Oil Prices and Currencies: Analysis

By Mark McCormick and Ilan Solot

NEW YORK ( BBH FX Strategy) -- In this piece, we look to analyze which currencies in the G10 are the most sensitive to oil prices and take a brief look at the policy implications following the roughly 12% increase in oil since early February.

First, it is important to note that while there are some differences between the correlation of WTI and Brent, for the most part, the correlations of both oil benchmarks are pretty tight on a short-term basis. Between the two, recent FX moves tend to be more closely related with moves in the WTI. But on a five-year horizon, currencies are more sensitive to changes in the Brent, perhaps due to the fact that Brent is more influenced by global factors.

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The currencies most closely correlated with oil prices are the AUD, NZD, CAD and NOK, respectively. Against WTI, the rolling 60-day percent change correlation suggests that the Canadian dollar has the strongest relationship with the change in crude oil (-0.57). Both the New Zealand dollar and the Australian dollar have nearly same statistical relationship to WTI, with the 60-day correlation around -0.50. Norway has the lowest correlation in the study with the 60-day rolling correlation against WTI around -0.40.

Counter-intuitively, the currency of the one country with the lowest correlation to oil amongst the four, Norway, is the one that has the strongest trade links to oil. In fact, Norway is both the largest oil exporter in G10 and has the largest share of total exports as a percent of GDP amongst the four countries mentioned above, according to OPEC's 2010-2011 Annual Statistical Bulletin. The relatively lower correlation is probably explained in part by how Norway treats its oil profits, where the fiscal spending rule aims to limit the use of oil revenues.

In contrast, the AUD and NZD are more highly correlated with oil even though exports from both Australia and New Zealand are concentrated in metals and agriculture. AUD and NZD, however, are far more sensitive to shifts in risk appetite and commodity prices in general. Thus, the statistical results conclude that while the relationship between CAD and oil is intuitive, the relationship between NOK, AUD and NZD to some degree is not.

Bank Response

The policy response from central banks of oil exporting countries is likely to contrast with that of energy dependent, importing countries. All else equal, central banks of commodity producers are likely to be more hawkish relative to the central banks of commodity importers as higher oil prices improve their terms of trade, boosting economic activity. But, of course, this can be mitigated or exaggerated by differences in policy and changes in the exchange rate.

For example, the impact of higher oil prices on the Australian and New Zealand economies will be mitigated to some degree by currency appreciation (given the stable positive correlation mentioned above). This may limit its inflationary impact on both Australia and New Zealand. As such, the rise in oil prices have not been a large concern for both the RBA and RBNZ. Economic growth in both countries remains close to trend (based on the OECD's output gap) and the outlook for inflation remains within the central bank's target range.

In contrast, the price of oil converted into EUR and GBP are both at record highs. We do not think this will have any impact on the near-term decisions by the European Central Bank and Bank of England, but the potential is there.

Recall that headline inflation in both places has been stubbornly high despite all the economic pessimism. If higher oil prices are sustained, markets might start to question the viability of calls for further QE expressed in the last Bank of England minutes and maybe re-price the pace and magnitude at which the European Central Bank is expected to ease rates.

Moreover higher oil prices may even revive the old debate comparing the reaction functions between the Fed (focused on core inflation, PCE) and ECB/BoE (targeting headline inflation). A wider spread between Brent and WTI could even add another dimension to this discussion.

But with all three banks committed to loose monetary policy, it is still too early to get into this debate in our view. Before we see any significant shift in monetary policy we are likely to get government-led measures to protect consumers from higher energy cost, such as using the strategic oil reserves in the case of the U.S.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.