Straitened Markets: Assessing the Macro and Crypto Fallout of the Iran Conflict

Initial market response  

Market reaction has been relatively contained. Initial volatility in Bitcoin remained limited, while the response from the crude oil market, often a proxy for geopolitical risk in the Middle East, has been notable but not extreme. On 2 Mar, the first trading day after the strikes began, benchmark Brent crude spiked over 9% to an intraday high of $82.37 before paring gains to settle at $77.74. While substantial, the move is significantly lower than price spikes seen in previous conflicts; following the Russian invasion of Ukraine in Feb 2022, the price for a barrel of oil spiked to $127.

Spot gold prices surged 2% on 2 Mar, reaching an intraday high of $5,420 an ounce as investors sought safe havens following the initial strikes. However, this momentum reversed on 3 Mar as the US dollar strengthened, bolstered by concerns over persistent inflation and the probability of further interest rate hikes. The market response was sufficiently muted that a strong inflation print effectively overshadowed the geopolitical risk premium, even though gold remains up 19% year to date. Since the 2 Mar peak, the spot price has declined by 3%.

The impact was more pronounced in the liquefied natural gas (LNG) market. Dutch TTF Natural Gas Futures, the European benchmark, surged over 60% by 3 Mar, reaching an intraday high of €63.75 per megawatt-hour before settling at €54.29. The spike followed Qatar's announcement that it had halted production at its North Field gas reservoir, the world's largest natural gas field, due to regional instability. Similar price surges were reported across Asian markets. 

European LNG prices so far have yet to reach levels seen during the initial phases of the Russian invasion of Ukraine in 2022. Source: Investing.com

The significance of the Strait of Hormuz 

Iran sits along the northern coast of the Persian Gulf and the Gulf of Oman. Across these waters are several of the world’s most significant energy producers, including Saudi Arabia, the UAE, Qatar, Bahrain, and Oman, most of which depend on the Strait of Hormuz to export crude oil and LNG. This narrow waterway is a global choke point, handling roughly one-third of the world’s seaborne oil supply and one-fifth of its LNG.

According to Lloyd’s List Intelligence, the security crisis has caused maritime traffic through the strait to collapse, with transit volume down by over 80% as of Monday. 

Major energy importers maintain strategic reserves to mitigate short-term price fluctuations and supply shocks. China, the sole destination for Iranian crude, has established reserves covering 121 days of imports, while Japan maintains a buffer of 254 days.

As the conflict progressed throughout the week, specialized commodity markets have shown increasing vulnerability. June Goh, senior oil market analyst at Sparta Commodities, noted that jet fuel is particularly exposed due to its specialized tank storage requirements; unlike diesel and gasoline, inventories are limited. Consequently, Asian refineries have begun reducing runs as crude shipments remain stalled at the Strait of Hormuz.

What is the market telling us?

Given the scope of the military campaign and the significant geopolitical risks associated with the Strait of Hormuz, the initial market response has remained relatively muted, suggesting that investors are currently pricing the conflict as a short-term endeavor. However, more sensitive sectors, such as European natural gas and jet fuel, have already begun to show signs of strain, while price action in broader commodities like crude oil has remained choppy.

A prolonged conflict would likely be reflected in sustained rises for crude oil and gold, as well as shifts in safe-haven sovereign bond yields and, potentially, cryptocurrencies. To date, bitcoin has experienced only slightly elevated intraday volatility despite the intensifying geopolitical situation.

Market response appears to be a function of the conflict's severity and expected duration. If current engagement stretches into a prolonged war, a more severe reaction is anticipated in the coming weeks, likely triggering capital flight from risk assets into safe havens.

Goldman Sachs and JPMorgan estimate that oil prices could jump past $100 a barrel if disruptions to regional energy flows persist.

Policy response to a prolonged shock 

A prolonged war would likely result in a further spike in commodity prices, triggering a significant policy response from central bankers tasked with maintaining price stability. As seen during the war in Ukraine, a substantial energy price shock can permeate the real economy, increasing the costs of transport, goods, and services. These primary effects often lead to secondary pressures as rising salaries attempt to keep pace with costs, potentially igniting a period of spiraling inflation.

