A Murkier Currency Market Outlook Due to the Uncertain Fate of Oil Prices

February 25, 2011

A risk remains that oil and other commodity prices will remain extremely volatile in the period ahead.  The market is trading on political news headlines and therefore intrinsically less stable than when markets march to the beat of economic data.  At the high of $103.41 per barrel yesterday, oil prices had shot up 22.6% since the close on February 15.  No easy formula exists for calculating how oil price swings might impact the dollar and other key currency relationships because of the wide multitude of ramifications to consider.

  • Policymakers in the United States have done less than their counterparts in other advanced economies to wean the economy’s dependency on fossil fuels.  This is a bet on the long-term neutrality of oil prices, but if oil prices instead continue on a long-term uptrend, the United States will pay a relatively bigger price for being poorly prepared for this critically important relative price change.
  • The southern tier of the euro area imports much of its oil from Libya.  These are the same members of the European common currency bloc which have been grappling with difficult sovereign debt exposures.  A widening of their bond yield premiums versus German bunds has coincided with the recent steep elevation of oil prices.  A collateral concern has to be how European bank balance sheets will be affected by this fresh threat.
  • Oil prices have climbed because of greater political risk in North Africa and the wider Middle East.  Investors will continue to watch Libya, Algeria, Bahrain, Iran, Iraq and the biggest fish of all, Saudi Arabia.  What next happens to the Palestinian problem is more uncertain than ever.  Geopolitical danger promotes risk aversion, generally benefiting Treasuries, the dollar but in the recent case, the yen and Swiss franc even more so.
  • Higher oil prices will fatten the reserves of Russia and Middle Eastern exporters.  Their revenues arrive largely in dollars, but they were diversifying into the euro and other non-dollar stores of wealth even before Tunisia started the fire.  The Chinese have also been cutting their dollar portfolio shares.
  • The ECB and Bank of England are likelier to raise their interest rates than are the Fed or Bank of Japan in response to energy-fueled rises in inflation.  With the core personal consumption deflator in the United States at just 0.8% year-over-year, it’s even possible that quantitative easing might be retained beyond midyear.
  • A compulsive-obsessive streak runs through currency market behavior.  An issue like the Middle East unrest can take hold of the market and crowd out all other factors at least over the short term.

The dollar’s performance during other historic run-ups of oil prices has been generally negative, but there have been exceptions.  The first OPEC price shock helped boost the mark by 21% over the four months between mid-January and mid-May of 1974.  OPEC II during the Iranian Revolution saw the mark advance around 12.5% over the final seven months of 1979.  From the invasion of Kuwait by Iraq in early August 1990 to the low in the following February, the mark again advanced over 11%.  Bastille Day in 2008 saw oil prices peak at $147.91, and the euro’s all-time high of $1.6038 was reached the following day.  However, between December 11, 1998 and October 26, 2000 while oil prices were climbing threefold from $10.81 to $33.37 per barrel, the DEM-translation value of the euro fell by 30.3% to the euro’s all-time low of $0.8228.

In times like these when the dollar’s movement can be a geopolitical crap shoot, taking a long-term perspective can be helpful, and tomorrow’s 26th anniversary of when the dollar had its strongest value since first floating provides a convenient opportunity for such a reality check.  In 1963, some twelve years before floating, the dollar was worth JPY 360, CHF 4.373,  and 2.80 per pound sterling.  The greenback also fetched 3.986 marks, 4.901 French francs, and 621.6 Italian lire.  Those were the individual currencies of the three largest economies currently in the European Economic and Monetary System.  In the 1970s, the German mark, Swiss franc and Japanese yen established “hard currency” reputations based on low inflation and chronic and sizable current account surpluses. 

The table below measures the net movement of the dollar against six currencies over the 22 years between 1963 and February 26, 1985.  The period embodies the final decade of fixed parities embodied in the historic 1944 Bretton Woods monetary reform and the first dozen years of the floating exchange rate era.  Changes of the dollar over the whole period are expressed on a per annum basis.  Even at the dollar’s best floating rate era values, the greenback against the three hard currencies had cumulatively lost around 33% against the Swissy, 27% against the yen, and 13% relative to the mark.   In contrast, there were dollar gains of 250% relative to the Italian lira, 171% against sterling, and 117% versus the French franc.

