ROI-Europe can absorb this Mideast energy hit - but not much more: Mike Dolan

By Mike Dolan

LONDON, March 5 (Reuters) - The energy price jolt from this week's Middle East shock has left Europe fretting about an economic hit akin to the invasion of Ukraine four years ago. But initial fears may be overdone if - and it's a big "if" - futures markets prove accurate.

As the weekend's attacks on Iran marked the start of a full-blown - now region-wide - war that could last several weeks at least, European markets shivered at the prospect of yet another brutal energy squeeze spurring inflation and sapping demand.

Surging oil prices hit markets of big importing economies around the world. But Europe's particular exposure to renewed disruption of natural gas supplies - already severed when Russia invaded Ukraine in 2022 - is a potential double whammy.

Although below Tuesday's peaks, crude oil LCOc1 is still up more than 10% from last week and at its highest levels in more than a year. European natural gas futures TFMBMc1 are still more than 50% up on last Friday and also at levels seen over 12 months ago.

On cue, the euro EUR= has dropped almost 2% against the dollar even as money markets wiped out any probability of another European Central Bank interest rate cut this year and have started to price in the small chance of a rate rise. Benchmark 10-year government borrowing rates jumped more than 10 basis points and euro stock indexes lost up to 6%.

Too much, or just the beginning?

A brief glimpse at the reaction to the Ukraine invasion puts all of that in perspective.

In the six months that followed the February 2022 attacks, European gas prices trebled, ECB rates rose 100 bps, German bund yields piled on 135 bps, the euro lost 16% against the dollar and euro stocks plunged 22%.

We're not in that boat, not yet at least.

INFLATION EXPECTATIONS DON'T BLINK YET

Despite Qatar's halt to liquefied natural gas production on Wednesday after its installations were hit and exports blocked, the gas price surge is clearly nowhere near the initial Ukraine spike.

But one key area of difference between now and then is how markets price changes in long-term inflation expectations.

Using five-year, five-year forward inflation-linked swaps EUIL5YF5Y=R that cover the subsequent decade, those expectations soared by 70 bps in the seven months that followed the Ukraine invasion to 2%. And even though we're only five days after the Iran attacks, they have barely budged so far.

Part of that is down to a dogged assumption among most investors that the conflict and energy supply hiatus in the region will be limited and allow normalization of pricing through the summer. The Polymarket prediction market, for what it's worth, sees about a 40% chance the current Iranian government will fall by midyear.

But more concretely, energy traders themselves see this as a very time-limited supply outage. The futures curve for Brent crude oil, for example, sees prices drop more than $10 per barrel again by year-end - and back to pre-attack prices.

Natural gas futures see prices stay higher for longer - pricing year-end rates about $10 higher than they were a month ago. But the gap closes within a year.

And this is where most economists hover around the potential economic damage, in as much as anyone can see through the fog of war at the moment.

While some ECB hawks are wary of attempting to "see through" any inflation rise in a way they mistakenly did post-pandemic and Ukraine, when many say central banks at large tightened too late to head off steep price rises, there are key differences in the backdrop this time around.

Monetary and fiscal policy is already much tighter now than it was then, for a start. Plus the ECB's main risk before this was, arguably, a significant undershooting of its 2% inflation target over the next year.

Deutsche Bank economists point out that the relatively limited energy futures moves so far and undisturbed long-term market inflation expectations are "more consistent with removing the risk of undershooting of the 2% inflation target than with clear overshooting."

"Rising energy prices muddy the waters but, broadly speaking, don't yet challenge the ECB baseline of inflation on target in the medium term," they concluded, adding the situation was clearly fraught with uncertainty and that in itself is a drag on the economy.

Using its standard rule-of-thumb models, or "ready reckoners," Deutsche Bank estimates the rise in geopolitical uncertainty overall this year could lop some 0.25 percentage point off euro zone GDP if it persists. The geopolitical shock of 2022, by comparison, knocked about one full point off GDP.

Europe is doubtless still vulnerable to global energy markets, not just in the Middle East but also due to its heavy reliance on U.S. LNG at a time of increasingly fractious trade and diplomatic relations with Washington.

But as it stands, it can likely take this one on the chin.

(The opinions expressed here are those of the author, a columnist for Reuters.)

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