How Can the Dollar Rally As Oil Soars?

by Jack Crooks

It seems everyone's most hated "asset," the U.S. dollar, is heading north.

(By the way, most don't even consider the dollar an "asset," so the fact that the dollar is gaining is a good indication that we may be approaching a sentiment extreme.)

This could be just knee-jerk optimism over yet another rescue package from our Heroes on the Hill. Ben and Hank are back to solve this credit crisis once and for all.

But maybe it's something entirely different than that. Here is a short story for you to ponder if you wish. Quite frankly, this story could still be fiction, but stranger things have happened in the world of finance.

Not too long ago, I wrote about how we were seeing an interesting story play out in crude oil. Specifically, it seems the crude oil - U.S. dollar correlation was becoming a bit less correlated. Now, correlations typically ebb and flow, but it was still odd that the dollar didn't make a new all-time low when crude oil blew off to a high of US$150 per barrel.

In fact, the all-time low (measured by the U.S. dollar index) came when crude oil was around US$104 per barrel -  that's dirt cheap in retrospect! Since then, oil prices have climbed 44% and the dollar has actually rallied slightly.

Since When Does the Dollar NOT Go Against Oil Prices?

Increasingly, the majority of oil companies are shedding profit margins because refining margins are being squeezed.

So, despite another $46 dollar blow-off move in oil, the U.S. dollar continued to hover above its low (which incidentally was made on the same day Bear Stearns was "saved"). What's happening?

What's Going On Here?

I see 3 possible scenarios:

Scenario 1: Perhaps oil producers aren't running from the dollar like they used to. Maybe they were "convinced" a bottom is near (that could be thanks to consecutive visits, and carrot stick shmoozing, by V.P. Cheney, President Bush, and Treasury Secretary Paulson, who made consecutive trips to the major oil-producing region beginning in March).

Scenario 2: It is a correlation — and correlations by their very nature can be nebulous and useless at times, especially over short-term time frames.

Scenario 3: Falling global demand for oil is leading to a closing of the crude carry trade. Say what? Yes, it is a theme I've been working on/thinking about/conjecturing about...and it goes like this:

1. Country X, a non-oil producer, needs to import crude oil, which is invoiced in U.S. dollars.

2. Country X notices the dollar price of crude rising and the dollar falling, so Country X decides to borrow dollars to buy crude. And over time Country X notices that paying back those dollar loans is costing less and less. So, why not continue to make this trade, using less of Country X's government budget to buy crude directly, why not just keep borrowing more dollars?

3. Now this is the tricky part that we have been thinking about, but can't confirm with hard numbers. But I have a hunch that two things are changing that lead to a closing, or reversing, of the crude-carry trade:

• The credit crunch i.e. access to available credit is making it harder to borrow dollars
• Falling domestic demand for energy, because of slowing growth in Country X, means there is less oil needed to support the economy. Thus, the need/ability to borrow dollars to pay for crude declines.

And as this pressure is relieved, the dollar stabilizes and even rises relative to Country X currency, especially if Country X is of the emerging/developing nation variety where central banks are way behind the inflation curve.

How You Go from a Credit Crunch to a Strengthening Dollar

This is a classic self-reinforcing process...lack of global credit leads to slowing global growth....which then leads to slowing oil demand....which leads to more closing of the Crude Carry Trade...which leads to change in dollar sentiment...which leads to new price trend leading short-term players, and that leads to dollar perma-bears finally surrendering their eternal anti-dollar position.

Apparently our leaders whispering "the dollar is nearing a bottom" softly into the ears of the Gulf States is paying big dividends — especially to a world that desperately needs its defacto central bank (the U.S. Fed) to have a bit of credibility in the form of value flowing credit.

And with crude falling and the dollar rising, a little allocation from oil producers back into dollars starts to make some financial sense. This just reinforces this trend.

Still a Theory, But Could Become a Fact

Remember: This is just a theory. I could be wrong. But the premise makes sense. The probabilities of all this happening exactly as I hypothesized... well, that's anyone's guess really.

But as I said before, thinking about alternative themes and staying open to the market information flow is all we can do to position ourselves for the next big move, no matter what we trade.

And here at the Agora Financial Symposium in Vancouver, I've yet to hear one person say anything good about the dollar. All I can say is: Don't hate! There is still a chance we can avoid Banana Republic Land after all.

Until I get confirmation on that...I'm open to all possibilities - the ONLY way to stay nimble in the currency markets.

Comments

[Ames Tiedeman:]

Any rally in the dollar will be short lived.

2008 Jul 25 06:58 AM

[keo:]

The USD is far from hated - yet. Look at all the $ held by Asians and Arabs ! The $ still has a long way to go.

2008 Jul 25 07:04 AM

[buyitcheap:]

If everyone is saying they hate the dollar, then might that be a contrarian indicator for a strengthening $?

2008 Jul 25 08:53 AM

[je:]

I think the author pulled up alittle bit short by leaving out other things that would support the $ such as the future bank closings and the liquidation of their assets going into Treas. or the increased prices of grain exports and their contribution to trade balances..........

2008 Jul 25 08:56 AM

[bbzz24:]

you are retarded. have you bothered to look at exchange volume data?
only 9% of global oil demand is being 'traded' or more accurately said hedged on exchanges. the price on the exchange has nothing to do with real demand and supply.

