If you want to know which way the euro’s headed, ask an oil trader.
The euro-dollar rate is tracking crude prices more closely than at any time in the past two years. The European Central Bank gives more weight to the impact of energy prices on inflation than the Federal Reserve, so when oil started falling in the middle of last year it was one more reason for Europe to step up monetary stimulus to boost price growth.
The result: the euro lost almost 25 percent of its value against its U.S. counterpart through mid-March, before rallying in line with oil. Given the growing correlation, analyst predictions that crude prices won’t rebound in the next several months are providing support for the view that the single currency will fall toward parity with the dollar.
“Having seen how the bounce in oil prices coincided with the bounce in the euro against the dollar, I’m starting to take this relationship more seriously,” said Stephen Jen, managing partner and founder of hedge fund SLJ Macro Partners LLP in London and a 13-year veteran of Morgan Stanley until 2009. The correlation has become “very strong” and is “linked to the difference in the way the Federal Reserve and the European Central Bank approach inflation,” he said.
The 120-day correlation between euro-dollar and generic prices for West Texas Intermediate oil has climbed to 0.4, the highest since April 2013, data compiled by Bloomberg show. A figure of 1 would mean the two rates moved in lockstep, while minus 1 would mean they were moving in opposite directions.
WTI crude will decline to $58 a barrel in the third quarter from about $61 now, before ending the year at $65, according to median forecasts in a Bloomberg survey. OPEC is also meeting this week to discuss the overproduction that sent oil tumbling last year.
Predictions that oil isn’t about to revisit its highs of $107.73 almost a year ago are giving confidence to euro bears such as Credit Agricole SA, which forecasts a drop to parity with the dollar by December, from $1.1030 as of 7:58 a.m. in New York.
While SLJ’s Jen is less sure, saying he urges “caution” as long as oil remains supported, the median forecast in a Bloomberg strategist survey puts the single currency at $1.05 by year-end.
The link to oil was demonstrated Tuesday as the euro strengthened 0.9 percent versus the dollar while crude jumped 1.2 percent. It comes down to the different inflation measures watched by the euro-area and U.S. central banks when setting policy.
The ECB’s sole mandate is to maintain price stability, which it defines as consumer-price inflation — a measure that includes energy prices — of just under 2 percent. It was at 0.3 percent in May, underlining why the region’s undertaken a 1.1 trillion-euro ($1.2 trillion) quantitative-easing program.
The Fed’s preferred inflation gauge also includes an energy component, but U.S. central bankers have historically paid more attention to a measure that excludes food and energy prices. When this core index rose more than economists predicted on May 22, the dollar rallied against its major peers.
“Core is seen by the Fed as a better predictor” and unlike headline price growth, “it hasn’t declined recently,” said Michael Pond, head of global inflation research in New York at Barclays Plc, one of 22 primary dealers that trade with the U.S. central bank. “The Fed may dismiss low headline inflation.”
The ties between oil and expectations for consumer prices have strengthened in Europe but weakened in the U.S., bolstering the link with euro-dollar. Crude’s correlation with the euro’s so-called five-year, five-year forward inflation rate has risen to 0.2, the most since October 2012, while the equivalent figure for the U.S. is virtually zero, data compiled by Bloomberg show.
This all means U.S. policy makers are free to keep preparing to raise borrowing costs later this year. ECB officials will keep their benchmark rate unchanged at a record-low 0.05 percent when they meet on Wednesday, according to all 43 economists surveyed by Bloomberg.
“The falling oil price is seen as a boost to the economic recovery in the U.S. while making the ECB’s job in reviving inflation expectations a bit more difficult,” said Valentin Marinov, head of Group-of-10 currency research at Credit Agricole’s corporate and investment-banking unit in London.