Crude oil prices are influenced by a host of factors that range from global consumption of oil, global supply of oil, economic growth of countries, geo-political and financial uncertainties, natural calamities, etc. Apart from these factors, the US Federal interest rates have a significant impact on the oil markets. There are varying theories that explain the correlation between crude oil prices and the US interest rates. Some of these state an inverse relationship between the two. The rationale for this is that a higher interest rate tends to make the US dollar stronger in comparison to other currencies. Since crude oil is globally traded in US dollars, it is likely to become more expensive for other countries (with weaker currencies) to buy crude oil, thereby, reducing the demand and prices of the commodity.
Conversely, some theories believe that lower interest rates allow customers to spend more freely, which in turn drives the demand for oil. While there is no certainty regarding the exact correlation between these two, a change in interest rates almost always has an impact, whether positive or negative, on crude oil prices by causing volatility in the markets. With this backdrop, in this note we discuss how the current rate hike by the US Federal Reserve impacted crude oil prices.
The Great Recession of 2008 had led to a slowdown in the US economy, as unemployment in the country grew, forcing people to restrict their discretionary spending. As a result, the US central bank drastically reduced the interest rates from 4.25% in 2007 to merely 0.25% by the end of 2008, in order to support the gradual recovery in the economy. With the help of several rounds of quantitative easing and effective monetary policies, the country finally showed signs of recovery in 2015, when the Federal Reserve announced the first interest rate hike of 25 basis points, after almost 6 years of the onset of the economic recession.
Although this coincided with the inception of the commodity slump, the US economy has been consistently growing slowly, however, steadily. Thus, despite the crude oil prices falling below $30 per barrel in early 2016, the Fed announced another rate hike of 25 basis points in December 2016, taking the interest rates to 0.75%.
On 15th March 2017, the Federal Reserve announced its second consecutive interest rate hike of 25 basis points. Though this time, the market had well-anticipated this move. That said, this rate hike was expected to have a negative impact on crude oil prices, according to majority of the market experts. However, crude oil prices jumped almost 2.5% breaking its losing streak of over a week, rather than sliding as per market estimates. (For more details read: Here's Why Crude Oil Prices Have Dropped For The First Time Since The OPEC Deal )
This sudden spike in oil prices was driven by the fact that the investors had expected a more hawkish stance about the future rate hikes from the Federal Reserve. Although the central authority maintained the dot plot chart for the year, implying that the market should expect two more rate hikes in the coming quarters. This caused the US dollar to weaken against other currencies post the announcement of the rate hike. For instance, the US dollar to Euro exchange rate fell from 0.94 on 15th March to under 0.93 at present (see chart below). In consequence, the demand for oil improved, since the dollar-backed commodity is perceived to have become relatively cheaper for the rest of the world. Thus, we saw a sudden rise in crude oil prices.
Exchange Currency - US Dollar vs. Euro
While the current interest rate increase has helped the crude oil markets, we believe that the impact of this rate hike could be short-lived, as there are other significant factors, such as the US oil inventories, US oil production, and the OPEC production, that play a far more crucial role in the estimation of oil prices. However, one can never under-estimate the long term impact of interest rates on oil prices.
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