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U.S. Dollar Tipped to Gain in an Oil Price Shock

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- USD tipped as big winner from oil rally at ING and UBS.

- ING says oil price gains negative for global growth outlook.

- Eyes central bank rate cuts, not hikes, and more USD strength.

- UBS says oil price rise "helps, not hurts" USD, tips as a buy. 

The Dollar is likely to be the big winner in any oil price shock, according to foreign exchange strategists, who say the greenback should remain on the offensive in the weeks ahead as the production outage in Saudi Arabia disrupts oil markets and stokes fears for the global economy. 

Oil prices were off their highs Tuesday but that didn't prevent the Dollar from extending gains over most of its major rivals as investors remained averse to risk assets in the wake of a weekend drone attack on the Abqaiq processing facility and the Khurais oilfield in Saudi Arabia. The attack has knocked out half of Saudi Arabia's production capacity, which is equivalent to nearly 6% of global output per day, and Brent crude oil futures prices are now up 15% for the last month and 26.15% for 2019.

"The oil moves generated little impact for G10FX, though the most critical aspect is whether a supply shock weighs on a global economy dealing with a host of lingering concerns. We think the growth story offers a better signal than the oil beta, suggesting a negative growth shock would reinforce the recent strength of the USD," says Mark McCormick, head of FX strategy at TD Securities.

Investors eschewed risk assets after the U.S. and Saudi Arabia accused Iran of having been behind the attack. President Donald Trump said via his Twitter account Monday the U.S. is "locked and loaded" as well as willing to respond to Iran on behalf of Saudi Arabia. He also later said the U.S. does not "want a war" with Iran, although that wasn't enough to persuade investors to bid firmly for much other than the Dollar in the currency market.

"News that Saudi output will allegedly get back to normal fairly quickly has driven Brent crude lower," says Simona Gamborini at Capital Economics. "We continue to think that US-China trade tensions and the outlook for Fed policy remain more important drivers of oil prices. Nonetheless, we would not rule out entirely the possibility of an escalation in tensions, leading to an outright conflict in the Middle East. In that case, we would not be surprised to see oil prices reach, and perhaps even rise above, $150."

Above: Brent Crude oil futures price shown at daily intervals.

Fears are that surging oil prices will further trouble an already slowing global economy and that tensions between Iran and the west could easily lead to conflict in the Middle East.

"The disruption looks set to add to recessionary fears, keeping yield curves flat and, barring a dovish surprise from the Fed, the Dollar bid," says Chris Turner, head of FX strategy at ING. "European activity currencies have once again underperformed, with the prospects of higher energy costs adding to the already weak outlook for industrial production. Unless the Fed turns exceptionally dovish, worried that an oil shock undermines the key source of US growth – consumption – then it looks like the dollar can stay relatively bid and EUR/USD sinks into a 1.05-1.10 range into year-end."

Saudi Aramco, the company operating the oilfield and refinery, says it's working to restore production capacity as soon as possible although many analysts have been sceptical about the odds of a quick return to normal. And the longer the outage lasts, the more acute supply shortages may become and the higher oil prices could rise,. The greater the extent and longer the duration of any increase in the prices, the greater the risk for the global economy.

Above: Dollar Index shown at daily intervals.

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A sharp increase in the price of oil can lift inflation because of its broad use in energy and manufactured products, and reduce 'real GDP' growth. The global economy has already slowed rapidly this year due to repeated escalations of the still-ongoing U.S.-China trade war so any oil-induced slump would come at a bad time for markets. But some economists say prices would need to rise much further than they have done currently in order to really cause trouble.

"We've discussed the parameters for reversing the strong Dollar environment: a rebound in global growth and a reduction in the USD's yield advantage. Clearly, the spike in oil prices leads to neither," says Vassili Serebriakov, a strategist at UBS. "This is not a recipe for USD weakness. In addition to a bearish view on EUR and CAD in the G10, we have recommended ZAR and TRY shorts last week and both could be vulnerable if the spike in crude weighs on risk sentiment."

Both ING and UBS tip the safe-haven and high-yielding Dollar to continue benefiting from the unease in global markets, with both looking for the Euro-to-Dollar rate to be among the biggest victims of the current environment.

ING looks for it to fall to within the 1.05-1.10 range over the coming months while UBS has a target of 1.09 for year-end, although the Swiss banking giant also tipped the USD/CAD rate as a buy this week. 

Above: Euro-to-Dollar rate shown at daily intervals.

"The type of oil price move matters a lot for commodity exporter currencies. Both CAD and NOK tend to benefit most from 'demand' rather than 'supply' induced moves. This is intuitive: supply moves are more vulnerable to a reversal and both currencies are positively sensitive to risk. We think that the mild dip in USD/CAD represents a buying opportunity her," Serebriakov says.

Gains for the Dollar come ahead of the September Federal Reserve interest rate decision due at 19:00 Wednesday, which will also be key to the direction of the Dollar in the weeks and months ahead. 

The Fed is widely expected to cut its interest rate from 2.25% to 2% this week but investors are also hoping the bank will provide a solid hint that even more rate cuts are in the pipeline for the months ahead. If the Fed happens to disappoint with its guidance, the Dollar could find itself with an even stronger wind in its sails in the weeks ahead, but if the bank indulges markets that are eager for reassurance from the world's central bankers then other currencies might suddenly find themselves with room to breath.

"We are simply staying away from EUR/USD and USD/RMB in front of the FOMC rate decision. We continue to think the bigger picture warrants selling EUR/USD on rallies and buying dips in USD/CNH, but we need to get through the next few hurdles before we can see the appropriate entry points more clearly," says Stephen Gallo, European head of FX strategy at BMO Capital Markets.  

Above: USD/CAD rate shown at daily intervals.

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