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
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
• 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
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.,
• 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
• 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
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.
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.