The dollar has taken a tumble from its near a three-week high against the euro, after traders got a return of the jitters over crisis in the US credit markets.

No surprise there. What is surprising, says currency expert Jack Crooks, is that the dollar appears to be becoming less correlated with the price of crude oil. The US currency, after all, didn’t hit all-time lows when crude soared to above $150 per barrel.

In fact, the dollar index rallied from its all-time low when crude was around $104 a barrel as oil prices began their steep climb. Jack says there are three possible explanations…

Scenario 1: Perhaps oil producers aren’t running from the dollar like they used to. Maybe they were “convinced” a bottom is near (that could be thanks to consecutive visits, and carrot stick schmoosing, by V.P. Cheney, President Bush, and Treasury Secretary Paulson, who made consecutive trips to the major oil-producing region beginning in March).

Scenario 2: It is a correlation - and correlations by their very nature can be nebulous and useless at times, especially over short-term time frames.

Scenario 3: Falling global demand for oil is leading to a closing of the crude carry trade. Say what? Yes, it is a theme I’ve been working on/thinking about/conjecturing about… and it goes like this:

1. Country X, a non-oil producer, needs to import crude oil, which is invoiced in U.S. dollars.

2. Country X notices the dollar price of crude rising and the dollar falling, so Country X decides to borrow dollars to buy crude. And over time Country X notices that paying back those dollar loans is costing less and less. So, why not continue to make this trade, using less of Country X’s government budget to buy crude directly, why not just keep borrowing more dollars?

3. Now this is the tricky part that we have been thinking about, but can’t confirm with hard numbers. But I have a hunch that two things are changing that lead to a closing, or reversing, of the crude-carry trade:

• The credit crunch i.e. access to available credit is making it harder to borrow dollars
• Falling domestic demand for energy, because of slowing growth in Country X, means there is less oil needed to support the economy. Thus, the need/ability to borrow dollars to pay for crude declines.

And as this pressure is relieved, the dollar stabilizes and even rises relative to Country X currency, especially if Country X is of the emerging/developing nation variety where central banks are way behind the inflation curve.

How You Go from a Credit Crunch to a Strengthening Dollar

This is a classic self-reinforcing process…lack of global credit leads to slowing global growth….which then leads to slowing oil demand….which leads to more closing of the Crude Carry Trade…which leads to change in dollar sentiment…which leads to new price trend leading short-term players, and that leads to dollar perma-bears finally surrendering their eternal anti-dollar position.

Apparently our leaders whispering “the dollar is nearing a bottom” softly into the ears of the Gulf States is paying big dividends - especially to a world that desperately needs its defacto central bank (the U.S. Fed) to have a bit of credibility in the form of value flowing credit.

And with crude falling and the dollar rising, a little allocation from oil producers back into dollars starts to make some financial sense. This just reinforces this trend.

Remember: This is just a theory. I could be wrong. But the premise makes sense. The probabilities of all this happening exactly as I hypothesized - well, that’s anyone’s guess really.

Source: How Can the Dollar ‘Rally’ When Oil Soars?