US Dollar and Oil: the arm wrestle continues

Lately the antics of traders racing back and forth between oil and the US dollar have been particularly schizophrenic. Each morning brings a brand new vote as capital floods out of the dollar and into oil, or back to oil and out of the dollar. On Tuesday US Fed Chairman Bernanke prompted a big dollar rally (and corresponding fall in oil which is priced in US $) as he described US inflation as “significantly higher” than the US would like to see it. This sounded an “all on the dollar trade” bell as speculation roared that the US Fed may be done cutting rates and may soon be tightening again in an effort to slow inflation.
Yesterday, an opposite catalyst came from European Central Bank President Trichet's comments (see video clip) that the ECB may look to increase rates in the near term as it struggles to squeeze down inflation to its mandated 2% target rate. The ECB already has an overnight rate of 4% more than double that of the US, and this has been one of the key forces driving the Euro to escalating highs against the U$ over the past several months. So the dollar fell back on such news, and oil (again) spiked in response to catch up for currency weakness.
This week as oil spiked the energy heavy Canadian Index topped fresh highs. But before we Canadians bring on the marching band, let us see one thing clearly. The parabolic spike in the price of oil is not a good thing for anybody. It is not a healthy sign of a strong global economy. As I have said many times of late, recent jumps in the price of oil have nothing to do with consumption demand. If anything constructive is coming from rocketing prices, it is that consumers all around the world are in fact quickly reducing consumption.
Soon it is likely that Asian governments who also heavily subsidize their domestic oil prices will scale back on this increasingly costly enterprise and let oil prices float up. This will plunge weakening demand even further as has already been happening in western countries where subsidies are lower. We can be sure that the “invisible hand” will eventually correct overzealous prices.
This week we also received further confirmation that gasoline prices face an even greater downside price risk than crude oil. US auto sales have plunged as gas prices have peaked, and as such US gas demand has now fallen to its lowest level in more than 10 years.
See BCA:US gasoline demand destruction ahead.
Meanwhile if we look at recent inflation data around the world we have reason for considerable alarm. In my view, we also have ample reason to expect that central bankers will be unable to cut rates much further in this climate.
“In China, Thailand, the Philippines and at least eight other Asian economies, benchmark borrowing costs are lower than the rate of inflation [in the US too], resulting in negative real interest rates, according to data compiled by Bloomberg. The risk is that prices will spiral even faster, leading to overheated economies and an eventual bust.”
For some recent inflation statistics: see China leads Asia in retreat from inflation battle
China: may accelerate to 10 % as early as this month
Brazil: inflation exceeds 5%
Russia: consumer prices up 14% in April from year earlier
Indonesia: 10% expected by year end
Vietnam: up 25% in May
The spiralling prices threaten the credit ratings of emerging-market nations, Fitch Ratings said in a report May 27. Russia is the most vulnerable of the so-called BRIC economies, which also include Brazil, China and India; in Asia, Vietnam and Sri Lanka are among the top 10 at risk, according to the report.
High inflation is a cancer on world stability. Leaders all over the world will be focused first on stemming this disease, even at the expense of restricting further economic growth. When push comes to shove they must target inflation as the greater evil. As Marie Antoinette and many other leaders have learned the hard way, when people can't afford basic necessities they rise in revolt.

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