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Oil price slide spells danger for euro

The descent in the price of oil is likely to weigh on the euro, raising the prospect that European Central Bank (ECB) policymakers will become uneasy about their loose monetary policy stance.

From a peak just below $120 a barrel in February, the price of Brent crude is down 20%, breaking lower through the $100-a-barrel threshold for the first time since July.

The drop in crude prices has accelerated in recent days amid a broad correction lower in commodity prices, with many pointing to the collapse in gold prices as the main catalyst.

While some point to the requirement of Cyprus to sell its gold holdings as part of its bailout deal as the trigger for the slump in commodity prices, there are other reasons behind the fall in crude prices.

Concerns about global growth stem from a number of sources, from the current soft patch in the US economy induced by the fiscal cliff, a first-quarter slowdown in the Chinese economy and a downbeat World Economic Outlook from the IMF. All of those factors point to reduced demand for oil.

Meanwhile, there are also supply-side pressures on oil prices, with Brent underperforming other crude blends, partly due to increased supply as Total’s Elgin field in the North Sea re-opens.

Will EURUSD start to follow oil prices? 

As the chart above shows, the descent in crude prices has not triggered a sell-off in EURUSD, but investors should expect it to play catch up if oil continues to fall.

Steve Barrow, head of FX strategy at Standard Bank, says the reason for this is the impact it could have on relative monetary policies between the US and the eurozone.

“We tend to see much lower oil prices as more of a support to growth in the US than in the eurozone – and less of a deflationary force,” he says.

The simple reason for that is that the Federal Reserve tends to look at core inflation – excluding food and energy prices – while the ECB targets only headline inflation.

Barrow believes the ECB board members who have been resistant to easier monetary policy will change their tune if they see lower oil prices sending inflation careering down towards 1%.

“This is important for, in our view, there’s a much more robust association between relative monetary policies and EURUSD than there is between oil prices and EURUSD,” says Barrow.

Of course, there might be other effects of lower oil prices on currencies than the influence of relative monetary policy.

If sliding oil prices are seen as a function of weak global demand, it could spark a sell-off in other asset such as stock. This will fuel haven demand for the dollar, not just against the euro, but also against commodity currencies such as the Australian and Canadian dollars.

Either way, sustained weakness in oil prices should put pressure on EURUSD.