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USD, Fed Implications Around Oil’s Doha Disappointment

USD, Fed Implications Around Oil’s Doha Disappointment

Christopher Vecchio, CFA,

Talking Points:

- US Dollar failing to capitalize on risk-off mood around energy prices.

- EUR/USD pressing above $1.1300 ahead of Thursday's ECB meeting.

- As market volatility rises, it's a good time to review risk management principles.

If you look at the USDOLLAR Index, you wouldn't blink twice: price action is reminiscent of a summer Friday during the World Cup. Yet around other instruments and asset classes, this couldn't be further from the truth. Crude Oil (CFD: USOIL) was lower by nearly -7% overnight after the Doha meetings failed to produce a production freeze. Equity markets, which themselves have been tracking commodity prices, expectedly gapped lower to start the week on the announcement.

Yet here we are: despite the initial major swoon in higher yielding currencies and risk-correlated assets at the market open, the USDOLLAR Index is now negative on the day. Equity markets around the world are recovering, and even Crude Oil has nearly halved its losses. Even though energy markets may be disappointed by Doha, risk sentiment may not be.

There is good reason to believe that part of the reason for no production freeze may be an effort by large producers, mainly driven by Saudi Arabia, to squeeze smaller producers out of the market. (Nevermind the geopolitical implications of having Iran back on the international market.) While nothing explicitly has been said, it's not a far reach to suggest that the production freeze will have direct implications on the US financial sector.

After the latest round of Q1'16 banks' earnings, it's evident that banks are starting to become more concerned with energy companies defaulting on their obligations. Put simply, time is running out for energy prices to recover to keep smaller E&P operations in business; solvency is an issue, not just liquidity.

So how does this tie back to the US Dollar?

With the US yield curve continuing to flatten, US banks have seen their net-interest margin - the difference between the income received on loans and the interest paid out to lenders (depositors) - diminish greatly over the last few years. According to the Federal Reserve Bank of St. Louis, net-interest margin for all US banks was 3.83% in Q1'10 and had declined to 3.02% by Q4'16. Banks margins have gotten thinner, and any energy-related writedowns (despite provisions being built up) may prove to be problematic.

While a 2008-esque GFC around low energy prices seems like a low probability outcome right now given banks' higher capital ratios and loan loss reserves established, that doesn't mean the Federal Reserve will turn a blind eye. Should a rising tide of defaults in the energy sector unfold, it stands to reason that the Fed will hold back on its plans to normalize policy; it would be self-deprecating (and seemingly pro-recessionary) to tighten financial conditions as banks are racking up losses.

Markets today may already be factoring in that: lower oil prices translates to increased probability of defaults in US energy sectors, which translates to pressure on US banks' balance sheets, which will create the necessity for Fed to keep rates lower for longer. I thus posit, half-sarcastically: when does QE4 begin?

See the above video for trade implications and technical considerations in SPX500, USD/CAD, GBP/USD, Crude Oil, EUR/USD, USD/JPY, and the USDOLLAR Index.

Read more: Energy Loans Put Pressure on Major Banks as Provisions Increase

If you haven't yet, read the Q2'16 Euro Forecast, "EUR/USD Stuck in No-Man’s Land Headed into Q2’16; Don’t Discount ’Brexit’," as well as the rest of all of DailyFX's Q2'16 quarterly forecasts.

--- Written by Christopher Vecchio, Currency Strategist

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.