Wall Street analysts watch oil prices like hawks. During the early part of 2008, oil prices skyrocketed from near $75 to almost $140 within a few short months. This was more than a 100% increase in oil prices in a few months. All over the world, countries started feeling huge pressures on their balance of payment accounts. Many hedge fund managers heavily speculated on the increase in oil price.

It is being studied whether the increase in the prices was due to speculation by the hedge funds. When the stock markets crashed in the middle of 2008, most of the hedge funds had to liquidate their investments in crude oil futures to cover the redemption pressure on them. Prices collapsed and are down now due to low consumer demand because of the global recession. But it is being predicted by the experts that with a recovery in the global economy, the oil demand will rise and the prices will go up again. Oil demand in China and India plays a major role now.

As oil prices go up, consumers have to spend more on oil. The more they spend on oil, the less they spend on other products. The less they spend on other products, the less profit companies making these products make. Declining profits means declining stock prices.

The opposite case is also true. The less the prices become, the more Wall Street becomes exuberant about the profit potential of companies. This increased exuberance translates into increase in stock prices. Two large futures exchanges are used to determine the prices of crude oil. One is the New York Mercantile Exchange (NYME) and the other is the International Petroleum Exchange (IPE).

Historically, rising prices of crude oil have been associated with falling stock markets. NYME is where most of the crude oil futures are traded. By monitoring the movement of the crude oil futures in NYME, you can develop a feel of the future economic situation of the United States. Since oil is heavily traded in US Dollar, this affects the US Dollar. The net effect is however a bit complicated.

Let's take a look at it more closely to understand the two effects that pull USD with oil. When oil prices increase, the demand for US Dollar also increases. Most of the countries need US Dollar to pay for their oil imports. High demand for US Dollar means that it should appreciate.

But this is not the whole picture. We have to take another aspect into account. Increased oil prices also hurt the US economy. Now, which effect is more important for the currency markets?

The effect varies for different currency pairs. Suppose you are watching a currency pair that involves the USD and a currency representing a country that does well during the times of high prices of crude oil. Take Canada that has huge oil reserves after Saudi Arabia. The effect would be depreciation in the value of USD/CAD pair. US imports more oil from Canada than any other country. And if you are watching a currency pair that involves USD and a currency whose economy is harmed by the rising prices of oil, the demand for USD will rise.

So what we can say is that some currencies have positive correlation with oil prices and other currencies have negative correlation. The currency pair CAD/JPY shows the strongest reaction to rising oil prices. Japan imports almost 100% oil.

When oil prices are going to rise again, watch for CAD/JPY currency pair. CAD is positively correlated and JPY is negatively correlated. So CAD/JPY has the strongest reaction to rise in oil prices. It can be a very good currency pair to trade during times of rising oil prices.