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Interest rates and oil prices: How one impacts the other

Investors consider the potential impact of interest rate decisions this week on crude markets

Oil prices inched higher in early trade on Tuesday after declining the previous session as investors weigh what path central banks might take on interest rates this week. Photo: Getty.
Oil prices inched higher in early trade on Tuesday after declining the previous session as investors weigh what path central banks might take on interest rates this week. Photo: Getty. (bymuratdeniz via Getty Images)

Oil prices edged higher on Tuesday morning after ending the previous session lower as traders continued to worry about demand in China – and also considered the potential impact of interest rate decisions this week from the US Federal Reserve and the European Central Bank (EBC).

At the time of writing, US crude oil, or West Texas Intermediate (CL=F), gained 0.58% to trade at $67.51 (£53.71) a barrel, while Brent crude (BZ=F) rose 0.86% to $72.46 a barrel.

How interest rates impact oil prices?

The mixed oil prices over the last couple of days come as traders expect the Federal Reserve to pause its 15-month rate hiking campaign, and to potentially raise rates next month, in a bid to tame inflation.

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“As things stand, markets are largely pricing in another 25bp rate hike in July,” Matthew Ryan, head of market strategy at global financial services firm Ebury, said.

Meanwhile, Ryan and other analysts are of the view that the ECB will hike rates this week.

“We see another 25bp rate increase from the ECB on Thursday as a near certainty, although the Governing Council is once again likely to keep its cards close to its chest, and steer clear of providing any clear forward guidance,” he said.

Higher interest rates have caused oil prices to fall in the past as it translates to less demand for oil as activity declines with higher costs, slowing the economy. On 3 May, for example, oil prices fell 4% after the US Federal Reserve raised interest rates as investors fretted about the economy.

Impact of oil prices on the economy?

Giles Coghlan, chief market analyst, consulting for HYCM, highlighted to Yahoo Finance that the US, the UK and the EU are less dependent on oil than perhaps they once were. However, he said the impact of oil prices on the economy remains.

“In the current climate, the Bank of England, the European Central Bank and the Federal Reserve are likely to exercise caution, considering that higher oil prices increase transportation and production costs. In truth, higher oil prices could not have come at a worse time. As central banks are already grappling with inflationary pressures, this could further reduce the spending power of consumers, which in turn, would make inflation a more protracted affair.”

Read more: Trust in supermarkets falls to nine-year low as shoppers feel 'ripped off'

He further noted that, in general, central banks are unlikely to respond immediately to a rise in oil prices – however, he said they may do so if there are knock-on effects, like businesses increasing their prices, or increasing wages for their employees.

“Ultimately, the OPEC+’s latest move [to extend output cuts] could mean that interest rates stay higher for longer, making the prospect of a recession more likely.

“However, there are those that are happy to sell oil at current levels, seeing early signs of slowing global growth ahead. On top of this, China's post-Covid recovery has been tepid, disappointing oil bulls. The oil market is still expected to tighten in the second half of this year, so any relief from the current fall in oil prices could be short-lived,” he added.

Other factors impacting oil prices

Of course, slowing economy fears is just one factor playing into what position crude traders might take, as analysts at ING also pointed out this week, noting how chatter about an interim US-Iran nuclear deal had also put downward pressure on prices, although both countries have denied any progress on the deal for now.

Moreover, Opec will publish its monthly oil market report today, an indicator of sentiment in energy markets. Also this week, the International Energy Agency (IEA) is scheduled to release its monthly oil report, which could also sway market sentiment.

Read more: Wage growth jumps to record high but still behind inflation

Meanwhile, Francisco Blanch of Bank of America Global Research said in a note, reported by Reuters on Monday, that oil prices are caught in a clash between two opposing forces – bearish asset allocators who point to monetary contraction and bullish oil speculators expecting lower inventories.

"The bearish allocators will maintain the upper hand for now, as oil prices struggle to rally until the Fed eases money supply," Blanch said.

Moreover, the Fed's rate hikes have so far strengthened the US dollar, making commodities denominated in the US currency more expensive for holders of other currencies, also weighing on prices.

Oil price outlook

This week, Goldman Sachs cut its oil price forecasts.

The bank's December crude price outlook now stands at $86 a barrel for Brent, down from $95, and at $81 a barrel for WTI, down from $89.

Watch: Global central banks expected to continue in their rate hikes

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