Forex Blog: Currency Trading News & Analysis.

March 5th 2011

Oil Prices and the FX Conundrum

I haven’t blogged about oil prices in quite some time. After prices collapsed in the wake of the financial crisis, there really wasn’t much to talk about. However, the price of crude oil has risen more than 50% since June, and it now seems to be at the forefront of investor consciousness. Currency market watchers, in particular, need to brace themselves for the nuanced and sometimes contradictory ways in which oil prices bear on exchange rates.

Under normal conditions, the impact of rising oil prices on the currency markets is somewhat straightforward. First of all, the currencies of oil-exporting countries will typically experience some degree of appreciation. In addition, since oil contracts are still mainly settled in US Dollars, oil prices and a weak Dollar tend to go hand-in-hand. Second, insofar as rising prices drive inflation, the same can be said for Central Banks that are proactive in tightening monetary policy. As real interest rate differentials widen, (risk-averse) capital will naturally gravitate towards the highest returns.

The same logic cannot be applied to the current situation, however. That’s because this time around, oil prices aren’t being driven by economic fundamentals and rising demand, but rather by concerns over supply. You don’t have to be an expert to understand the connection between the continuing Mid East political crisis and oil futures. In the last two weeks alone, prices have risen a whopping 15% and show no sign of abating, as long as tensions linger unresolved.

From that standpoint, you might expect the political tensions to drive safe haven flows to the US Dollar. On the other hand, you would also expect that the resulting high oil prices might crimp the US economic recovery, and cause traders to punish the Dollar. However, you also need to consider that rising oil prices might also cause the Fed to eventually raise interest rates, or at least rein in QE2, which would be Dollar-positive.

Enough with the theory; let’s look at what’s happening in reality! The Canadian Dollar and Australian Dollar are rising, even though oil accounts for only 7% of theĀ  former’s exports, and is a nil factor in the latter’s economy. It looks like forex investors are confusing oil prices with commodity prices, which are also rising, but at a much slower pace. In addition, since higher energy prices will probably erode economic growth in energy importing countries, this could actually hurt some commodity currencies over the long run.

The US Dollar has fallen across-the-board. While Ben Bernanke has insisted that the impact of higher energy prices on the US economy will be minimal, the markets are either taking the opposite view or are punishing the Dollar for the Fed’s dovishness. In other words, if Bernanke isn’t concerned about oil, he probably won’t cap QE2, and certainly won’t steer any interest rate hikes in the near-term.

Meanwhile, the European Central Bank (ECB), whose mandate is tilted towards maintaining price stability, has begun to voice concerns about the impact of rising commodity prices on inflation. Consumer and producer price indexes are rising across the Eurozone, and members of the ECB have suggested that they will take a proactive stance in preventing them from spurring inflation.

In conclusion, while both the EU and the US are net oil importers, the Euro is poised to outperform the Dollar, all else being equal. In addition, as long as the mid east political protests don’t drive further instability and contribute to any major supply shocks (especially in Saudi Arabia and Iran), there won’t be any impetus towards safe-haven capital flows. At the same time, while I don’t pretend to be an expert on oil prices, I would expect prices to stabilize and for a handful of minor corrections to materialize in the fx market. Traders are still looking for an excuse to short the Dollar in favor of, well, everything else, but sooner or later they will have to accept the limits of this trade, high oil prices or not.

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Posted by Adam Kritzer | in Commentary | No Comments »

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© 2004 - 2023 Forex Currency charts © their sources. While we aim to analyze and try to forceast the forex markets, none of what we publish should be taken as personalized investment advice. Forex exchange rates depend on many factors like monetary policy, currency inflation, and geo-political risks that may not be forseen. Forex trading & investing involves a significant risk of loss.