The recent increase of oil prices and a threat of a deteriorating situation in Iraq, have spurred concerns over a further rally in Brent towards 150 USD/barrel. This week we will look at two things:

1) The relationship between oil and the major currency pairs and the implications for the monetary policy.

2) Examine whether high oil prices could trigger the return of volatility in the FX markets.

Assuming that the currencies are freely floating, higher oil prices should have a positive effect on currencies of oil exporting countries, i.e. Canada, and a negative effect on oil importers, i.e. the UK, Eurozone and partially the US (although this is changing in the long term with the shale oil revolution).

Implications for currency markets

Higher oil prices can impact currencies in two ways. First is the direct impact that is driven by fear in the financial markets. This psychological effect takes place immediately, spilling into currency markets soon after the markets realise the increased implied risk.

The second impact is indirect and material, through increased producer, retail and consumer prices. The recent increase of oil prices signal a danger of rising inflation that is one of the key drivers behind monetary policy. A combination of a further advance of ISIS in the south and disruption of oil and gas supplies from Russia due to the dispute with Ukraine could drive the price of Brent crude up to 150 USD/barrel.

 

“If Iraq’s oil supply goes offline, crude prices could hit $150-$200 a barrel, that’s where you have to kill demand with price. That’s the only way you can do it, because oil won’t be there.”

 

 

T. Boone Pickens, the founder of BP Capital, Interview with Street Signs

Should oil prices rally to this 6 year high, this would have a significant knock-on effect on inflation in all oil importing countries. In theory, this could lead to tightening by the major central banks and serve as a trigger for higher volatility. However, what is the likelihood of tightening and what is the impact on the major currencies?

The Federal Reserve Bank (The Fed)

The Governor of the Fed Janet Yellen made it clear that they will disregard monthly inflation-data as an indicator for monetary policy actions. US inflation is currently slightly above the Fed’s target of 2%. The Fed is unlikely to pursue an accelerated tightening path based on the recent pick up in oil prices, as food and energy prices are always discounted as volatile and don’t have the same resonance as an inflation increase due to over-heating growth. On the contrary, higher oil prices directly translate into slower growth.

Despite the US being an oil importer, the dollar has an exorbitant privilege (reserve currency status). As such, a worsening situation in Iraq and Ukraine would encourage investors to direct their capital towards a safe-haven currency, partially off-setting the impact of higher oil.

Expectations: HIGHER OIL = STRONGER DOLLAR

European Central Bank (ECB)

The ECB has pursued an easing programme aimed at tackling a risk of deflation. As the Eurozone is an importer of oil with negligible own reserves, the increase in oil prices would have a negative impact on the Eurozone’s economy and weaken the euro. However, due to high liquidity, the euro is perceived as a “secondary reserve currency”. Hence, the potential negative impact of higher oil could be off-set by an increased flow of capital into this safe-haven currency.

Expectations: HIGHER OIL = WEAKER EURO

Bank of England (BoE)

Currently, markets are pricing in an increase of interest rates by the BoE at the end of 2014, and more importantly before the Fed. Inflation has come down and is currently 1.5%.

Higher oil prices, all else being equal translate into higher inflation and rate increase, but there is a compelling argument why this is not the case for Mark Carney. There is a general consensus that a 10 USD/barrel increase in oil prices translates into a 0.2%-0.5% decrease in growth. In the case of the UK, the unbalanced recovery and GBPUSD trading above 1.70, along with higher oil prices, could raise concerns over growth and further postpone the interest rate hike.

Expectations: HIGHER OIL= WEAKER STERLING

Bank of Canada (BoC)

The Canadian dollar has traditionally had a strong positive correlation with oil prices. The CAD has been viewed as a “petrocurrency”, as its value rises with the rising oil price, primarily because Canada is a net exporter (and one of the top 10 producers in the world) of oil.

Expectations: HIGHER OIL = STRONGER CANADIAN DOLLAR

In addition to the factors described above, a high oil price in itself could be strong enough trigger for the return of volatility to financial markets generally. As such, should the oil price rally higher towards 150 USD/barrel, it would spur chaos in the financial markets that would lead to panic and result into a significant jump in volatility. This would likely support the USD, and hurt carry trade beneficiaries such as emerging market currencies and GBP.

Zarina Niyazova