High oil prices likely to increase pressure on the dollar

By Steven C. Johnson
Reuters
Tuesday, March 18, 2008

http://www.reuters.com/article/reutersEdge/idUSN1761610620080318

NEW YORK -- The longer oil prices remain above $100, the worse things are likely to get for the U.S. dollar.

With the greenback hitting all-time lows and no end to its slide in sight, oil exporters are likely to shift a larger share of their revenues into other currencies.

That weakens the dollar further, making dollar-denominated oil more costly for American consumers. Inflation fears also prompt investors to buy commodities as a hedge and favor strong currencies over the weak dollar.

It's what Morgan Stanley global currency strategist Stephen Jen called a "vicious circle" that can be very hard to break.

"A lot of the premium in commodity prices now is directly correlated to dollar weakness, and you need to see a dollar turnaround for oil prices to pull back and U.S. growth to start to pick up again," said Greg Salvaggio, an FX trader at Tempus Consulting in Washington.

If that doesn't happen, some worry that investors could stop buying U.S. Treasury debt, causing interest rates to spike, inflation to worsen, and living standards to slide.

That's troubling news, particularly now that economists believe that the United States has already entered a recession that may prove more persistent and painful than any since the 1930s.

At current prices, Jen said, oil exporters stand to earn $2.1 trillion in annual revenues, with some 90 percent of it likely to be poured into global capital markets.

In the case of the Middle East oil exporters and Russia, Jen said, much of the money is likely to be managed by state-run wealth funds, which are far more willing to invest in riskier, non-dollar assets than central bank reserve managers.

"Sovereign wealth funds are not loyal dollar buyers. They are more likely to buy equities over sovereign bonds, and that is not a pattern that's friendly to the dollar," he said.

Already down about 7 percent this year alone against a basket of major currencies, the dollar also has fallen to record lows against the euro and Swiss franc and a 12-1/2-year low against the yen.

In addition to equities, Jen said the flows of future oil revenue are likely to favor the yen and emerging market currencies over both the dollar and the euro.

... Mideast dollar pegs next to go?

Rising oil prices and the rapid growth of foreign-exchange reserves have added some $2 trillion in assets to these funds' coffers in recent years. Jen has predicted that holdings could rise to $12 trillion by 2015.

Some analysts also warn that higher oil prices increase the pressure on countries such as the United Arab Emirates and Qatar to unhitch their currencies to the dollar and peg them to a basket of currencies instead.

High oil prices and a weak dollar have translated into rising inflation in these economies. And with the dollar pegs, central banks have been forced to mimic recent rate cuts from the Federal Reserve at a time when many economists feel that they should be increasing interest rates to dampen higher prices.

In a recent research note, analysts at Danske Bank said a move away from dollar pegs would send the dollar sharply lower and would likely put heavy pressure on U.S. stocks and bonds.

But Brad Setser, a fellow in geo-economics at the Council for Foreign Relations, said political ties to the United States and hopes of a future currency union will likely leave Mideast oil exporters closely tied to the dollar.

That would require their central banks to keep accumulating dollar reserves to maintain the fixed exchange rate, likely offsetting diversification by their sovereign wealth funds into other currencies.

Some also say a U.S. recession will eventually slow growth in the euro zone and beyond, causing commodity prices to ease and letting the U.S. dollar regain some ground against other currencies.

"I can foresee a situation 12-18 months down the road where U.S. assets and the dollar will look cheap and very attractive," said Mike Moran, senior currency strategist at Standard Chartered in New York.

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