Chart of the Week | The Decoupling of Oil Prices and the US Dollar

Over the past few decades, oil prices and the U.S. dollar have generally exhibited an inverse relationship. However, this correlation has weakened since the COVID-19 pandemic. What’s behind the weakening inverse correlation between oil prices and the dollar in recent years? Where do oil prices and the dollar go from here? In the following analysis, we delve into the different mechanisms through which oil prices and the dollar influence each other.

I. Forces Shaping the Dollar-Oil Correlation

There are several mechanisms through which the dollar and oil prices affect one another:

1. Trade: When oil prices rise, oil-exporting countries see an increase in exports and current account balances, which benefits the countries’ nominal exchange rates and strengthen their currencies. Conversely, with the U.S. being a net importer of oil historically, rising oil prices generally led to a weaker dollar. Among the various drivers of the inverse relationship between the greenback and oil prices, trade is the most significant one.
2. Purchasing power: Since crude oil is denominated in dollars, when the dollar depreciates, oil prices tend to rise.
3. Interest rate: The dollar is more likely to depreciate when the Fed lowers interest rates. Meanwhile, the subsequently loose monetary conditions usually drive up commodity prices, including oil.
4. Inflation: A stronger dollar can lead to imported inflation in non-U.S. economies. Rising inflationary pressures can drive capital flows into commodity markets as a hedge, thus pushing up oil prices.

Historically, these mechanisms have resulted in an inverse relationship between the dollar and oil prices. When the dollar strengthens, oil prices tend to fall, and when oil prices rise, the dollar weakens.

II. Why Is the Inverse Relationship Fading

Given its immense domestic oil consumption, the U.S. has historically been a net importer of crude oil, as domestic production alone could not meet its needs. Consequently, rising oil prices exacerbated the U.S. trade deficit and put a drag on the dollar.

However, that dynamic has changed. Since 2008, the U.S. shale oil revolution has significantly boosted the country's oil production capacity. Furthermore, the Russia-Ukraine war that broke out in 2022 acted as a catalyst, prompting many countries to sanction Russian oil and turn to the U.S. for crude, transforming the U.S. into a net exporter of oil.

This shift indicates that the U.S. is no longer “exporting” dollars to pay for oil imports, but actually earning dollars through oil exports. That is, the country is now on the other side of the trade mechanism mentioned above, where rising oil prices benefit the dollar’s strength. When oil prices rise, demand for the dollar increases, bolstering the dollar index. The two now move in the same direction. This shift in the dollar-oil relationship explains why the inverse correlation has gradually weakened.

MM Research Insights

There have been instances in the past where oil prices and the dollar moved in the same direction, such as 1998~2000 and 2004~2006. During these periods, strong economic growth in the U.S. boosted demand for commodities, pushing up commodity prices and leading to demand-pull inflation. In response, the Fed raised interest rates, resulting in the simultaneous appreciation of the dollar and increase in oil prices. Nevertheless, these episodes were temporary, as they were mainly driven by exogenous factors, which did not fundamentally alter the four ways the dollar and oil prices influence each other described above.

However, the current decoupling differs from previous cases, as it stems from a fundamental shift in the crude oil trade structure that has directly reversed the trade mechanism for the U.S. As long as the other mechanisms remain the same and the U.S. continues to be a net oil exporter, the inverse relationship between oil prices and the dollar will continue to diminish.

Do you think the decoupling of oil prices and the US dollar will continue?

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