$29 OIL AND THE DOLLAR / THE WALL STREET JOURNAL REVIEW & OUTLOOK

Review & Outlook

$29 Oil and the Dollar

As the greenback keeps rising, commodity prices keep falling.

  

Photo: Getty Images/Ikon Images

Equities took another beating on Friday, on the heels of one more Chinese market selloff and oil sinking below $29 a barrel for the first time in 12 years. The Dow industrials and the S&P 500 are down more than 8% in two weeks, and the growing fear is that this is a harbinger of recession.

Amid the hunt for culprits, one place to look is the link between the price of oil and the dollar.

There has long been an inverse correlation between dollar strength and commodity prices, as we saw more than a decade ago. As the Federal Reserve made its historic mistake of staying too easy for too long in the early 2000s, oil began its long march upward to $100 a barrel and beyond. The correlation has been going in reverse in the last year as the dollar strengthens and oil plunges.

Morgan Stanley MS -4.35 % tracked this correlation in a smart research note earlier this week.

While not ignoring the fundamentals of oil supply and demand, especially lower oil demand from slower growth in China, Morgan Stanley estimated that increasing dollar strength could take the oil price down to $20 a barrel.

The Fed’s inevitable unwinding of its post-panic monetary exertions explains part but not all of the dollar’s rebound. Central banks in Japan and Europe have been pursuing a devaluation strategy and capital flight from China is causing the yuan to depreciate. As more investors demand dollars, the greenback strengthens and the chances of currency markets overshooting grows.

If oil does fall to $20, the economic pain is likely to be considerable throughout the oil patch and commodity markets. Energy bankruptcies will proliferate. Eventually low prices will lead to cuts in supply and oil will find a bottom. But the carnage might be reduced if the dollar stabilized against major currencies. Meantime, the world desperately needs pro-growth economic policies, but it’s hard to see where they’ll be coming from any time soon.