Sat, May 29, 2004 page9

• Oil costs fuel dollar fears in uncertain trading scene

  • By Justyna Pawlak / REUTERS
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  Soaring world oil prices should damage the US dollar, investors bet earlier this week.

  But are they right?

  Only last week many market participants believed that the dollar should benefit from a global flight from riskier assets that was sparked by uncertainty over fuel costs and their impact on the global economy.

  But doubts about such benefits have crept into the market this week, showing that the long-term effect on currencies of the oil price's rise to 21-year records is far from clear.

  One key question for the dollar is whether high fuel prices will hamper flows into equities or bonds needed to cover the US current account deficit.

  Another is whether the European Central Bank (ECB) will be more hawkish than the US Federal Reserve in countering any inflationary pressure from high energy costs.

  Much will depend on how many investors still have large holdings of riskier assets that tend to be sold for dollar investments in times of uncertainty and on how US consumers react to costly fuel, analysts say.

  "High oil prices will affect all major economies, so it is a symmetric shock," said Thomas Stolper, global markets economist at Goldman Sachs in London.

  "In the end, all three G3 [Group of Three] countries will be hurt by high oil prices. So there is no clear argument for a stronger or a weaker dollar."

  So far, the dollar has shed more than US$.02 against the euro after US crude oil futures hit a peak at $41.85 on May 17, the highest level in their 21-year history. The dollar hit two-week lows around $1.2125 per euro on Tuesday.

  On Tuesday, oil prices kept near $41 per barrel on persistent concerns over whether supply can meet spiralling global demand.

  Many currency strategists argue that a prolonged rise in oil prices and an associated high level of risk aversion in financial markets would eventually bring market attention to the US current account deficit, damaging the dollar.

  As the world's largest net oil importer, the US would feel the pressure on its trade balance from the rising cost of oil imports.

  "But now there is a window of opportunity for the dollar," said Ian Gunner, head of foreign exchange research at Mellon Bank in London.

  "If the oil price was to shoot up again, I would imagine the big dollar positive is that higher risk aversion would mean people exiting trades such as emerging markets for the dollar."

  However, any boost to the dollar from investors closing growth oriented bets in high-yielding currencies would eventually run out of steam and leave the US current account deficit exposed.

  "Let's assume the liquidation of high risk trades is complete and ev-ery-ne is left underweight, and we are also seeing increased risks to the US economy," Gunner said.

  "Then this would inhibit flows to the US and expose the trade deficit. This is negative for the dollar," Gunner said.

  In addition to the long-term impact of high oil prices on cross-country investment flows and their ability to cover the US trade deficit, investors are eyeing the outlook for Fed rate hikes.

  So far expectations of Fed tightening have been the key driver of the dollar's recovery from February's record lows against the euro.

  But analysts remember the rate cut ordered by the Fed in 1973 to offset the inflationary effect of oil prices soaring under the pressure of an Arab oil embargo.

  "If high oil prices start to impact US consumer spending then they will limit rate hikes from the Fed," said Gunner.

  "On the other hand, strong employment should be boosting confidence," Gunner said.

  Any inflationary effect from high oil prices would also impact the oil-importing euro zone, but some analysts said the ECB was likely to be more aggressive on inflation than the Fed.

  "The ECB would be very reluctant to cut rates while the Fed may be more flexible if high oil prices lead to a large fall in equities and in consumer confidence," said Mansoor Mohi-uddin, chief currency strategist at UBS in London.

  However, many analysts also note that for now concerns over oil impact on world growth may be overdone as prices, in inflation-adjusted terms, are still only half of what they were during the 1970s oil shocks.

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