- Oil prices are soaring, with Brent crude up nearly 30% this quarter. The supply side is driving the rise, increasing the risk of significant deterioration in global activity and upside to inflation.
- Markets have reacted: equity prices are deeply in the red this month, while recent dollar betas to market factors show oil prices have jumped into the driver’s seat.
- This unsettling development threatens already anaemic global activity. If it continues, it will likely lead to further risk reduction, dollar upside and high beta FX (alongside EUR) underperforming NOK and CAD.
Oil Prices Soaring
Oil prices have soared since the beginning of September. Initially, the break above the 2023 highs ($89.16) gave a technical bullish signal, then Saudi Arabia’s decision on 5 September to extend production cuts until yearend reinforced it. The Brent crude price is up c.30% QoQ, at around $95pb.
My central market scenario envisages range trading in equities and a trendless dollar for now. Yet I recently argued the main risk was a sharp acceleration in oil prices that would (a) renew pressure on central banks and (b) increase global recession risks.
We are not quite at levels that I would consider highly dangerous ($120pb+), but the moves are certainly alarming, and markets have taken note. The dollar has broken above recent ranges (BBDXY higher than 1260), and equities have come under pressure, with SPX down nearly 5% MTD.
Oil Prices – Not Yields – Drive FX Markets
The latest FOMC meeting was hawkish and triggered upward repricing in the Fed’s rate path; the dollar rose. Yet rather than US yields, oil prices are driving this appreciation in September. Currency markets have changed factor sensitivity significantly.
For most of this year, dollar returns have been impacted by typical factor returns (positively by yields, negatively by oil and equity price returns – assuming the latter two reflect underlying global demand/growth dynamics).
However, this has dramatically changed in the last month, coinciding with the sharp energy price increases: the dollar’s beta to oil price changes has turned positive, while the impact of US yields is now statistically insignificant (Table 1). This is largely reflected in the broader G10 FX bloc (Table 2). Notably, correlations between the market factors are fairly low and unlikely to distort the multivariate regressions in Table 1 (Table 3).
Are (Supply) Oil Price Shocks a Risk to Growth/Markets?
Presumably the pattern in the dollar sensitivities is because investors are now concerned that the rise in oil prices – driven by supply factors and met with muted global demand – has increased downside risks to global growth directly via demand destruction and indirectly by pressuring central banks to keep monetary policies tighter for longer.
Below, I calculate quarterly oil price returns in excess of copper price returns (the latter proxying global demand). More specifically:
- In 3Q23 so far, Brent crude prices have risen by 31ppt over copper prices (excess oil price return); this is unusual and indicates the shock’s supply-side nature.
- Historically (since 2005), there is a clear negative correlation between excess oil price return and next quarter’s global activity.
- Moreover, there is a negative correlation between excess oil price return and next quarter’s SPX performance.
- Extreme excess oil price returns precede significant equity losses in the next quarter.
The jury is still out on whether oil prices will keep increasing, but current developments are alarming. Also, EIA assesses that oil inventories are likely falling by 0.6mn b/d in 3Q23, while 4Q23 will see further reductions, albeit by a more moderate 0.2mn b/d (though current price levels are above the US Energy Information Administration’s forecasts). Wednesday’s US Department of Energy data release showed further inventory draws.
This unsettling development threatens already anaemic global growth. My base case of muted but not collapsing global growth is under intensifying downside risks.
Continued upside in energy prices will likely see further dollar strength and more risk reduction, with the US equity market outperforming most global peers.
In FX, this suggests EUR weakness as well as high-beta currencies underperforming (as per Table 2), while CAD and NOK should outperform AUD, NZD and SEK due to oil dependencies. Separately, I still see further GBP/NOK and GBP/CAD downside.