BofA: The American Energy Boom Is Creating A Sea Change For The US Dollar

BofA Merrill Lynch strategist David Woo is out with a report this week on the changing nature of the U.S. dollar’s relationship with oil prices and what it means for the future of the American economy.

The main conclusions of the piece are that a stronger dollar will help remove volatility from the business cycle in the U.S., make more people want to invest in U.S. assets, and further enhance U.S. economy’s competitiveness vis-a-vis China and Europe.

All of this is thanks to the American energy boom. 

Woo says that the biggest surprise of 2013 so far has been the noticeable decoupling of a longstanding negative correlation between the U.S. dollar and world stock prices – “one of the most enduring features of financial markets over the past decade” – as illustrated in the chart below.

U.S. dollar versus world stock prices
U.S. dollar versus MSCI world stocks (click to enlarge)

[credit provider=”BofA Merrill Lynch Global Research”]

According to the report, a big component of this inverse correlation between the U.S. dollar and global growth over the last decade has been the rise in Chinese energy consumption.

When global growth rose (driven by China and other emerging markets), so did oil prices. Because the U.S. was pretty dependent on energy imports over the same time period, the dollar became negatively correlated with rising oil prices, and thus global growth.

This negative correlation has been “a major source of volatility for the U.S. economy and risk premium for U.S. assets,” writes Woo, because it “often led to overshooting of oil prices which created many little boom-bust cycles (Chart 21).”

ISM manufacturing and Brent crude futures
Click to enlarge

[credit provider=”BofA Merrill Lynch Global Research”]

However, that is all starting to change now.

A surge in U.S. energy production, even while consumption has flattened out, has allowed the U.S. to pare its current account deficit, which is supportive of the dollar.

And since that means the U.S. is becoming less independent on imports for energy, the boom in U.S. oil and gas production has also allowed the problematic negative correlation between the dollar and oil prices to ease.

Correlation between oil prices and US dollar
Click to enlarge

[credit provider=”BofA Merrill Lynch Global Research”]

Now, the energy portion of the U.S. current account deficit is improving, even as it worsens in other major advanced economies like those of the euro zone and Japan.

Thus, the U.S. is becoming more competitive against these economies, and Woo estimates that this edge could amount to 1.5 percentage points of extra GDP growth per year for the U.S. relative to Europe.

Woo writes that the weakened correlation between oil and the dollar also “eases the inflation-growth trade-off in the U.S., thereby making U.S. assets more attractive.”

The conclusions for investing: look for a stronger U.S. dollar (especially against the euro), sell 10-year TIPS, which are meant as an inflation hedge and should thus fall from current all-time high levels as the inflation risk premium recedes, sell oil, and buy natural gas.

“Going forward, it will be Europe rather than the US that will have to bear the brunt of the cost associated with the growing number of Chinese and Indian consumers and their appetite for energy,” writes Woo.

BofA expects the euro to fall to 1.25 against the dollar by the end of the year.