The growing parallels between 2015 and 1998 in global market forces—soaring U.S. dollar, plummeting oil prices, rising equities, rising volatility and flattening U.S. yield curve—are startling.
They also have been bolstered by the rise in mergers and acquisitions in the oil and gas industries as falling energy prices force “big oil” to seek economies of scale through strategic tie ups (see “The future of fracking”). Knowing the repercussions of U.S. dollar strength in 1998, should we be concerned with today’s dollar advances?
Last month’s announcement from Royal Dutch Shell to buy BG Group for $70 billion was the first oil and gas mega-merger agreement in more than a decade. The deal will be the year’s biggest and the largest in the oil sector since Exxon paid $82 billion for Mobil in 1999. You may recall 1998 also saw BP’s $55 billion takeover of Amoco, Total’s €52.6 billion acquisition of Elf (1999). BP Amoco bought ARCO in 2000, followed by Chevron acquiring Texaco in 2001 for $39.5 billion.
More oil and gas M&As followed in the ensuing years and were built on the same causes. Similar to 1998-1999, 2015 saw oil prices drop 60% from their 2014 highs, with many experts anticipating further declines or for prices to remain near $60. As the dollar soars and oil prices plummet, big oil players race to bolster balance-sheet and overcome rising breakeven costs.
The currency parallels between 2015 and 1998 could prove worrying for USD bulls (see “It didn’t end well,” below). The 28% rise in the dollar index from its May 2014 lows is the biggest since the advances of 1998-2002 and 1995-1998, when the strong dollar weighed on emerging market. Nations, which previously pegged their currency to the rising USD lost via deteriorating trade competitiveness, forcing them to devalue their currencies, further driving up the soaring cost of their state and corporate debt, priced in U.S. dollars. Today, most emerging markets are better prepared for the USD bull market thanks to the use of local currency bond markets and larger holdings of forex reserves, estimated to have grown nearly 6X from 2003 to 2013.
Concerns linger with the amount of foreign currency chasing emerging market investments at a time when macro dynamics have faltered. Brazil, Russia and China are among the major emerging markets to be in or nearing recessions. Emerging market investors have shown greater differentiation among markets, no longer selling entire baskets in a single swoop as was the case throughout the 1990s.
Any amplification in the cause of contagion could become a problem in and of itself. A soaring dollar may no longer be a force to the detriment of emerging market paper and global equities, but further intensification in dollar dynamics could make the difference between a soft landing and a recession.
The Federal Reserve made no secret of its growing concern with rising greenback on U.S. exports. The March FOMC minutes noted, “further appreciation of the dollar and recent weakness in spending and production data as reasons …[to revising down GDP growth]”, and that recent appreciation of the dollar are likely to continue to restrain U.S. net exports for some time.
In the case of USD/JPY, there is more than 30% probability that the pair will extend towards the 130s from the current 120 on the premise that the Bank of Japan stands ready to step up its monthly asset purchases as early as May to stem the tide of slowing inflation. The “this time it’s different” reasoning is further backed by diverging policy paths between the Fed and the Bank of Japan.
But such optimism in the pair may be misplaced. Global Central banks are reported to have increased the yen allocation to their forex reserves in order to keep the ratio of yen currency constant in USD terms within their holdings as JPY tumbled against USD at the end of 2014. The yen’s share of global central bank reserves stands at about 4% according to the latest IMF.
If the Fed did muster the courage to raise rates this year (we think it’s unlikely), it will keep rates on hold for an extended (and volatile) period, throughout which further USD strength will likely weigh on oil prices as was the case in in 1998, which would only complicate the BoJ’s reflation objective. It has been 37 months since USD has begun its 57% appreciation against JPY, comparing to the 85% appreciation of the 1990s, which lasted 40 months. Will the similarity repeat itself in magnitude or duration? I think so.