Without a Doha accord on an oil production freeze, the markets may suffer through an extended period of low oil prices, potentially causing a ripple effect that could extend to financial sector and U.S. dollar exchange traded funds.
“While nothing explicitly has been said, it’s not a far reach to suggest that the production freeze will have direct implications on the US financial sector,” Christopher Vecchio, Currency Analyst at DailyFX, said in a note.
The Financial Select Sector SPDR (NYSEArca: XLF) has been among the worst performing sector ETFs this year, falling 3.9% year-to-date, and the recent earnings results reveal potential hurdles that the sector needs to overcome.
Specifically, first quarter earnings results revealed that banks have become more concerned with energy company defaults, raising cash reserves to potentially offset the shortfalls.
“Put simply, time is running out for energy prices to recover to keep smaller E&P operations in business; solvency is an issue, not just liquidity,” Vecchio said.
Meanwhile, an unfavorable low-yield environment continues to weigh on banks’ profits. With U.S. yield curve flattening, banks have seen net-interest margins – the difference between income received on loans and interest paid to depositors – decline from 3.83% in the first quarter of 2010 to 3.02% by the fourth quarter of 2015.
“Banks margins have gotten thinner, and any energy-related writedowns (despite provisions being built up) may prove to be problematic,” Vecchio said.
[related_stories]If the low oil environment persists and causes a tide of defaults in the energy sector, Vecchio argued that the Federal Reserve would not idly sit back but would probably hold off plans on interest rate normalization.
Markets may already be factoring in the potential risks, which could mean that the Fed will keep rates lower for longer and even reverse tightening if the situation deteriorates.
Consequently, the PowerShares DB U.S. Dollar Index Bullish Fund (NYSEArca: UUP), which tracks the price movement of the U.S. dollar against a basket of developed market currencies, may not find much support from the central bank. Year-to-date, UUP has already fallen off 4.3%.