For instance, after seeing a precipitous drop in crude oil prices, market makers, quants/hedge funds, and arbitrageurs will attempt to bring the rest of the market into equilibrium by buying the dollar and selling other commodities. This makes sense; since crude oil is traded globally through the Petrodollar, weaker crude oil prices should imply a stronger dollar. A stronger dollar should imply across-the-board weaker commodity prices also traded in the greenback or on American exchanges (natural gas, precious metals, crops, etc.), which then in turn could be a leading indicator for deflation. Speculative fears of deflation could trigger equity sell-offs, which we saw last August via the Shanghai crash and the S&P "flash crash".
However, I argue that these are only secondary responses to a rapid drop in crude oil prices and that there exists a more proximate and parsimonious explanation for the rapid drop itself. This requires us to backtrack a bit to the ending phases of our little war in the Middle East, also known as "Operation Enduring Freedom" (formerly known as Operation Iraqi Liberation or "OIL").
The war, which began in late 2001 and concluded in late 2014, saw a generalized increase in crude oil prices. Excluding the economic crisis of 2008, we saw an increase of its price up until 2011-2012 when the price had stabilized and was range-bound in the $90-110 area for quite some time. It wasn't until late 2014 that the price had started to drop, coincidentally around the time when the United States declared an official deescalation of operations in the region.
Following our rapid exit in Iraq and Afghanistan, a vacuum of power allowed the Islamic State to rapidly rise, taking control of vast quantities of crude oil production which many attributed as its primary source of funding. Now the obvious conclusion to me at the time was that ISIS was selling crude oil aggressively "at market" to rapidly goose down the global price of crude oil. Assuming this to be true, the aggressive selling served two functions: 1: to fund its war and 2: to weaken shale producers in the United States. Official figures show that the Middle East/OPEC can produce crude oil at a cost of anywhere between $10-$20 a barrel, whereas domestic shale producers in the United States need oil to be trading above $50-$60 to be profitable. The drop in crude prices certainly hurt our domestic shale producers which caused a slight panic in the markets.
Now this is where the story gets a bit more interesting. About five months ago, Russia had decided to intervene in the region as ISIS expanded its territory, taking a vast majority of Syria and putting Putin-backed Syrian President Bashar Al-Assad in palpable danger of being overrun. Last week, Putin declared his intervention a success and withdrew a vast majority of his forces from the region. Reports indicate that Putin had ordered airstrikes on oil derricks and production facilities to deplete ISIS of its funding. This makes sense as we saw the bottom in crude oil last month.
Given the chart, the narrative seems logical. But this is where the story gets a little more interesting.
Last week, Putin deescalated military operations from the region following peace talks with the United States (keep in mind that we also have interests and allies, i.e. the Kurds and Sunnis, in the Middle East). There was also another important event that occurred last week: the Federal Reserve's FOMC meeting.
In the meeting, the Federal Reserve decided to leave the Federal Funds rate unchanged which surprised some, but otherwise was what the market had largely anticipated. The one aspect of the meeting that was perhaps the most surprising was the dovish tone of the Fed along with a less aggressive stance on further easing this year. Of course, this implies a weaker dollar which would further imply higher commodity prices (crude oil). The timing of the two events (Russia pulling out of Syria and the FOMC meeting with dovish undertones) may have just been a coincidence but I came across an interesting article via OnlyPriceMatters that brings the coincidence into doubt:
During 2014, Russia had ceded Crimea as its territory and was purportedly involved in further operations in Ukraine. Although the US had not directly intervened, we were essentially engaged in a proxy war with Russia via Ukraine. Just around the peak of that conflict, Chairwoman Yellen started engaging in more hawkish tones regarding the Fed Funds rate, effectively threatening to end the six years of "zero-interest rate" policy. Of course, the United States implemented overt economic and political sanctions against Russia but perhaps the Chairwoman's threat of increasing the Fed Funds rate was the more subtle and damaging of sanctions implemented against the nation.
Russia's national revenue is highly dependent upon selling crude oil and natural gas to other nations. Interestingly, following that July 2014's FOMC meeting, we saw a sell-off in crude oil and other commodities because of the implied dollar strength from a hawkish Federal Reserve. In the days following, the Russian ruble plunged forcing Putin to adjust interest rates to counter-act the currency's weakness (their risk-free rate still stands near an 11%). This makes sense as lower profit margins from weak crude oil prices implies a weaker Russian national revenue.
Following the recent cease-fire talks with Russia and its subsequent withdrawal from Syria, along with a dovish Fed, we saw a strong reversal in crude's downward trend and a strengthening of the Russian ruble. It seemed as if some sort of economic sanction was lifted from Russia.
Perhaps the timing and language of FOMC meetings along with global political events are serendipitously linked. Perhaps they are not. But what we can clearly see is that the Federal Reserve and the United States have the ability to flex political might through financial markets alone. Perhaps the vague language of Federal Reserve governors are veiled threats that leave just enough flexibility and ambiguity to threaten anyone that attempts to misbehave in the global arena.
What does this imply about the ability of the Federal Reserve and the United States to affect foreign economies? Let's remember that the Chinese stock market did crash about 50% after the Fed Funds rate was threatened to be hiked in August 2014. What does this imply about the relationship between the Federal Reserve and the US government? If Fed policy can affect global markets, how much can they dictate domestic ones? Is the "grand experiment" of zero-interest rate policy and QE really just an experiment if they knew that a 25 basis point hike would squeeze the Russian economy?
In the 21st century, is war now waged through finance?
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