The holiday season has been anything but holy in the holy land this year, with massive violence in Palestine and Israel again threatening geopolitical stability.

There have been manifold consequences for the forex market during the otherwise thin trading days of the Christmas-New Year week. The long term effects may be minimal, but for the first week of 2009, related speculation will be partly driving the market.

The main source of volatility has been fears that violence in the region will continue to the point that Arab countries disrupt oil supplies to the United States. The US stands alone in the international community in its support of heavy air strikes in residential Palestinian communities.
Like other highly visible media events, speculation has driven the market far more than actual concerns over oil market disruption. The probability of anything beyond symbolic oil market disruption actually occurring remains tiny.

For the forex market, 2008 closes on an appropriate note, with political events driving the market. With the volatility caused by this year’s oil markets and the subprime-related market crash, forex traders have turned their attention towards governments as the only institutions large enough to be at all capable of resolving the year’s crises. Within this environment, oil markets have reigned sovereign over the forex market. Indeed, Bloomberg recently found a correlation of .9 between the oil market and the US/Euro price. A correlation of 1, of course, would mean that oil prices perfectly predict the price of euros in dollars. A 90% predictive ability, though, ain’t bad. It’s an astounding statistic, really. For all the wild ups and downs the US dollar has endured this year against the euro, a forex trader would only have had to watch the price of crude, act accordingly, and he would have been right 90% of the time.

When a correlation is so strong, social scientists are trained to look for multiple sources of causation. This case is no different. First, there is the primary market fundamental: As the world’s largest oil importer, the United States will feel a drain on its currency increase as the cost of its largest import goes up.

That’s always been the case, though. What’s more important – and can pressure the dollar in opposite directions, depending on the circumstances – is the flight to safety dynamic that has dominated most of the year. Sometimes, when geopolitical crises hit, oil rockets upwards and investors fly to safety, which often takes the form of purchasing treasury bonds.

If the crisis is big enough to take down much of the global economy, though, the third major oil-dollar/euro dynamic emerges: Oil prices dives due to the fall-off in long term demand that results from contracting economies, and investors’ flight to safety instincts still dominate. So, the dollar goes up and oil goes down. This scenario is what we saw for much of the year, as the global crisis – subprime-related stuff – didn’t cause many geopolitical worries.

Getting back to the current crisis – wherein the first and second, but not the third, dynamic has predominated – the effects have been felt in many more currencies than just the US dollar. Holders of Norwegian krones, for instance, couldn’t be happier. Similarly, investors worried that the dollar was overbought funneled most of their flight to safety instincts into the gold market, thus fueling a rise in the Aussie.

It’s important to emphasize that this crisis will likely abate quickly and the forex markets will return to normal after a quick adjustment. Until Israel stops its bombing, though, there will be downward pressure on the dollar, perhaps even to the point of it becoming notably oversold.

This entry was posted on Wednesday, December 31st, 2008 at 8:40 pm and is filed under British Pound, US Dollar. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.