By Alun John, Yoruk Bahceli and Samuel Indyk
LONDON, March 2 (Reuters) - European financial markets are under strain as the air war in the Middle East revives concerns about an energy supply shock exacerbating inflation.
ING says the euro zone is the most exposed major economy to the conflict, a setback for a region that had benefited from investors' diversification from the United States.
UNWELCOME ENERGY
For starters, the jump in oil and gas prices evokes memories of Russia's invasion of Ukraine in 2022,
which triggered a global energy crunch and hit Europe particularly hard.
Since Friday, Brent crude is up nearly 10%, while European natural gas prices have shot up 50%. The region is almost entirely dependent on imports for oil and gas.
Major liquefied natural gas exporter QatarEnergy said on Monday it had halted production.
But, unlike 2022, European buyers don't have to wean themselves off one major energy supplier, as they did with Russia. Unlike Ukraine, this conflict has erupted as winter heating demand ebbs.
Furthermore, the euro is still some 4% higher than in February 2022. So, barring a spike in the dollar, euro strength helps limit the energy import bill - unlike other big importers like Japan, South Korea, whose currencies have weakened.
INFLATION, NOT AGAIN
For interest rates, it's all about the impact of energy prices on inflation.
The immediate outlook for the European Central Bank hasn't changed. But traders now see only an 8% chance of another rate cut by December, down from around a 40% chance last week.
Rate-sensitive German two-year bond yields rose 6 basis points on Monday.
The ECB already expects inflation to undershoot its 2% target this year and next, so it has some leeway, but, on its calculations, a permanent 14% jump in energy prices would lower growth by 0.1% this year and raise inflation by up to 0.5%.
Oil prices are over 20% higher than its December forecast, which it refreshes on March 19.
A sustained rise in oil to around $100 would raise inflation to just under 3% from 1.7% today, Commerzbank's Chief Economist Joerg Kraemer said, but also hurt euro zone growth, posing a "dilemma" for the ECB.
EURO TRASHED
The euro was a big faller among developed market currencies on Monday, down 0.7% to $1.1732 and hitting an over-10-year low on the Swiss franc that triggered threats from authorities they might intervene to weaken the franc .
It could fall further if the economy gets hit by higher energy prices, and investors reverse previous bets on euro appreciation.
JPMorgan said if Brent crude reaches $100-$120, as it could if the conflict lasts more than three weeks, the euro could weaken to $1.10-$1.13.
"We recommend tactically unwinding euro/dollar longs today," it said on Monday.
Sharp shifts under the surface are also telling. Three-month risk reversals, a derivative product, show investors are paying a small premium to insure against euro depreciation. A month ago, the cost of protecting against euro appreciation was its highest in nine months.
BRITISH MARKETS FEEL A STING
Sterling touched its lowest against the dollar since December, while gilt yields jumped on concerns that rising oil prices will feed into inflation.
The Bank of England estimates that a 10% rise in the price of Brent crude adds around 0.2 to 0.3 percentage points to UK inflation.
While trending down, Britain still has the highest inflation in the Group of Seven industrialised economies. No surprise traders have trimmed March BoE rate cut bets.
"Although you could say that (the change in rate cut bets) is sterling supportive in the short term, the reality is higher energy prices in the UK at a time when taxes have gone up would have a very negative business impact, growth impact, and political impact," said Rabobank head of FX strategy Jane Foley.
BANKS UNDER PRESSURE
European banks were hit hard on Monday, extending Friday's losses on concerns about private credit.
European banks have shed 5% in two days, heading for the biggest two-day drop since last April's tariff turmoil.
"It's very classic risk-off. Just broad selling of equities across the board," said Marlborough portfolio manager Rory Dowie.
Banks are considered cyclical stocks, typically underperforming during risk-averse periods.
While European banks do have counterparty exposure in the Middle East, the European Banking Authority's 2024 risk assessment noted this made up only a fraction of the EU/EEA banking sector's total.
MAKE EUROPE GREAT AGAIN
Some noted a silver lining to the selloff, should U.S. policy strengthen Europe's push to invest in defense and infrastructure.
That would boost long-term growth.
"The European story is underappreciated and growth will surprise on the upside this year," said Lloyds FX strategist Nick Kennedy.
"The strikes on Iran are also a reminder of the tricky nature of dealing with Trump and galvanise that approach to invest more in defense and become more independent."
(Reporting by Alun John, Yoruk Bahceli, Samuel Indyk, Dhara Ranasinghe and Amanda Cooper; Editing by Sharon Singleton)
