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A Currency Response To Oil
Oil shocks and oil's relationship to the U.S. dollar may have investors wondering when the next hurricane warning, OPEC pricing change or geopolitical event will have immediate repercussions. The following reviews how the U.S. dollar has responded to fluctuating oil prices along with other world currencies that could provide a hedge against an up and mostly down U.S. dollar. (Speaking of currencies, check out Common Questions About Currency Trading.)
Inverse Relationship
On July 3, crude oil prices crossed over into record territory by clearing $145 per barrel. Approximately 10 days later the United States Oil ETF (AMEX:USO) reached its highest closing price of the year finishing at $117.48. On the same day the PowerShares DB US Dollar Index Bullish ETF (AMEX:UUP) closed at one of its lowest prices of the year at $22.29 reflecting the downward pressure high oil prices have on the U.S. dollar.
Why the Negative Correlation?
The U.S. Congressional Budget Office reported that the U.S. federal budget deficit was $486 billion for the first 11 months of fiscal 2008. The deficit is unlikely to be helped by a $700 billion bailout plan for U.S. banks. The large debt puts downward pressure on the value of the U.S. dollar. One theory suggest that since crude oil prices are denominated in U.S. dollars a weakening dollar makes crude oil less expensive for other nations to buy. The additional buying creates additional demand thereby driving the price of oil upward. The exact reasoning for the inverse relationship of the U.S. dollar and oil prices is open for debate, but history reveals the following.
Hedges
A sinking U.S. dollar gives buyers of U.S. goods and foreign travels good reason to smile as their currencies strengthen in the opposite direction. The CurrencyShares Swiss Franc Trust (AMEX:FXF), the CurrencyShares Euro Trust (AMEX:FXE) and the CurrencyShares Australian Dollar Trust (AMEX:FXA) were a few of the best performers through mid-July returning 10.08%, 8.22% and 10.36% respectively through July 14. The UUP ETF was down -5.38% over the same time frame. As oil prices began to retreat after mid-July possibly due to a reduction in demand in the U.S. tied to increasing prices for fuel and food the trio of currencies mentioned above reversed course against a newly strengthened U.S. dollar. (For more, see Five Ways To Find A Winning ETF.)
Recent News
The announcement on Monday, Sept 22, of the government's $700 billion rescue plan sent oil futures contracts up by $25 before retreating down to about $120 per barrel. USO closed up 3.06% for the day while UUP was down less than 1%. Likewise the FXF fund followed USO's lead by rising about 2.13%.
Final Thoughts
The dance between the U.S. dollar, world currencies and oil prices is likely to continue. History suggests that high oil prices are not the best time to buy into foreign currency, but rather a time to watch for a pullback that could create an opportunity to hedge against a falling U.S. dollar with foreign currency ETFs.
Inverse Relationship
On July 3, crude oil prices crossed over into record territory by clearing $145 per barrel. Approximately 10 days later the United States Oil ETF (AMEX:USO) reached its highest closing price of the year finishing at $117.48. On the same day the PowerShares DB US Dollar Index Bullish ETF (AMEX:UUP) closed at one of its lowest prices of the year at $22.29 reflecting the downward pressure high oil prices have on the U.S. dollar.
Why the Negative Correlation?
The U.S. Congressional Budget Office reported that the U.S. federal budget deficit was $486 billion for the first 11 months of fiscal 2008. The deficit is unlikely to be helped by a $700 billion bailout plan for U.S. banks. The large debt puts downward pressure on the value of the U.S. dollar. One theory suggest that since crude oil prices are denominated in U.S. dollars a weakening dollar makes crude oil less expensive for other nations to buy. The additional buying creates additional demand thereby driving the price of oil upward. The exact reasoning for the inverse relationship of the U.S. dollar and oil prices is open for debate, but history reveals the following.
A sinking U.S. dollar gives buyers of U.S. goods and foreign travels good reason to smile as their currencies strengthen in the opposite direction. The CurrencyShares Swiss Franc Trust (AMEX:FXF), the CurrencyShares Euro Trust (AMEX:FXE) and the CurrencyShares Australian Dollar Trust (AMEX:FXA) were a few of the best performers through mid-July returning 10.08%, 8.22% and 10.36% respectively through July 14. The UUP ETF was down -5.38% over the same time frame. As oil prices began to retreat after mid-July possibly due to a reduction in demand in the U.S. tied to increasing prices for fuel and food the trio of currencies mentioned above reversed course against a newly strengthened U.S. dollar. (For more, see Five Ways To Find A Winning ETF.)
Recent News
The announcement on Monday, Sept 22, of the government's $700 billion rescue plan sent oil futures contracts up by $25 before retreating down to about $120 per barrel. USO closed up 3.06% for the day while UUP was down less than 1%. Likewise the FXF fund followed USO's lead by rising about 2.13%.
Final Thoughts
The dance between the U.S. dollar, world currencies and oil prices is likely to continue. History suggests that high oil prices are not the best time to buy into foreign currency, but rather a time to watch for a pullback that could create an opportunity to hedge against a falling U.S. dollar with foreign currency ETFs.
by
Gregory S. Davis
Gregory is a freelance writer for Investopedia.com. He has a consulting background in the banking, telecommunications and healthcare fields. Gregory is a graduate of the Wharton School of Business. Click here to visit his website.
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