Chaos in Yemen Could Undermine Dollar

Yemen, a country south of Saudi Arabia, and with an economic output roughly the equivalent to that of say, San Antonio, Texas, is sinking deeper into chaos. Though in the grand scheme of things in the Middle East, that chaos stems from a relatively small country, it is likely to have widespread ripples that could affect market sentiment, in general, and specifically, in the FX market. One might ask how on earth Yemen, a small country that is primarily desert and which is categorized as among the world’s poorest, could affect trends in the Dollar, the Euro and other currencies?

Yes, it’s Oil Again

The answer, as you might have guessed, and the only way that trouble in a small Middle Eastern country could have repercussions on global markets, is through Oil. Despite the fact that Yemen produces less Oil than Denmark and its direct effect on Oil supply is marginal, its location is critical. Yemen is situated on the banks of the Gulf of Aden, the 4th largest passage for Oil in the world and a key passage for seaborne Oil and gas from the Middle East. Analysts point out that with the country deteriorating into chaos, the risk of Oil tankers being hijacked by pirates grows much higher and thus heightens Oil supply risks. Now, while this might be a plausible risk scenario, it is not the real

reason why Yemen’s chaos is an issue in the global markets. The real reason is the potential geopolitical threat that chaos, which is currently contained within Yemen, could continue to heat up and then “boil” or spill over. That spillover could result in a military showdown between Saudi Arabia and Iran, the Middle East’s two largest oil producers. The Iranian government is actively assisting the rebels against the Yemen president, Abed Rabbo Mansour Hadi, who is an ally of the Saudis. And Saudi forces are actively engaged against the rebels in an effort to protect their own (Saudi) interests. Thus this potential for a spillover could, in reality, eventually devolve into a major conflict between Saudi Arabia and Iran which could jeopardize Oil supplies and thus impact Oil prices.

Back to the FX Market

So, back to the question, how can this mess impact sentiment in the FX arena? Quite simply, if this Middle East hotspot spills over, Oil prices could bounce higher and thus encourage investors to move into risk-on mode. “Risk-on” sentiment tends to favor currencies oriented closely with commodities, such as the Norwegian Krone and the Aussie, Kiwi, and Canadian Dollars, while at the same time being rather negative for the US Dollar. In other words, if things do de-escalate towards a risk of real war, Oil could surge further and possibly generate a shift towards commodities and away from the US Dollar, thus being a potential catalyst for a Dollar correction.

Why the Dollar is Vulnerable

The Fed had just laid out its plans to raise rates when all of a sudden the data suggested it wasn’t necessarily warranted and so a dovish Fed prevails. With the biggest hurdle to rising interest rates being low inflation, one might presume that higher Oil prices would raise inflation expectations and thus increase the chances for an interest rate hike. However, under the current circumstances, that presumption would be wrong.

For Oil prices to generate inflationary pressures they need to rise constantly and create a buildup of expectations for higher prices. Currently, Oil fundamentals remain weak since the market is oversupplied and given that there is still excess capacity in the Oil market the chances are that any surge in Oil prices would be temporary and would likely even out over the long term. Even if Oil does eventually stabilize above $60 a barrel, the chances are it won’t be on a constant upward trend because for that to happen, supply has to really turn tight. This is why the mere risk of war between Saudi Arabia and Iran could push Oil to settle higher but it would not necessarily initiate a long-term bullish trend.

Hence, any impact would be more of a short-term nature than a long term one, and inflation expectations won’t likely be affected. Investors would prefer to move into short term speculative bets, buying into riskier currencies while curbing bets on the Dollar, which could mean that the Dollar is expected to slide lower if Oil prices surge on the back of Yemen’s chaos. In the broader scheme of things, of course, this could be just another “excuse” for Dollar bulls to diverge away from the Dollar after a very lucrative year. But whatever their reasons or rationale, until investors get the long awaited Dollar correction they will become increasingly uneasy with their Dollar holdings.

Look for my post next week.

Best,
Lior Alkalay
INO.com Contributor - Forex

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.