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Lower oil prices greasing the gears of global financial markets

TOKYO/HONG KONG -- Falling crude oil prices have financial markets around the world turning bullish, as cheaper gasoline will likely compel central banks to step up liquidity injections, stimulating both consumer spending and business activity.

     Crude oil prices fell further from already low levels after the Organization of the Petroleum Exporting Countries decided not to cut production at their meeting on November 27.

     Crude oil futures have declined roughly 16% since November to sink below $68 per barrel. Bank of America Merrill Lynch estimated in November that a 15% drop in crude oil price would push down global inflation, running at just under 2% at the time, by 0.1 percentage point in the first year, resulting in the lowest level since the global financial crisis.

Slipping further

The likelihood of inflation heading lower is a headache for the central banks that have been struggling to meet their price targets. It is widely accepted that lower crude oil prices were behind the Bank of Japan's decision on Oct. 31  to step up its monetary easing and unleash even more liquidity into the country's financial markets.

     Japan's consumer price index came in at 0.9% on the year in October, factoring out the impact of the consumption tax hike in April. The first sub-1% figure in one year means the country's inflation rate is now further away from the central bank's target of 2%. Because crude oil prices have declined even more since then, "it is inevitable that markets now expect even more easing by the Bank of Japan," an analyst at a Japanese brokerage said.

     The BOJ is not the only central bank in an industrialized country that has been struggling to meet its price stability target.

     The European Central Bank's target is slightly less than 2%, but a recent consumer price index shows inflation in the eurozone is running at around 0.3%. An estimate by the Organization for Economic Cooperation and Development suggests inflation in the region will not reach 1% until at least 2016. Expectations are growing that the ECB will eventually decide to join other central banks and embrace quantitative monetary easing.

     The Bank of England was expected to be one of the first central banks in the developed world to start raising interest rates. That view has fewer subscribers today, though, as the bank has indicated it anticipates inflation in the U.K. to slow.

     Asia is not immune to falling crude oil prices and disinflation. China's central bank cut interest rates for the first time in two years and four months in late November, as the economic slowdown had held down inflation. Because the country's economic trajectory remains unclear, the People's Bank of China will "introduce additional easing measures, such as a lowering of the reserve ratio," according to an analyst at Haitong International Securities.

     In South Asia, the Reserve Bank of India decided to keep its policy rate unchanged on Tuesday. However, the central bank said inflation will likely continue to decline, a remark many interpreted as a hint that an interest rate cut may be coming early next year.

     In South Korea, "views that another interest rate cut is coming" after the one in October are gaining support, according to Credit Agricole. The country's consumer price index is at 1%, far below its central bank's target range of between 2.5% and 3.5%.

Tapering concerns tapering

After flooding the world with the greenback through a series of massive monetary easing measures, the U.S. Federal Reserve is poised to start raising interest rates next year. Prospects of a U.S. interest rate hike once triggered flights of speculative funds out of emerging economies, but this is not the case today. Many investors believe the vacuum created by the Fed's tapering will be filled by other central banks.

     Global financial liquidity will remain plentiful because the ECB, BOJ and PBOC will move toward more monetary easing, according to Andre de Silva, head of Asia-Pacific rates research at HSBC.

     Many financial market watchers predicted that the Fed will hike interest rates as early as next spring, but there is a growing view that declining inflation will "delay the timing of the Fed's interest rate hike," Koichi Fujishiro, deputy chief economist at the Dai-ichi Life Research Institute said.

     Declining inflation creates a very comfortable market environment for bonds. In Japan, two-year government bonds are now carrying negative interest rates, while five-year bonds are changing hands at record-low yields. In Europe, yields on 10-year German bonds sank to their lowest-ever level of below 0.7% in late November, as more market players have come to expect the ECB will start buying bonds in bulk, as the BOJ has done. Consequently, long-term interest rates also remain at historically low levels in France, Italy and Spain.

     U.S. long-term rates are also at low levels. Long-term interest rates are now at year-to-date lows on India and South Korea.

Back to bull

Anticipation of further liquidity injections around the globe has encouraged stock market bulls.

     The U.S. Dow Jones Industrial Average stock index recently rose to a new record, while Germany's DAX index has been hitting year-to-date highs. The Nikkei Stock Average is at its highest level in seven years and four months.

     Lower oil prices are also expected to fuel stock price gains, since they are likely to stimulate consumer spending and corporate activities and give a boost to the economies in the U.S. and other industrialized countries. The Bank of America Merrill Lynch estimate also suggests a 15% drop in crude oil prices would lift the global economic growth rate by 0.2 to 0.3 percentage point in the first year.

     "It is merely an income transfer from oil producing countries to non-oil producing nations. In other words, it means the risk of an economic downturn has just shifted to oil producers," Tsuyoshi Shimizu, chief strategist at Mizuho Asset Management said.

     In the presence of deeply entrenched monetary easing bias, bond and stock prices will likely continue to rise, barring flare-ups in geopolitical risks.

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