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Equity traders watch currencies, oil traders watch the dollar, and lately everyone watches the price of oil. The relationship between the price of crude oil and the value of the dollar has been unusually close in the past year, and especially so following the peak crude oil price on July 14th. The inverse correlation has been strict; as the dollar rose, oil fell. Even the dates for the reverses in each market mimic each other. The dollar reached a bottom against the euro the day after oil reached its apogee. July 15th , the day of the dollar’s plunge the Dow closed at 10,962.54. Since then, oil has fallen more than 20%, the dollar has gained 8.5% against the euro, and the Dow has returned 5.3%, (all dated to the Friday close).

The effect of a lower oil price has been much less pronounced on equities than on the dollar. This is odd because oil acts on the currency markets and the equities in much the same manner: through its effects on the US economy. What insight can we gain from comparing the behavior of the three markets since the oil bubble was punctured in mid-July?

That oil was in a bubble has been clearly demonstrated by its behavior since the peak. When Hurricane Gustav became a potential threat to American oil and natural gas production in the Gulf of Mexico, the price of crude rose more than seven dollars on world exchanges. When the Federal Government announced that oil would be released from the Strategic Petroleum Reserve to counter any shortage created by the storm, the price of crude fell back almost to its starting point. That is a normal commodity market reaction, not a bubble induced lunge.

On July 14th, President Bush lifted the executive order prohibiting drilling on the US continental shelf and challenged Congress to do the same with its own prohibition. Oil began its long fall that day, the dollar its month long rise the next. There is no coincidence in these dates. Oil traders know that 70% of the American population supports drilling for oil in American territory. The congressional ban on offshore drilling expires on September 30th. Congress must act to renew the prohibitory regulation or the ban will lapse. Traders were betting that in an election year, with a very close presidential race, the Democrats will be forced to permit drilling or risk seriously damaging the fortunes of their nominee Barack Obama.

What was obvious then is even more obvious now that the Republican presidential candidate John McCain has chosen Sarah Palin the Governor of Alaska as his vice presidential running mate. The Republicans clearly intend to make energy policy, and specifically drilling for oil, a major topic in the election. Sarah Palin is both pro-drilling and well versed in energy politics. As the campaign progresses, the pressure on oil prices from the potential for increased supply will intensify.

The dollar has been boosted by several factors: the US economy out-performed the European Monetary Union [EMU] by a wide margin in the second quarter; the Fed rate reduction of 325 basis points has given the US economy the edge on recovery, and the ECB has provided no stimulus for the European economy; the next rate move by the Federal Reserve is likely to be a hike and the ECB will probably cut; the belief is that the US is ahead in the economic cycle, having fallen briefly into negative growth in the fourth quarter of last year while the EMU did not shrink until the second quarter of 2008.

US equity markets have several factors leaning against any prolonged upward move. The residue of the sub-prime and asset backed securities problems are proving much more of a threat to the financial system and the resumption of normal credit markets than many anticipated. The financial system will be hard pressed to resume normal functioning until the housing market has stabilized. As long as the underlying market continues to decline, assets based on valuations from that market will continue to fall as well.

The best hope for a sustained US recovery now rests with the US consumer. US exports, for many months the driving force behind GDP growth, will begin to wane as the dollar rises. Consumer spending as given by real Personal Consumption Expenditures [PCE] was only 0.7% higher in July over the previous year. There is little doubt that rising oil prices -- headline inflation was 5.6% in July -- is one of the primary stops on US consumer spending and sentiment. If lower oil prices can help bolster the US consumer and transfer some economic growth from exports to domestic consumption, the US economy stands a good chance of avoiding a prolonged period of slow or negative growth.

In a very accurate sense, the American voter has identified the one factor that has the greatest chance of preventing a painful decline in the US economy—lower oil prices. It is also the factor that will do the most to press the rise in the dollar.

Source: A Tale of Three Markets