Dollar up, Oil Down

September 2, 2008

Continuing their tandem trade, the dollar is skyrocketing while oil is plummeting.

  • A dollar now buys .56 British Pounds.  Two months ago it bought only .50
  • A dollar now buys .70 Euros.  Two months ago it bought only .63
  • Oil is off over 6% to $108 per barrel in early trading today.  Back in July it got up to $145.  (At the time, some bloggers were saying geopolitical forces could push oil to $200.  Oops.)

In my humble opinion, with interest rates so low, speculative capital had been looking for an asset to play.  Commodities, especially oil, were sexy.  As the value of the dollar fell, oil’s price—quoted in dollars—skyrocketed.

Well, two things seem to have gone wrong.  Oil demand is falling and the dollar is coming back.  Call it addition by subtraction…..

Oil demand is falling because energy consumption is, in large measure, a function of economic growth.  If the worldwide economy slows, demand for oil falls with it.  Oil is a commodity like any other and, over the long run, supply and demand forces play a starring role in determining price.  As demand falls, so should price.

Helping to drive oil’s price down is the resurgent dollar.  When the dollar’s value increases, it means it can buy more goods relative to other currencies—goods like oil.

The dollar isn’t bouncing back because U.S. economic fundamentals are improving.  Instead investors have realized that the Bank of England and the Euro area are facing their own recessions.  Both are likely to cut interest rates as a result.  As I’ve noted in detail under the Tutorials section, relative interest rates are a key determining factor when it comes to relative currency values.  If I can get 5% interest on deposits held in British Pounds (vs. 2% on deposits held in U.S. Dollars) then I’m more likely to sell my dollars in exchange for pounds so I can park them in a British account where they’ll earn more interest.

As the Fed cut interest rates here in the U.S. (while the Bank of England and European Central Bank held steady), the dollar lost value as folks traded their savings into higher-yielding currencies.

Why addition by subtraction?  The dollar’s value isn’t coming back due to improving economic fundamentals in the U.S.  It’s coming back due to deteriorating fundamentals elsewhere.

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