Everyone is talking up the fact that the USD was unable to rally during last week’s brief swoon in risk appetite. But before we make too much hay about the power of crude prices having caused this – let’s have a close look at a few correlations and the real reason the USD did not respond to the risk sell-off.
The market is making a big deal out of the fact that the USD found no safe haven bid on the (wow – can you believe it – a gargantuan -2.7% from the close on Friday the 18th to Thursday the 24th on the US S&P 500 – and yes, that is sarcasm you detect.) risk sell-off last week. Many are attributing this development to the rise in oil prices and the US’ vulnerability on the oil issue. At least one bank has sent out a detailed piece on the USD and oil correlation, and yes it is fairly easy to find some evidence of this correlation, though we would argue that at times, oil was at times more correlated with risk assets rather than supply fundamentals at times over the last few years, and so was the USD.
As at least one analyst today has pointed out, however, the potential disruption from the specific source of this supply pinch (particularly Libya) is far worse for Europe than for the US – particularly Italy. US oil consumption is actually down slightly (about -2%) from a few years ago and US production is running a solid 10% higher over that same time frame. Make no mistake – the US is ridiculously dependent on foreign oil – but far less ridiculously than especially Japan or mainland Europe. The US has a very diversified list of suppliers as it is dead serious in its avoiding strategic risks to the country as a lesson learned from the oil crises of the 1970’s. The US also has enormous strategic reserves of over 700 million barrels. Take Saudi Arabia completely offline and the US can keep consuming from other suppliers and its reserves at unchanged levels for two years (that would never happen, of course, as oil prices would probably triple or worse if Saudi was taken off-line, but it is just to make a theoretical point that Saudi imports are only a fraction of US consumption). If a Nigeria goes off-line, on the other hand, then we have a more specifically US-related supply problem.
Chart: USD (G-10 vs. USD) vs. Crude Oil Price
It appears from the following chart that the USD is indeed at high risk from the oil price headed higher (Just remember that the last time the USD was collapsing, it was because it was dealing with the sub-prime blowout and threatening to cut rates at the same time as the rest of the world was booming out of control). Also, the situation was far different in 1999-2000 when both oil and the USD were strong because everyone was pouring money into the US stock bubble and only had one eye on the oil price in pairs like USDCAD. Here we use Brent Crude as the crude oil price.
It appears from the following chart that the USD is indeed at high risk from the oil price headed higher (Just remember that the last time the USD was collapsing, it was because it was dealing with the sub-prime blowout and threatening to cut rates at the same time as the rest of the world was booming out of control). Also, the situation was far different in 1999-2000 when both oil and the USD were strong because everyone was pouring money into the US stock bubble and only had one eye on the oil price in pairs like USDCAD. Here we use Brent Crude as the crude oil price.
It’s not crude – It’s the Fed!
We would suggest that while crude is playing an important role here because it is getting many of the world’s central banks excited about raising rates to fend off cost push inflation from higher commodities prices, it is really the idea that the Fed will be far slower to react to said higher crude prices and commodity inflation than anything else and will therefore have zero credibility on maintaining the greenback’s value. (Also a part of the entire bit of circular logic is the idea that the careless Fed has set off the chain of destabilizing geopolitical events due to its money printing engendering a spike in commodity prices in the first place.) So to get lift-off for the USD, we need for crude oil prices and risk appetite to fade simultaneously, as this would cool the global rate expectation environment – a development that would favor the USD due to its low yield and low expectations for future moves.
We would suggest that while crude is playing an important role here because it is getting many of the world’s central banks excited about raising rates to fend off cost push inflation from higher commodities prices, it is really the idea that the Fed will be far slower to react to said higher crude prices and commodity inflation than anything else and will therefore have zero credibility on maintaining the greenback’s value. (Also a part of the entire bit of circular logic is the idea that the careless Fed has set off the chain of destabilizing geopolitical events due to its money printing engendering a spike in commodity prices in the first place.) So to get lift-off for the USD, we need for crude oil prices and risk appetite to fade simultaneously, as this would cool the global rate expectation environment – a development that would favor the USD due to its low yield and low expectations for future moves.
Chart: USD vs. Interest Rate spreads.
A chart of the USD vs. Interest rate spreads (an aggregate measure of 2-year swap spreads of the USD vs. the rest of the G-10.) shows that it is the markets belief that the Fed will be the slowest mover in the event of a continued push higher in commodity prices. Crude oil has played a part in this, of course, with the Fed’s focus on core rather than headline inflation, but we would point this out: from early March of 2008 until early July of 2008, the crude oil price ran up from 100 dollars to over 145 dollars – the USD vs. the rest of the G-10 during that time frame? Unchanged. During that same period, rate spreads against the USD (as shown in the chart) narrowed about 30 bps in the USD’s favor – evening out the influence of crude prices and creating a stalemate for the broader USD picture. Interest rate spreads are more influential than crude oil prices.
A chart of the USD vs. Interest rate spreads (an aggregate measure of 2-year swap spreads of the USD vs. the rest of the G-10.) shows that it is the markets belief that the Fed will be the slowest mover in the event of a continued push higher in commodity prices. Crude oil has played a part in this, of course, with the Fed’s focus on core rather than headline inflation, but we would point this out: from early March of 2008 until early July of 2008, the crude oil price ran up from 100 dollars to over 145 dollars – the USD vs. the rest of the G-10 during that time frame? Unchanged. During that same period, rate spreads against the USD (as shown in the chart) narrowed about 30 bps in the USD’s favor – evening out the influence of crude prices and creating a stalemate for the broader USD picture. Interest rate spreads are more influential than crude oil prices.
A look at the USD vs. Risk
A look at the USD versus our risk measure – shows that at first, the USD did quite well during a recent surge in risk appetite late last year (helped out by strong economic data driving US rate credibility a bit higher in the spreads) but that the correction in risk that has been under way recently (so far, we’re seeing far less of a bounce in EM and corporate credit than equities are showing – as risk still looks shaky) has failed to do much for the USD. Against the major currrences, the USD is generally weaker, but the focus on the risk to EM currencies on higher commodity prices has seen our USD carry trade basket (which includes AUD, NZD, MXN, PLN, IDR, ZAR, BRL) more or less flat over the last couple of months less the carry.
A look at the USD versus our risk measure – shows that at first, the USD did quite well during a recent surge in risk appetite late last year (helped out by strong economic data driving US rate credibility a bit higher in the spreads) but that the correction in risk that has been under way recently (so far, we’re seeing far less of a bounce in EM and corporate credit than equities are showing – as risk still looks shaky) has failed to do much for the USD. Against the major currrences, the USD is generally weaker, but the focus on the risk to EM currencies on higher commodity prices has seen our USD carry trade basket (which includes AUD, NZD, MXN, PLN, IDR, ZAR, BRL) more or less flat over the last couple of months less the carry.
All of this underlines how critical the Wednesday and Thursday Bernanke testimony will be for the USD’s fate here, particularly as it is poised at critical support on the USD index and as we are close to those all time lows in the USD vs. the rest of the G-10. We know that Bernanke will present a dovish front at the testimony and defend his policy tooth and nail, despite the fact that he has been wrong about everything at every turn since assuming the most important single position in public office for global markets in the world. A continuation higher in oil prices and a continuation of Bernanke’s sway over markets virtually guarantees a weaker USD. He’ll of course also try to bewitch the lawmakers into believing that Fed policies are helping the economy recover (Look at how we pumped that stock market, isn’t it sweet?) and that the Fed will be there again if need be with QE to infinity. It’s your turn, US lawmakers to wake up, smell the coffee and put an end to this three-ring-circus - will you?