This energy price shock represents a stagflationary supply-side disruption. Because rising prices naturally suppress demand, the shock carries the potential to trigger an economic recession. This environment leaves central bankers in a precarious position; monetary policy is traditionally designed to address demand-side fluctuations within the business cycle. Contractionary policy, achieved by raising interest rates, is intended to slow demand by curbing consumption and investment to restore balance. However, a supply-side shock already effectively damages demand as prices rise, complicating the impact of further tightening.

A hawkish monetary policy, while necessary to regain control over prices, risks suppressing economic activity to the point of recession. Central banks took this path during the energy shocks of the 1980s, a period when oil was more integral to global output than in today's advanced service economy.

Central bankers have likely learned from the supply-side shocks caused by the war in Ukraine and the excessive fiscal measures that followed. During that period, inflation proved far less "transitory" than initially predicted, as central banks largely waited out the price spikes. Consequently, inflation remained above targets for years. Central banks appear determined not to repeat these mistakes. Even within the current environment of fiscal dominance, policymakers remain inclined to hike interest rates to defend their mandates.

Minneapolis Federal Reserve President Neel Kashkari echoed these concerns, noting to the Wall Street Journal that prior to the strikes on Iran, the economy appeared to be moving gradually toward stability. Reflecting on the inflationary lessons of the war in Ukraine, Kashkari admitted he had previously been on "Team Transitory," acknowledging that while price spikes were indeed temporary, they proved much more severe and persistent than anticipated. Cautioning against a repeat of that period, he questioned whether the central bank should risk another "Transitory 2.0" by underestimating the duration of the current shock.

The energy shock pass-through  

The Russia-Ukraine war serves as the most recent empirical reference for an energy-driven price shock. According to ECB economist Jakob Feveile Adolfsen, the immediate aftermath of that conflict saw the prices of oil, coal, and gas surge by approximately 40%, 130%, and 180% respectively. This shock reverberated globally as higher energy costs were passed through to transportation and consumer goods, driving significant headline inflation.

Quantifying this impact remains a focus for researchers. Federal Reserve data suggests that a 10% increase in the foreign oil supply can raise headline inflation by 0.15% within the first year. However, Lutz Kilian and Xiaoqing Zhou of the Federal Reserve Bank of Dallas find limited evidence that positive crude oil shocks have a persistent, long-term impact on inflation. Further research by PhD students Daniele Colombo and Francesco Toni indicates that natural gas demand shocks can be even more potent, with a 10% increase in real gas prices leading to a 0.25% peak increase in inflation.

While the US remains energy independent, acting as the world’s largest LNG exporter, it still imports crude oil, though global energy shocks now have a relatively small impact on its domestic price inflation. In contrast, the euro area faces a more significant vulnerability. ECB staff projections from late 2023 modeled a scenario where spikes in crude oil and gas prices by 57% and 74%, taking them to $130 per barrel and €83 per MWh, respectively, would increase headline inflation by 0.9 percentage points in the first year and 0.4 percentage points in the second.

According to Bank of England estimates, a 10% increase in the price of Brent crude typically adds between 0.2 and 0.3 percentage points to CPI inflation. Similarly, research from ING suggests that a 10% rise in oil prices raises headline inflation by an average of 0.2 percentage points across Asia, though this impact can climb to 0.4 percentage points in more vulnerable markets like India and the Philippines.

Importance to risk assets 

The energy shock presents a significant headwind for risk assets. From a policy perspective, a prolonged price surge will likely compel central banks to maintain or raise interest rates, effectively draining liquidity from the financial system.

However, early indicators suggest the impact will be uneven. The euro area and the UK appear more vulnerable to these fluctuations than the US and Japan, which maintain lower relative exposure to Middle Eastern energy volatility. This divergence is expected to drive distinct, medium-term policy responses from the respective central banks in these regions.