Oil prices have just increase to above $100 a barrel for the second time in 4 years. The last time it breached the $100 dollar mark and peaked at $145 per barrel was in 2008. While the high oil price was not the cause of the severe recession, it nonetheless contributed to the sharp slowdown in consumer spending that made it far worse than it would have been.
Now the turmoil in the Middle East is again putting pressure on the oil price. But since then the world has changed. The United States has suffered and is still weak from the last contraction in economic activity and undertaking QE2, which has never been implemented on such a scale. The economic prowess of China is under question as inflation currently at 5% y/y led to recent downgrade of target growth level from double digit 10% to 7% – 7.5%. Europe faced a debt crisis which placed the existence of the whole union to the boiling point. But there is one aspect of the financial equations, the major economies relative value or exchange rates to the US dollar, that could ensure that the outcome of a high oil price will lead to a different result this time.
The US dollar is the world’s reserve currency; also it is the currency that most commodities are quoted in. Hence, Market convention calls for the price of oil is quoted in the US dollars. But what about the fluctuation of various countries exchange rates, how would that impact the price of oil in their own currency units? The graph below shows the price in terms of the currency of major US trading partners, EUR, JPY and CNY. The start date was 18/07/2007, with the oil price at $65.08 and the prices have been standardized to capture the relative movements.
As it can be seen from above, while oil was more expensive in terms of EUR in the period leading up to the worst of the financial crises, the price of oil in EUR and USD has tracked each other relatively closely. Even if the dollar index (See US dollar shorting risks) is at almost 12 month lows due FX traders aversion to Fed’s QE2 program. There hasn’t been a large discrepancy from exchange rate movement’s impact on the price of oil in EUR or Dollar terms.
The standout line from the chart above is the price of oil in Yen. It is well known that Yen has been appreciating in the last few years against the pairs trading partners. However the silver lining from this is that the cost of oil for Japanese producers and consumers is equivalent to $65 in 2008 terms. The could mean that while the manufacturers and consumers in European states and US are facing headwind of $100 oil price in the near future, the Japanese are on exchange rate basis only paying $65 equivalent. This could put a large boost to near term Japanese economic growth and adds minimal pressure on domestic inflation.
The little progress on the Chinese authorities to appreciate the Chinese Yuan can also be seen form the graph above. Oil prices in US dollar terms has tracked closely in Chinese Yuan, it is only recently that the gap has increase, where it is cheaper in CNY due to Yuan appreciation to US dollars. China facing inflation problems of its own could take a lesson from the Japanese and let the Yuan appreciate which would lower the cost of imports, which would dampen recent inflation pressures from commodities.
One implication if oil price continue to rise is that I increasing bets against the Yen. It would most likely to outperform in the near term as it would be affect the least from supply shocks. While the other major economies would suffer from higher price levels, those with free floating exchange rates would benefit from automatic stabilizers through natural adjustment which limits the negative effects.