The Middle East conflict has put energy prices “at the wheel” of global financial markets, investors say, as the oil shock creates a sharp dividing line between winners and losers from an upsurge in inflation.
The fallout from soaring oil prices has become a dominant trade across bond, currency and equity markets as investors conduct a sweeping reappraisal of those economies and countries most exposed to an energy shock and those likely to benefit.
Traders have rushed to dump bets on interest rate cuts in economies viewed as most likely to be hit by an inflationary surge, haunted by the experience of past energy shocks. In the process, the US dollar has been revived from a year-long slump, as investors bet on the country’s economic resilience as an oil producer.
“Energy prices are back at the wheel,” said Jeremie Peloso, a strategist at BCA Research. “The disruption level is global.”
As the International Energy Agency warned of the “largest supply disruption in history” to the oil market, traders looked to the 2022 energy crisis in Europe that followed Russia’s full-scale invasion of Ukraine or back to the oil shock that followed the 1979 Iranian revolution, for a worst-case scenario of how the war’s economic impact could play out.
Record intraday swings in oil prices have created volatile trading in government bonds as the market reprices the path for inflation and interest rates with each surge and dive in Brent crude.
Exporter currencies such as the Australian dollar have been rare winners on currency markets, while importers such as South Korea have suffered in a broad shake-out.
“Oil dominates the short-term narrative,” said Andrew Sheets, global head of fixed income research at Morgan Stanley. “It is so important and the range of outcomes is so wide.”
In government debt markets, short-term bonds have borne the brunt of the pain, as the market has shifted to price out interest-rate cuts by global central banks amid inflation fears.
This has been most acute for countries with a pre-existing inflation challenge. The Bank of England — facing inflation already running at 3 per cent and worries over the UK’s vulnerability to rising gas prices — is now viewed as more likely to raise rates later this year, compared with the two quarter-point cuts priced in before the conflict. The European Central Bank is now expected to raise rates once or twice.
“If you’re worried about inflation, it becomes about who loses this race to the bottom,” said Geoff Yu, senior Emea market strategist at BNY.
The US is being viewed as a relative winner. The dollar, which had fallen to a four-year low earlier this year as the Greenland crisis fuelled worries over US President Donald Trump’s economic and trade policies, has been revived.
Despite the pull from higher rate expectations, the euro is down about 3 per cent against the dollar since the conflict began, back under $1.15 and on track for one of its worst months in recent years, as investors worry about the impact on growth from higher oil and gas prices.
So-called risk reversals in the euro-dollar exchange rate, which show the relative cost of options bets on the currency pair, this week shifted to the most bullish position on the dollar since before last year’s “liberation day” tariffs announcement raised fears over US policy.
Popular trades such as shorting the dollar or so-called bond market “steepeners” — where investors bet that short-term debt will outperform long-dated bonds — have gone into reverse, in a sweeping pain trade that has left some macro hedge funds nursing big losses.
All major currencies have dropped against the dollar since the conflict began, but the worst performers include the South African rand and the South Korean won, the currencies of two of the economies most dependent on energy imports, which are down more than 5 per cent and 3 per cent, respectively.
Emerging markets face a “double blow” from surging oil prices and a stronger dollar, “hitting fiscal budgets, weakening current accounts and stopping further interest rate cuts”, said Mansoor Mohi-uddin, chief economist at Bank of Singapore.
Bank of America analysts said this week that the option risk premium in trading the South African rand against the dollar — the extra cost investors are prepared to pay for insurance against falls in the rand — has outweighed even that in crude.
The Canadian and Australian dollars are among the best-performing major currencies apart from the US dollar, helped by their status as commodity exporters and bets on interest rate rises.
The oil scare has also begun to reorder equity markets too, with European and Asian stocks giving up a chunk of their outperformance so far this year against the US, as investors head back to big tech stocks and away from energy-intensive sectors.
“Tech was in some ways the last man standing,” said Matthew McLennan, a portfolio manager at First Eagle Investments, as the market priced “where it felt the damage would be most obvious”.
As politicians both in developed and emerging economies consider food and fuel subsidies as they strive to avoid a cost-of-living crisis, bond fund managers warn that this will spread the pain deeper into the sovereign bond market.
Measures to absorb the impact on the public — the UK is keeping under review a rise in fuel duty, while the EU is considering subsidising gas bills — will reignite worries over spending and debt issuance, they warn. The UK’s 30-year borrowing cost climbed above 5.4 per cent this week to its highest level since October.
“The first phase of this rates sell-off was removing the cuts that had been priced in,” said Mike Riddell, fund manager at Fidelity International.
“We expect the next phase to be higher long-dated borrowing costs: the higher energy prices go, the more expensive this will get.”
Data visualisation by Ray Douglas. Additional reporting by Emily Herbert and Joseph Cotterill
