The Iraq crisis has pushed oil prices modestly higher but we expect this to be temporary
Due to the Iraq crisis, tensions in the oil market have risen. Iraq is the second-largest OPEC oil producer after Saudi Arabia, and the sixth-largest worldwide. Fears that oil production will be affected by advancing ISIS rebels have modestly pushed up the oil spot price. This has not gone unnoticed by currency markets. We have seen some softening of currencies of countries that import oil, while currencies of oil exporters have been supported. Our base scenario is that Brent oil prices will be stable to moderately lower in the months ahead.
What if oil prices were to rally sharply?
However, there are upside risks to oil prices, so it is worth considering the relationship between oil prices and the various currencies in our universe. We conclude that the Canadian dollar, the Norwegian krone, the Mexican peso, the Brazilian real, the Russian ruble and the Australian dollar tend to do well in an environment of higher oil prices. This is not surprising given that they are energy exporters. In contrast, the dollar tends to be negatively affected.
Emerging market currencies of net-oil importers tend to be more resilient that one would expect…
Emerging market currencies of net-oil importers tend to do better than one would have expected. Some currencies are managed (China and Singapore) and therefore pressure on the currency will be mitigated. More importantly, central banks of net-oil importers that also face inflationary pressures will have a strong incentive to dampen the impact of higher oil prices on their currencies in order to avoid additional inflationary pressures. These currencies will be less sensitive to oil prices in our view as long as oil prices rise for only a short period of time so that the global economic outlook and investor sentiment are not negatively affected and central banks can proactively dampen the impact of higher oil prices.
…but a prolonged oil price shock will change the picture
The above mentioned picture for emerging market net-oil importers will change dramatically in the case of a prolonged oil price surge driven by a supply shock. Such a shock will often go hand in hand with a deterioration of the global economic outlook and a deterioration in overall investor sentiment. This will be very negative for currencies of net-oil importers, because of the impact of higher oil prices on their economy and the overall deterioration in sentiment. In addition, the adjustment in growth outlook and deterioration in investor sentiment, will also hurt risky assets including emerging market currencies generally. Currencies of oil exporters will initially benefit due to an improvement in the trade balance and terms of trade. However, the deterioration of the global growth outlook and investor sentiment would ultimately hurt them in the end, while traditional safe haven currencies (JPY, CHF and USD) would outperform.