Why Higher Oil is Negative for the Dollar

I have written my own piece on How Oil Prices Impact the U.S. Dollar but Jens Nordvig of Nomura has an equally thorough take that is worth reading:

What does the spike in oil prices mean for the dollar?

Recent memories suggest that higher oil prices are bad news for the dollar. First, we have been used to a generally negative correlation between oil prices and the dollar since around 2004. This was especially the case in the first part of 2008, when the correlation between EUR/USD and Brent reached very high levels. Second, past episodes of tension in the Middle East suggest that the dollar tends to weaken when there are oil supply shocks. This was the case during the first Iraq war in 1991 and in the run-up to the second Iraq war in 2003.

Beyond the observed correlations, there are also fundamental reasons to explain why the dollar should be negatively correlated with oil prices. We can think of three:

1. High US energy intensity: the US economy is more energy intensive than most other developed market economies. Linked to this, the US is a bigger oil importer than the eurozone. This again means that the US’s terms of trade deteriorate more than other economies when oil prices go higher.

2. Petrodollar flows:
When oil prices rise, oil-exporting countries generate more revenue. If a significant proportion of additional revenue is allocated into non-dollar currencies, the net impact can be USD selling. In 2008, when oil prices rose above $100/barrel for the first time, we saw a strong correlation between EUR/USD and oil prices (Figure 2). This correlation is consistent with an increasing share of euro in the reserves of oil-exporting countries, such as Russia and the Middle East.

3. Asymmetry in inflation targets:
Oil price shocks affect monetary policy differently in different countries. The Fed tends to focus on core inflation (Greenspan used to focus on the core PCE deflator for example). This means that higher oil prices are not a primary concern in relation to monetary policy. The ECB by contrast focuses on headline inflation, and we have observed in the past that upward pressure on headline inflation from global energy prices (such as in mid-2008) has the potential to trigger rate increases. This asymmetry in inflation targets creates a weak USD bias in the face of oil prices shocks, at least in relation to EUR/USD.

How Does an Oil Crisis Impact the U.S. Dollar?

Oil prices are on the rise and everyone is talking about the possibility of $100 oil. Right now, the rise in oil is accompanied by a rise in the U.S. dollar but will this relationship last? Taking a look back at the two prominent oil shocks of the past four decades (1973 and 1979) and others beyond that, we see that the dollar eventually weakens.

1973 Oil Crisis: Initially Dollar Bullish, Eventually Dollar Bearish

In 1973, oil prices jumped 134% when the members of the OAPEC, which is OPEC plus Egypt and Syria, announced that they were no longer shipping oil to nations that supported Israel in its conflict with Syria and Egypt. This effectively shut down exports to the US, Western Europe and Japan. As a result, prices rose significantly to account for the sharp reduction in supply. At the same time, Saudi Arabia, Iran, Iraq, Abu Dhabi, Kuwait, and Qatar unilaterally raised prices by 17 percent and announced production cuts after negotiations with major oil companies.

In response to this oil shock, the trade weighted US dollar index* as measured against the major currencies first strengthened alongside oil and then sold off immediately. At that time, the Federal Reserve was combating inflationary pressures by raising interest rates. The jump in crude exacerbated the need for further rate hikes, forcing the central bank to bring the Fed Funds target rate from 7.5 percent in May 1973 to a high of 13 percent by the summer of 1974. The focus on inflation was initially dollar bullish but once the rate hikes started to have a serious impact on US growth, the trend turned dollar bearish. Between the third quarter of 1973 and the first quarter of 1975, GDP growth contracted five out of the seven quarters and in response to the deterioration in growth, the US dollar erased all of its gains.

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1979 Oil Crisis: Initially Dollar Bullish, Eventually Dollar Bearish

The US’ second oil crisis in 1979 was triggered by the Iranian revolution and exacerbated by a gasoline shortage. OPEC raised prices by 14.5 percent on April 1st and the US Department of Energy announced phased oil price decontrols which involved the gradual increased of old oil price ceilings. Shortly thereafter, OEC raised prices a second time by 15 percent, the US halted imports from Iran, while Kuwait, Iran and Libya cut production. Saudi Arabia also eventually raised their market crude prices to $24 per barrel and because of all of these factors, crude oil prices increased 118 percent between January 1979 and December 1979.

The price action of the US dollar during that time was very similar to the price action of the greenback in 1973; it first rallied and then sold off. At that time, the Federal Reserve was also hiking interest rates to combat inflationary pressures and the oil price spike exacerbated their degree of rate hikes. Between January 1979 and December 1979, rates where taken from 10 percent to 14 percent and by March of 1980, the Fed Funds rate hit a high of 20 percent. Quarterly GDP growth dropped 7.8 percent in the second quarter of 1980, triggering the dollar’s demise.

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1990 Oil Price Spike: Persistent Dollar Weakness

Between June and October of 1990, oil prices also jumped 113 percent as a result of the first Gulf War. Interestingly enough, the US dollar behaved very differently for two reasons. The first was the short-lived nature of the oil spike; prices started falling 6 months after the initial rise and the second was the Fed’s monetary policy cycle. Unlike the oil crisis of 1973 or 1979, the Federal Reserve started cutting interest rates before the spike and continued to reduce rates throughout 1990 and into 1991 and the dollar was already in a downtrend due to the loosening of monetary policy. The weakness continued as growth slowed with GDP remaining stagnant in third quarter of 1990, and then falling 3 and 2 percent respectively over the next two quarters.

