from my former colleagues, a more nuanced explanation of how the price of oil is linked to the dollar. The gist is that there are several factors that cause the price of oil to rise when the dollar goes down in value. This is bad but it will likely continue for some time.
By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions
While it is difficult to establish statistical evidence of causality, we believe that the USD and oil will likely remain negatively correlated, for various reasons. Oil prices, therefore, will remain an important – though not the only – consideration for the dollar. Specifically, lower and stable oil prices should be positive for the USD, while rising oil prices should be negative for the USD.
The Oil-Dollar Link
The circle of rising oil prices and a falling dollar was vicious. In contrast, the recent reversal of these trends is virtuous and, all else equal, positive for the world. Not only will lower oil prices help to support global demand, they should also permit greater monetary flexibility to deal with lower economic growth. (There are two aspects of the nexus between oil and the dollar: their correlation and the direction of causality. We have conducted Granger Causality tests, and found that, in practice, and for the most recent period (1992-2008), the dollar tends to lead oil, rather than the other way around.)
Until around 2003, higher oil prices were correlated with a stronger dollar. This was primarily because petrodollars were not only recycled back in to the US through trade but also because of financial flows: the US was dominant in every way back then, in terms of the attractiveness of its exports and assets. However, since 2004, this correlation has evaporated, and since 2006, the correlation has turned intensely negative.
There are several possible explanations for this negative correlation between oil prices and the dollar, especially the EUR/USD bilateral cross. We have, in previous work, touched on some of these reasons (see The USD and Oil Prices: Some Conceptual Issues, August 9, 2007). We list them here, paying particular attention to the direction of causality.
There are primarily three channels through which oil prices could affect the dollar:
• Link 1. Petrodollar recycling less dollar-friendly. The economic reliance of oil exporters on the US has declined over the years. Specifically, petrodollar owners now have a higher marginal propensity to consume European-made products than before. (Back in the 1970s, around 18% of OPEC’s imports were from the US. Now, this ratio has fallen to 9%, and OPEC sources 26% of its imports from the EU.) Also, they are likely to have a lower marginal propensity to invest in USD assets, simply because the array of assets in the world available to the petrodollar investors is now much wider than before. This is also related to the issue of reserve diversification by oil exporters. The establishment of the EMU has enhanced the liquidity of EUR-denominated assets, and intra-Eurozone divergence has preserved the diversification benefits of investing in EUR assets. Petrodollar owners have responded to these changing global financial markets. Thus, the higher the oil price, the more diversification takes place, and the weaker the dollar is.
• Link 2. Different central bank responses to oil shocks. Investors have different opinions about how the Fed and the ECB may react to rising oil prices, one opinion being that the latter might act more aggressively than the former, because of their different mandates. Thus, higher oil prices tend to lead to general expectations of a more hawkish reaction from the ECB – an inflation targeter – than from the Fed, which has a ‘dual mandate’ on growth and inflation. In other words, rate hikes in response to oil price rises appear more ‘automatic’ for the ECB than for the Fed. This may help to explain why EUR/USD and oil are correlated on a real-time basis – a trend that cannot be satisfactorily explained by the diversification argument mentioned above. Thus, in general, a higher USD price of oil may have conveyed to the world the impression that there was more global inflation than there really was. Monetary tightening in response to this positive inflation shock had further depressed the dollar, thereby perpetuating the circle.
• Link 3. High oil prices hurt the US C/A deficit. The US C/A deficit has shrunk rapidly since 4Q05, especially the non-oil portion of the C/A. (The US C/A deficit reached a peak of 6.8% of GDP in 4Q05, and has just breached the 5.0% GDP mark in 4Q07. It is likely to decline to around 4.5% by end-2008.) Indeed, trends in non-oil and oil trade balances have diverged substantially since 2005. While the former improved from U$40 billion to around U$30 billion a month, the oil trade balance – reflecting the sharp move in the US terms of trade – deteriorated from around U$20 billion to U$30 billion a month. In short, high oil prices have offset the tremendous improvement in the US external imbalance that has and continues to take place, and have prevented the dollar from being rewarded for this improving trend.
