Since 21 July 2005, there appears to have been a close relationship between the dollar index and crude oil prices: to be precise, there has been a 76 per cent inverse correlation between the daily performance of the dollar index and that of front month NYMEX light sweet crude contracts. Although the reasons for this remain open to debate (higher energy prices are possibly seen as exacerbating the scale of the US trade deficit), it indicates that developments in oil markets must be followed extremely closely.
It has not, of course, just been the currency markets that have demonstrated a marked relationship with oil price movements over the past six months. It has been particularly noticeable, for example, that equity markets have not reacted particularly well to crude oil prices much above $60 a barrel. This has been most clearly exhibited by the S&P 500 index, which remained consistently under pressure in the period between early August and late-October and which looked particularly weak in the middle of January (as NYMEX light sweet crude established itself comfortably back above $64 a barrel).
This stock market weakness was not confined to the US indices. In particular, the Nikkei 225, the Kospi and the Taiwan weighted indexes all broke their uptrends from late October as the second half of January got underway. Although it could be argued that these pullbacks were no more than a reflection of the “Livedoor” story in Tokyo, they nonetheless coincided with an aggressive rally in oil prices. However, despite their modest bounce back, there is inevitable concern about the outlook for these indices given the sheer amount of international capital that has flowed into these markets over the past six months and the growing risks of a price spike in oil. Data indicates that a rapid acceleration of inflows occurred since last summer – indeed, inflows of foreign capital into South Korean equities since the summer of 2005 are estimated to account for over 50 per cent of all the inflows seen in the past two years.
This leaves an interesting conundrum: the long-term technical picture for the dollar index appears to be taking on a very negative tone. In particular the 23 January fall in the index took it out of the upward channel that had defined trading for the past 12 months. This, in turn, leaves last year’s rally looking increasingly like a correction (rebounding away from the historic lows first established for the index in the early to mid-1990s) within the long-term down trend that got under way in the second quarter of 2002. It is also noticeable that this comes at a time when speculative accounts (according to the Commodity Futures Trading Commission) appear to have only recently moved back to neutral positioning in the majors (the only real exception is in euro contracts).
Given this, it seems that any spike in oil prices has the potential to send the dollar spiralling lower. However, given the risk identified that east Asian equity markets could also take a sharp hit on the back of higher crude prices, it is clear that investors need to be especially careful about selecting the currencies to go long on against the greenback. Although we continue to favour the idea of holding the South African rand and Canadian dollar (to reflect an ongoing bullish view on gold), it may also make sense to avoid some of the Asian currencies and to instead focus on holding such relatively safe haven currencies as the euro, Swiss franc and possibly, sterling.
Neil Mellor is a currency strategist at the Bank of New York.
Researched and published in association with the Bank of New York.
