What is the correlation between a strong US dollar and the fortunes of crude oil? American private trader and author Alan Farley points to a “hidden string” that binds the two together, with a variety of factors moving the two assets in concert and opposition with each other.
Most prominently, the price of crude oil is quoted in US dollars. Countries that import oil pay for it with US dollars, while those that export receive payment in the greenback. Since 2018, the US has been the world’s largest producer of oil and gas in the world and a net exporter.
Typically, a strong US dollar means weaker commodity prices, and vice versa. When the US dollar is strong, investors need fewer US dollars to buy a barrel of oil. Conversely, when the US dollar is weak, the price of oil is higher in dollar terms.
However, this historical tie appears to have frayed. Crude oil prices peaked above US$110 ($153.59) in March and June, before settling around US$88 as of Nov 9. The US dollar index, however, has steadily crept from 96 points at the start of the year to some 109 points today, down slightly from a year-to-date peak of 114 points in late-September.
The US dollar is the standout outperformer amongst the G3 currencies this year, says Peter Chia, senior FX strategist at United Overseas Bank (UOB). “The US dollar index has jumped more than 15% year-to-date and is on track for the strongest yearly gain in more than 40 years.”
According to Chia, the historic US dollar move is driven solely by aggressive rate hikes by the US Federal Reserve, which is unmatched in pace and quantity compared with the US’s developed market peers.
2022 is a year of “marked polarisation” within the G3 currency space, says Chia to The Edge Singapore. The disparity between the US and its G3 peers is obvious: the Euro has slumped about 12% this year to parity with the greenback, weighed by stagflation concerns.
Chia says the Euro bloc is “almost certain” to enter a recession next year. “The energy crisis — a fallout of the Russia-Ukraine conflict — intensified while inflation in the bloc rose to a record 10.7% y-o-y in October.”
Meanwhile, the Japanese yen has fallen more than 21% this year against the US dollar. Driving this underperformance of the yen is the wide monetary policy divergence of Japan compared to its developed market peers, says Chia. “The Bank of Japan is the only central bank within the G-10 space that is sticking to its ultra-accommodative monetary policies while others have tightened considerably this year.”
Investing in oil with a strong US dollar
In 2023, UOB expects the G3 currencies to begin a normalisation phase as the US Fed starts to slow and eventually pause its rate hikes.
“As US rates start to reverse lower to price in a slowdown in the US economy, the US dollar will lose the tailwind that has anchored its gains this year,” says Chia.
As such, Chia forecasts the euro/US dollar to rebound to 1.04 by end-2023. Meanwhile, the US dollar/yen pair will start to retrace a portion of its gains this year as the US dollar rate advantage over the yen narrows. “We expect the pair at 140 by the end of 2023.”
Before the other G3 currencies — and by extension, other major currencies — catch up with the US dollar, investors could consider adding oil to their portfolios in the remainder of the year.
Micro-contracts for oil futures and options allow investors to buy exposure to crude oil for a fraction of the full price. Micro-contracts reflect actual oil prices; while avoiding fees, such as those levied on exchange-traded funds (ETFs), and bypassing potential corporate governance issues in public equities.
At one-tenth the size of benchmark WTI Crude Oil contracts, Micro WTI Crude Oil futures and options let investors trade on a smaller scale to manage crude oil price exposure with greater precision.
Demand is coming from around the world. According to derivatives marketplace CME, close to 40% of trading volume for its micro WTI Crude Oil futures comes from investors outside of the US.
The world’s markets trading oil and currencies thrive on big, global shifts, but there are always opportunities available for individual investors to make a profit.