Oil, caught in the cross-hairs of the currency war ?

Despite rising geopolitical tensions (Iraq, Libya, Russia), oil prices have shed more than one third of their value since peaking at $115 at the end of June (see chart 1). Although the fall in the oil price is good news for western consumers, this phenomenon should nonetheless be analysed in a global context in order to draw any conclusions regarding asset allocation.

It is true to say that weaker oil prices impact western households in the same way as a cut in VAT, in that it enhances purchasing power within a segment of domestic spending which is otherwise difficult to reduce. However, the question arises as to whether the fall in the oil price corresponds to factors which are endogenous or exogenous to the global economic climate.

In the case of an exogenous shock, such as the introduction of new extraction technologies for example, a drop in the oil price is unambiguously positive for growth and the financial markets (with the obvious exception of oil sector equities). In this current context however, prices have been driven lower by a downgrade in growth forecasts for global oil demand, particularly among emerging markets. The fall in crude prices is therefore more symptomatic of the deterioration in worldwide growth outlook than a positive shock in the global economy. It is acting as an inherent buffer against the slowdown in demand, but without entirely cancelling it out. In the USA in particular, real domestic income generated by the fall in the price of oil would be entirely offset by a 2.5% decline in US exports, which appears low in the light of downgrades in global growth.

However, the current price correction has been surprisingly sharply in comparison with the preceding episode of doubt regarding growth in demand among emerging markets, particularly China, during the first half of 2012. In this case, macrofinancial factors come into play, including oil-price setting. The major difference between the two bearish episodes is that in 2012, US real long-term rates were easing (the Fed’s quantitative easing programme), whereas rates are now steepening marginally. Hotelling’s rule intuitively explains the link between real interest rates and the price of a non-renewable storable commodity (such as oil). When real interest rates are low, producers maximise the value of their mining resource stock by conserving reserves underground, thus driving prices higher due to a lack of supply, rather than extracting their resources and selling them cheaply on the open market and investing their revenues at low real interest rates. Chart 2 illustrates this negative correlation between the oil price and US real long-term rates.

Furthermore, Hotelling’s theory should also be applied to forex markets. Oil producers effectively receive income in dollars, the denomination currency of most commodities markets. Major producing countries (Middle East, Russia) also enjoy high saving rates, which helps smooth out mining resource revenues over time. They therefore have heavy revenue flows in dollars which are partially invested as savings in the financial markets. These countries already have very large foreignexchange reserves in dollars, and seek to marginally reduce their dependence on the greenback. When crude prices are high, diversification of dollar-denominated savings by oil-producing countries into other currencies therefore generates a selling flow of dollars in the forex market. Thus, there is also an inverse correlation between the price of oil and the dollar exchange rate, as illustrated in chart 3.

The accelerating fall in the oil price can therefore be linked to the sharp increase in the dollar since early summer. The dollar rally stems from monetary decoupling between the USA and other developed countries. The US economy is growing at a rate of 3% and is fast approaching full-employment, justifying a normalisation of Fed policy, whereas the euro zone and Japan are faced with the threat of deflation which renders their household and public debt potentially less sustainable. While the Fed is considering the best timing to start hiking rates, the ECB and the Bank of Japan have announced, over recent months, their intention to significantly increase the size of their balance sheets in order to weigh on the entire yield curve. The explicit (in the case of Japan) or implicit (in the case of the ECB) aim of this intervention is to drive the domestic currency lower against the dollar. The Swiss National Bank has already capped the Swiss franc against the euro. Meanwhile, the Bank of England and the Swedish Riksbank are also considering intervening to prevent their currencies appreciating too sharply against the European single currency, which is being driven lower by the ultraaccommodating stance assumed by the ECB. On the other hand, the Fed has so far issued no significant comments regarding the strength of the dollar, meaning that the greenback remains the primary vector for the euro to express its weakness. This accounts for the surge in the dollar, and, in correlation, the exaggerated fall in the price of the barrel. The dollar therefore remains, for the time being, the victim of the opening clashes of the potential ‘currency war’ between the G7 countries. Furthermore, the correlation between the dollar and the price of oil is self-perpetuating: European and Japanese monetary easing is driving the dollar higher and weakening the oil price, which weighs on European and Japanese inflation and provides the central banks with the pretext to further ease their monetary policy. This is the mirror image of the 2008 dollar-oil spiral.

The fall in the oil price is thus attributable to a real phenomenon (the downward revision in global energy demand), but which we consider to be amplified by macro-financial interest-rate issues (steepening US real rates) and foreign exchange factors (dollar rally). Its significance for the current state of global growth must therefore be viewed in perspective - the fall in the oil price greatly exaggerates a downturn in global growth in our opinion - and it would therefore be unwise to consequently adopt an over-pessimistic view regarding the current valuation of risky assets. Furthermore, the oil price may rebound once the bullish dollar trend is inversed. The Obama administration may also bring matters to a close, judging that the dollar alone should not have to bear the burden of an adjustment among the European and Japanese economies. The US Treasury Secretary Jack Lew has already expressed this sentiment. The oil price is therefore likely to remain volatile throughout 2015, as the currency war wages on.