Although the U.S. dollar is rising right now, the abundance of spare capacity and the muted level of inflation means that the Federal Reserve is not pressured by the increase in oil prices. The market basically doesn’t believe that the Fed will start raising interest rates – and they have good reason to feel this way because based upon the last 3 oil shocks, the recovery could suffer from higher commodity prices. Back in the 1990s, the Fed took a break from cutting rates like they are expected to do in June, but they quickly resurrected their rate cuts as the economy slowed. Of course, interest rates were much higher then than they are now, but if growth does not pick up, the Fed may be forced to prolong its asset purchase program.

Dollar Unfazed By Mixed Economic Data

The US dollar appears to be unfazed by this morning’s mixed economic data. An improvement in consumer confidence has failed to help the dollar while the weaker news has pretty much been baked into the markets.

Christmas and New Years week is a time when traders are more focused on seeing family than making profits. It is probably truer this year than most because of the sharp volatility in the financial markets and the deep losses endured by most investors.

Third quarter GDP remained unrevised at -0.5 percent even though personal consumption slipped and core prices eased. Investors are more worried about the Q4 numbers than the Q3. The global recession and the stronger dollar could take a big bite out corporate earnings and growth.

The housing market also remains weak with new home sales falling for the fourth consecutive month and existing home sales falling by the largest amount on record. Sharp discounts on new homes is helping to slow the pace of falling demand.

The one piece of good news that we did see this morning was consumer confidence which was revised upwards in the month of December. Given that almost everyone knows someone that has been laid off, the price of gasoline is the only reason to cheer this holiday season. Prices at the pump have fallen close to 60 percent from its summer highs. For drivers, lower gas prices is like a tax cut. At a time when salaries are being frozen and bonuses are being reduced, a tax cut in the form of lower gasoline prices is welcomed with open arms.
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Gas Prices Continue to Fall

I was in New Jersey this weekend and was amazed to see gas prices at $1.89 a gallon! Sometimes reality doesn’t set in until you venture outside of the Big Apple because at the Mobile Station on the corner of the West Side Highway and Canal Street in NY, a gallon is still selling at $3.10.

The national average is $2.087 a gallon, down 50 percent from summer highs – 16 states have average gas prices below $2 a gallon.

With everyone crying about a global recession and retail sales seeing a record decline, the fall in gas prices is a silver lining. Although gas station receipts will a take a hit, lower prices at the pump will free up money for Americans to spend on basic necessities and holiday purchases. In no way will it single-handedly turn the economy around, but it will help in other ways such as reducing heating bills going into the winter season.

Dollar Closing In on 5% Targets, Where are the Value Points?

The type of moves that we have seen in the currency market during the Asian and European trading sessions are typically what we see in a quarter or a half year. USD/JPY has fallen 5 percent, AUD/USD is down more than 8.5 percent while the NZD/USD is down 7 percent. The sell-off in the Japanese Yen crosses are even more severe with AUD/JPY down 13.5 percent and NZD/JPY down 12 percent. Here is a list of the biggest movers as of 9am ET:

Yesterday, I warned against a premature top in the EUR/USD!

Although it may be very tempting to say that the dollar has hit a top, especially against the Euro, in order for this EUR/USD rally to be real and for investors to be convinced to stop selling higher yielding currencies, we need to see stabilization in the financial markets and a return of confidence.

The mentality in the currency and stock markets is sell now, ask questions later. The low yielding US dollar and Japanese Yen continue to be the biggest beneficiaries of risk aversion. The only thing that investors want right now are safe haven plays. The dollar’s strength will force emerging market countries to rush to prevent a flight of capital out of their currencies – more rate hikes could be likely. With deleveraging being the theme of the day, when confidence is lost, it will be difficult to recover.

Where are the Value Points for the Currency Market?

In the Wed edition of my Daily GFT Report and on CNBC and Bloomberg I talked about how the dollar could rise another 5%. At that time, the EUR/USD was trading at 1.2829 and the GBP/USD at 1.6236. The GBP/USD has already hit my 5 percent target and at one point this morning even became undervalued on a purchasing parity basis. Although the UK GDP report confirms that the country is headed for a recession and validates the weakness, I believe that we have seen a near term low in the currency pair.

The EUR/USD on the other hand has only dropped 2.5 percent. The EUR/USD does not become a value play until 1.15-1.20. As for USD/JPY, it has also reached my target of 95. Although I won’t be a buyer at these levels, I won’t be a seller either. There are no rewards for heros in this type of market.

Will the BoJ Intervene?

If you are wondering about Bank of Japan intervention, don’t expect it to happen. As an export dependent nation, a strong currency is not in Japan’s best interest. However unlike in the past where the BoJ has intervened when USD/JPY fell below 105 and 100, we may not see any action by the Japanese government this time around. Since the problems are inherent in the US and the Eurozone, intervening at this time may be counterproductive for the Japanese. The Japanese government needs to stand aside and allow the US and Eurozone governments to take their measures to spur growth and not strengthen the dollar for their own short term relief.

If intervention was on the table, the Japanese PM would not make the following comment this morning:

RISE IN YEN NOT ALWAYS BAD BECAUSE IT PUSHES DOWN OIL PRICES FOR JAPAN”

Risk of Limit Down Day in US Stocks

With S&P futures already trading at limit down this morning, there is a decent chance that circuit breakers may be hit in the first hour of trading. The moves in the Dow Jones Industrial Average these days is strikingly similar to the move in 1906 and 1907 (Here is a chart from Barclays). In the last phase of the sell off between Q2 of 1907 and Q4 of 1908, the Dow dropped 37% before it bottomed out. From the August 11500 levels in the Dow, a 37% move would take the index down to a new 6 year low of 7245.

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Barclays Capital

Barclays Capital

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