Dollar/oil correlation unlikely to return soon

NEW YORK (Reuters) - The break in the link between oil prices and the dollar seen for much of the past 18 months is unlikely to be reestablished soon.

Crude and the greenback, which historically had little to no direct trading relationship, began to show a strong negative correlation from 2007, when investors rushed into commodities as the dollar weakened.

Investors had sold the dollar as U.S. economic prospects dimmed and bought oil as a hedge against inflation and uncertainties in the supply of raw materials.

The relationship eased late last year as fundamental pressure from slumping demand and the slowdown of the overall economy pushed oil lower independent of the actions of the dollar, and analysts said the link might not return in the near term.

(To view a graph showing the oil/dollar relation, click: here )

"(Oil's correlation with the dollar) has become negligible and oil is moving lower regardless of the movements in the dollar," said Greg Salvaggio, senior vice president for capital markets at Tempus Consulting in Washington.

"I think oil prices will be dictated by the state of the global economy."

Analysts said the start of the U.S. Federal Reserve's cycle of interest rate cuts in 2007 spurred the influx of cash into commodities markets by feeding inflationary forces.

The fund rate went from 5.25 percent during the summer of 2007 to a range today at zero to 0.25 percent, with the Fed indicating that it may keep it at low levels for some time.

Cutting interest rates typically depresses the U.S. currency as it reduces the yield on dollar assets. It also drives up inflation, supporting commodity prices.

Oil prices surged during the period, peaking at a record $147 a barrel in July as the money flowed in amid projections of strong global demand driven by emerging markets like China.

"A lot of people were saying there's an inverse correlation, because as inflation gets worse you invest less in equities and more in commodities," said Sarah Emerson, director of Energy Security Analysis Inc in Boston.

Energy analysts also pointed out that a weaker dollar makes commodities more affordable to buyers using other currencies while at the same time reducing the real revenues of energy producers like Saudi Arabia that can influence prices by adjusting production.

Crude prices have since tumbled to $40 a barrel since July and are now trading with a closer relationship to the stock market and economic indicators.

The dollar, on the other hand, has strengthened as the global recession deepened. Investors view the dollar a safe haven amid expectations the United States, the first major economy to hit recession, will be the first among industrialized nations to emerge from the economic slump.

Many of the ingredients that made the trading relationship attractive have broken down, however. Oil demand has cratered due to the recession, and the Fed has little room to maneuver rates.

The breakdown of the negative correlation with the dollar became apparent in December, when the value of the dollar fell about 6 percent against a basket of major currencies even as oil gave up 20 percent of its value over the month.

"In December, we had some important breakouts in the dollar and oil didn't move," said Peter Beutel, president of Cameron Hanover in New Canaan, Connecticut.

"Certainly in this new year, oil doesn't make a move without checking the Dow (Jones industrial average .DJI) ticker first."

(Editing by Christian Wiessner)