Oil crisis and forex market

Oil prices have hit $143 a barrel and there appears to be little let-up as traders push the energy commodity to record highs, almost on a daily basis. At the same time the US dollar is hovering near record lows against a line of major currencies with markets continuously seeking to send the US currency lower. Commodity traders jump on any reason, no matter how minute, to send crude prices higher. The subsequent rise in oil prices is then taken as a vote of no confidence in the dollar and the greenback duly obliges, going lower in value. This would not be so bad were the related moves in some way proportionate, but the reality is that since last summer every 1% fall in the US dollar index has corresponded to a massively disproportionate 10% rise in the price of crude. Of course there are other factors driving crude prices, but it is no coincidence that oil prices began scaling the current spike around the same time the US Federal Reserve embarked upon an aggressive rate cutting campaign, a policy move that caused the US dollar to nosedive. Oil prices have reached such an alarming level that they are now having a damaging effect on global stock markets (inflated energy costs are eating into disposable income and drying up consumption demand for other products and services). US and European bourses are today officially in bear markets (the major indices having lost 20% from the peaks achieved within the past 9 months). As investors scramble for returns outside of equities, we are seeing some major fundamental disconnects in currency markets, something which has been amplified in recent weeks.

What are these disconnects?

1) A rise in risk aversion no longer translates into liquidation of carry trades. If one glances at the major carry pairs – EUR/JPY, AUD/JPY and NZD/JPY, one will notice that even in a situation where equity markets have plummeted over the past month, these carry pairs have in fact gone higher. The reason for this is twofold: a) while stocks have retreated, commodity prices have gone up and commodity currencies like the Aussie and Kiwi dollars have been well bid and b) Volatility levels as measured by the VIX indicator have remained low, even while stocks were selling off at a record pace in June. This is encouraging risk takers to keep selling the yen against higher yielding currencies.

2) Weak economic data is not weakening a currency in the current market. A case in point here is sterling, which has appreciated against every other major currency over the past 2 weeks, despite some dire economic releases from the UK which point to an ailing economy on the brink of recession. The euro has also been appreciating against a backdrop of softening economic data. Why? The Central Banks in the euro area and the UK have highlighted that they are more concerned about rising inflation trends than slowing growth conditions. The ECB is expected to raise interest rates this week at a time when the euro zone economy is slowing rather sharply, while the Bank of England has hinted the next move by the MPC is more likely to be a rate hike rather than a rate cut (markets had been expecting further cuts given the economic downturn). For the immediate term investors are more interested in higher yield, not growth prospects, and the comfort of higher interest rates is attracting their money. This of course is having a damaging effect on the dollar, with the Fed less concerned about rising inflation than the ECB and Bank of England, even though headline inflation is running higher in the US than in the euro area or in the UK.

This disconnect of course cannot last. Eventually markets will reach breaking point, which will happen when there is clear evidence of demand destruction for crude oil, or when spiralling energy inflation sparks some form of direct market intervention, or when the Fed is forced to hike US interest rates before they would like to do so. It may be premature to start expecting conciliatory tones from an ultra-hawkish ECB.

This disconnect situation does throw up some interesting medium term value trades in currency markets. The one that currently jumps out is GBP/USD, which is on offer to sell today just below the 2.00 mark. The UK economic situation is fast developing into a crisis and it is difficult to see how sterling can hold its elevated market position, regardless of what reality disconnect appears to be gripping the Bank of England. The euro also looks to have been on an extended honeymoon, although the ECB still holds considerable street cred with traders and Trichet & Co. cannot be dismissed as lightly as a Bank of England which is less than consistent in its policy approach.

Ted B - Jul 1