Oil Power

February 3, 2015

Plunging oil prices in the second half of 2014 and all but the end of January exerted a profound effect on financial markets including foreign exchange.  The direction of oil’s move was never in dispute, but the size of the decline continually astounded market players and became a source of uncertainty regarding an appropriate market equilibrium.  Even in mid-2014, the euro area was dangerously close to zero inflation.  In Japan. positive inflation mostly reflected a three-percentage point sales tax hike in April, and a recession posed a new threat of deflation.  Plunging oil costs, while providing a boost discretionary income and corporate costs, created a big short-term policy problem for a number of central banks, but not the Federal Reserve.  Growth in U.S. real GDP and jobs had acquired self-sustaining momentum, while inflation was below target but not so much that there was ever any risk that U.S. monetary policy would be eased.  The third round of U.S. quantitative easing was wound down to zero in a scheduled, predictable, and measured way, and the view that a first interest rate hike would happen in mid-2015, more or less, took hold early and has not been dispelled. 

While Fed policy has taxied away from years of plentiful accommodation and preparing for the launch of tightening.  In contrast, a wide variety of central banks have cut rates, even Russia last week by 200 basis points after tightening 650 basis points in mid-December.  The ECB announced that quantitative stimulus will begin in March and at a somewhat greater pace than assumed.  The Bank of Japan last October ratcheted up its quantitative ease, and China’s key lending rate was reduced in November.  In December, the Norwegian and Swiss interest rate were sliced by 25 basis points.  Last month saw central bank rate cuts of 100 bps in Pakistan, 50 bps in India, Turkey and Egypt, 45 bps in Denmark, and 25 bps in Canada, Romania, Peru, and Albania.  February kicked off with a 25-bp rate cut in Australia.  Other central banks such as the Swedish Riksbank have shift forward guidance to indicate that zero interest rates are likely to be maintained longer than imagined earlier.  A stark monetary policy contrast between the Federal Reserve, and to a lesser extent the Bank of England, on the one hand and most other central bank stance on the other has been a source of considerable support to the U.S. dollar.

But make no mistake, the changing oil price dynamic has been the straw that stirred this drink.  In that regard, the nearly-20% recovery of oil’s price since January 28 bears very close watching.  After an nearly 60% drop in less than seven months, a rather wide range of possible future price levels exist.  The bounce in oil has meanwhile depressed the dollar this month by about 1.5% against the euro and kiwi, but other key bilateral dollar relationships against the yen and Aussie dollar have barely moved. 

The potential contrast of monetary policy directions in 2015 hasn’t been affected by the the bounce in oil.  It thus seems probable that the U.S. currency will work its way to new highs against the yen, euro and many other currencies.  If oil has bottomed, however, market volatility should simmer down and the dollar is apt to trace a more orderly route.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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