How Oil Prices Matter to the US Dollar

01/13/2010 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

Fundamentals are finally catching up to the US dollar with foreign investors bailing out of the greenback following Friday's abysmal non-farm payrolls report. An improvement in risk appetite is contributing to the rally in the euro and other high-yielding currencies, but the positive sentiment once again stems from China and not the US.

As our colleague, Boris Schlossberg, reported this morning, Chinese exports surged 17.7% last month, pushing China above Germany as the world's largest exporter. With no US economic data on the calendar this morning, the EUR/USD should hold onto its gains. On Friday, we talked about how a breakout in the currency pair was imminent and now that it has materialized, there is scope for a further move higher. However, in order for a new trend to emerge in the EUR/USD, the currency pair needs to break above its key resistance level of 1.4690 (the 50 and 100 SMA).

Oil Prices Hit 15-Month Highs


Click to Enlarge

The weakness of the dollar has driven oil prices to 15-month highs above $83 a barrel and gold prices up more than $20 an ounce. This is particularly important because it is inflation week in the foreign exchange market with many countries releasing their consumer price reports.

Oil prices have risen 6.75% since the beginning of December, but from last month's lows, it increased close to 20%. The above chart illustrates the relationship between crude oil and US CPI. As you can see, the higher crude prices rise, the stronger the inflationary pressures. As central banks start to consider exit strategies, persistent inflation could force them to tighten monetary policy earlier than they would otherwise like.

Therefore, even though job losses in the US increased last month, if the trend continues to improve and oil prices continue to rise, the Fed could still raise interest rates in the third quarter—which would help the dollar recover. In the meantime, keep an eye on the Beige Book, which is due for release today (Jan. 13), to see if any of the Fed districts are reporting price pressures.

By Kathy Lien of GFTForex.com

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