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One of the biggest stories in the financial markets is the sharp rise in oil prices. Last week, crude hit a one year high of $82 a barrel, more than doubling its beginning of the year prices. Judging from the trading pattern of oil, there is a possibility that by the end of the year, a barrel of oil could cost more than $100. For some countries, higher oil prices can be a big drag on recovery and for others the impact may be minimal. We take this opportunity to talk about how different countries will be affected by the recent rise in oil prices and what that means for monetary policy.

Since the beginning of the year, the price of oil has increased more than 100 percent, with 15 percent of that move happening in October alone. The following chart indicates that oil prices could rise another 10 percent before hitting resistance.

Weekly Chart of Oil

Source: Bloomberg

This week, inflation reports are expected from 3 countries - Australia, the Eurozone and Japan. Despite the rise in oil prices, countries with appreciating currencies have not seen a meaningful pickup in consumer prices. The only places that we have seen stronger inflationary pressures is the U.S. and New Zealand. This is the main reason why we haven't heard many central banks like the ECB come out and openly express concern about the appreciation of their currencies. Future growth will undoubtedly be affected, but for these inflation focused central banks, a stronger currency helps to keep price pressures under control. There is a limit however - So far we have only seen Q3 or September inflation reports. Once the October reports start to trickle in, we should see evidence of stronger price pressures.
Which Countries will be Affected the Most by Higher Oil?

The following chart compares the latest annualized CPI rates with the movement of the respective currency over the past month. As you can see, consumer price growth is the strongest in New Zealand but the currency has also seen a sharp appreciation. Therefore, we may not see the same strength in consumer prices in the fourth quarter that we saw in the third quarter. The Japanese Yen on the other hand has depreciated over the past month which means that we may actually see a pickup in inflationary pressures. The change in the U.S. dollar is not shown because the data is based upon the dollar but the dollar has continued to weaken which means that U.S. policy makers could be growing increasingly uncomfortable with the combination of a weakening dollar and rising oil prices. Although some people may argue that the abundance of slack in the global economy will prevent runaway inflation, if the recovery continues to gain traction, higher inflation rates may be unavoidable. For inflation focused central banks, it may be worthwhile to preempt the risk by unwinding their unconventional monetary stimulus sooner rather than later. A few years ago, the International Energy Agency released a study that said a sustained $10 a barrel rise in oil prices reduces world GDP by at least 0.5 percent, other things being equal. This is the fine line that central banks will have to walk since higher oil prices could also stifle their recovery.

Source: FX360.com

What Does This Mean for Currencies?

For forex traders, what this means is that as long as oil prices continue to rise, central banks may feel less inclined to talk down their currency. One of the few things that can stop the dollar from falling is verbal or physical intervention and the tone of the comments from central bankers could be determined by the relative rise in their currency versus the rise in oil prices.

About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.