In times of market turbulence like this, I find it useful to do two things: make simple observations, and seek solace in the wisdom of others. So this week I have turned to the most voracious voice of reason, Winston Churchill, to help me make some sense of this all. This is what he has told me:

‘I never worry about action, but only inaction’

This simple expression from Churchill underlines the conundrum that the US currently faces. It is loose monetary policy (= low interest rates) which has spurred on the rally in equities and commodities in the past two years. Interest rates reached an historic low of 0.25% in December 2008, as the US central bank (= the Federal Reserve = ‘the Fed’)  took extreme steps to boost an economy in the midst of a severe recession.  

The logic was that low interest rates would encourage both individuals and businesses to borrow and spend, leading the economy back into recovery. This was partly effective, as economic data bottomed out and employment, manufacturing, spending, housing, and sentiment all made a tentative comeback.

However, it was not good enough, as the economy started to stall, and the government had to introduce quantitative easing (to the tune of $1.75 trillion in late 2008) and then the sequel, quantitative easing two (QE2 - a further $600 billion in late 2010) to try and revive the economy by essentially pumping liquidity into the system (by printing money, and buying US debt). 

These two endeavors unfortunately did not achieve their goal of spurring on a sustained economic recovery, leaving the Federal Reserve to announce on Tuesday it will be keeping interest rates at a record low until at least mid-2013:   

So while Winston Churchill warns of the perils of inaction, the Fed is left between a rock and a hard place. The rock is interest rates anchored at near-nil. The hard place is considering QE3.

‘If you have an important point to make, don’t try to be subtle or clever. Use a pile driver. Hit the point once. Then come back and hit it again. Then hit it a third time – a tremendous whack’

So the alternative of inaction by the Fed is further monetary stimulus, which would likely take the form of a third round of quantitative easing. This is considered an increasingly plausible option, especially if  the economy continues on its path to recessionary conditions, and inflationary pressures wane and give way to deflationary fears (while inflation can be fought by raising interest rates, there is nothing to fight deflation – ask Japan).

So while QE3 may seem ludicrous, the Fed may be given no choice if conditions turn armageddonesque. And after the failure of the prior two rounds to spur a lasting and robust recovery the Fed would likely feel pressure to really raise the stakes this time around, and hit the market a third time…with a tremendous whack.   

‘Kites rise highest against the wind – not with it’

Perhaps the most surreal event of the last week – that of the US having its debt downgraded for the first time in history – has prompted a similarly surreal event in…US debt. A combination of this news with a bout of poor economic data have sent equities and (most) commodities spiraling lower. This in turn has sent a flood of money heading into the safe-haven of US government bonds, regardless of the downgrade. Bond yields across the curve have hit fresh lows, as buying appetite has been insatiable:

This move into bonds tells us a number of things; that there is a rapidly rising expectation for a double-dip recession; that deflationary concerns are rising; and that the downgrade of US debt is of little material concern to risk-fleeing Treasury buyers. So as the headwinds for the US economy suddenly hit gale-force gusts, the kite of US debt flies to its highest point.

‘Everyone has his day and some days last longer than others’

Finally, current events are causing heightened volatility across asset classes, which leads us back to commodities. The point of this post was to talk about the bigger picture, as the implications of how current economic events play out will have a profound effect on commodities, and specifically energy. 

With crude oil taking direction from the equity markets (the litmus test for risk appetite and market sentiment), it is only natural to see prices reacting accordingly with such volatility, and with such a sharp correction. And the volatility at least will likely continue over the coming weeks as uncertainty continues to unfurl.

Meanwhile, other commodities such as US natural gas and coal are showing a muted reaction, somewhat insulated by their own market-specific fundamentals. And then there is Dr. Copper (the metal so good at gauging the economy it is considered to have a Ph.D in economics) and gold (the ultimate safe-haven). Copper is crestfallen, while gold is having its day and hitting all new nominal heights. And just as volatility is set to persist in general markets, gold is likely to see its day is lasting longer than others:  

My kingdom for a horse.

Once again, time carries us over the threshold of another quarterly milestone. These past three months have brought us confirmation that the last recession has ended (in June 2009), while general markets have rallied on the hope that things are so bad that further measures will be taken to keep us from contracting again. The past ninety-two days have seen BP finally plugging the oil spill in the Gulf of Mexico (as oil prices nonchalantly went on their way), while natural gas has continued its slide down the pricing pole on further faltering fundamentals. Spain won the World Cup, the US dollar lost its luster, and some people in China spent a chunk of this past quarter in a traffic jam. Let’s use this juncture to take a look at the energy highs and lows and somewhere inbetwixts: 

Scores on the doors for Q3, 2010:   