And there are three links through which the dollar drives oil quotes, in addition to the numeraire effect:
• Link 4. Feedback through the de facto dollar zone. The de facto dollar zone could also help to explain the link between the dollar and oil, and the causality running from the former to the latter. While the de facto dollar zone is looser now than two years ago, many Asian and other EM currencies are still quite ‘sticky’ vis-à-vis the dollar. Dollar depreciation effectively makes Asian exporters even more competitive, and economic buoyancy in these dollar zone countries (i.e., Asia) has led to high consumption of energy products. Therefore, a weak dollar may, on balance, increase the world’s demand for energy products.
• Link 5. Financial investment in commodities. There are anecdotal signs that institutional funds may be starting to treat commodities as a separate asset class. To the extent that real commodities are treated as ‘anti-dollars’, there could be a negative relationship between these two variables. Similarly, if commodities are seen as a hedge against inflation, expectations of higher US inflation will drive the dollar down and oil prices up.
• Link 6. Weak dollar and the lack of oil demand destruction. Many countries have tried to let their currencies appreciate in the past quarters so as to offset the impact of oil price increases in USD. But what may make sense from an individual country’s perspective has in fact been inflationary from the world’s collective perspective. Essentially, strong currencies provided an implicit subsidy on oil, and rising oil prices have not caused the level of demand destruction they should have done. As a result, oil prices continue to march higher, the longer this strong currency policy is maintained.
These are some explanations for why oil and the dollar have been so negatively linked since 2006. However, a further theory we have is that oil and the dollar could appear correlated only because they are driven by the same factor. We see this thesis as particularly relevant for the recent episode of oil price correction and the rise in the dollar. The dollar could have risen in the past month due to the ‘Dollar Smile’ effect. At the same time, a broad-based deceleration in global growth, on top of the oil demand-destruction that had already begun in many developed countries, should driver oil prices lower. As a result, the dollar rose at the same time as oil prices fell, not because one ‘caused’ the other, but because they were both driven by the same factor: a deteriorating global economic outlook.
Our Outlook for the Dollar, Conditional on Oil Price
We have two thoughts:
1. A strong dollar helps the world to rationalise on oil consumption. The vicious circle between a weak dollar and high oil prices was bad for the global economy. The contraction in Germany’s GDP was due to weak domestic demand, rather than exports. This raises the whole concept of ‘de-coupling’ and ‘re-coupling’, that Germany has not weakened because of a weak US or a weak world. Rather, it has weakened due, possibly, to the sharp energy shock and the credit crunch. As we argued under ‘Link 6’, a stronger dollar would force the rest of the world to rationalise energy consumption. A currency-based policy reaction to the oil price rise – such as the strong EUR policy adopted by the ECB – never made sense from a global perspective, in our view. This was a ‘negative-sum’ solution, due to the lack of oil demand-destruction. We believe that a virtuous circle of a stronger dollar and lower oil prices is what the world needs now.
2. Inflation-targeting central banks to become more dovish. Calmer commodity prices make sense if the global economy is decelerating. This should help anchor inflation expectations and permit inflation-targeting central banks to ensure that two-year forward inflation does not fall below their targets. The speed with which the RBA may make a U-turn (it last tightened in March, and may ease on September 2) on its policy and the market’s positive reaction to the RBA’s flexibility are a good example of what other inflation-targeting central banks (ECB, BoE, Sweden’s Riksbank, RBI, BoK, SARB and RBNZ) could do – though such a policy reversal may not come as soon as the case of the RBA, further supporting the dollar.
Bottom Line
The USD and oil are likely to remain negatively correlated for some time; the performance of the USD will in part be determined by the evolution of oil prices. For the global economy, a strong dollar/low oil price combination is much better than a cheap dollar/high oil price combination. Calmer commodity prices should also temper the hawkish bias that some inflation-targeting central banks have had.
