Many pundits have come out recently reminding us of the historical inverse relationship between the U.S. Dollar and the price of crude oil. With many analysts saying oil could possibly bottom in the $20 range, this implies a significant rise in the value of King Dollar. This would cause severe hardship to commodity exporting emerging markets as they are hit with a double whammy of lower prices and more difficult external financing. Borrowing in dollars would become much more expensive. The U.S. economy could also be harmed with a continued, overly strong currency. European exports could be damaged as well as the U.S. economy slows. However, I believe this analysis is looking backwards and is ignoring the significant de-dollarization of the commodities markets which has already happened and is ongoing. Is it different this time with the dollar and oil?
The main reason oil and the dollar have had an inverse relationship is that most global commodities historically have been priced in dollars. As the dollar weakens, it takes more of them to buy a barrel of oil. It’s not rocket science; but, the black swan most are not taking into account is that China, Russia, and even our European allies are actively setting up the financial infrastructure to ex-out the dollar in global trade. The Swiss, English, Australians, et cetera have all joined the party. It’s obvious why totalitarian countries want to get out from under global dollar hegemony, they don’t want to be exposed to U.S. financial leverage as Russia finds itself currently. Russia and China have been very active in increasing economic cooperation in their local currencies. Our European and other allies don’t want to miss out on business opportunities in the immense Chinese, or to a lesser extent, Russian markets, so they are also setting up swap lines in yuan.
The Chinese are dead-set on converting the yuan into a global reserve currency with all the consequences that entails. This means inclusion into the International Monetary Fund’s Special Drawing Rights, or SDR, that is essentially a basket of reserve currencies. Most analysts think this inclusion is only a matter of time, regardless of the overt manipulation of Chinese equity and currency markets. Therefore, over the medium term, the inverse correlation between crude and USD will weaken. It’s inevitable and will have significant consequences for the American economy in the future.
Friday, newly released economic data in the U.S. showed that wage growth is stagnant but there is upward pressure on economic activity. The dollar weakened somewhat on the higher probability that the Fed will wait until after September to begin to raise short term interest rates in the U.S. It seems to me that the American economy will drift with anemic growth for the next year until there is more clarity on the outcome of the U.S. presidential election and the Fed will delay raising rates accordingly. The election will have a material impact on American economic policy going forward and will be the event that drives the it one way or the other.
The dollar has been the cleanest dirty shirt in the pile for months now with Europe in financial distress and the desperate Chinese arresting large sellers in their equity markets to stop the sell-off bleeding. These geopolitical events seem to be resolving themselves at least temporarily. All of this means less upward pressure on the value of the dollar. If the correlation between crude oil in the dollar is weakened as I suspect, then we may be seeing the high point in the dollar’s valuation.
L. Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is also an author of historical fiction thriller novels. His first of several books, Currency, deals with the consequences of overwhelming sovereign debt. He is a contributor to many media outlets and is a foreign correspondent for Newsmax TV. LToddWood.com