Investing legend Warren Buffett famously said, “After all, you only find out who is swimming naked when the tide goes out.”  Recently, it has become apparent that there is some nudity in the oil patch.  In the first chart below, I compare the price action of the S&P 500 Energy Sector Index, on a relative basis, to the S&P 500 (“the tide,” red and black line), against the price of West Texas Intermediate Crude Oil (“the nude swimmer,” black line).


 
 What is clearly evident, since January of this year, the tide has run out on oil prices.  Energy stocks are sending a warning that the supply demand equation for oil does not lend support for oil at this price level.  One reason oil prices may be at these levels is that the Saudis have their largest oil company going public soon (Saudi Aramco, Co.), and are desperate to raise as much money as possible on the IPO.  High oil prices will help them in that endeavor.  Given the past relationship of energy stocks and oil prices, we can deduce one of two things; either oil prices are too high or energy stocks are a screaming buy.  The two lines will revert back to each other, at some level, at some point in the future.  The last time this happened was in May of 2015 (chart below).  There too, energy stocks underperformed oil prices, and that was a warning of the eventual collapse in oil prices that caused so much turmoil in late 2015 and early 2016.


 
So why do I bring this up?  Well, oil is a big contributor to price inflation.  Oil is used in just about everything that is produced in the world, and if oil prices get cheaper, just about everything gets cheaper.  I believe this is why inflation expectations are down, and thus, why long bond yields are down.  How this performance divergence gets resolved will answer a lot of questions about what happens to interest rates and the shape of the yield curve in the future.  Do we continue to get flatter or do we steepen later this year?  Inquiring minds want to know!
 

Today, because of recent developments, I wanted to give you a brief introduction to one of my favorite tools I use to prepare my discussion topics when I consult with ALCOs.  I was going to introduce this at the ALMEdge Conference in April, but I wanted to give you a heads up now. 

I refer to this tool as my “Business Cycle Model” (BCM).  The beauty of this model is it has zones.  In each of these zones, there are discussion topics that are derived from researching the different economic data that tends to occur in each zone.  Some of the topics researched in each zone are things like credit spreads, loan growth, interest rate changes, credit risk and the unemployment rate.  Why am I bringing this up today?  Well, we recently crossed an important threshold in the BCM that implies that the business cycle should accelerate and put more pressure on the FOMC to increase rates, and in today’s testimony to Congress, Janet Yellen seemed to confirm what the BCM is indicating.  She specifically mentioned her fear of the consequences of waiting too long to raise rates.  In the chart below, you can see the model crossed above the upper threshold for the first time since the summer of 2007. 
 
 
 
 The chart below is the interest rate section study from the BCM, and as you can see, we have two developments of note.  The first happened in October 2015.  When the green bar appears, the model is alerting to an environment where the FOMC typically changes directions on interest rate policy.  Low-and-behold, the FOMC raised rates at its December meeting.  We got an even more important red bar in August of 2016 when we crossed the upper threshold on the BCM (chart above).  This is when we typically should expect a pickup in inflation and a tightening in the labor markets such that the FOMC needs to continue its new trend with interest rates (in this case, higher).  Again, the Fed raised rates at its December meeting.  Now, the BCM has breached the 90 level which means the FOMC is typically “behind the curve” and may need to pick up the pace of its rate increases. 


 
 
 
Remember, we have been waiting a long time for the normalization of rates, and this sure beats the heck out of having to talk about negative interest rates.  Thankfully, that discussion topic is in the rear view mirror.
 

Now that oil prices and commodity prices have rebounded and stabilized, we can pretty much say the manufacturing recession has ended.  This is great news and it is confirmed by some recent strength in a very important model of mine.  Those of you who can’t take hearing some good news from me, don’t read on.
 
According to my Future Production Barometer (below), we are set to see continued improvement in industrial production and this should improve U.S. GDP numbers in Q1 of 2017.  We may even be able to achieve 2.5% growth in Q1. The supply/demand setup looks primed to take us to some of the best YOY% growth rates in production we have seen in a while.



 
 
The great news for us as bankers is this will greatly improve our credit risk for the foreseeable future (see chart below) as well.  Now, this is a broad-based, generalized comment.  There are still pockets of weakness in the oil, Ag and restaurant sectors but a future pickup in production should begin to minimize the credit risk in the trucking industry. 




Under these conditions, we should see some overall earnings improvements which should improve company cash flows this year and we will hopefully enjoy a pickup in lending later this year. I will have more on this at the ALMEdge conference in April.   Sorry to disappoint, but that is it, no gloomy “on the other hand” for you today.