The fluctuations of the oil prices, the Fed’s policy rate and the U.S. dollar are intertwined. In fall 2015/spring 2016, the Fed’s impending rate hikes will cause substantial turbulence in emerging markets.
Until recently, oil prices were recovering. However, after rallying earlier in the year, oil plunged nearly 20 percent in July (and briefly fell below $47 per barrel). In the past, that has often heralded the coming of a bear market.
Since oil is a dollar-denominated commodity, the timing of the impending interest rate hike by the U.S. Federal Reserve has a significant impact on the U.S. dollar and thus on oil prices. Monetary hawks would like to see the Fed raise short-term interest rates by September, whereas doves argue that the international environment is far too fragile and such a move could have an adverse impact on the lingering U.S. recovery and world markets overall.
Still others warn about the adverse consequences of premature rate hikes. This is why the International Monetary Fund (IMF), in early June, warned the Fed to delay the rate hike until 2016; until there are sure signs of a pickup in wages and inflation.
In the past few years, Japan, the EU, and Sweden have all experienced these situations, which typically led to a quick reversal of policy. The case of the United States, however, is different, due to the large scale of its economy and significant contribution to global growth prospects.
Any premature rate hike would not only have potential to undermine recent economic progress; the repercussions would be global.
Diminished prospects, strengthening dollar
In the U.S., the recovery, though stronger in relative terms than in other advanced economies, has been a slow crawl. In Europe, there are weak signs of recovery, but overall the continent is amid a lost decade. And as the Greek crisis has demonstrated, disruptive turns remain fully possible, despite the current deal between Athens and its creditors.
In East Asia, the situation reflects similar vulnerabilities. In Japan, Prime Minister Abe’s monetary gamble has failed to re-ignite economic growth and while contraction has been avoided, stagnation is now the new normal.
In China, the deceleration of growth has been accompanied by high market volatility, local debt deleveraging, and overcapacity across sectors (although real estate appears to be bottoming out).
These trends are reflected in the U.S. Dollar Index, which measures the strength of the greenback relative to other world currencies. As the Fed stopped the asset purchases and began to taper down QE policies, and Europe’s challenges caused the dramatic plunge of the euro, U.S. dollar soared from 75 in mid-2014 to 90 last January. That’s when oil prices took a heavy hit across the world.
U.S. dollar and oil have an inverse relationship. When dollar goes up, oil tends to come down. Conversely, when dollar falls, oil tends to go up. Today, the Index is around 92. Currently, markets are keeping their breadth.
The Fed’s impending rate hike will prove challenging to all emerging markets, particularly to those economies in which growth or trade rely on oil revenues. The skeptics like to argue that historically stronger U.S. growth tends to reinforce growth in emerging markets as well. The problem is that U.S. dollar appreciation is likely to mitigate the impact on real GDP growth in emerging markets.
While U.S. dollar plays a central role in oil prices, it is certainly not the only driver. Initially, oversupply fears emerged amid high U.S. production, which is a reflection of the U.S. shale revolution.
Another major factor is the case of Iran. While Secretary of State John Kerry is pushing the Iran nuclear deal in the Congress, U.S. and Iran could soon go head to head on the world oil markets. For all practical purposes, that could contribute to further fall in global oil prices, even if U.S. prices might rise slightly.
In turn, Iran may increase oil exports even when its oil revenues remain locked in escrow accounts. It will seek to sustain market share, avoid damage caused by shutdowns, boost employment and economic activity from increased production.
The Fed’s impending rate hikes will also materialize in a new international currency environment. China and the IMF are working to make the renminbi a reserve currency, possibly by October this year when the IMF will hold its vote about the issue. That decision could trigger a transfer of hundreds of billions of dollars into Chinese assets in few years, which, to a degree, is predicated on the sales of US Treasuries.
In 2014, naira fell more than 15 percent against the dollar. In spring, Nigeria’s senate voted to cut its benchmark expectation for oil prices in 2015 to $52 a barrel. At the same time, the value of the naira was pegged to the U.S. dollar at 190. Today, naira is about 200, while oil prices remain close to $50.
Recently, emerging market currencies slumped to 15-year lows, as falling commodity prices and China’s equity volatility reverberated through the global economy. However, turbulence will increase once the Fed will begin to hike interest rates. That’s when the real rollercoaster ride will begin.
This article appeared at Business Today and is reprinted with permission