Mike Dolan: ROI-Europe is able to absorb the Mideast energy shock, but not much else.

Europe is worried about an economic blow similar to the invasion of Ukraine in 2004. Initial fears could be exaggerated if futures markets are accurate. That's a very big "if".

The European markets were shivering at the prospect of yet another energy crunch that would drive up inflation and sap demand.

The soaring?oil price has hit the markets of major importing countries around the globe. Europe is particularly vulnerable to the resumption of disruptions in natural gas supply, which were already halted by Russia's invasion of Ukraine in 2022.

Crude oil, although below the Tuesday peaks, is still more than 10% higher than last week. It's also at its highest level in over a year. European natural gas futures remain more than 50% higher than last Friday, and are also at levels from over a year ago.

Money markets have begun to price in a small possibility of a rate hike, even though they have ruled out the probability of another European Central Bank rate cut. Benchmark 10-year government lending rates increased by more than 10 basis point? and euro stock indices fell up to 6%.

Is it too much or only the beginning?

All of this is put into perspective by a quick glance at the reaction to Ukraine's invasion.

The six-month period following the February 2022 attack saw European?gas prices triple, ECB interest rates rise 100 basis points, German bund yields increase 135 basis points, the euro fall by 16% against the US dollar, and euro stocks plummet 22%.

Not yet, at least.

Expectations of inflation are not changing yet

The gas price spike is nowhere near Ukraine's initial spike, despite Qatar's Wednesday halt to liquefied gas production after its installations and exports were blocked.

The key difference is the way in which markets value long-term inflation expectations.

In the seven months following the invasion of Ukraine, these expectations rose by 70 basis points to 2%. Even though the Iran attacks occurred only five days ago, expectations have barely changed.

Most investors are firmly convinced that the energy shortage and conflict in the region is temporary and will allow prices to return to normal by the end of the summer. For what it's really worth, the Polymarket prediction market sees a 40% probability that the current Iranian government falls by mid-year.

Energy traders see it as a time-limited shortage. Brent crude oil prices, for instance, are expected to drop by more than $10 a barrel before the end of the year, and return to their pre-attack levels.

Prices of natural gas futures are higher for a longer period of time. The rates at the end-of-year are about $10 more than they were one month earlier. The gap will close within a year.

Most economists are concerned about the economic impact of the war, but no one can really see it at this time.

There are some key differences this time around. While ECB hawks may be wary of trying to "see-through" an inflation rise, as they did in the past, after the pandemic or in Ukraine, where many said central banks tightened too late in order to prevent steep price increases, there are also important differences.

For a start, monetary and fiscal policies are?already tighter than they were then. The ECB was also at risk of a significant undershoot of its 2% target inflation over the 'next year.

The economists at Deutsche Bank point out that the relatively small energy futures movements so far, and the undisturbed expectations of long-term inflation on the market are "more consistent" with eliminating the risk of inflation undershooting the 2% target than with overshooting.

The ECB's baseline for inflation is still on target, but rising energy prices are muddying the waters.

According to its "ready reckoners" or standard rule-of thumb models, the increase in geopolitical uncertainties this year could result in a 0.25 percent drop off of euro zone GDP. Geopolitical shock in 2022 knocked one point off the GDP.

Europe is still vulnerable to the global energy market, not just in the Middle East, but also because of its heavy reliance on U.S. LNG during a period when trade and diplomatic relations between Washington are fractious.

As it is, the system can probably take it on its chin.

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(source: Reuters)