Currency Outlook Highly Dependent on Price of Oil

April 19, 2016

Juxtaposed against rising oil prices, the dollar has depreciated around 2.5% on a trade-weighted basis over the past month.  The U.S. currency has declined by similar percentages against the yen, loonie, and Australian dollar and even more sharply versus the kiwi.  Smaller drops of roughly 1% occurred against the euro and Swiss franc.  A major currency that has performed more weakly than the dollar has been sterling, which slid about 0.75% against the U.S. currency.  In just over two months since hitting a low of $26.05 per barrel on February 11, West Texas Intermediate crude oil has soared 57%.

The relationship between the dollar and oil is neither simple nor consistent.  In contrast to their divergent trends in recent weeks, instances can be found in the past when the dollar and oil moved in the same direction.  The United States, unlike Japan or Germany, has abundant domestic sources of fossil fuel energy but also a current account deficit.  Federal Reserve policy is in tightening mode in contrast to other advanced economy central banks, but policy divergence has been slowed by sub-target U.S. inflation that in part reflects cheap commodity prices.  Indeed, the context of the aforementioned 57% rebound in oil prices lately is that such was preceded and is still dwarfed by a 75% slide over twenty months between mid-June 2014 and mid-February of this year. 

In current circumstances, the factor that most powerfully links the dollar to the fate of oil has been the influence over investor sentiment.  Downdrafts in commodity prices like oil have induced risk aversion, and vice versa, and the dollar and yen have been the most favored paper currencies in times when risk aversion has spiked upward.  It is less clear from current levels whether oil prices will on the whole trend up or down than that day-to-day swings will remain large.  From a day to day perspective, elements of noise in movements of the dollar may transcend sustained directional changes. 

Among major traded currencies, sterling will continue to march to a different beat.  This is ironic for what had behaved like a petro-currency back in the days of Margaret Thatcher’s rule.  Yet sterling’s theme these days has a strong Thatcherian undertone.  Sentiment toward the pound has become extremely guarded, pending the June 23rd referendum when voters will signal whether they wish Britain to leave the European Union.  Thatcher opposed a more European-aligned Britain.  An object of her ire back then was the European Exchange Rate Mechanism (ERM), a forerunner of the euro which bound several currencies in the region into tight trading bands with one another but allowed flexible movement against the dollar.  The ERM had been launched in March 1979, but Britain did not join until October 1990 around the time when an in-party coup replaced Thatcher with John Major.  Within 23 months, however, relentless speculative selling pressure on the pound forced the currency to abandon the currency arrangement, and this proved to be an enormous embarrassment to the government’s leaders. Leaving the ERM ironically proved to be a great stimulant for British growth.

When the single currency euro was launched seven years later, the U.K. chose not to participate and never regretted that decision.  For much of the intervening years, the British economy outperformed the eurozone, and a variety of dire warnings, for instance, about the demise of Britain’s financial services industry and sky-high long-term interest rates never transpired.  Similar warnings can now be heard should voters choose to leave the European Union.  Known formerly as the Common Market and the European Community, the EU started in the late 1950’s but did not include Britain until the start of 1973.  The ramifications of Brexit (an EU without Britain) do indeed appear much more credible than the earlier decision not to participate in the EU.  Until proven otherwise or until voters opt to remain in the EU, the possibility of Brexit will be an enormous negative for sterling, outweighing other factors including what happens to oil prices.

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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