July 22, 2016—Even the most casual observer could look at a chart of the U.S. Dollar (USD) and oil prices and quickly recognize that they appear to move in opposite directions fairly consistently. That inverse relationship is widely recognized yet little understood. Additionally, the strong relationship is a relatively recent phenomenon, becoming strong only after the year 2000. Despite the recognized negative correlation, there is little consensus on the nature of the relationship, specifically whether there is direct causality and, if so, the direction of that causality. Do movements in the exchange rate of the USD cause movements in the price of oil? Or is it the reverse? No one knows the answer with certainty, likely because the causality runs in both directions.

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Source(s): Bloomberg; The Federal Reserve

Causality
On the direction of causality, I argue there is a disconnect between the findings of research and the frequent characterization observed in financial market media. I would characterize the media as implicitly favoring the position that causality runs from foreign exchange markets to the price of oil. One does not need to search very hard to find a news article or a commentator arguing that some phenomenon (usually central bank policy) will lead to an adjustment in the foreign exchange value of the USD, which will then drive an adjustment in the price of oil. The experience since mid-2014 is a perfect example, where many will argue that the prospect of Federal Reserve tightening, combined with the easing from other central banks (the European Central Bank, or ECB, and Bank of Japan, in particular) drove the 20%–25% appreciation of the USD ,which in turn drove the collapse of oil prices. It is far harder to find in the financial press an account of causality running in the other direction, i.e., that an adjustment in the price of oil leads to an adjustment in the exchange value of the USD.

Research on the topic strongly suggests: 1) causality runs in both directions; and 2) the case that adjustments in the price of oil cause adjustments in the foreign exchange value of the USD is as strong as the case that adjustments in the USD cause adjustments in the price of oil.

One statistical method to examine the relationship between two time series is so-called “Granger causality.” This involves iterative regressions with lags to check whether information about one variable provides predictive power for the other variable.* I performed Granger causality tests on monthly data for West Texas Intermediate crude and the Trade Weighted Broad Dollar Index; first, across the 1990-2016 period, and then restricted to 2000-2016.

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The results in the table are coded green when the causality is supported with a 90% statistical significance, and red when there is not statistical support for causality. The prominent feature of the results is the rejection of causality running from the USD to crude oil at short horizons during the 1990 to 2016 timeframe. When the analysis is restricted to the post-2000 period, the argument is much stronger that the causality runs in both directions.

ECB paper and other research
There is ample research on the topic to support the result that causality runs both directions, but there are differences depending on time period and whether other variables are included. The most recent comprehensive paper on the topic was published by three researchers at the ECB in 2014. They analyze the USD and oil, but also include other relevant variables including the U.S. equity market, the U.S. short-term interest rate, the VIX (volatility index), and the number of open oil futures contracts, dubbed the “financialization” of oil. Their results are extensive, and I am summarizing them (crudely, no pun intended) in the graphic below. Put simply, they find a strong bi-directional causality between the USD and oil, but also strong impacts from the other factors. In particular, both the USD and oil are directly affected by movements in the short-term interest rate while oil is strongly affected directly by volatility. They also find a strong indirect impact from equity markets on the price of oil that flows through interest rates and volatility.

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Source: European Central Bank: Working paper series NO 1689 (July 2014)

Other recent research in economics and energy journals find a variety of results. I reviewed four papers that all found strong causality running in both directions, especially in the longer run, but beyond that finding the details were mixed. Two of them found that in the short run (a couple of months), the USD was driving the oil more so than the reverse. Another paper found the opposite. The fourth investigated movements against individual currencies and found (perhaps intuitively) that increases in the oil price led the USD to depreciate against major oil exporters, but to appreciate against oil importers.

Inverse movements not a guarantee
The findings from the three ECB researchers in particular help explain why the inverse relationship, though strong, is far from ironclad. Using monthly data, the negative relationship shows up very strong with a simple correlation of -0.52 from 1995 to 2016. Restricting the data to the post-2000 period, the correlation is dramatically stronger at -0.92. But an apparent strong relationship in a chart and in a simple correlation may not be as strong as it looks. It is not clear that one should always expect them to move in opposite direction, especially over our 12-month investment horizon. Year over year, the two have moved inversely in 146 of 198 months since the start of 2000, or about 74% of the time. Put differently, if you were forecasting inverse movements in the USD and oil over a 12-month horizon for the past 16 years, you would have immediately been wrong (regardless of magnitude) 26% of the time because that’s how often they moved in the same direction.

Core narrative
In forming our core narrative we have been—as we must be—mindful both of the fundamentals that affect oil markets and the USD, as well as the strong inverse relationship between them. On oil, we continue to expect drawdown of the large inventory that has accumulated over the past several years. U.S. production is declining, and worldwide demand is expected to remain solid, all of which is supportive of future crude prices. However, the relative strength of the U.S. economy compared to major international developed economies, as well as the expected continued divergence in monetary policy, will be supportive of the USD. The strong inverse relationship then creates a dampening effect for the supportive fundamentals. Ultimately, we expect the price of oil to remain high enough to drive overall inflation numbers higher. Even if it stayed at this week’s price around $45/barrel, the year-over-year comparisons would become flat and then very positive in the second half of 2016. We expect the USD to appreciate mildly against other major currencies, but not as much as it did over 2014–2015.

* It is important that “Granger cause” does not imply direct causality in the literal sense of the word. It means that the variable improves prediction in the statistical sense. If adding the variable x to a regression of y on its own lagged values improves the prediction of y, then x is said to “Granger cause” y.

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