In this article we discuss the relationship between the US Dollar (NYSEARCA:UUP) and crude oil (NYSEARCA:USO), arguably the most important currency and commodity in the global economy today. More specifically, we make the argument that the fundamental backdrop that has driven the relationship between these two variables in the past has changed dramatically over the past five years, potentially portending a coming seismic regime change. We conclude by briefly outlining some of the key risks or fault-lines such a regime change could unearth.
Traditionally, oil and the US Dollar have been negatively correlated over extended periods of time. As the chart of the two variables shows below, although this relationship does not necessarily hold on a month to month basis, protracted periods of rising oil prices has often been associated with a weaker USD. Due to the large spike in oil prices between 2006 and 2008, we have broken up the period from 1980 into two charts, the first one depicting the two variables between 1980 and 2002 and the second from 2002 to October 2017.
Source: St Louis Federal Reserve Database
As we can see, the USD appreciated quite significantly between 1980 and 1985, a period which saw oil prices decline by more than 60%. The USD then entered a new weakening phase from 1985 to 1990, where oil prices rebounded, peaking in 1990 with the invasion of Kuwait by Saddam Hussein. Between 1990 and 1995 both oil and the USD traded largely sideways. From 1995 to 2001 the USD strengthened, a period in which the price of crude collapsed down to $10 a barrel in 1998 before rebounding quite sharply. The period between 1999 and 2002 is interesting in that the USD remained reasonably firm, while the oil price actually rose by almost threefold off its December 1998 lows. Part of the deviation in the relationship is likely a function of the fact that the oil price had collapsed so sharply between 1997 and 1998 and was therefore significantly oversold. Furthermore, the OPEC cartel also instituted a series of coordinated supply cuts that helped the oil price recover quite sharply in 1999.
If we look at the time period between 2003 and 2017, we can see a similar inverse relationship holds, although given the large relative spike in oil prices, the amplitude or “beta” for a change in the oil price relative to the USD is much greater.
Source: St Louis Federal Reserve Database
As we can see above, the oil price appreciated sharply between 2003 and 2008, a period of sustained USD weakness. Since 2009, the USD first traded sideways then appreciated back to its 2002 levels on a broad trade-weighted basis. Following the crash in oil prices during late 2008 and early 2009, crude oil did recover back to $100 per barrel, remaining at this level until 2014 before collapsing in price during 2015 and 2016. Although the USD had already embarked on a new appreciating trend from 2009, the USD bull market only really started to accelerate in 2014, just as crude oil prices started to decline in earnest.
From 2016 onwards we have had a relatively stable USD in tandem with an apparent nascent recovery in oil prices. On balance, we can therefore say very loosely that the USD has been inversely correlated to oil prices. Indeed, the correlation coefficient for the two variables over this time is negative (implying an inverse relationship) albeit only at 0.21.
What is the fundamental reason for this inverse relationship?
There are two key factors which potentially explain this inverse relationship. Firstly, ever since US conventional oil production peaked in the early 1970s, the US’s consumption of foreign or imported oil has grown. In fact, as the chart from the EIA below shows, net US oil imports reached a record 13mn barrels a day in 2005. As a result, the US’s net energy deficit grew substantially between 1970 and 2005, making the country’s trade balance extraordinarily vulnerable to rising energy prices and specifically oil prices.
A second reason is the historical role that the US’s Federal Reserve has played as the de facto global monetary policy hegemon. Periods of falling interest rates or accommodative monetary policy in the US typically led to a fall in the USD’s value relative to other major currencies. However, falling interest rates also typically foreshadowed a recovery or pickup in US economic activity, which, given the US economy’s large global share of output and hence commodity demand, would also drive up commodity prices in anticipation of higher demand. Thus was borne the broader inverse relationship between the USD and commodities in general, not just oil in isolation.
But do these fundamental factors still hold today?
