How euro correlates with crude and why analysts predict euro-dollar parity looking back at oil prices

Undoubtedly, European turmoils take toll in the euro volatility. But if you want to know what's gonna happen to the currency in the long term, have a look at crude.

The euro-dollar rate is tracking crude prices more closely than at any time in the past two years, says Bloomberg.

If you want to know the euro direction, ask an oil trader.

When oil started falling in the mid-2014, it was one more reason for Europe to step up monetary stimulus to boost price growth, because the European Central Bank gives more weight to the influence of energy prices on inflation than the Federal Reserve.

The correlation has become “very strong” and is “linked to the difference in the way the Federal Reserve and the European Central Bank approach inflation,” said Stephen Jen, managing partner and founder of hedge fund SLJ Macro Partners LLP in London.

As a result, the euro dropped almost 25 percent against the dollar through mid-March, before climbing in line with oil.

As correlation is mounting, analyst predictions that crude prices will not recover in the next several months are backing the view that the single currency will slip into parity with the dollar.

“Having seen how the bounce in oil prices coincided with the bounce in the euro against the dollar, I’m starting to take this relationship more seriously,” Jen said.

Forecasts that oil isn’t about to hit its peak of $107.73 almost a year ago are giving confidence to euro bears such as Credit Agricole SA, which predicts a decline to parity with the dollar by December.

ECB vs Fed policy

The ECB aims to keep price stability, which it defines as CPI (consumer-price inflation) - a measure that includes energy prices - of just under 2 percent.

Meanwhile, the Fed’s preferred inflation estimate also includes an energy component, but historically, U.S. central bankers have paid more attention to a measure that excludes food and energy prices. When this core index climbed more than economists predicted on May 22, the dollar rallied against its rivals.

The links between oil and expectations for consumer prices have strengthened in Europe but weakened in the U.S., bolstering the link with euro-dollar.

As Bloomberg says, crude’s correlation with the euro’s so-called five-year, five-year forward inflation rate has risen to 0.2, the most since October 2012, while the equivalent figure for the U.S. is virtually zero.

This witnesses that the Fed officials are free to keep preparing to lift borrowing costs later in 2015. Meanwhile, ECB officials will keep their benchmark rate unchanged at a record-low 0.05 percent when they meet on Wednesday, Bloomberg says.