Percent Per Annum 1963 – 1985 1985 – Present
USD vs Yen -1.4% -4.4%
USD vs Swiss franc -1.8% -4.3%
USD vs Mark -0.6% -3.9%
USD vs French franc +3.6% -3.0%
USD vs Lira +5.9% -1.7%
USD vs Sterling +4.6% -1.7%

The right-most column in the above table compares the movements of the dollar since its February 26, 1985 highs, a span of 26 years, to the movements during the earlier 22-year period.  Changes are again expressed in percent per annum terms in order to allow for comparisons of periods that are slightly different in length.  For roughly the first 14 years of the latter period, Germany, France and Italy had their own currencies, and such did not move in lock-step.  That’s why the changes in those three dollar pairs are not identical even though they were merged together on the final day of 1998. 

The table illuminates a couple of major themes.  First, the yen, Swiss franc and synthetic mark have continued to perform against the dollar as the hard currencies that they were, and that’s as one would expect since all three economies still enjoy exemplary price stability and strong trade and current accounts.  In fact, the dollar depreciated more sharply in the second period than the first, which is explained in part by the choice of a base date for comparison in 1985 when the dollar was quite strong.

Second, the table discredits a view held for many years that the dollar’s secular depreciation since the late 1960s merely reflected an adjustment for the rebuilding of the European and Japanese economies after World War 2 that was also associated with rapid economic growth.  This logic is analogous to what’s happening now in many developing economies in Asia and Latin America.  The view was that this adjustment would prove self-limiting eventually, once those economies fully recovered any ground lost in the first part of the 20th century. 

Third, after the merger of European currencies, the euro behaved more like a hard currency than a GDP- or trade-weighted hybrid of its individual parts.  If the latter had instead occurred, Euroland’s peripheral members would be more competitive now than they in fact are.  Why, one has to wonder, did the euro mimic the mark more closely than the lira, peseta or drachma?  One answer lies in the institutional creation of a central banking authority cast in the Bundsbank’s image.  Another reason is that secular dollar depreciation is a story about dollar weakness even more than one about hard currency strength.  The Fed under Alan Greenspan and Ben Bernanke has pushed the envelope of economic growth, taking advantage of a very long period of downwardly trending U.S. inflation.  The dollar has also been a victim of the perils of being the world’s predominant reserve currency.  Sterling suffered the same fate.  Economic power is not stationary whether one is comparing companies or sovereign states.  The lure of diversification eventually kicks in.  When you’re top dog, the only direction is down.

Fourth, although Britain did not join the European Common Currency Union, sterling’s behavior has been very similar to the lira’s.  In part, this transformation partly reflects the transfer in May 1997 of authority over British interest rate policy from elected politicians to an independent central bank.  But that hardly accounts for such a dramatic shift.  Another element is Britain’s history of double-digit inflation, seen as recently as 1990 when such crested at 10.9% in September-October.  In that regard, the Bank of England maybe ought to err on the side of restraint now more than it has been doing.  U.K. inflation of 4.0% is twice as high as the central bank’s medium-term target, yet the Bank Rate of 0.5% remains at a cyclical low.

A final thought not highlighted by the table but related to it concerns the disconnection between relative economic growth and the dollar, which continues.  In the second half of 2010, real GDP expanded 2.7% annualized in the United States, 2.0% in the euro area, 1.1% in Japan, and 0.2% in Britain.  The impression is strong that through thick or thin, U.S. economic growth tends to outshine those in Japan and Europe.  Between mid-2010 and the end of the year, the dollar in spite of the fastest economic growth lost 8.6% against the euro, 7.3% against the yen, and 4.3% relative to the pound.  This year, the dollar is hardly changed on balance against the yen but has depreciated nearly 3% against the euro and sterling.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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One Response to “A Murkier Currency Market Outlook Due to the Uncertain Fate of Oil Prices”

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