Will Rising Oil Prices Bring Back Carry Trades?

If you want to know why the Federal Reserve refuses to budge from their hawkish inflation bias, all you have to do is look at the price of oil. Crude prices have increased over 15 percent in the past week and 30 percent since January. This rapid move has sent traders scrambling to adjust their interest rate expectations because up until last week, the market had been anticipating a rate cut by the Federal Reserve as early as June due to the escalating problems in the subprime lending sector.

However, no one expected the Iran conflict to reach the level that it did when they gained the upper hand by capturing 15 members of the UK’s Royal Navy Crew. Over the past few years, we have seen oil become the primary driver of inflation and hawkish monetary policy across the globe. The higher oil prices rise, the longer central banks will keep interest rates high, which in one word, boils down to CARRY.
High yielding currencies have already resumed their climb, with strength seen in the US, Australian and New Zealand dollars. This intimate relationship between oil prices and US consumer prices can be clearly seen in chart below. Back in 2006, when oil prices hit their peak, annualized consumer prices in the US accelerated by more than 4 percent, while CPI levels in the UK and the Eurozone rose solidly above their 2 percent inflation targets. As long as oil prices keep on climbing, the central banks of these respective countries may have no choice but to leave interest rates at their currently lofty levels, which will keep demand for carry trades intact.

Not the First Time Iran Has Rocked the Boat
The primary driver for the rise in oil prices and the real wildcard at the moment is undoubtedly Iran. This is not the first time that they have rocked the boat. In May of 2006, the newly elected Iranian President Mahmoud Ahmadinejad announced that they have successfully produced low grade enriched uranium, which allows them to become a country with nuclear technology. They refused to discontinue this program despite calls by countries around the world. As a result, this led to a strong 9.5 percent jump in crude price. For the record, Iran is ranked in the top 5 of global oil producers, and they are responsible for almost 4 million barrels a day.
So why does this matter? Simply put, crude prices are rising back to levels seen in the summer of 2006. Although some had expected a more stable price at $50, the fact is that contracts have been moving higher above $60 a barrel this week alone. The fear here is that tensions between the major industrialized world, in this case the UK, and Iran would leave oil supply short on Iran’s refusal to release the captives. Even though the US does not import oil from Iran, many countries do. Therefore the absence would definitely be felt in the global trade markets. As a result, with oil prices higher, central banks around the world may either have to raise interest rates, if growth supports it, or leave them unchanged at higher levels for a longer period of time even if the economy is vulnerable. With the US dollar being one of the market’s favorite carry trade currencies over the past year, further strength or weakness will be dependent upon oil. Technically, the rise in oil prices is looking tired, but as long as Iran fails to release the troops, we could be facing an even bigger mess in the Middle East. RIA Novosti, a Russian News Agency has already reported a “flurry of activity by US Armed Forces near Iran’s borders.” According to a high-ranking Russian security official, "The latest military intelligence data point to heightened U.S. military preparations for both an air and ground operation against Iran.” If the US gets involved in the conflict, oil prices could easily spike to $70 a barrel. At that point, expect all of the Yen crosses, including USD/JPY to head back towards their January highs.
Crude contracts advance by a total of 30 percent in just the first quarter

What about the Problems in the US?
Of course, the US economy’s ability to weather the rise in oil prices is also important since higher oil prices act as a tax for US consumers. Therefore e are keeping a close eye on the subprime sector and the housing market as a whole because US consumers may not be able to weather the triple blow of higher mortgage payments, falling house prices and rising oil prices all at the same time. This is not a problem yet, which is why the dollar has strengthened, but it could be problem in the future. The Federal Reserve has to walk a very fine line in terms of balancing growth with inflation. Other central banks in the Eurozone, Canada, Australia and New Zealand on the other hand do not have as difficult of a predicament, which means that carry trade demand against the Yen and Swiss Franc could benefit those currencies the most.