Well, this is where things get interesting in our opinion. As the EIA chart above also shows, the shale revolution and rebound in domestic US oil production has consequently led to a renewed and marked decline in the country’s net oil imports. From the aforementioned peak of roughly 13mn barrels per day in 2005, net oil imports have declined to an average of around 4mn barrels per day (three-month average for June, July August 2017).
Given the further anticipated growth in US oil production and exports as well as natural gas or LNG exports, it is not inconceivable that the US economy may eventually cease to be a net importer of energy all together. The elimination of the country’s net energy deficit is something of real significance to the global economy and cannot be overemphasized enough. As can be seen in the table below, countries traditionally seen as less “energy intensive” and whose currencies therefore appreciated against the USD during times of rising energy prices are now much larger net energy importers relative to where the US stands today (let alone potentially in two or three years time).
As the table below shows, if we focus on total net energy imports including gas and coal, the US’s level of GDP generated per imported energy unit (oil equivalent tonne) is already much higher than any other major economy. This ratio will only rise further in the next few years, and will likely deteriorate significantly for countries such as China and India assuming their consumption of energy will continue to grow at roughly the same pace as domestic demand.
What this really suggests is that in a rising price environment for energy commodities, the USD should really appreciate on a broad trade-weighted basis. Especially vulnerable are currencies tied to emerging market economies that are large net importers of energy, such as India, Turkey and South Africa. In the past, these countries would have had some relief from the pressure of rising energy imports on their currencies from a weaker USD. If we are now entering a new world order or regime change which sees the USD increasingly positively correlated to global energy prices, these emerging economies with large energy net imports could be especially at risk of a large and potentially destabilising devaluation in their currencies at some point.
As it pertains to the second factor or the USD relationship with commodity prices more broadly, this may still hold true to some extent. However, even here, China is now the predominant consumer of a range of key commodities including iron ore and copper. Therefore, the price for these commodities should become far more tied to economic conditions in China as opposed to the US and as such, even disconnected from shifts in US monetary policy or US economic activity. It is quite possible that even with the backdrop of a stronger US economy, should the Chinese economy weaken substantially (or more specifically fixed investment spending), certain commodities could still come under significant pressure.
How important is this potential regime change?
We think it is crucially important and may ultimately end up triggering the next financial crisis. This is particularly relevant in the event that energy prices spike due to some kind of geopolitical event, in which case the USD safe-haven status could become even more compelling in this new “energy” world order. Rising energy prices in the past have been an important factor leading to a widening the US current account deficit, and by implication an increase in global USD liquidity. This increase in global USD liquidity helped to weaken the USD and ultimately support a countervailing easing in global monetary conditions. This helped net energy importers absorb the cost of the rise in energy prices and therefore ‘soften’ the blow on their economies.
However, if the US current account now becomes ‘unresponsive’ to changes in global energy prices and the USD starts to become positively correlated with energy prices, then net energy importers are now likely to face a “double whammy” so to speak. As the USD strengthens, it will exacerbate the inflationary pressures in their own economy ultimately leading to tighter, not looser monetary conditions. As we have already mentioned, this dynamic could become quite acute in the case of smaller emerging economies with large imported energy requirements, as well as those countries with large external USD-denominated debt.
We are also entering an era where the US labour market is probably as tight as it has been at any time over the past 60 years, while US households remain less leveraged than at any time over the past 30 years. In fact, the positive impulse (on economic activity) of an increase in energy prices on oil-producing states within the US, taken together with these aforementioned factors, means that the US is probably in far better shape today to handle higher energy prices coupled with a further appreciation in the USD than at any time in the past 50 years.
As such, those that would expect US monetary policy to quickly change direction in the event that a positive correlation between the USD and higher energy prices starts to gain traction could end up being surprised at how high the USD would have to go before it would impact or change the trajectory of US monetary policy. In fact, one could easily make the argument that the global economy will break first before the US economy succumbs to the twin forces of an appreciating currency and higher energy prices.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.