The price of crude oil has become a major driver of the foreign exchange market, as it crushes inflation expectations and highlights the diminishing impact of ultra-loose central bank policies. Oil has long been a big factor affecting the currencies of major producers such as Canada, Norway and Russia. But in recent weeks, as global benchmark Brent crude has traded between $30 and $32 a barrel, drops in the price have underpinned the euro and the Japanese yen while hurting the dollar and the pound.
"The sharp drop has increased the already high deflation risks, triggering a risk-off market move," said Thanos Vamvakidis, head of G-10 FX research at Bank of America Merrill Lynch. "(This) has supported the yen and the euro, as they are both funding currencies, against the dollar and the British pound," Vamvakidis said, and the deflationary pressure is pushing back market pricing of interest rate increases by the Federal Reserve and the Bank of England.
Huge asset-purchase programmes by the European Central Bank and the Bank of Japan, along with negative interest rates, have made the euro and the yen cheaper for investors to borrow to fund positions in higher-yielding currencies or riskier assets like stocks during less volatile times in financial markets. Those trades are unwound during times of economic or market uncertainty, when investors prefer safe-haven assets and currencies backed by large current account surpluses.
The unwinding has seen these currencies appreciate and highlighted the inability of central banks to keep their currencies weak, even with the imposition of negative interest rates. The Swiss franc also falls into the category of funding currencies, since Swiss National Bank rates are negative and Switzerland has a huge current account surplus. And while the dollar has long had an inverse correlation with commodities and oil, because they are priced in dollars, that relationship has been tested in recent weeks as investors pared back expectations of a rate increase by the Federal Reserve amid increased volatility in global markets.
That sell-off doesn't seem to be coming to an end soon, some say. Sovereign wealth funds, with trillions of dollars in assets under management, might take a further $404 billion out of global listed equities in 2016 if oil prices stay between $30 and $40 a barrel, the Sovereign Wealth Fund Institute said.