Over the past three years, hedge funds and other investors have benefited mightily from the correlation between the weakening dollar and the rising price of crude oil.

“Basically, people have been buying commodities and hedging themselves against a declining currency,” says Anais Faraj, global strategist at investment bank Nomura.

While the relationship between the two often has been imperfect, a sharp breakdown in the past two weeks has led observers to conclude that deeper economic concerns have trumped the effect of a weak dollar on energy prices.

At its peak a week before the U.S. election, crude had rallied 216 percent from its level three years earlier. In the same span, the dollar had slid 43 percent against the euro. Since a surprise interest-rate hike by China’s central bank on Oct. 28 and the U.S. presidential election a week later, crude has slid 14 percent from its peak, even as the buck has plunged to an all-time low against the euro and multi-month lows against other currencies.

“We’re seeing a complete elimination of speculative length across the entire energy complex in the last two weeks,” says Michael Lewis, global head of commodity research at Deutsche Bank. “There definitely seems to have been a sea change in terms of confidence.”

Why has the relationship broken down? With rumblings of a much anticipated Chinese yuan revaluation suddenly growing louder and concern that the reelection of President Bush means the U.S. is throwing the last shreds of fiscal prudence to the wind, fears of a sharper dollar correction have grown.

While a weakening greenback, all things being equal, should lead to higher energy prices—oil becomes cheaper in other currencies and oil producers need a higher price to keep their purchasing power intact—all bets are off if a sharp adjustment comes to pass.

“In the currency markets, the foreigners have a much less positive view of U.S. growth,” says Faraj. “It’s definitely a new trade in the market right now. Essentially, what you’re seeing is the link between the dollar and commodities breaking down.”

The trauma to the global economy of a full-fledged dollar rout could crush the demand-driven boom in oil prices, potentially sending them much lower. Although this grim scenario has been trotted out for so long that the threat has begun to ring hollow, there are credible reasons to believe that a sharper sell-off may lie ahead.

The euro has borne the brunt of the adjustment so far. Asian currencies have been far steadier against the greenback through a variety of hard- and soft-currency pegs that have seen a massive $2.2 trillion in dollar assets, or two-thirds of global reserves, wind up on the balance sheets of regional central banks.

With more than two out of every three dollars of the world’s savings now subsidizing U.S. consumption, the growing difficulty in increasing the dollar buying necessary to maintain these exchange rates has, in the calculations of some traders, raised the odds of a sharp correction. Former Federal Reserve Chief Paul Volcker sees a 75 percent probability of a severe dollar correction in the next five years, according to a book published earlier this year by Peter G. Peterson, chairman of the Council on Foreign Relations. “If delayed much longer, the dollar’s inevitable fall is likely to be much larger and much faster,” C. Fred Bergsten of the Institute for International Economics warned in a September article.

Econometric models suggest that cutting the current-account deficit in half would require a 30 percent adjustment in the value of the dollar against the currencies of the nation’s major trading partners, though foreign-exchange markets’ tendency to overshoot might make an eventual correction even bigger at first.

Commodities have been the best-performing asset class in the past couple of years, in part because traders have been hedging against dollar weakness but primarily because of unexpectedly strong demand, especially from Asia. But the headwinds from record energy prices and rising interest rates may dent global demand. That may be part of the reason for the recent sell-off in energy, now that continued fiscal profligacy in the U.S. and Chinese efforts to rein in growth have raised questions about the sustainability of the commodity boom.

If Asian central banks were to pull the plug on the greenback and by default stop propping up the U.S. bond market, interest rates would rise and consumer purchasing power would drop. SUV-driving Americans and their energy-hungry Asian enablers both would be hit hard.

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Spencer Jakab is a reporter for Dow Jones Newswires.

—Barron’s, November 15, 2004