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Falling oil price and appreciating dollar: is it normal?

Monnaie & Finance Environnement & Ressources Naturelles 
Billet du 27 janvier 2016
Par Virginie Coudert, Valérie Mignon
Dollar changes impact negatively oil prices most of the times, except when the dollar reaches particularly high levels. During these episodes of high dollar values, the relation between both variables turns positive.
This question has become even more acute with the recent sharp fluctuations observed on both the oil and U.S. forex markets. Indeed, the oil price has been falling since June 2014, while the U.S. currency has exhibited an appreciating trend. Is the evolution of oil price and US dollar in opposite direction a typical feature regarding historical records?

As a matter of fact, both the real price of oil and the U.S. dollar real effective exchange rate have regularly displayed large fluctuations since the seventies. However, both variables evolve sometimes in parallel direction, and other times in opposite directions, as shown in Figure 1A. Hence, if a relationship exists between the oil price and the dollar, it is not a linear one. For instance, in the early 1980s, both variables upsurge, leading to a positive relationship. On the contrary, since the mid-2000s, they exhibit a scissors movement, typical of a negative relationship. The current situation characterized by an appreciating dollar and a decreasing oil price falls within this latter context. Besides, the correlation between the change in real oil price and the USD real exchange rate also exhibits strong evolution over the last decades (Figure 1B). Whereas it was quite unstable from 1974 to 2005 but on average slightly positive at 0.11%, the correlation coefficient turned strongly negative, reaching -55.37% on average from January 2006 until August 2015.

A key issue concerns the direction of the relationship between the two variables. This issue is particularly relevant in the recent context in which the appreciating dollar resulting from the anticipated exit from the quantitative easing policy in the U.S. tends to put prices under pressure, making oil investments less attractive for investors. Is this conjunction of factors—strong dollar and low oil price—a mere coincidence?

Figure 1 – Real oil price and U.S. real effective exchange rate
1A. Real oil price (left scale) and U.S. real effective exchange rate (right scale)
1B. 2-year rolling correlations between both variables
Note: data are monthly and expressed as indexes based 100 in 1990. Correlations are calculated on the monthly change in the logarithm of the two variables.

In a recent CEPII working paper,[1] we show that previous findings of the literature highlighting a positive link between both variables are called into question when updating data to include the recent period. Indeed, working over the 1974-2015 period, we find evidence of a short-run relationship going from the dollar real exchange rate to the oil price variations. We show that this relationship is negative over the whole period, although it is found positive when considering the subsample ending in the mid-2000s.

Given such fluctuations in the direction of the relationship across time, we investigate the possible nonlinear effects, relying on the smooth transition regression model framework. This nonlinear formulation allows us to account for changes of signs in correlations between the two variables observed over the last decades. Such specification is particularly attractive for our purpose, since the nexus between the oil price and the dollar can be assessed differently according to the situation on the foreign exchange market.

The estimation results allow us to show that dollar changes have a negative impact on the oil price most of the times, except when the dollar reaches particularly high levels.  During these episodes of high dollar values, the relation between both variables turns positive. Over our sample, this situation occurred only in the early eighties, when abnormally high interest rates in the U.S. pushed up the dollar exchange rate. At that time, the surging oil price led oil-exporters to recycle their surpluses in purchasing the highly rewarding dollar assets, contributing to the dollar hike and the positive relationship—this effect being accentuated by the lack of alternative currencies to invest in at this period. Moreover, as the U.S. foreign assets declined after the surge in the oil price, the normal adjustment that should have brought about a dollar drop, was inhibited by the oddly high interest rates, encumbering the normal negative relationship between our two variables of interest.

To interpret the negative link prevailing nowadays, we have to take into account the fact that oil and commodity markets have become more and more financialized for the last decade. As investors and asset managers regularly arbitrage across financial and commodity markets, they are likely to find commodities less attractive when the dollar is expected to go upward. Meanwhile, the diversification of OPEC’s portfolios specifically through sovereign wealth funds has wiped off the positive relationship that used to link oil price to the dollar through petrodollar recycling.

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