Mike Dolan explains how oil shocks and financial stress are often mutually reinforcing.

The central banks are watching the Iran oil shock with hawk-like eyes. Even if the main concern is inflation, it is not the only one. The worst case scenario for top policymakers would be that the crude price spike proves to be a breaking point in multiple financial stress fractures.

Already, the central banks are being challenged by the surge in oil prices due to supply disruptions caused by more than a week of "war" in the Middle East.

It's an age-old debate whether oil price spikes, which raise inflation and inflation expectations, ultimately hurt household and business finances to the point that they lower demand and prices. Then there is 'the toxic scenario, where they both do this. This leaves policymakers in a dilemma of whether to prioritise 'taming inflation? or supporting consumers and jobs.

Hawks argue that if you act quickly to reduce prices, the impact on demand will be lessened. This is especially true for central banks where maintaining price stability is their main or sole goal. Others propose "looking through" volatile prices, similar to what central banks did after the pandemic, but with hindsight.

All of this is based on a blizzard "ifs" - how the policy was set up before the shock. It also includes the possibility of government subsidies, energy price caps and the length of the conflict.

These uncertainties may lead you to wait and watch events and the markets for a while before making any conclusions.

There's also another factor that most central banks consider, and it is called financial stability.

BOND MARKET TERMITES

Senior officials are concerned that the mega-macro disruptions in energy, inflation rates, currencies, and interest rates could expose some of the trends and excesses they have been watching in financial markets.

Some people are worried about the possibility of a perfect hurricane.

Watchdogs are aware of many issues, but four in particular stand out. They usually involve "shadow banks", which are outside the traditional banking system.

Asset managers are lending directly to businesses through private credit funds, which now exceed $3 trillion in value. What happens in these vehicles when a shock occurs is still unnerving to many, even without the public spotlight of traditional bank lending or bond market pricing.

Regulators are concerned that the lack of transparency may cause investors to rush out of these funds. This could have ripple effects on borrowers, and ultimately for banks, who still finance or manage most of these vehicles.

The rising percentage of government debt financed by hedge funds is a source of concern. Since years, there has been growing concern about their activities in the vital securities repurchase markets, also known as repo markets, and in today's massive U.S. government bonds arbitrage trades that exploit small differences between futures and cash pricing.

These players can smooth out government funding, but they also expose the economy to significant shocks.

In January, the G20 Financial Stability Board focused on repos, and warned of the possible impact to sovereign bonds of a sudden deleveraging from cash borrowers. The Financial Stability Board also highlighted the risks of a counterparty risk that was not adequately priced, with no haircuts often on sovereign bonds used for repos. Last year, more than $16 trillion of repo backed with government bonds were outstanding. About 60% of this was in America.

The accumulation of stablecoins, which are crypto tokens that are pegged to dollars or other currencies by using "assets held in reserve", and the fact that they have become major holders of sovereign bonds is also a cause for concern.

The $300 billion market is set to grow further. Any disruption to this ecosystem, or run on tokens could cause a unwinding of the assets and bonds backing them. Meanwhile, they could rob banks out of their deposits.

It's also worth mentioning the long-standing concern of savers and investors about?the highly concentrated and overvalued artificial intelligence universe.

What impact might the Middle East war have on all these fragile states? The behaviour of regional oil wealth and sovereign funds is one obvious example. Another is a traditional rush for dollar cash over paper or physical assets.

The two main ways would be an increase in equity volatility and a change in interest rates due to a rise in energy prices.

In the last week, we have seen the rumbles of this second scenario with the?increase in government borrowing rates as well as the jolts that central banks felt when they adjusted their interest rate horizons. The disturbance is not yet at destabilising levels.

Since this type of financial stability has become a part of the remit of all central bankers, one wonders how they would cope with an event of this magnitude.

Another question is whether these financial risks could work against a strong and decisive response by the central bank to any inflation threat.

The Ukraine invasion and its inflation and interest rate shocks did not cause too many problems, at least after a couple of years with poor asset returns. However, there was the 2023 U.S. regional banking shakeout.

There are no two shocks alike, but triple-digit oil prices and the pressure to act by central banks are not likely to go unnoticed.

The opinions expressed are those of the columnist, author. This column is a great read! Open Interest (ROI) is your new essential source of global financial commentary. Follow ROI on LinkedIn and X. Listen to the Morning Bid podcast daily on Apple, Spotify or the app. Subscribe to the Morning Bid podcast and hear journalists discussing the latest news in finance and markets seven days a weeks.

(source: Reuters)