These are rocky times for most investments. The S&P 500 and Nasdaq have each fallen for seven consecutive weeks while the Dow Jones Industrial Average has fared even worse, dropping for eight weeks straight, the longest losing streak for the index since the Great Depression, in 1932. The S&P 500 is now down 13.9% in the year-to-date while Nasdaq has dropped 23.1%. Meanwhile, a 10% contraction in global bonds only looks tame when compared to Bitcoin's more than 30% decline in 2022.
But it has been a wonderful stretch for the dollar.
The U.S. Dollar Index, which pits the dollar against a basket of six global currencies, is hovering around 20-year highs. Since the beginning of the year, the dollar index has gained 8%; and in the last 12 months, it has risen 14%. The dollar index hit a two-decade high above 105 earlier this month and is currently trading less than 3% below those peaks. The dollar has performed even more spectacularly against single currencies: Against the Japanese yen, the dollar has appreciated more than 13% this year alone and gained 36.30% in 14-months against the sterling pound.
What’s interesting is that the very forces that are responsible for unsettling the stock and bond markets, including Fed rate increases, sky-high inflation, global sanctions on Russia and China’s lockdowns, have actually been buoying the dollar thanks to its well-established status as a global safe haven.
But a brawny dollar has failed to stop one commodity in particular: crude oil.
The oil price bull run has been taking little notice of the greenback’s advance, and has managed to snap crude's historical inverse link to the dollar thus signaling it still has room to run based on current market fundamentals.
There's normally an inverse relationship between the value of the dollar and most commodity prices including oil. Historically, commodity prices have tended to drop when the dollar strengthens against other major currencies, and rise when the dollar weakens against other major currencies. Although the correlation is not perfect, there's often a significant inverse relationship over time between the dollar and commodity prices.
Oil prices and the dollar have been moving in the same direction higher since late March, and hit the highest positive correlation since May 2019.
The usual inverse correlation between oil and the dollar remained unchanged in 2020 and into early 2021 as demand for crude was undermined by the global pandemic. But many analysts now expect the positive link to persist given the tight oil market and broader risks to the global economy.
"Considering that spare capacity is low, there are likely larger supply disruptions ahead of us, and that oil demand will likely keep increasing, I would expect that oil will primarily be driven by its own fundamentals," UBS analyst Giovanni Staunovo has said.
With oil currently trading around $115 a barrel, JPMorgan expects Brent prices to average $114 a barrel over the second quarter as whole, and even surge to over $120 a barrel at one point.
Another factor that has been contributing to the disconnect between a stronger dollar and oil prices is the fact that the current energy crisis has hit Europe the hardest: "Historically, energy crises and inflationary shocks were centered on the U.S. and hence dollar bearish," MUFG's head of emerging markets research, Ehsan Khoman has said. Europe-- the region most heavily reliant on Russian energy imports--now happens to be the epicenter of the crisis, and is already grappling with deep energy trade deficits.
"As coal, gas and oil prices continue to remain elevated on supply scarcity, global growth ex-U.S. is suffering more than the U.S. economy, and by extension, the U.S. dollar is appreciating," Khoman has added.
In other words, this is no longer only about the Fed.
Changes in the federal funds rate are known to impact the U.S. dollar. Whenever the Federal Reserve increases the federal funds rate, it typically increases interest rates throughout the economy. Higher yields attract investment capital from investors abroad seeking higher returns on interest-rate products such as bonds.
In turn, global investors sell their investments denominated in their local currencies in exchange for U.S. dollar-denominated investments, resulting in a stronger exchange rate in favor of the U.S. dollar.
The Fed’s hawkish stance including quantitative tightening fueled the initial stages of the dollar rally. But energy security concerns as well as major geopolitical upheavals in Europe are now fueling a second phase of not only the dollar rally but the oil price rally, too.
By Alex Kimani for Oilprice.com
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Global underinvestment has also contributed to the skyrocketing oil prices by making the oil market tighter and also increasing the shrinking of the global spare capacity including OPEC+. Moreover, the rhetoric by the EU about banning Russian oil imports is fanning the flames under oil prices.
The continued rise in oil prices is happening despite the dollar because the market fundamentals are very bullish. Moreover, the rise in the value of the dollar in the current circumstances isn’t a health sign for a US economy bedevilled by a rising inflation headed towards 9%-10%. Its rise is fuelled first and foremost by the Fed’s hawkish anti-inflation measures.
However, the US economy and the dollar will pay a heavy price for the surge in oil prices. The reason is that the United States is the world’s second largest importer of crude oil after China currently importing an estimated 9.0 million barrels a day (mbd) and therefore its economy is the most vulnerable to oil price shocks among the major economies.
Furthermore, the petrodollar is already coming under pressure from President Putin’s demand to be paid in rubles for his oil and gas exports. This could potentially be a huge blow against the petrodollar. The ruble is already on the way to becoming an oil currency. Moreover, this could encourage other countries to use their national currencies to pay for oil. China and India are already competing with each other for Russian oil imports. Between them they account for more than 24% of globally traded oil. Soon India will insist on paying for its oil imports in rupees while China will also demand that Saudi Arabia and other Arab Gulf exporters accept the petro-yuan for payment for oil imports.
Were Saudi-led OPEC to replace the petrodollar with the petro-yuan, China to pay for its crude imports by petro-yuan, India to pay in rupees with Russia selling its 8.0 mbd of exports in ruble, Venezuela and Iran to accept the petro-yuan for their exports, the petrodollar will certainly lose an estimated 80% of global oil trade and its status as the oil currency of the world. This could lead to a loss of one quarter to one third of its value against other major currencies.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London