EUR/USD and the Price of Oil

October 14, 2015

EUR/USD and the price of oil (West Texas Intermediate) have moved more or less inversely since the cost of energy peaked in June 2014.  This correlation can been observed in the table below of month-end to month-end changes in the dollar against the euro and of the price of oil.  The direction of change in these two variables is different In all instances except February, May and June of this year.  The dollar’s change each month shows greater consistency with oil price variation from month-end to month-end than with movements in the 10-year U.S. Treasury yield and shifts in the differential between the U.S. and German 10-year sovereign debt yield at the end of each month.  This latter change is shown in the right-most column.  In the case of October 2015, comparisons of current conditions to end-September 2015 are indicated.

  EUR/USD Oil Price U.S. 10Yr U.S./GE Spread, Chg
Oct to date -2.3% +3.1% 2.00% -2 Basis Points (bps)
Sept 2015 +0.5% -8.4% 2.04% +3 bps
August -2.2% +4.4% 2.22% -12 bps
July +1.4% -20.8% 2.18% -4 bps
June -1.4% -1.4% 2.35% -4 bps
May +2.2% +1.1% 2.12% -4 bps
April -3.5% +25.3% 2.03% -8 bps
March +3.6% -10.7% 1.93% +8 bps
February +1.0% +3.2% 2.00% +33 bps
January 2015 +7.1% -9.4% 1.64% -29 bps
December +3.6% -33.9% 2.17% +13 bps
November +0.7% -17.9% 2.20% +1 bp
October +0.8% -11.6% 2.33% -6 bps
September +4.1% -5.0% 2.50% +9 bps
August +1.9% -2.3% 2.35% +5 bps
July 2014 +2.3% -7.9% 2.56% +13 bps

When oil prices shifted from a cumulating downtrend to a volatile but generally trendless pattern early this past spring, the dollar transformed from an appreciating trend to a see-sawing downward-sloping vector.  Monetary officials at the Fed, Bank of Japan, European Central Bank and elsewhere assume that oil prices will be flat to gently recovering in the future.  This is a key presumption, which enables them to infer that inflation should better reflect the absorption of economic slack.  In one of the aforementioned few months when the dollar and oil either strengthened or weakened together, the 10-year U.S. Treasury yield and its premium over the comparable German bund rose by an outsized 36 basis points and 33 bps, respectively, last February. 

The revealed expectations of investors in the marketplace are not entirely confident about a normalization of inflation.  Note above that the current 10-year Treasury yield of 2.00% still lies 56 basis points below its level at end-July 2014.  Published minutes from the FOMC meeting of mid-September observe that “a couple of members expressed unease with the decline in market-based measures of inflation compensation over the intermeeting period.”

The FOMC minutes made a number of other interesting points, clarifying how U.S. officials are assessing developments.  Traders are accustomed to thinking of EUR/USD and USD/JPY as more important dollar relationships than others.  But Fed officials weighed the implications of dollar appreciation, not depreciation, in the month.  Even though the dollar had fallen against both the yen and euro since the prior FOMC meeting in July, it had risen against the currencies of many other trading partners such as Canada, emerging markets in Asia and Latin America, and commodity-exporting countries.  Meeting almost a month ago, the group was not especially concerned about asset price volatility, which was seen exerting a small influence on coming decisions.  Continuing subdued wages would not be an automatic deal-breaker in deciding when to start rate normalization.  More concern was expressed about meeting the inflation mandate and the labor market objective because while tangible progress had been seen on the latter, the basis for progress on achieving 2% inflation still rested on theory primarily.  Moreover, the inertia of inflation justified to some allowing unemployment to fall even below its long-run normal level as a way to “speed up” the path to the inflation target.  For some, the longer inflation stays way below target, the greater might be the risk of falling longer-term price expectations, and that danger could be amplified if rate normalization commences without more direct evidence of recovering inflation.

Since the FOMC met, a surprisingly soft labor force survey has cast some doubt on the health of the labor market.  The IMF has lower its forecasts for world growth.  The latest U.S. producer price figures, released today, revealed a larger-than-expected 0.5% month-on-month drop in the PPI, with energy falling 5.9% (23.7% on year), food dropping 0.8% (2.9% on year) and all other producer prices collectively staying unchanged from August and exhibiting a smaller on-year uptick of just 0.2%.  Most of the FOMC hawks continue to voice a belief that rate normalization will start soon, but some are more doubtful.  St. Louis Fed President Bullard this week said a hike would be tough to do by October, and Governor Tarullo no longer thinks a move in either October or December would be appropriate.

Market participants are thus stuck in the third broad stage of the Fed’s exist strategy.  The first was the taper tantrum of 2013 when a mere whiff that zero rates wouldn’t be maintained forever produced a bout of investor hysteria, causing officials to take the trial balloon away.  Phase two was the actual gradual reduction and end of quantitative stimulus, and it went off without the sky falling.  Phase three commenced a whole year ago after quantitative easing had been eliminated completely.  Call this the Great Waiting, that period of anticipation of the Fed’s first rate hike since June 2006.  This interval was expected initially to be much shorter than a year.  It’s been overtaken by strong global disinflationary headwinds and crisis conditions for key emerging economies like Brazil, South Africa and Russia, uneasiness about China’s continuing slowdown and the reliability of Chinese economic data. 

The most intriguing stage is yet to come, and that will be the period of gradual hikes in the federal funds rate from the first move onward.  This will be a step into the unknown especially since current conditions are not as optimal for tightening as they were at the beginning of the last four such cycles (see this prior update).   Exits from ultra-accommodative monetary policy stances have been difficult in other economies.  Since the Great Recession, nobody has managed to return to a semblance of the old normal, and the Bank of Japan has been trying to do that for the better part of two decades. 

If conventional monetary policy can no longer be employed with reasonable effectiveness, currency manipulation will become all the more tempting.  Let the currency wars begin.

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

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