1997 lessons: Oil, dollar and market linkages

Updated: Sep 30 2007, 08:32am hrs
Oil is up, the dollar down; and if the petroleum part of the relationship doesnt change significantly, which looks unlikely, nor probably will the currency piece. For three decades, the correlation between two of the worlds most important prices was strongly positive, with oil and the dollar rising and falling in tandem.

Petroleum is bought and sold in dollars. That meant that as oil prices climbed, so did the global demand for dollars. The appetite for dollars increased further during recurrent oil shocks, as rising risk-aversion prompted investors to seek safety in US Treasury securities.

The US currency was also buoyed by oil exporters propensity to both invest their export proceeds in dollar-denominated securities; and when they spent the funds on goods, they usually bought American.

Since early 2002, however, the correlation between oil and the dollar has been negative. When oil rises, the US currency falls.

From about $19 a barrel in late January 2002, the price of oil has catapulted to $82.25. Over the same period, the dollar has tumbled 39% to $1.4045 to the euro and 33% on a trade-weighted basis.

After the Federal Reserve on September 18 cut its federal funds rate by half a percentage point to 4.75%, crude oil rose to a record $82.51 a barrel.

Oil exporters propensity to import from the US has declined in recent years, while their tendency to import from Europe and Asia has risen steadily, says Stephen Jen, global head of currency research for Morgan Stanley in London. Opec nations currently buy more than three times as much from the European Union as from the US, he says.

To the extent that oil exporters keep buying European, Europes economy may be less affected by higher oil prices than the US economy, prompting investors to favour European investments. And since oil imports account for about a third of the US trade deficit, high and rising oil prices may be particularly bad for the dollar, Jen says.

Whats more, many investors see the Fed reacting to rising oil prices by cutting interest rates to preserve growth and the European Central Bank by raising rates to ward off inflation.

Since the start of 1993, the dollar has been the worst performer among the worlds 10 major currencies when oil-price growth is stronger than usual, Paul Robinson, foreign exchange strategist at Barclays Capital says. Goldman Sachs Group Inc this week raised its year-end oil-price forecast to $85 a barrel. The firms commodity analysts had previously projected $72.

That isnt good news for the dollar.

Monetary policies

Wall Street may be breathing a sigh of relief - or even dancing a jig - following the Feds decision to cut its Federal funds rate by 50 basis points. Yet from the average investors perspective, the best news is that the major central banks are singing from the same hymnal.

While the Fed lowered rates, central banks in Europe, the UK, Canada, South Korea and Australia have held off raising rates. Even the Bank of Japan, which has been chomping at the bit to normalise monetary policy, this week chose to leave its overnight lending rate at 0.54% with only one of nine board members dissenting.

Policy makers have their critics. Fed Chairman Ben Bernanke continues the Greenspan put and assists those that made poor credit decisions without the consequences of market discipline, says Andrew Busch, Chicago-based global foreign-exchange strategist at BMO Capital Markets. Like a teenager with a car and no curfew, well be having more problems down the road from these actions.

Even so, a lack of coordination among central bankers may jeopardise the health of the world economy, which is much more important than fretting over concerns that easier monetary policies are tantamount to bailing out investors and banks that made stupid bets.

Historical view

Investors seeking guidance on where global stock markets are headed following the Feds rate cut may want to take a look at the second half of the last decade.

In early 1997, markets were abuzz with speculation about Thailands ability to defend its currency and service its debts.

Analysts mostly ignored the issue. By early 1998, Thailand had morphed into an Asia problem and begun to hurt the stock prices of US banks. Then Russia defaulted and in the fall of 1998, hedge fund Long-Term Capital Management had to be bailed out.

The Standard & Poors 500 Index fell 15% in six weeks, the Nasdaq Composite Index tumbled 30% in less than three months.

The Fed responded by cutting rates three times in September, October and November of 1998. Concerns about the year 2000 computer bug also prompted the Fed to pump huge doses of liquidity into markets.

Result: The Nasdaq soared 86%, and the S&P 500 rose 20% in 1999.

The late 1990s show that investors can make money in aging bull markets that become bubbles. They had just better be prepared to get out before the pop.

Bloomberg / Michael R Sesit