Emerging markets continue to lose ground in 2014, carrying over the malaise that began with the beginnings of the Fed taper in 4Q 2013. Citi Research published a report yesterday on the potential impact of the ongoing emerging market turmoil on commodity prices, specifically oil. Analysts Seth M. Kleinman et al. point out that the problems in EM economies are already leading to lower demand for oil and that this trend is likely to continue. They also highlight the fact that the long-term, robust negative correlation between oil and the U.S. dollar is clearly breaking down.

Emerging markets energy balances

Fed taper leading to rising interest rates in emerging markets

The Fed taper has triggered a series of events in the international economy that is forcing major EM’s such as Brazil, India and Turkey to raise interest rates. It boils down to a 21st-century version of a currency war, if you will. The taper is causing increased strength in the dollar, weakening EM currencies and forcing them to increase interest rates to protect their economies.

The Fragile Five EMs

The Citi Research report follows the lead of the media in calling the emerging markets of Brazil, India, Indonesia, South Africa and Turkey the “Fragile Five“. All five have seen large losses in both their currencies and their equity markets. Kleinman also highlight that the “Fragile Five” account for 250k barrels a day of the IEA’s projected global oil demand growth for 2014 (1.3 m b/d global total).

Emerging markets oil imports

Negative correlation between oil and USD is breaking down

The analysts also argue that the macroeconomic situation is such that oil prices are not going to be impacted by the U.S. dollar the way they have been since 2008. This say this means the price support previously enjoyed by oil markets when the dollar strengthened is not going to help much this time around, and further supports the bear case for oil prices.

“Prior to 2003 the relationship between the two was a random walk, but in the run-up to the 2008 financial crisis the correlation strengthened, bolstered by financial flows trading the correlation. The negative correlation was reinforced in late 2008 by falling oil prices and a more resilient USD due to its safe-haven status, this continued during the risk on-risk off trading period of 2009-2012. The surge in US shale oil production and the resulting drop in US oil imports and improvement in the US trade balance are taking the relationship between oil and the USD from firmly committed back to an occasional flirtation.”