Something strange is happening in markets. While the dollar and the oil price have historically moved in opposite directions the correlation has suddenly flipped positive: a higher oil price is helping the dollar rally and vice versa.
Is this sustainable? In many ways it could be: Fed hawkishness was driving the dollar stronger against both currencies and commodities last year. This time round, the oil price rally is pushing US inflation expectations and US long-end rates higher.
How important is this as support for the dollar?
For EM currencies reliant on unhedged local debt inflows it is very important: a US bear steepening driven by higher inflation expectations and bond risk premia is far more distruptive to EM FX than a slow Fed hiking cycle that keeps the US back-end stable.
For low-yielding G10 FX like the EUR and JPY we’re less convinced that the current rate re-pricing is a material dollar support. Both currencies are more sensitive to short-end real rates, in turn reliant on a hawkish Fed and/or better US growth data. Either of which has yet to happen, with the recent re-pricing of US breakevens pushing EUR/USD “fair value” on real rate differentials higher to 1.10, not lower. Our yearend forecast for EUR/USD is 1.05, but we are a little cautious that higher oil prices and US breakevens may not be sufficient to get us there.