In our last take on the subject, we suggested that in a world that is fundamentally oversupplied, marginal demand was the main driver of crude oil prices. Given China’s voracious appetite for oil this year, prices have been supported by a 12%+ increase in year-over-year physical demand from China. The bear case for oil assumes falling future demand from China in rate-of-change terms, given economic headwinds in the country. While fundamental supply and demand clearly influence the price, crude oil is also heavily subject to financial flows – particularly those relating to future inflation expectations.
Trump in the crosshairs
Following Trump’s inability to pass healthcare reforms last March, the market has grown wary of betting on the ‘Trump trade’. Given his broader agenda, which includes reducing taxes while increasing infrastructure and military spending, markets had bet on rising inflation. Government spending has historically been a significant source of inflation, thus big political changes tend to drive future inflation expectations.
This can be seen clearly when looking at 5-Year, 5-Year Forward Inflation Expectations, a measure of future US inflation expectations tracked by the Federal Reserve. While expectations shot up after Trump won the election alongside a Republican House and Senate, they started falling in April and recently bottomed in June.
Can the ‘Trump trade’ rise again?
Return of the ‘Trump trade’?
Looking at the gauge since June, inflation expectations have been gradually rising. On June 19 (when expectations bottomed), Brent crude was trading below $50. Since then, the commodity has rallied by over 10%, and is today changing hands above $55/barrel. The positive relationship between inflation expectations and crude oil appears to be intact.
We have argued in that past that today’s negative sentiment towards Trump is at an extreme. Last November, the market priced in most of Trump’s agenda, after the Republicans took control of the White House, Senate and House – clearly this was premature. Later in June, markets went to the other extreme, as it appeared that Trump ‘can’t get anything done’.
Given the very low bar today, even a small win in moving forward Trump’s agenda has the power to change the market’s views very quickly. Looking at the current tax reform debate, this means that a Reagan-style tax overhaul of the current system is not necessary to ignite future inflation expectations.
Passing the baton: China to the US
Thus the bull case for oil is the return of the ‘Trump trade’. While China has done the heavy lifting for the commodity for most of 2017, the US will have to assume responsibility from here. If Trump can make even limited progress on his agenda, sunny days lie ahead for crude oil prices. If he fails to deliver, the bear case we published earlier is likely to lead oil prices lower.