How Major Currencies Would Respond If Oil Stays Sub $50 To 2020? - BofA Merrill

We organized a roundtable discussion with our economists and strategists to discuss a “lower for much longer” oil price scenario driven by a continued positive supply shock. While not our base case, what if today's spot and forward markets are right and oil prices remain stuck in a $25 to $50/bbl range for the next 5 years? 

How would the major currencies to respond if low oil prices are here to stay?

Assuming oil prices remain low because of strong supply rather than weak global demand, this is a scenario that eventually should be positive for the USD. So far, the negative implications from low oil prices have dominated the market reaction for the major currencies. The sharp drop has increased the already high deflation risks, triggering a risk-off market move. The latter has supported the JPY and the EUR, as they are both funding currencies, against the USD and the GBP. The deflationary shock has also contributed to pushing market pricing for Fed and BoE rate hikes to later.

However, if oil prices stabilize at low levels, we would expect the positive implications from the positive supply shock to start dominating FX markets. Inflation expectations in the US (and the UK) should increase following the one-off oil price shock and the USD should appreciate as the Fed continues tightening. At this stage, monetary policy divergence will become again a driver for FX, which should support the USD, primarily against the EUR, as the Eurozone suffers from more sustained deflationary pressures—deleveraging and a still large output gap. The USD and the GBP should also do well against the JPY, as risk appetite increases again.

Beyond the current business cycle, low oil prices are also positive for the USD because the US economy uses the most energy among the major G10 economies. In this context, the US economy will benefit the most if oil prices remain low. In the longterm, we would expect this effect to dominate the short-term negative shock of low oil prices in the US energy sector, particularly if oil prices stabilize at a historically low but somewhat higher than currently level.

Within the commodity currencies in G10, CAD seems to have overshot the most and could therefore correct higher in relative terms if oil prices were to stabilize. Compared with our estimates of the long-term equilibrium, NOK and CAD are the most undervalued G10 currencies. However, oil production is more important for Norway than for Canada, suggesting that the long-term implications from low oil prices will also be more severe. Other commodity currencies, such as AUD and NZD, seem to have responded as one would have expected to the drop in oil and other commodity prices and are not far from their long-term equilibrium. However, AUD/NZD is undervalued according to our estimates, suggesting upside risks once commodity prices stabilize. Bottom line, we would buy CAD and AUD against other commodity currencies if oil prices stabilize at low levels.

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