BIS Research (July 2015) – The sharp appreciation of the US dollar and the rapid fall in the oil price are two of the most noteworthy market developments of the past year. Diverging monetary policies played a key role in the dollar’s strength, whereas a combination of increasing supply, falling demand and market-specific factors were important in explaining the oil price drop. It is less clear, however, to what extent the two phenomena are linked. Here we discuss some of the possible links.
The relationship between the trade-weighted US dollar exchange rate and the price of crude oil has changed over time (please refer to the left-hand panel of the graph). Evidence from before the 1990s points to a positive correlation. The reason is unclear. One argument is that oil exporters spent a large share of oil revenues on US goods, which had a tendency to improve the US trade balance, and hence to boost the dollar exchange rate, when oil became more expensive.
Accordingly, as the share of oil producers’ imports from the United States declined relative to the US share in their oil exports, this channel became less potent. Another possible explanation is that a worsening economic outlook in the United States would typically result in a weaker currency and a lower demand for oil. This channel, too, would have become weaker as the US share in global output declined.
Since the early 2000s, a stronger US dollar exchange rate has gone hand in hand with a lower oil price, and vice versa (please refer to the left-hand and centre panels of the graph). The prominent role of the US dollar as invoicing currency for commodities is one possible explanation: oil producers outside the United States may adjust the dollar price of oil in order to stabilise their purchasing power. At the same time, increasing investment activity in oil futures and options may also play a role.
The monetary policy stance of the Federal Reserve or flight to safety episodes that naturally influence the US dollar exchange rate may also affect financial investors’ risk-taking, prompting them to move out of oil as an asset class when the US dollar becomes a safe haven currency and into oil when they are willing to take on more risk. Consistent with this view, the right-hand panel of the graph illustrates the increasingly strong negative relationship between oil prices and financial investors’ risk aversion, as measured by the VIX index.
Another financial channel could reflect the attributes of oil as both the main source of income and an asset backing the liabilities of oil producers. For example, when the oil price stayed high, EME firms borrowed, sometimes heavily, to invest in oil extraction, with oil stocks acting as implicit or explicit collateral in these debt contracts. As access to credit and collateral prices are closely linked, the fall in oil prices eroded oil producers’ profits and simultaneously tightened their financing conditions. This would induce firms to hedge or cut their dollar liabilities, thereby increasing the demand for dollars. The strong negative relationship between oil prices and spreads on high-yield debt of oil producers is consistent with this view.