The Link Between Oil and the US Dollar

What does the faltering oil price tell us about the strength of the global economy? The price of the international benchmark, Brent crude, has gone from US$115 a barrel in June to US$92 now. That’s a 20% decline in just over three months!

Does this tell you that the global economy has slowed sharply in recent months? Or is it more a US dollar strength story? That’s what I’m going to try and figure out in today’s Markets and Money.

First, take a look at the chart below. It shows the Brent crude price over the past two years. While the recent price decline has been dramatic, a far sharper decline occurred in early 2012. That was in response to the waning momentum of the ‘Arab Spring’, where Egypt and Libya were on the brink of revolution.

Back then, panic selling followed panic buying and the US dollar wasn’t really a factor in the price movement. It was really all about geopolitics.

Oil price falls point to weak demand

But now, there’s a lot more going on. The sharp drop in oil prices is symptomatic of some major movements of capital across the globe. It’s all about the end of the US Federal Reserve’s quantitative easing (QE) program.

The Fed has gone from pumping US$85 billion per month into global asset markets up until the end of 2013, to pretty much nothing now. That’s a lot of liquidity that has just disappeared. Formerly, this liquidity found its way into emerging markets (stocks, bonds and currencies) as well as anything with a decent yield like the Australian dollar and dividend paying blue chips listed on the ASX.

But now, the ‘drying up’ of this liquidity is having a major impact on asset markets around the world. The biggest impact you’re seeing so far is in the currency markets. The US dollar is again assuming its mantle as ‘King Dollar’. It’s the strongest currency in the world right now.

US dollar strength is most notable against emerging market currencies like the Turkish lira or the Brazilian real. The Aussie dollar hasn’t escaped either. In early September, currency traders decided the Aussie was simply a commodity currency…again. In that short timeframe, the greenback has surged around 8%. When it comes to currency markets, that’s a very big move.

A sharply rising US dollar usually signals a lack of global liquidity. For example, in the credit crisis of 2008, the dollar surged higher as stocks and commodities all tanked.

A similar scenario is unfolding this time around, although it’s nowhere near as acute. Still, for Aussie investors, it’s pretty painful. As well as the dollar falling, the local stock market is down, as previously created Fed liquidity evaporates into thin air.

Which brings me back to the oil price. You can put a large part of its decline down to the strength of the US dollar. Regardless of demand and supply dynamics, when the US dollar strengthens, anything priced in US dollars, like gold or oil or any other commodity, will fall.

What should worry the oil bulls though is that considerable geopolitical instability isn’t helping the price out. You have heightened tensions between Russia and the West…and Russia is one of the largest energy suppliers in the world. And you also have yet another war going on in the Middle East, the product of past wars in the Middle East designed to stop future wars in the Middle East.

That these geopolitical risk premiums are not providing any price support suggests the demand outlook for oil is weak and getting weaker.

You can put that down to China. There is little doubt that China’s economy is slowing. And as you’ve seen over the past few months, China’s rulers are no longer interested in resorting to large scale stimulus measures whenever growth disappoints. They did that in 2012 and 2013 and it only blew China’s credit bubble bigger.

Making matters worse for China, a strong US dollar is painful for their economy. They loosely peg their currency, the yuan, to the dollar. So a strengthening dollar hurts export competitiveness.

You’re not seeing any visible signs of this discomfort yet, but if US dollar strength persists, it could become a problem. It could also become a problem for other emerging market nations, especially those who have borrowed in US dollars but must repay interest and principle in their local currency. Borrowing in a strong currency and repaying in a weak one is rarely a good combination.

Moving closer to home, the biggest impact on Australia so far is via the iron ore price. Thanks to a slowing China and strong greenback, iron ore prices are now under US$80/tonne, down from around US$130/tonne at the beginning of the year. Given it’s Australia’s largest export and has underpinned our recent economic expansion, such a sharp price decline is a very big deal.

It impacts budget revenues at both the state and federal level, and it indirectly effects Aussie wages via its influence on ‘national income’.

I won’t go into that today. For now, it’s enough to point to the performance of the world’s largest iron ore miners, BHP and Rio, both down 2% this afternoon. Not to mention previously emerging, now submerging, iron ore player Fortescue, down 4%.

The Australian stock market can’t catch a break right now. A strong lead from Wall Street is no longer enough to push stocks higher. That’s because with the iron ore price collapse, foreign capital is getting out. For the Aussie economy, the flow on effects from this price collapse will be considerable.

Luckily, we have a strong property market that will help weather the coming storm, right?

Right?

More on this tomorrow…

Regards,

Greg Canavan+
For Markets and Money

Join Markets and Money on Google+


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money