The relief in Oil markets on news that Iraq would resume exports via Turkey didn’t last long. News that another important Iranian official has been killed and Iranian energy facilities attacked turned the market upside down, as Iran threatened the Gulf countries with fierce retaliation, highlighting that their energy facilities have now become ‘a legitimate target’. Qatar already reported extensive damage to one of the world’s largest LNG export plant.
So, Oil and Gas prices rebounded, wiping out the early optimism across stock markets. The war is escalating rather than showing signs of easing. And risks in oil prices remain tilted to the upside. That ultimately means that risks to equities remain to the downside as:
- Rising energy prices increase costs and weigh on earnings.
- The Federal Reserve (Fed) and other major central banks will remain cautious – possibly hawkish – in the coming months to ensure that inflation doesn’t spiral out of control.
Released yesterday, the US PPI update wasn’t encouraging. Producer prices accelerated more than expected in February: core PPI rose to 3.9% y-o-y from 3.5% a month earlier, above the 3.7% expected by analysts. Meanwhile, US gasoline prices have risen nearly 40% since the beginning of March. Diesel has crossed $5 per gallon, also marking a nearly 40% increase since the start of the month.
Still, the Fed kept its calm at this week’s meeting, maintaining rates unchanged as widely expected, while the dot plot pointed to one rate cut this year, though the distribution shifted toward fewer cuts. Inflation expectations were revised higher, but Jerome Powell said that it’s ‘too soon’ to assess the impact of higher oil prices and that ‘no one knows’ what the impact will be. He noted that if this is a textbook energy shock, they have the option to look through it, but continued to insist that tariffs are a potential risk to inflation.
He said that it’s ‘important to keep policy either mildly restrictive or close to that, but not too restrictive given the downside risks in the labour market. We are balancing these two goals.’
The decision and the accompanying statement were perceived as relatively hawkish by markets: the 2-year yield rose and equities fell. I personally found Powell’s remarks rather balanced. He even said that if there is progress on inflation by mid-year, we could see a rate cut. But in fine: no one knows.
Overall, the market reaction was hawkish.
Beyond the US, the Bank of Canada (BoC) and the Bank of Japan (BoJ) also left their policy rate unchanged, while citing heightened risks due to the Middle East war. Canada is a net energy exporter, placing it on the ‘right side’ of the table. The same is not true for Japan and Europe.
Europe today is a net importer of energy and more importantly, the continent has been relying heavily on US and Middle Eastern supplies since turning its back on Russia following the war in Ukraine. Today, the situation is becoming critical. Energy prices are rising and, combined with a stronger US dollar, are pushing inflation expectations higher. This, in turn, is leading investors to adopt a more hawkish stance on central bank policy.
Today, the European Central Bank (ECB), the Bank of England (BoE) and the Swiss National Bank (SNB) will announce their policy decisions. Even though all three are expected to keep rates unchanged, the recent rise in energy prices and its impact on inflation expectations will likely lead to cautious — and possibly hawkish — statements. How hawkish? We will see.
It’s true that central banks tend to place less emphasis on food and energy prices because they are volatile. But time is not your friend in a war, and Europe has learned this the hard way. The energy crisis triggered by the war in Ukraine is a stark reminder that prolonged disruptions in energy supply can lead to sustained price pressures and must be addressed accordingly. European policymakers have recently stressed their desire to avoid repeating the same mistakes made during that crisis.
As a result, the ECB’s statement will likely be hawkish, possibly hinting at tighter policy later this year, depending on the duration of the Middle East conflict and its medium-term impact on oil prices.
Across the Channel, the BoE will likely shelve the rate cut it had been preparing to deliver. Even though growth remains anaemic and calls for support, the British economy is highly sensitive to energy prices. The 10-year gilt yield has risen by as much as 50bp since the February 27 low.
There is not much MPC members can say today — no one has a crystal ball, and no one knows how long the war will last. But the longer it lasts, and the higher energy prices climb, the further away the dream of a BoE cut drifts.
In both cases, rate hikes from the ECB and the BoE are unlikely to support the euro and sterling if energy becomes expensive. Tighter monetary policy driven by a supply shock tends to slow growth, which is ultimately negative for currencies. As such, both the euro and sterling are likely to remain under pressure from a stronger US dollar as long as the Middle East conflict persists and keeps oil prices elevated.
In Switzerland, the situation is slightly different. Switzerland is also a net energy importer, but the strength of the franc helps cushion the economy against rising oil prices to some extent. The SNB will likely prefer to wait and see.