US natural gas prompt month: -16.1%
US natural gas calendar 2011 strip: -16.8%
NBP UK natural gas prompt month: +4.0%
NBP UK natural gas calendar 2011 strip: -7.4%
German power prompt month: +2.9%
German power calendar 2011 strip: -6.2%
WTI crude oil prompt month: +5.7%
WTI crude oil calendar 2011 strip: +6.4%
S&P500: +10.7%  
US Dollar Index: -8.5% 

The above price performances sliced and diced in 156 words: 

US natural gas was whoop-bang-walloped in the past quarter as production rose to a record high, more than negating the fourth hottest US summer on record and the increased cooling demand (= air conditioning) this brought. A non-eventful hurricane season only added further color to this bearish picture, and both prompt and calendar strips both slid. Across the pond, Europe saw modest gains on the prompt month for both natural gas and power due to unpredictable flows from such exporters as Norway (as well as a contangoed contract rollover), while hope that these supply issues were a transient glitch ushered the longer end of the curve lower. Crude saw a strong quarter across the forward curve as a weaker dollar and strong emerging market demand continued to rev the global economic engine (from stalling), whilst equities also buoyed the crude complex on hopes of a global recovery, regardless of  being souped-up by government intervention or not. 

Biggest energy-related non-event of the quarter: 

Hurricane Season. Despite there being an above-average number of named storms this year (15 with Otto appearing yesterday, versus the average of 11.3), and despite the EIA predicting 146 Bcf of production to be shut in due to hurricane season, only hurricanes Alex and Bonnie caused any outages of note. And the impact of this gruesome twosome totaled less than 10 Bcf.  An eventful non-event it has been. 

The oddest energy-related event of the quarter: 

One thing that has taken the crude complex by surprise is the blowout in the crack spread for heating oil  (the exchange-traded name for the diesel contract). Despite distillate inventories being at historically glut-like levels, the crack spread (measuring the profitability of producing a barrel of heating oil from a  barrel of crude) has risen as high as $15 on increased demand from Europe and refinery outages in Latin America. 

 The claustrophobic event of the quarter: 

Chilean miners spent the majority of Q3 trapped underground. 

Burrito crystal ball prediction for next quarter: 

Q4 will be the quarter for rollovers. Precipitously-poised economic data will topple to the dark side - manufacturing data, housing numbers, and the unemployment rate. Eeekola. 

The positive end to this review: 

Fall, Thanksgiving, Christmas, and mulled wine – Q4 rocks.

Sometimes it is very easy to get whirlwinded up in capital markets, believing we are at an absolute tipping point, an extremity of extremities, a turn signal the likes of which we have never seen before, only for prices to continue on and on. And on. Markets, like humans, are not dictated wholly by logic, and we need to remember: they too provide tales of the unexpected.

So despite the utter brilliance of the turbulence they provide, sometimes we need – and wish - for an anti-outlier: an expected outcome. So it is with that in mind, I present three such hopes:

First up, we hit the peak of hurricane season tomorrow (September 10th), with all but a half-hearted fanfare. Although the Atlantic hurricane season runs from 1 June to 30 November, the below image illustrates how activity ramps up in late August, only to fall off just as precipitously by the start of October:

This reason for such apathy of late with this hurricane season is not due to it being less active than normal (we’ve had 9 named-storms thus far – from Alex to Igor, via Bonnie and ferociously-named Colin - compared to the average of 11.3 for the entire season), but because it was projected to be one of the the most active in recent times. All this said…it ain’t over ’til it’s over. (Lenny Kravitz said so. And so did Yogi Berra, come to think of it).

Next up, we have Opec set to meet in mid-October, for only the second time this year. It is not that surprising that we haven’t heard much mumblings and grumblings from the cartel of late, in a past year that has had them declaring prices to be ‘perfect’, stuck solidly in their sweet-spot of $70 – $80 a barrel.  That said, their continued non-compliance with production quotas has been causing unrest within the group, and will once again be addressed next month in Vienna. Any formal production cut would be a ginormous surprise, and would likely only occur should crude prices fall precipitously below the aforementioned sweet spot (the chart below illustrates the adaptive nature of Opec production to price moves):

The third and final chart wishing for no alarms is the outlook for US GDP (gross domestic product a.k.a economic growth). This chart reflects the lowest view from 68 economists on Bloomberg. The reason I’m showing the low-balled view and not the average is simply because consensus appears too optimistic. In the same fashion that last quarter saw growth revised down from an initial 2.4% reading to 1.6%, we will likely see continued downward revisions so that forward projections converge  to meet reality. And the hope is that this low-end view will become reality, and not any worse….  

So in the choppy seas of this current economic environment, I place my hope in the above three anti-outliers to be a place of calm within this current storm. As for my current spate of music-related blog posts, I’m gradually becoming more current; last week the Beatles, this week Radiohead…next week maybe I’ll feature Katy Perry. In the meantime, no alarms and no surprises…..please.