For as long as there is tension in the Middle East there will be upside pressure on the oil price. While this is good news for commodity bulls, for central bankers it's something of a headache.
Just as we have got used to the prospect of central bankers in the West, particularly the Bank of England and the European Central Bank, hiking rates later this year, for the BOE potentially as early as May, the spike in the oil price throws this into doubt.
The market is pricing in the chance of nearly 2 rate hikes by the end of the year for the UK, and at least one for the ECB over the same time period as headline inflation rates continue to surge. In the UK inflation is running at twice the BOE's target rate. Due to FX markets' sensitivity to yields this has boosted the pound and the euro in recent months especially versus the greenback.
But oil price inflation can actually have a negative impact on core prices - where volatile energy and food prices are stripped out. Unless they are accompanied by a wage hike, higher commodity prices eat into peoples' pockets as they use more of their income to buy essentials like food and petrol rather than spending it on discretionary items on the high street. In other words it erodes consumers' purchasing power parity, which central bankers don't like.
This is when inflation can become deflationary. For central bankers dealing with this double-edged sword is a thankless task. To ensure the economy doesn't suffer from rising oil prices the Banks should keep interest rates accommodative even though they may face criticism for failing to ward off the spectre of commodity price inflation. This is the quandary that BOE Governor Mervyn King now finds himself in. He is holding firm and arguing against a rate hike even though three members of the MPC have voted against him and want to hike rates.
Likewise, the ECB also needs to be wary of hiking rates too quickly. Wage pressures in the European periphery are weak, since these countries are in the process of restoring competitiveness to their economies, which requires lower wages. Even in Germany changes in labour laws over the last two decades will keep a lid on wages even as growth powers ahead.
So what does this mean for forex investors? Firstly, European currencies could be at risk. During the recent bout of Middle Eastern unrest, rather than turning to the dollar as a safe haven asset investors bought the euro and the pound with gusto as UK and European interest rate expectations grew in recent weeks. But dollar bears are at risk if a reversal in rate expectations occurs anytime soon.
Any hint of dovishness from the ECB or the BOE in the coming weeks would trigger a hard landing for the euro and the pound as it would erode a major pillar of support for both currencies - yield. Alternatively, the dollar could benefit. Expectations for higher rates in the US have tumbled recently, so even a subtle shift in stance by the Fed may cause the dollar to soar.
Right now the market is still happy to be long the euro and the pound, but pound longs started to fall last week and the same thing could happen to the euro. We continue to believe that above 1.40 and 1.62 respectively the euro and pound will find it hard to sustain further gains. While this hasn't been a theme so far in Q1 2011, as we approach Q2 stretched interest rate expectations may start to dominate the forex markets' consciousness.
Kathleen Brooks| Research Director UK EMEA | FOREX.com