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.

1973oil

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.

1979oil

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.

In the Financial Papers: Today’s Top Forex News 07.15.08

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In the Financial Papers:

 

Podcast Covers:
Fannie, Freddie Tumble on Concern U.S. Rescue Will Sacrifice Shareholders
Dollar Drops to Record Low
Retail Sales, Producer Prices
Mortgage Insurers Raise the Bar
Paulson Drove Plan to Shore Up Fannie and Freddie
IndyMac Reopens, Halts Foreclosures on Its Loans
Bailout fails to calm nerves
China Falters on Inflation Fight
China Sees Slower Growth in Forex Reserves

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Oil Hits Record Highs, Geopolitical Risks Hurts the Dollar

Oil prices are driving the currency market. Over the past 2 days, prices have increased more than $10 a barrel. As a result, the US dollar has weakened across board, particularly against the Australian and Canadian dollars. The AUD/USD even hit a new 25 year high this morning.

For the greenback, politics is trumping economics as fears that Israel may attack oil rich Iran makes traders jittery. This fear is also reflected in gold prices which is near a 3 month high. Flight to safety is the market’s top priority with geopolitical risks on the table. Even the better than expected US trade balance numbers could not help the dollar, because the sentiment in the market is very dollar bearish.

Oil prices drove the import balance higher, but a weaker dollar helped to drive exports up 0.9 percent. This wasn’t a big surprise since the export component of the manufacturing ISM report already clued us into the possibility of a strong report.

With oil determining monetary policy, the fact that they are within a whisker of the record highs will keep most central banks hawkish. Consumer confidence will probably remain weak as $5 gasoline becomes an increasing reality for drivers around the country. However watch out for a big surprise in the dollar next week with retail sales due for release.

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