2008 Jul 25 09:41 AM

[NOWHEREMAN:]

The US Treasury is willing to pour an unlimited amount of dollars toward support of Fannie and Freddie, dollar supply cannot shrink as needed to support the dollar.

No country in the world would be willing to support the dollar if it meant a large jump in their inflation rates. Commodities must drop before a dollar appreciation can be allowed. A worldwide recession/depression would be a catalyst for such an event.

Bill Gross guestimated a Trillion dollars worth of write offs for the US Banking sector, think the dollar will appreciate in the face of that?

2008 Jul 25 09:49 AM

[CaptBob:]

In todays world talk has more leverage than hard numbers.
The hard numbers are so skewed they lie almost as much as the talk.
Todays promises are tomorrows forgotten memories.
Skilled and creative thieves lurk in every loophole on the currency highway.
Nothing is as it seems --so anything is possible!

2008 Jul 25 12:06 PM

[OldLimey:]

Any possibility that the USD isn't like a stock that can be 'bottom-called' and ridden to recovery? Any possibility that it's a reserve currency in long-term secular decline as a result of both monetary and fiscal mismanagement at home and shifts in the economic balance of power in the wider world? Any possibility that spikes upwards are just bumps on the long road south?

2008 Jul 25 02:10 PM

[Phil Anthropy:]

In addition to the dollar nearly holding its own as oil prices increased, it is noteworthy that the dollar has actually strengthened against the yen while weakening against the euro. This would seem to indicate a revival of the yen carry trade, which is somewhat surpising if true, because it would mean that carry traders are betting the dollar will not weaken further.

In terms of dollar strength (or lack of weakness) against rising oil prices, just consider that it recently took 40% more dollars than before to buy oil. Foreigners had to buy (or spend from reserves) 40% more dollars for all oil purchases for delivery outside the U.S. Therefore, hundreds of billions of additional dollars have been bought on the currency markets in order to make payments for the oil. This increased demand artificially bolstered the dollar, in my view.

High oil prices also offset the monetary inflation effect of the "economic stimulus" money recently sent out -- most of which was sucked to buy higher priced gasoline (a product of oil, so the money still goes to OPEC). The dollars received by OPEC, China and Japan, among others, must be coming home to roost, recycled into our treasury bonds, because otherwise the world would be awash in dollars and our interest rates would be sky high.

After observing the unusual fluctuations of oil prices over the past few years -- fluctuations often uncorrelated with expected seasonality or transient demand increases -- it seems difficult to relate them to a single force, whether supply/demand, speculation, or "commoditization" of the dollar. I think all of these play a part, but perhaps there is more to it.

One explanation that seems the pass the "Occam's Razor" test as being simple and covering most of the facts is that oil prices are manipulated on a grand scale to further short-term economic goals of the big players. Right now the goal of the U.S. is to keep interest rates down and save the banks. That could not happen if we had dollar monetary inflation. When oil prices are high and resulting demand for dollars is high, interest rates can remain artificially low.

So, whom shall we blame for high oil prices? Perhaps we should audit our various government and quasi-government entities and see what commodities trades they've been making over the past few months.

2008 Jul 25 05:28 PM

[carey_jim:]

Good analysis. Economics is the art of modeling and not, in spite of what the academicians tell us, a science -- dismal or not.

Most Americans fail to see the instability of the rest of the world and only see their own mess.

Can we afford to forget that Europe plunged itself into two entirely preventable civil wars, World War I and II, and almost annihilated itself completely?

The Euro is the only serious threat to the supremacy of the dollar
and some people think the European Union is very ill. I don't believe that but I don't have "unrealistic" hopes about its health either.

If predicting the financial future were easy no one would be posting here. We would all be lying on the beach somewhere sunny and warm and ....

A lot of Americans have made a lot of money betting on the Euro and they don't want to give up on that pony yet. Don't expect too many of them to agree with you ... yet.

2008 Jul 25 05:36 PM

[CaptBob:]

Jim: I am lying on the beach--in the Florida Keys--all sunny and warm.
But that is based on past predictions, not present.
Present is: Our debt far out paces our ability to ever repay, even with deliberately depreciated dollars.
The number of fiat dollars in circulation has not the remotest linkage to our gold holdings, natural assets, GDP, or even Gods blessings for being a good people.

The almighty dollar is doomed, rosy talk by Hank & Ben notwithstanding.

The patient has a terminal illness and the Rx to date has been the infusion of more fiat dollars, tantamount to yesterdays piling on of more Leeches as the patients Blood Pressure drops.

2008 Jul 25 06:39 PM

[Steven Hansen:]

even if we could see all the influences on the dollars relative value, i doubt if we could comprehend the impact of each on the dollar, or how they interact. nor do we really understand what the controllers of the dollar want it to do.

but the truth is that if i were in control of the dollar, i would gradually weaken its value to keep jobs and our economy growing. look at europe and the euro. they allowed their currency to strengthen and got the gift of cheap imported items, only slightly more expensive local items, and an economic engine which has failed. this is what happens when you subjugate your national currency for an international currency (eg you lose the ability of your currency to help control your economy).

as long as i control fiat dollars, i am able to manipulate international trade to my advantage. this is exactly what japan has been doing for years, and the rest of asia (especially china) is doing today.

what i cannot control is the price of energy which is the achilles heal. to me the war on terror is insignificant comparison.

2008 Jul 26 12:46 AM