Dollar trouble, oil's bubble could derail recovery

Reuters (Link) - Wanfeng Zhou and Barani Krishnan (November 11, 2009)

The weakness in the U.S. dollar risks inflating a bubble in the oil market, which could threaten consumer spending and potentially cause a double dip recession.

The greenback's decline this year has been lauded as good for America as it benefits earnings, stimulates exports and helps rebalance the U.S. economy. But runaway oil prices could be the Achilles' heel to the thesis that sees only a benign impact of a weak dollar.

This year, when the dollar has been weak, oil has been strong; a weaker dollar supports oil because dollar-priced commodities become cheaper for buyers using other currencies. The inverse relationship between the dollar and crude has been remarkably tight: the 200-day correlation coefficient between the dollar index and oil is -0.94, Reuters data showed.

In some respects, this is a repeat of last year when a weak dollar, along with low interest rates and growth in energy-intensive Asia, drove oil to a record near $150 a barrel, which contributed to a deep global recession.

"Many factors are the same as the summer of 2008," said Ethan Harris, head of global economics at Bank of America Merrill Lynch in New York. "What are the things that would derail the recovery? I think that an oil price bubble is near the top of the list."

There's a reason for fear of excessively high oil prices. Rising energy costs caused consumers to curtail spending in mid-2008, even before the financial crisis erupted, and another spike could sap demand anew, especially with this economic rebound still a fragile one.

The dollar has dropped 15 percent against a currency basket since highs set in March .DXY. Crude, meanwhile, has rebounded from lows around $30 a barrel early this year to top $80 in recent weeks.

Another drop in the dollar toward $1.60 per euro could help push oil back above the $100 level. That's enough to cause economic stress given the still-fragile state of global recovery, analysts say.

"If oil goes to $100 today, it will have the same effect on the global economy as what $147 oil had last year," said Nouriel Roubini, the economist noted for his early warning about the U.S. housing bust and global oil shock.

Oil at above $100 would be damaging to the United States, the No. 1 energy consumer, which remains hindered by a weak job market and subdued spending.

FUNDAMENTALS VS FLOWS

Oil prices plunged from over $147 a barrel in July 2008 to below $33 in December as the recession sapped spending. Expectations for a recovery helped oil rebound, but analysts say high inventory levels and weak global demand indicate the market may be driven more by speculation than fundamentals.

"Commodities have been viewed as more of a high-yield trade," said Michael Woolfolk, senior currency strategist at BNY Mellon in New York. "There's too much liquidity flushing around both in the U.S. and global financial markets, fueling the speculative trades."

A falling dollar in recent months has spurred investors to buy commodities as a hedge against loss of value in other assets. The market has also been boosted by an expansion in carry trades -- in which traders borrow in the low-yielding dollar and yen and use the proceeds to buy currencies and assets with greater returns.

Strategists say the dollar could drop to $1.55 per euro by year end, while a decline to $1.60 -- near the record low of $1.6038 set in July 2008 -- in the next several months cannot be ruled out. The euro hit $1.5048 on Wednesday.

Avery Shenfeld, chief economist at CIBC World Markets in Toronto, said roughly speaking, a 1 percent move in the dollar against a broad index generates about a 2 percent rise in the price of oil.

Some analysts cautioned dollar weakness alone may not be enough to drive a prolonged rally in energy prices.

Ashraf Laidi, chief market strategist at CMC Markets in London, said the decline in the dollar is driven by weak U.S. economic data and speculation of a Federal Reserve on hold, but there could come a time when worries about U.S. weakness "may dominate and lead to renewed risk aversion." He cited oil's struggle on Wednesday to rise above $80.50 a barrel as a sign there is a limit to the benefits of a weak dollar.

Still, a bubble is a real risk, Bank of America Merrill Lynch's Harris said. If oil prices rise to $120 a barrel, that would qualify as a bubble.

"The housing market is a long way from a bubble. The stock market has only recovered part of its value. So if there's going to be a bubble in the asset markets, it seems to me the commodity market would be a likely candidate."