and equities markets.
The official statement was the FOMC would continue with its current monetary policy, which includes buying mortgaged-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. It also said the board of governors would continue to hold its primary rate at or near zero until 2015. Giving a time frame of when interest rates may be raised was the news from this policy release.
However, at the conclusion of the FOMC meeting, Bernanke provided additional comments that gave insight into the current thinking of the FOMC. He said if the economy continued to show signs of improvement the FOMC would start phasing out its economic stimulus later this year. The phaseout of bond buying would end in 2014.
This news sent markets plunging. Below is background needed to understand why this decision had such a huge impact.
In late 2008, with the economy reeling and unemployment high, the Fed began trying to boost economic activity by reducing interest rates charged to banks to near zero. Later, the FOMC began adding stimulus to the economy. Essentially that means it was printing money.
By early 2009, crude was trading just less than $35 per barrel and the Dow just less than 6,600. From that point, the economy began a slow and erratic improvement. The FOMC has continued to pump money into the fledgling recovery. At the beginning of 2008, before moves resulting from the economic crisis, the Federal Reserve held $869 billion in securities and now holds more than $3.4 trillion.
Even though the economy has not been strong, the Dow Jones Industrials more than doubled since the Fed began its accommodative monetary policies.
Crude prices (representative of commodities) have nearly tripled in value.
At least part of the reason is that Fed policy forced investors into riskier assets to achieve any type of return. It is possible that commodities and equities have become overvalued as a result of the Federal Reserve policies. In essence, the Fed may have caused a bubble in commodities and equities values.
There was enough belief in that theory to cause equities markets to start declining last month when the Fed hinted of ending its stimulus. Then, with Bernanke’s recent, more definitive statement on that possibility, investors are unloading some of their length in risky assets. The result is a fall in equities indexes and most commodities.
There are a couple of reasons commodities and equities could decline more, even though stimulus measures are still in place.
First is the belief by some that the economic expansion cannot yet sustain itself without the Fed’s help. That means the prospects for U.S. companies’ revenue and earnings to be hurt. If that is true, stock prices may be overvalued.
Second, when the Fed starts raising interest rates (expected in 2015), other asset classes, such as bonds and treasures, will be more appealing. That will divide investment dollars into more investment classes, thus removing some of the cash fueling the possible commodities and equities bubble.
Investors could start trying to get ahead of this transition, even before the stimulus measures are actually changed. This will all have to be worked out in the marketplace as reflected since these announcements were made. It is safe to say that as of the last FOMC meeting there is more downside risk to commodities and equities.
As propane retailers, we find ourselves having to make decisions about our winter supply with major changes in the underlying economy and value of crude likely underway. That means there is increased risk of taking supply positions.
Unfortunately, as we discuss often, there is a lot of transition in the supply and demand for propane, which adds even more risk.
When conditions are extremely risky, with valid potential scenarios existing for prices to move in either direction, one should consider options. For a premium, we can transfer supply risk to someone else. As we have priced options for this winter’s supply, we have found them to be reasonable, especially when compared to recent years.
Options establish the highest price we will pay for supply. They also allow us to lower our price without being hurt, making them more flexible than swaps and pre-buys. The premium we pay (which we add to the cost of supply) becomes our known risk to price changes. We highly recommend doing a cost/benefit on options as part of supply decisions.
If you need more help in pricing or understanding options, don’t hesitate to call us at the number below.
Call Cost Management Solutions today at 888-441-3338 for more information about how Client Services can enhance your business, or drop us an email at info@propanecost.com.
WEEK IN REVIEW
Crude fell following the Fed announcing its plan to start phasing out economic stimulus before the end of this year.
Propane found buyers on Friday to cut into losses for the week.
We move from bearish to neutral to begin the week as it appears some pent-up demand has built for propane. Falling crude is likely to limit the upside, however.
LAST WEEK'S DAILY HIGHLIGHTS
Monday: Propane remained in a sharp downtrend, even as crude found support from worries about supply due to fighting in Syria.
Tuesday: Crude gained on expectations the Fed would keep its easy money policy, but propane couldn’t follow.
Wednesday: Conway propane shook off a bearish Energy Information Administration report for propane and falling crude to moving higher. The U.S. Federal Reserve kept its stimulus measures in place, but comments after its meeting by Chairman Ben Bernanke had markets moving lower at the close.
Thursday: Crude fell sharply with equities markets following Bernanke’s comments on Wednesday that the Fed could start phasing out its bond buying later this year.
Friday: Propane found a lot of buying interest to gain, even as crude continued to fall. |
