The inverse relationship between oil and the dollar is well known.Does that mean an oil spike would be really bad for the dollar?
Not necessarily, in fact it could be dollar bullish, according BofA.
Clearly the recent increase in oil prices will slow the global economy, and if prices were to rise further as the Middle East turmoil continues, the risk of a sustained global slowdown increases significantly (Oil price shock in progress, 2 March 2011). If this were to happen, the USD should do very well. Historically, the best economic regime for the USD is when ISM is below 50 and falling.
In the current business cycle, there are a number of channels that could reduce the threshold level of oil prices at which the EUR/USD – oil price correlation becomes nonlinear. For example, a further increase in oil prices may add fat to the fire at a time many emerging market countries are already struggling with mounting inflationary pressures. Many of these economies have high oil intensity that renders their growth more vulnerable to a further oil shock. A further slowdown of these economies could slow capital inflows, the pace of reserve accumulation, and the reserve rebalancing related demand for euros.
We may be nearing that inflection point already:
Our commodity colleagues have just revised up their oil price forecast (Revising baseline oil forecasts and decomposing tail-risk, 7 March 2011). They are now looking for a further increase in oil prices through Q2 that will send spot Brent spot prices to $135pb and average price for the quarter to $122pb. However, to the extent that they believe this will bring about meaningful demand destruction, they expect oil prices to peak in H1 and start declining gradually in H2 (down to $94pb by Q4). Our European economics colleagues have also revised up their ECB rate forecasts; they are now looking for four rate hikes this year starting in April (An ECB rate hike for Easter, 3 March 2011). The rally in oil and selling-off of European bonds are reminiscent of the environment in Q2 2008 just before oil prices peaked at $140bp and the lone ECB rate hike.
Our commodity colleagues have noted that energy input is now approaching the highest level of global GDP in four decades. We would also note that with the 15% rise in gasoline price since September already taking out more than $50bn out of US household disposable income (Chart 15), a further rise towards $4 a gallon will wipe out half of the 2% payroll tax cuts enacted under the fiscal stimulus program agreed in December.
No doubt there are a lot of folks positioned for the dollar and oil to move inversely to each other. A reversal of this behaviour would no doubt sting.