Why a Saudi-led risk retreat helps the USD, a little – Deutsche Bank

Alan Ruskin, Macro Strategist at Deutsche Bank, explains ha The big event in macro this week has been events around the Arabian peninsula as The “corruption crackdown” in combination with the missile attack from Yemen, is widely seen to have added another dimension to instability in the region.

Key Quotes

“One question is why should the USD benefit from a flight to quality that emanates from this source, when the USD seems to benefit very little when N.Korea is the catalyst for negative risk?”

“Here are a few reasons:

i) The impact of higher oil prices on Central Bank policies. Higher oil prices will tend to lead to some increase in inflation expectations across many countries. The correlation between US inflation breakevens and oil is often stronger than we would expect. In current circumstances, breakevens are NOT responding to the oil spike. However, it is still reasonable to assume that of the G10 Central Banks, the Fed is likely to be the most (hawkishly) responsive to higher inflation at least over the next 6 months, in no small part because it is the only major Central bank already on a persistent rate hiking path.

ii) The SAR peg to the USD essentially means that spec and non-spec private sector pressures tend to concentrate on the USD. The counterweight is that Saudi USD reserves will tend to be pressured. In an Alpha Alert, FX blog on Oct 2nd, it was noted that “After being fashionable a couple of years ago, speculation surrounding the Gulf currency peg trades went silent. Meanwhile IMF data shows reported Saudi Arabian reserves have dwindled by a stunning $250bn off their peak. The current pace of the drawdown probably cannot continue for more than another 2 years without a confidence based self-fulfilling acceleration in capital outflows.” While higher oil prices may help Gulf oil producer trade balances, this is apt to be swamp by the capital flow implications of the crackdown and freezing of bank accounts.

iii) Terms of trade. The US trade deficit on petroleum products is running around a negligible 0.3% of GDP that separates itself from other flight to quality alternatives like Japan and the EUR area that are much more dependent on the region for energy supplies. This may also explain some of the unambiguous Trump administration (tweeted) support for recent shifts in Saudi Arabian policy. At least as important from a currency risk perspective, higher oil prices are simply rotating the shock around, this time adding to problems with the popular INR carry trade, while digging a deeper hole for the likes of TRY and ZAR.”

“In sum, normally the causality tends to run from a stronger (weaker) USD to a weaker (stronger) oil price. More rarely, like now, do we see stronger oil prices associated with a stronger USD. At least in the short-term this causal link between higher oil prices helping the USD is expected to be maintained. However, the link will be weak, mostly because oil prices impact on inflation/policy is seen muted as oil futures backwardation shows a market skeptical that oil price gains will be maintained.”