DB FX Daily: A Renewed Rally in Crude Oil Could Add to USD Pressure

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FX Daily: A Renewed Rally in Crude Oil Could Add to USD Pressure

A Renewed Rally in Crude Oil Could Add to USD Pressure

The rally in crude oil over the past week has seen a return to levels last seen in December 2006 and has made another month/month increase in crude oil prices likely following February's gain. The oil rally has so far failed to break the $63-64/bbl level which has been the ceiling in the front WTI future since September and therefore the impact on FX markets may be limited for now. But a look at the oil and FX correlation over recent years points to a potential negative impact on the USD if the recent crude oil rally were to continue further. The chart at left below tracks the rolling 13-week correlation of weekly returns on the front WTI future and the DXY dollar index.

Despite previous academic work which has generally identified a positive USD impact from higher oil prices due to petrodollar recycling in USD securities markets or imports from the US and the transactional boost from most oil being traded in USD, the correlation has clearly been more negative in recent years. In our view, further oil price gains would likely weigh on the USD through two channels. First, it could potentially exacerbate the current fears over sub-trend growth and elevated inflation levels which have seen a steepening of the US yield curve and increase in breakeven inflation spreads. As we discussed in the last FX Strategy Weekly, we see such an environment as negative for the USD. The second transmission channel would likely come through the rebalancing of oil exporter reserves from USD revenues into a reserve mix with a heavier weight on EUR and especially GBP.

Looking across currencies, it appears that realised correlations between oil and currency returns have increased the most in GBP, EUR and CHF rather than the usual focus NOK and CAD. Though those two energy exporters may still have the highest level of correlation between their currencies and crude oil prices, but GBP and EUR have been catching up as the general negative correlation with the USD has picked up and perhaps the influence of other oil exporter reserve manager demand for GBP and EUR has become more important.