Wall Street always watches crude oil prices. During the early part of 2008, oil prices jumped skyward from near $75 to almost $140 within the span of a few short months. It was more than a 100% increase. All over the world, consumers started feeling huge pressures on their monthly bills. People started using bicycles. Many hedge fund managers heavily speculated on crude oil futures. Some made a windfall, other lost when the oil prices suddenly collapsed in a few months.
Most of the increase in the oil prices was due to speculation by the hedge funds. When the stock markets crashed in the middle of 2008, most of the hedge funds had to liquidate their investments in oil futures to cover their stock portfolio losses. The prices came down just as they had gone up. The prices are down now due to low consumer demand in a global recession. But it is being predicted by the analyst that with a recovery in the global economy, the oil prices will go up again.
Now, lets discuss how oil prices affect the markets. As oil prices go up, consumers are forced to spend more on their oil/gasoline bills. The more they spend on oil/gasoline, the less income they have to spend on other products. The less they spend on other products, the less these products sell. Lower sales decreases the profit companies make. Declining profits made by these companies mean declining value of their stocks in the stock markets.
The opposite case is also true. The less the oil prices become, the more Wall Street becomes exuberant about the profit potential of companies. This increased exuberance translates into increase in stock prices. Two large futures exchanges are used to determine the prices of crude oil. One is the New York Mercantile Exchange (NYME) and the other is the International Petroleum Exchange (IPE).
Historically, rising oil prices have been associated with falling stock markets. NYME is where most of the crude oil futures are traded. By monitoring the movement of the crude oil futures in NYME, you can develop a feel of the future economic situation of the United States. Since oil is heavily traded in US Dollar, this affects the US Dollar. The net effect is however a bit complicated.
Lets take a look at it more closely. When oil prices increase, the demand for US Dollar also increases as most of the countries need US Dollar to pay for their oil imports. Increased demand for US Dollar means that it should appreciate.
But this is not the whole picture. Increased oil prices also affect the US economy. The question is which effect is more important for the currency markets.
Net effect varies for different currency pairs. Take a currency pair that involves the USD and a currency representing a country that does well during the times of high oil prices. Canada that has huge oil reserves after Saudi Arabia. US imports more oil from Canada than any other country. High oil prices help the Canadian economy. Net effect would be depreciation in the value of USD/CAD pair. Suppose you take a currency pair that involves USD and a currency whose economy is negatively affected by the rising oil prices. The demand for USD will rise.
So what we can say is that some currencies have positive correlation with oil prices and other currencies have negative correlation with rising oil prices. The currency pair CAD/JPY shows the strongest reaction to rising oil prices. Japan imports almost 100% oil.
So when oil prices rise again, watch for a currency pair that has the strongest correlation with oil prices like CAD/JPY. CAD is positively correlated with oil prices and JPY is negatively correlated. So CAD/JPY can be a very good currency pair to trade during times of rising oil prices.