This Energy Price Shock Isn’t Like The Last One

At risk of sounding like a bit of a stuck record, this is not a 2022 redux.

Impulsively, market participants have leaped to concluding that the current energy price shock is going to pan out exactly like the last, which occurred almost exactly four years ago, when Russia’s invasion of Ukraine begun.

While the gains in key commodity prices – such as crude, and natural gas – are comparable to what we saw back then, DM economies are presently in a very different place to that where they resided at the start of 2022.

Put simply, 2022 marked the early stages of the business cycle, with the economy still re-opening and recovering from the pandemic. 2026, in contrast, demonstrates something akin to late-cycle behaviour, with almost any economic variable one wants to pick being in almost the exact opposite place compared to when the global economy was last bracing for the impact of a surge in energy prices.

As the above table demonstrates, the monetary policy stance is considerable tighter; broader economic momentum considerably weaker; inflation not only lower, but falling; and, considerably more labour market slack now being present. Combined, all this paints a picture of an economy where the probability of so-called ‘second-round’ inflation effects occurring is considerably lower, and is in fact fairly minimal.

Not only do corporates possess significantly less pricing power compared to the recent past, employees also have considerably less bargaining power to request higher wages to compensate for higher inflation. In turn, this not only substantially reduces the risk of a ‘wage-price spiral’ developing, but also substantially increases the risk of the surge in energy prices actually triggering a sizeable negative demand shock, exacerbating the already-anaemic economic momentum that we see across the board, especially in Europe.

Markets, however, appear to have assumed that a linear relationship is present, in the form of higher energy prices automatically leading to higher spot headline inflation, which in turn will lead to central banks delivering rate hikes. Not only does this over-simplify the dynamics involved, where central banks focus not on where inflation is now, but where inflation is likely to be in 18-24 months, it also omits the fact that the monetary policy stance is already restrictive heading into the crisis.

With all that in mind, it seems much more likely that the policy response will be a ‘wait and see’ one from most DM central banks, choosing to stand pat for the time being, while remaining attentive to the risk of those second-round effects emerging, albeit not reacting to those risks unless and until they show up in incoming data.

From a market perspective, the trade is a relatively straightforward one, with the sell-off in near-dated STIR contracts looking overdone, as does the sell-off at the front-end of DM curves. Both of these moves, hence, seem attractive to fade in my book, albeit with the risk that a further, or renewed, spike in energy prices could reinforce the aforementioned linear relationship that the market believes in, even if it is likely not representative of the actual CB reaction function.