Falling Oil Is No Cure for Fed Hangover

The concern has shifted from crude prices to inflation and the central bank's likely reaction.
By Nick Godt ,

A slide in the price of crude oil was not enough to lift spirits in a jittery market the day after the

Federal Reserve

finally sounded the alarm bell on inflation, especially in the wake of a stronger-than-expected consumer price index report.

The

Dow Jones Industrial Average

fell 14.49, or 0.14%, to 10,456.02, while the

S&P 500

rose 0.82, or 0.1% to 1172.37. The

Nasdaq Composite

gained 0.88, or 0.04%, to 1990.22. Breadth indicated a far more negative sentiment: Declining issues ouptacing advancers 3 to 1 on the

NYSE

and 2 to 1 on the Nasdaq.

The price of crude oil dipped 3.8% to $53.81 in Nymex trading, and that provided some support for the major indices. Yet the slide in crude oil did not generate a massive response from the market today. Why not?

The answer, it seems, is that the Fed's statement Tuesday has shifted investor concern from the previously surging price of crude -- which had weighed on sentiment -- to concerns about inflation and the Fed's response.

On Tuesday, the Fed clearly signaled that its focus has shifted from accommodating growth to containing inflation. In that light, falling oil prices don't have the salutary effect they otherwise might if the Fed still were viewed as being "pro-growth."

As if to illustrate the Fed's assessment of inflation, the Labor Department said Wednesday that the CPI rose a larger-than-expected 0.4% in February. Excluding energy and food costs, the index also rose a larger-than-expected 0.3% and, on a year-over-year basis, rose at its fastest pace since August 2002. Higher prices at the pump were largely responsible for the jump in the headline index, but higher prices also were seen in housing, transportation and health care.

And so the market is adjusting to an environment in which interest rates will have to go higher than previously priced in by most on Wall Street. In the fixed-income arena, the yield of the 10-year Treasury retreated to 4.59% after shooting to an eight-month high of 4.63% Tuesday.

It remains to be seen if the Fed's tightening will be administered more firmly (in 50-basis-point increments), or still gradually but over a longer period of time.

Considering the stock market's oversold conditions and the dip in oil prices, Wednesday's action in equities remains rational, according to Ehrenkrantz King Nussbaum market strategist Barry Hyman.

The market identified and sold interest rate-sensitive sectors, such as the small- and mid-cap stocks on the Russell 2000, which fell 1%, to buy into big-name stocks on the S&P 500 and DJIA.

With only moderate inflation, and the price of crude oil dipping, Hyman expects stocks to solidify positively within a few weeks.

Those are a lot of ifs, of course, starting with continued lower oil prices. So are oil prices really in a corrective phase?

Many pundits have been calling for oil's peak for months, only to see prices keep surging to record highs. But there is now increasing talk that an oil correction of roughly $15 a barrel is in order for the balance of the year.

Wednesday's sharp drop in oil was led by Energy Department data. U.S. crude stockpiles ballooned by 4.1 million barrels last week, topping the analyst consensus for a 2 million-barrel increase. But gasoline inventories fell by an equal 4.1 million barrels. High crude inventories temper oil prices, but tight U.S. refining capacity also has supported higher oil prices.

The market's strong reaction to Wednesday's rather neutral weekly Energy Department data showed that traders are poised to test lower levels, says Thorsten Fischer, senior oil economist at Economy.com.

Several fundamental factors point in the direction of lower oil. The prospect of higher rates in the U.S. is also supporting a higher dollar. That in turn is putting downward pressure on commodities prices, including crude. The dollar rose 0.5% to 106.08 yen while it gained 0.8% against the euro, which slipped to $1.2987 from $1.3088 late Tuesday. The CRB index lost 6.51 to 306.51, continuing a two-day slide.

Speaking of the dollar, earlier this week Hong Kong Monetary Authority Chief Executive Joseph Yam warned Asian central banks against diversification, i.e., buying more euros than dollars. China -- which was likely behind Yam's statement -- was reminding Asia that a strong dollar helps keep Asian goods competitive in the U.S.

Meanwhile, there is talk that China has already bought a lot of its current oil needs through forward contracts, another factor that may weigh on crude going forward. "In China, and many other parts of the world, there has been growing demand from cautionary inventories due to fears of disruptions in supply," says Economy.com's Fischer.

Fischer believes that strong global demand has been behind the surge in crude oil, but that demand and supply fundamentals should put the price at $44 per barrel on average for this year. Therefore, slower U.S. economic growth in the second half would also put downward pressure on oil prices.

He also believes that hedge funds have been exaggerating oil price movements. That impact, he says, could be lessened as higher interest rates will make margin trading more expensive.

Housing Data Cool

Well, the housing sector is finally showing signs that it's cooling; that, together with higher rates, should help rid some of the speculative froth, if not full-blown bubbles, in the sector.

In the week ended March 18, volumes of mortgage applications fell by 9.5% from the previous week. And refinancing applications are 60% lower than they were at the same time last year, the Mortgage Bankers Association said.

U.S. existing-home sales also dropped 0.4% to a seasonally adjusted annual rate of 6.79 million units in February. That's still slightly less than the drop to 6.69 million than economists expected, and the median sales price of $191,000 is still up 11% from last year. But inventories rose 10.7% to 2.38 million units, or a 4.2 month supply, compared with a record low of 3.8-month supply in January.

The Philadelphia housing sector index fell 1.18% to 5.71.

"After operating in an environment where we've had ridiculously low interest rates for so many year, we're talking about a return to normal on rates and in the housing market," says Gary Wolfer, senior investment officer at Univest Corp.

Among stocks on the move,

Oracle

(ORCL) - Get Report

rose 0.2% after reporting third-quarter results last night. The software giant earned 16 cents a share before items in the period, a penny better than forecasts, and said license revenue rose 12% from a year ago.

General Motors

(GM) - Get Report

continued its downward slide, losing 2.97% to $28.66.

The Wall Street Journal

reported that GM is in talks with private equity investors about selling as much as half of its commercial finance division. The operation is part of GM's main profit center, General Motors Acceptance Corp., and a sale could raise as much as $1 billion to help pay down debt.

MCI

(MCIP)

rose 1.3% to 23.27 on reports its directors met today to consider

Qwest's

(Q)

most recent takeover offer, which clocked in at around $8.4 billion. MCI is currently betrothed to

Verizon

(VZ) - Get Report

and its $6.75 billion bid, but it has been hearing from shareholders wondering why Qwest's bids have repeatedly been dismissed. Qwest rose 0.8% to $3.8 and Verizon gained 1.3% to 34.91.

Finally,

XM Satellite Radio

(XMSR)

rose 8.6% on news that its radios will be factory-installed in every new Hyundai car starting next year.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

your feedback.

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