Dollar in a Bear Market for Crude Oil

December 9, 2014

Over the last five months, the price of West Texas Intermediate oil has fallen 41% from roughly $107 per barrel to a low yesterday of $63.20, near which the market is trading currently.  Oil oftentimes is volatile, swinging from $15.24 in June 1990 to $41.12 3-1/2 months later and then back to $18.88 by mid-March 1991.  And in the Great Recession, for another example, oil plunged from $147.61 in mid-July 2008 to $35.63 by the ensuing Christmas, but it posted calendar year averages between $94 and $99 in 2011, 2012, and 2013. 

Unlike these examples of large price changes, the current one appears neither transitory nor cyclical.  It is well grounded in fundamentals that will continue to linger.  Despite a strengthening U.S. economic upturn, global growth is lackluster and cutting into energy demand.  In addition to low demand, the supply metric has been transformed by the boom in U.S. production, but the case for an extended slump in in oil prices rests on more than market forces.  Western governments have a keen geopolitical incentive to maintain downward pressure, choking off financial resources for such foes as Middle Eastern terrorists and Vladimir Putin. 

An enduring multi-year return to cheaper oil prices would be a rare event for the post-1973 era.  The Yom Kippur war in October of that year was followed by an OPEC embargo and a quadrupling of prices in early 1974.  A second OPEC-induced spike associated with the Iranian Revolution of 1979, like the first price shock, created a widespread recession shared by many energy importing nations.  If oil prices stay at current or lower prices for a long time to come, the closest modern precedent would be the 67.2% dive from $31.72 in November 1985 to a low of $10.42 per barrel hit in July 1986.  The price averaged $18.26 in 1987-89, $22.18 in 1990-92, $18.03 in 1993-95, and $19.01 in 1996-98.  The trend bias since then has been upward, especially from the onset of the Iraq War.  The price averaged $25.10 per barrel in 1999-2001, $32.82 in 2002-04, $65.18 in 2005-7, and $80.92 in 2006-10.

It seems intuitive that the dollar would be well-bid in times of low and falling oil prices.  During the floating dollar era that also began in 1973, two factors that have whacked the dollar hard at times have been the chronic U.S. current account deficit and, prior to 2000, bouts of inflation.  Low oil prices alleviates both of these vulnerabilities.  Although perhaps a circumstantial fact, empirical support for a inverse correlation between the price of oil and the external value of the dollar is suggested by the juxtaposition between the euro’s all-time peak of $1.6038 on July 15, 2008 and the record high in oil of $147.61 on July 14, 2008. 

However, a number of the big slides in oil prices coincided with net changes in the dollar not exceeding 6% against the major European currency benchmark, that is the mark prior to 1999 and the euro subsequently.   Examples of such involved the drops in oil of 67% in Nov 1985 – July 1986, 41% between June 1987 and November 1988, 38% from January 1990 to June 1990, 54% from October 1990 to March 1991, 60% from January 1997 to December 1998, and 35% from July 2006 to January 2007. 

A time when oil dived at the same time the dollar soared happened between July 2008 and February 2009.  Oil slumped marginally more than 75%, and the dollar climbed 27% against the euro.  This is an intriguing base of comparison.  For one thing, the high-low move in oil prices was the sharpest of all the price declines mentioned above.  For another, the financial community believed at the time expected depressed oil prices to continue for the foreseeable future.  Fear of depression was omnipresent.  Equities were slumping, too.  In an earlier post in Currency Thoughts, evidence bearing on the relationship between declines in U.S. share prices and the contemporaneous behavior of the dollar proves inconclusive regarding the directionality of the dollar’s movement but significant in linking equity bear markets with large cumulating changes in the dollar.

It’s premature to tell if this week’s slide in stocks is in fact heralding and extensive drop or even a genuine bear market (i.e., a drop of 20% or more).  Such a development is plausible.  It seems overdue, since quite some time has elapsed since stock prices corrected sharply downward over a decently long span of months.  The Fed is likely to begin the carefully orchestrated verbal run-up to its first short-term interest rate hike, and a flattening of the yield curve will anticipate that moment.  Being elevated already, stocks are more likely to fall sharply than rise sharply in the next six months.  The period between July 2008 and February already demonstrated that the dollar can appreciate significantly in spite of a bear market in equities, especially of the cost of oil is falling, too.

Relevant information that the dollar will gain strength in the current slide of world oil prices is the already established direction of the dollar, up 10% against the euro since mid-June when oil prices in 2014 peaked.  Unless the dollar suddenly reverses course, a big drop in the dollar already has transpired during this years slide in oil.  Direction has been established, and it will continue to be fed, in addition to lower oil prices, by America’s relatively strong growth rate as Japan battles to escape recession, the euro area fights against the encroachment of recession and deflation, and British growth throttles downward.  Outside the United States, governments and central bankers are jawboning their currencies lower.  The U.S. current account deficit is at a sustainable size, and U.S. inflation and labor market conditions are moving closer to the Fed’s goals.  The fly in this ointment is the weak political support for President Obama even from his own party, and the coming installation of a new Congress even more hostile to the Federal Reserve.  It’s no coincidence that the two previous periods of multi-year dollar appreciation in Reagan’s first term and Clinton’s second one occurred at times when their public approval ratings were a lot stronger than Obama’s is now.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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