How the surging US dollar could help send America into a recession

Amid all the turbulence in bond and currency markets a sharp fall in oil prices over the past week has occurred without drawing much attention.

A week ago oil peaked at $US96.55 ($151.80) a barrel and appeared destined to break above $US100 a barrel. With the price tumbling more than $US5 a barrel on Wednesday, it is now trading around $US85.80 a barrel, or nearly $US10 below its price on Wednesday last week.

Pressure is building on the US economy. Credit: Bloomberg

That’s despite a meeting of OPEC’s monitoring committee on Wednesday that reaffirmed the cartel’s commitment to the production cuts that have driven the price up from just over $US70 barrels mid-year. The bulk of those cuts have been made by Saudi Arabia and Russia, which have pledged to keep them in place until at least the end of the year.

The dive in the price on Wednesday appears to have been driven by data on US petrol demand released by the US Energy Information Administration that showed seasonally adjusted demand is now at its lowest level for 22 years.

That may be partly a function of what had been the flow through to petrol prices of a soaring oil price, but it also probably reflects the attritional effects of the Federal Reserve Board-driven rise in US interest rates on consumers and economic activity.

Demand for credit in the US has dried up, the cost of borrowing for everything from credit cards to mortgages has shot up and a recession, given the Fed’s posture – its higher-for-longer positioning on interest rates and continued withdrawal of liquidity from the US financial system through its quantitative tightening – is looking increasingly likely.

Historically, there had been an inverse correlation between oil prices (indeed most commodity prices) and the US dollar. That’s because most commodities are priced in US dollars and therefore a strong dollar makes them more expensive for non-US buyers and a weak dollar cheaper.

That inverse relationship has been weakened by the emergence over the past couple of decades, thanks to shale oil and gas, of the US as both a major producer of oil and the world’s largest exporter of gas. In recent years, as the US emerged as a net exporter of energy, the correlation between oil prices and the dollar has been generally positive.

Along with the surge in bond market yields that gathered pace from mid-year, the OPEC+ cuts to production around that time that ignited oil prices might have been a factor in the dollar’s strength. The US dollar has risen more than 7 per cent on a trade-weighted basis since mid-July.

Interest rate differentials, the exodus of foreign investors from a slowing and more problematic China and slower global growth generally have seen capital flowing towards the traditional safe haven of the US treasuries market, also underpinning the dollar’s strength.

While the correlation between the dollar and oil might have remained quite tight until the past week, the inverse correlations with other commodities like gold and copper have been reflected in falls in their prices of 9 and 11 per cent respectively since July.

As with oil before the US achieved near self-sufficiency, dollar strength makes other commodities more expensive for non-US buyers and weakens activity and demand.

Also, US treasury bonds compete with gold as safe-haven assets. With bond yields spiking and the dollar strengthening – and the gold price falling away – they are more than competitive at present.

A strong dollar and high interest rates also impacts speculative activity. Over recent decades commodities have been increasingly financialised, with hedge funds and investment banks trading them, and derivatives based on the physical commodities, like any other financial asset.

The slump in the price of oil has been attributed to falling demand for petrol in the US. Credit: AP

The abruptness with which US bond yields have moved and the dollar has strengthened would be putting a lot of pressure on speculative trades and usually highly leveraged arbitrage activity and cross-border trades (“carry trades”) in particular, given the rate and degree to which other currencies have been impacted.

It will surprise no one if there are some significant hedge fund losses, or a big fund blows up, given the degree of volatility in financial markets and the pace at which financial conditions in the US have tightened and are continuing to tighten.

The plunges in the value of the Australian dollar since July, from around US69¢ to just over US63¢, and in Japan’s yen, from 138 yen to the dollar to 149 yen, are indicative of the degree to which the Fed’s aggressive monetary policy stance and the strengthening of the US dollar are disrupting other economies and exerting pressure on their policymakers to respond with decisions they might otherwise have preferred not to make.

The Bank of Japan may or may not have intervened (it’s saying nothing) on Wednesday to halt a freefall in the yen that was threatening to push the exchange rate above the 150 yen to the dollar level, but there is a point at which it, or the Reserve Bank, or their peers elsewhere, would step in to put a floor under their currencies either through interventions in markets, or through changes to their own monetary policies.

The re-emergence of the inverse correlation between oil prices and the US dollar may be momentary.

If the slump in demand for petrol is signalling a US recession, then the Fed might retreat from its higher-for-longer conviction and bond yields, the dollar and oil prices would fall back. The markets will inevitably price in any shift in the Fed’s stance before it actually happens.

Unhappily for OPEC+, which includes Russia, if the production cuts which drove the oil price up to almost $US100 a barrel contribute to a US (and probably more global) recession, they will, because of their over-reliance on oil revenues, be impacted by the fallout as well.

Dollar dominance exposes the rest of the world to the conditions in America’s financial markets and economy, for good and bad.

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