The Fickleness of Foreign Exchange
August 9, 2008
The above plot of oil prices against the dollar from the Money and Markets Newsletter illustrates a fact of life in foreign exchange markets. Currency movements seldom correlate with other variables all of the time. The chart shows a strong inverse correlation between oil prices, which were rising, and the dollar, which fell until mid-March. After that, oil costs continued climbing and in fact at a steepening pace. The dollar remained volatile but trendless, however. Now that oil prices are descending, the inverse relationship with movement in the dollar has resurfaced. The oil-dollar pattern was knocked off course in March by an external shock, namely the Fed-assisted rescue of Bear Stearns. That deal revealed how far U.S. authorities will go to prevent a complete financial market meltdown and became a watershed in the transformation of investor fear from being U.S. economy-centric to a much broader focus on the global economy. The accelerating increase in oil prices promoted this evolution. Survey evidence suggests that commodity-inspired inflation, not the global financial crunch, is the main drag on consumer and business confidence in Japan and Europe. Energy prices have turned downward too late and not yet by enough to abort the recessionary threat faced in these economies. But as an economy with huge trade and current account deficits, the United States will reap an immediate benefit from a reduced energy import bill. Moreover, the drop in oil prices coincides with a period of increasing stimulus from Fed interest rate cuts in the last quarter of 2007 and early this year. In other economies, no macroeconomic policy support is coming on stream to complement the fall-off in oil prices. Currency determination is complex. Rarely does a single factor explain the marketplace. Knowing the broader context surrounding a market driver, even one as important as energy costs, is crucial to understanding recent market activity and anticipating future direction in the dollar.
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