^{While Lee Oliver, Euromoney’s FX correspondent, is on summer break, the weeklyFiX is supplied by guest writers from the industry. Our third contributor is By David Woo, managing director and head of global FX strategy at Barclays Capital.}

The correlation between the two, which has risen dramatically since the start of the credit crisis last July, has recently climbed to its highest level in a decade. While this correlation has crucial implications for investors and policymakers alike, there is no consensus on either the drivers behind its recent increase or the sustainability of its current level (the correlation by itself tells us nothing about the direction of causality or the nature of the relationship).

In this article, we aim to contribute to the debate by employing the vector autogression (VAR) methodology to better understand what is driving this important correlation. Our findings are consistent with our long-held view that causality between the USD and oil prices runs in both directions. Moreover, they suggest that the difference in the policy reaction function between the ECB and the Fed to rising energy prices since last year has likely magnified the correlation. These results reinforce our view that a USD recovery will require either an exogenous sharp decline in oil prices or a meaningful shift of the focus of the Fed from growth to inflation.

We believe rising oil prices and falling USD have become mutually reinforcing, forming a vicious circle:

1. Rising oil prices have been pushing the USD lower against the EUR. The fact that the US is a highly energy intensive economy means that higher oil prices lead to a much worse inflation-growth trade-off than for most other economies. The dual mandate of the Fed means lower US real interest rates in the face of rising energy prices, which, in turn, lead to lower USD.

2. Falling USD is helping drive oil prices even higher. Investors increasingly view commodities as a hedge against further USD decline. Oil producers want to be compensated for the lower USD, but USD depreciation increases the purchasing power of non-US oil consumers.

So is there any evidence to support our hypothesis of the existence of a vicious circle? To answer this question, we run a reduced form VAR on three key variables of our circle: EUR/USD, oil prices (two-month WTI futures), and differential in two-year real yields of zero coupon swaps between the eurozone and the US. What we hope to find is evidence that: 1) higher oil prices have led to an increase in the differential of real interest rates between the eurozone and the USD; 2) the increase in interest rate differential drives EUR/USD higher; and 3) an increase in EUR/USD pushes oil prices higher still. We will use daily data and focus on two sample periods: July 2007 to July 2008 and July 2005 to July 2007. Given all our variables are highly non-stationary, the VAR is run on first differences. The Schwartz and Hannan-Quinn information criteria suggest that the optimal lag for the VARs is one day.

Impulse response analysis for the 2007/08 sample period shows that indeed oil prices drive interest rate differentials, interest rate differentials drive EUR/USD, and EUR/US drives oil prices. The directions of the responses are in line with our prior assumptions; the impact is immediate (and starts to diminish generally after the first day) and statistically significant. These results are consistent with the existence of our vicious circle. Moreover, these results indicate that a 1% positive shock to EUR/USD leads to a 1.2% increase in oil prices while a 10% shock to oil prices leads to a 1% increase in EUR/USD. Reinforcing these results is the fact that on days when we have seen big movement in one of these three prices, the other two often move in locked steps. A good example is June 6: following the ECB’s signal that they were considering hiking rates at the July meeting, EUR/USD, oil prices and interest rate differential all rose sharply.