Following recent drops in the price of oil, growth expectations in Europe and the US have been impacted. The question now is what will the economic impact of the oil price slump be on these two economies, and how will the EUR/USD exchange rate react as a result?
Owing to rising production and lower demand (because of the growth slowdown in Asia and Europe), oil prices have dropped sharply (this article was written in the first week of December). The pullback of the past two months has several implications for EUR/USD. In the immediate future, Europe and the US will be paying less for oil so the trade balance will improve – most of all in Europe, as the United States is itself an oil producer (so will need to import less). This state of affairs will strengthen the euro. In addition, falling oil prices are bound to influence growth expectations. Consumers will end up with more money in their pockets to spend on goods and services that are produced domestically, which will boost both economies. However, there are differences:
In the United States, energy exploitation has been an important growth engine in recent years. As this is a capital-intensive sector with high returns, the dollar has benefitted from foreign capital flowing into the US. Plus, the trade balance did improve on the back of domestic energy production. Now that oil prices have dropped, investment could decline and less capital will flow into the US. Moreover, many (small) oil companies have borrowed money based on the assumption that oil prices would continue to rise. As long as they do not, many experts fear bankruptcies and mounting losses. All of this will have a negative impact on the dollar.
The flip side of this is that cheaper oil will have a positive effect on US consumption. It will boost consumer confidence. Therefore, people will be inclined to buy other goods and services with the money they save on gasoline. Not unimportantly, the price of petrol will drop relatively faster in the US than in Europe because taxes play a less significant part in the United States.
On balance, we think lower oil prices will directly benefit the US to a somewhat greater extent, particularly as the US economy is already in an upward economic spiral (more jobs, expanding consumption, higher investment, increased employment, etc). Falling oil prices may provide a positive impulse, which could act as a catalyst. If so, the growth differential between both economies will increase, to the advantage of the dollar.
Chart 1: Crude oil production
Source: Thomson Reuters Datastream/ECR
Indirectly, the oil price slump will have various consequences. Inflation is bound to ease further. As the central bank is already worried that inflation is minimal and that inflation expectations are falling, it will come under pressure to ease its policy (large-scale QE). Not that the ECB will labour under the illusion that this will drive up oil prices – or inflation – but at least it will create the impression that it is serious about inflation. As a result, inflation expectations will not drop as fast and there will be a lower risk of a prolonged deflationary spiral. Simultaneously, lower oil prices will boost the economy. Specifically the strong EMU countries, which are opposed to massive QE, will use the latter as an argument to block a large-scale bond-buying programme. In our view, the ECB will steer a middle course; it will probably opt for large-scale QE but not as much as the weak Eurozone countries and investors are hoping. The result will be upward pressure on the euro.
US inflation to ease up?
The relevance of this to the Fed is that the oil price pullback will put downward pressure on inflation. Some policy makers will fear that inflation will ease too much. In combination with the uncertainty about the negative impact on the US oil industry and US growth in general, this could encourage the Fed to postpone its rate increases until the end of 2015 – even if lower oil prices will boost consumption and growth in the near future. At best, the delay will have a neutral effect on the dollar but it could also weaken the greenback. After all, many investors take into account that a rate hike will take place halfway through next year. By and large, we believe that lower oil prices will bolster EUR/USD. This will – temporarily – change the decade-long positive relationship between EUR/USD and oil prices.
A key question in regard to EUR/USD is why have oil prices dropped? Is it because of a rapidly expanding supply? If the answer is ‘yes’, this would:
Provide oil-importing countries (Europe, the US, China, and Japan) with a positive impulse while growth prospects could improve around the world.
Mean that the oil price slump will continue until demand increases or supply decreases. In the short term, demand is not that sensitive to price fluctuations. Therefore, supply will have to decline. US oil companies, in particular, will feel the effects because they face fairly high costs while production has increased strongly in the past period. In many other oil-producing countries, the oil industry is the most lucrative sector. Therefore, these governments will be inclined to subsidise production – more so than the US government, which is dealing with private businesses.
This amounts to a relatively negative scenario for the dollar in the coming months. If it holds true, a EUR/USD rally to 1.35 would not be a surprise.
An alternative scenario is that falling oil prices are the result of lower global demand due to decelerating growth. This could be true as the long-term growth prospects for Europe, Japan, and China are mediocre (see ECR’s recent Global Financial Markets reports). On top of this, for quite some time, lower bond yields have indicated that deflation risks are increasing. If this is correct, there will be ongoing downward pressure on inflation and growth in many parts of the world.
Chart 2: Crude oil and EUR/USD
Source: Thomson Reuters Datastream/ECR
The latter would strengthen the dollar as there would be mounting pressure on central banks in the countries where deflation risks are high (Europe, Japan, and China) to ease their policies and depress their currencies. As the US economy is doing better – mainly due to the performance of its domestic sectors – it is well able to cope with a strong currency. The United States will also become a more attractive investment destination.
For now, it seems that oil prices are falling due to increased production in the US alongside sluggish demand in Asia. In other words, we regard the pullback as a positive ‘shock’ to the economy and expect the euro to benefit more than the dollar in the coming months (= the first scenario). In our view, EUR/USD will, over the coming weeks to months, rise to 1.30-1.35.
However, once the negative impact of lower oil prices on US oil production and the postponement of the Fed rate hikes have been discounted in EUR/USD (somewhere between 1.30-1.35, probably), the pair can resume its downtrend. In the circumstances, the US economy will continue to have the best growth prospects (see also our regular EUR/USD reports). On balance, delayed Fed rate hikes will boost the US economy. Precisely for that reason, the Fed will likely need to increase its key rate faster at a later date. In contrast, we think there will be constant pressure on the ECB to do more – even after the central bank announces QE. Most of all, should the euro appreciate against the dollar in the months ahead, EUR/USD could drop to 1.10 over the coming quarters.