[Dan]

One could argue that rising commodity prices could lead to inflationary pressures in the US and hence trigger a change in Fed policy. However, higher commodity prices will hit most countries, and given the focus on core inflation in the US, the Fed may actually react more slowly than other, more headline focused central banks. Also the pass-through from commodity prices to inflation is likely to remain very limited given the size of the current US output gap, which is wider than in most other major countries. Overall, rising oil prices therefore would likely lead to a Dollar negative change in monetary policy differentials.

Moreover, the well-known negative USD-commodity correlation is becoming increasingly strong again. When oil prices also rose sharply, oil-exporting countries have increasingly shifted their import demand to Europe and Asia, and away from the US. As a result, a rise in oil prices has a more damaging effect on the US current account. A simple way to summarise this effect is to consider the oil price increase as an ‘oil tax’ imposed by oil-exporting on oil-importing countries. And, given the lack of offsetting factors, the US is seeing a bigger tax hike than Asia and Europe, which is not good for the Dollar.

On the more technical side, during the bout of deleveraging, USD-denominated valuation gains on commodity inventories often need to be hedged into other currencies and this typically entails mechanical Dollar selling. With rising financial investments in commodities in recent years, this looks like becoming an increasingly important market driver.

Lastly, many other currencies have direct long-exposure to commodities and tend to outperform on rising commodity prices, such as CAD, AUD, CLP and a number of other EM currencies. It is expected oil to rise to US$85/bbl by the end of the year, which would translate into further Dollar weakness all else equal.

[AndrewWoo]

The recent USD-negative factors – such as higher commodity prices and increasing inflation worries reflected in the continued rise in US breakeven spreads (the difference between nominal bond yields and inflation protected securities) remain in place. Beyond that, the long term focus on the credibility of US fiscal and monetary policy and the prospect for reserve asset diversification will also continue to affect USD sentiment adversely. While the short term trading patterns are shaping up on the EUR/USD negative side (a small Head & Shoulders reversal, with a breakdown neckline at 1.3810 is apparent on the 6-hour chart), the above noted USD-headwinds suggest that limited USD upside potential at the moment.

News reports from Russia today indicating that the central bank may switch some of its reserve assets from US Treasury bonds to International Monetary Fund (IMF) bonds had little impact on either the EUR or the USD even though the news is another indictment of investor concerns about the sustainability of enormous US fiscal imbalances. The IMF bonds may be denominated in SDRs or special drawing rights, the IMF’s quasi-currency. The amounts proposed at the moment are relatively small (Russia indicated that it may be interested in buying USD10bn worth of the bonds and China has indicated it would consider a USD50bn purchase) worth but the April G-20 meeting suggested that IMF resources needed to be increased by around USD500bn and if the “BRIC” nations, who meet in Russia next week, are as intent on reducing the influence of the USD (in trade and reserves) as they appear, the SDR formula for foreign exchange reserves may become more popular.