Oil & Currency Markets

By: Ahmad Hassam

Wall Street analysts watch oil prices like hawks. During the early part of 2008, oil prices skyrocketed from near $75 to almost $140 within a few short months. This was more than a 100% increase in oil prices in a few months. All over the world, countries started feeling huge pressures on their balance of payment accounts. Many hedge fund managers heavily speculated on the increase in oil price. Some made a windfall, other lost when the oil prices suddenly collapsed.

Most of the increase in the oil prices was due to speculation by the hedge funds. When the stock markets crashed in the middle of 2008, most of the hedge funds had to liquidate their investments in oil futures to cover their stock portfolio losses. The prices came down just as they had gone up. The prices are down now due to low consumer demand in a global recession. But it is being predicted by the analyst that with a recovery in the global economy, the oil prices will go up again.

Now, lets discuss how oil prices affect the markets. As oil prices go up, consumers are forced to spend more on their oil/gasoline bills. The more they spend on oil/gasoline, the less income they have to spend on other products. The less they spend on other products, the less these products sell. Lower sales decreases the profit companies make. Declining profits made by these companies mean declining value of their stocks in the stock markets.

The opposite case is also true; less the oil prices become, the more Wall Street becomes optimistic and exuberant about the profit potential of companies. This increased optimism and exuberance translates into a bullish stock market. Two large futures exchanges are used to determine the prices of crude oil. One is the New York Mercantile Exchange (NYME). The other is the International Petroleum Exchange (IPE).

Historically, rising oil prices have been associated with falling stock markets. NYME is where most of the crude oil futures are traded. By monitoring the movement of the crude oil futures in NYME, you can develop a feel of the future economic situation of the United States. Since oil is heavily traded in US Dollar, this affects the US Dollar. The net effect is however a bit complicated.

Lets take a look at it more closely to understand the two effects that pull USD with oil. When oil prices increase, the demand for US Dollar also increases. Most of the countries need US Dollar to pay for their oil imports. High demand for US Dollar means that it should appreciate.

But this is not the whole story. Increased oil prices also take its toll on the US economy. The question is which effect is more important for the forex markets.

The effect varies for different currency pairs. Suppose you are watching a currency pair that involves the USD and a currency representing a country that does well during the times of high oil prices. Take Canada that has huge oil reserves after Saudi Arabia. The effect would be depreciation in the value of USD/CAD pair. US imports more oil from Canada than any other country. And if you are watching a currency pair that involves USD and a currency whose economy is harmed by the rising oil prices, the demand for USD will rise.

So what we can say is that some currencies have positive correlation with oil prices and other currencies have negative correlation with rising oil prices. The currency pair CAD/JPY shows the strongest reaction to rising oil prices. Japan imports almost 100% oil.

Watch for CAD/JPY currency pair, when oil prices are going to rise again. CAD is positively correlated with oil prices. JPY is negatively correlated. So CAD/JPY has the strongest reaction to the increase in oil prices. It can be a very good currency pair to trade during times of oil price boom.

About the author:

Mr. Ahmad Hassam is a Harvard University Graduate. Learn Forex Nitty Gritty. Discover Forex Magic Machine. Try Netpicks Forex Signal Service.

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