July 14th – 15th marked the beginning of a sudden and dramatic reversal of the multi-year upward trend in crude oil prices and the multi-year downward trend in the value of the U.S. dollar. This sea-change points to, potentially, a significantly improved outlook for growth, inflation, and energy costs – but, is this really the long awaited turning point or just another false-top in oil and false-bottom for the dollar?
The value of the U.S. dollar compared to other currencies has been on the decline since 2002, losing about 38% of its value over that period – it bottomed against the Euro on July 14 – 15. The price of crude oil has increased by about 580% since 2002, and on July 14 – 15 was only about 1.5% below its all time high. The result of these steady body blows to our economy, over time, has been increasing inflation and a slow strangulation of economic growth that has brought us to the brink of recession (the mortgage situation hasn’t helped).
But three weeks ago both trends dramatically changed coarse, simultaneously. The figure below shows the price of crude oil on the left axis (data here) and the U.S. dollar index on the right axis (data here) since early June. Click image to enlarge.
Of course, these changes are not coincidental – oil and the dollar are very much linked, primarily because oil is priced in U.S. dollars in markets all around the world (all else equal, if the dollar falls the price of oil rises and vice versa). So, what is driving this? Is the dollar rising because oil is now falling, or is oil falling because the dollar is now rising? A little bit of both?
Its both, but I suspect oil is the key driver here. There are mountains of evidence that demand for oil is easing in response the run up in prices (for example, here), and more generally, economies around the world are slowing (albeit temporarily). At the same time, there are expectations of increased future supply from a wave of new drilling/exploration around the world and talk of offshore drilling in the U.S. (gee, what a novel concept).
On the other hand, there are other factors that could be helping to raise the dollar. The economic slow down in the U.S. has reduced inflation expectations here, which helps the dollar (still high inflation, but not as high). And there is the expectation that the European Central Bank will start cutting their interest rates, which will lower the value of the Euro. But then, even these factors circle back around to oil.
Bottom Line: It is a combination of all these factors – or at least, people’s expectations about them – that has seemingly reversed the course of oil and the dollar. Oil is still quite high and the dollar is still low, but we are going in the right direction now and this is a very good thing. But no one can predict where things will go from here – hopefully this is the real deal.
Addendum: This information also reminds us of the obvious: right now oil makes the world go around. And…More than 80% of the oil left in the world is controlled by Saudi Arabia, Iran, Iraq, Qatar, United Arab Emirates, Kuwait, Venezuela, Nigeria, and Libya. We need more domestic sources of energy: oil, natural gas, (clean) coal, nuclear, hydro, hydrogen, solar, wind, geothermal – All of ‘em!