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  1. Home
  2. / Markets
  3. / Currencies

Search the Currency Markets for Oil Clues

The implications of deflation from lower oil are worrisome.
By CARLEY GARNER
Dec 11, 2014 | 04:00 PM EST

Most active traders are focused on the price of crude oil and for good reason. Although lower energy costs will give a short-term boost to consumer buying power, the implications of deflation are arguably more worrisome.

Nevertheless, perhaps traders should be focused on the currency markets when looking for clues in crude oil, rather than trying to predict a chaotic cartel or determine how much pain U.S. drillers and oil traders are willing to accept before folding their hands. The U.S. dollar has been trading at a negative correlation of 91% relative to crude. In other words, the greenback and WTI (West Texas Intermediate) crude oil move in the opposite direction on most occasions. Thus, the fate of the dollar will undoubtedly have an impact on that of crude oil. The corresponding chart depicts a dramatic relationship between these two markets; the July extremes in each were a nearly identical inverse of the other.

Dollar vs. crude
Source: QST
View Chart » View in New Window »

In a more typical environment, the dollar tends to be weak throughout the latter part of November and December as multi-national corporations move money to their overseas operations (sell dollars) for year-end expenses. This has been particularly true in the last two weeks of the year. Obviously, this year hasn't worked out that way. Instead, surprise stimulus measures by the European Central Bank (ECB) and speculation about further money printing in "Euroland" had kept pressure on the euro; which has directly benefited the dollar index because of its heavy weighting in the Euro. However, we've noticed during previous bull markets in the dollar, even instances in which the bearish seasonals failed to dominate dollar trade in November and early December, DX prices generally succumbed to selling pressure in late December.

In addition, a look at the big picture reveals significant headwinds for the greenback from current levels. Specifically, the dollar index (DX) hasn't successfully breached 90.00 in three previous attempts since the financial collapse. Naturally, the fourth time might be the charm but thus far, it doesn't seem that way. After reaching a contract, and a multi-year high of 89.56 during Monday's session, prices have retraced considerably. Many technicians are describing the price action as a possible key reversal, and we have to agree. In our view, as long as the DX continues to close below 90, the bears have a distinct advantage.

Dollar Weekly
Source: QST
View Chart » View in New Window »

If this is in fact a reversal in the currency markets; there will be consequences in other markets. Not only should commodities such as crude oil find some sort of footing but grains and softs should also benefit. Conversely, the meat complex (particularly cattle) tends to move in lockstep with the dollar approximately 70% of the time; thus, the price of red meat could finally retreat from historical levels on the heels of a dollar slump.

On the other hand, should the dollar index find a way to break and hold above 90, then the current commodity market trends will most likely resume. This would likely be a very painful proposition for many oil producers and, perhaps, traders.

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At the time of publication, Garner was short February crude 58 puts and 66 calls (strangles). There is substantial risk of loss in trading futures and options; it might not be suitable for everyone.

TAGS: Investing | U.S. Equity | Currencies | Markets

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