by William Pesek 

    TOKYO – Suffice to say, virtually no one in Asia had a 5%-plus surge in oil prices in a single day in October on their economic Bingo cards.

    This surprise might pale in comparison to the intelligence failures from Jerusalem to Washington surrounding the shock attacks by Hamas on Israel over the weekend. But the fallout is a game-changer for Asian governments and central banks already grappling with elevated inflation and rising US Treasury debt yields.

    Already, the Bank of Israel scrambled to cobble together roughly US$45 billion to stabilize the shekel, the local currency. Coming two days after the latest barnburner of a US employment report, in which the world’s biggest economy added 336,000 jobs in September alone, the sudden crisis in the Middle East is altering the calculus for the Bank of Japan, People’s Bank of China and other Asian monetary authorities.

    The BOJ, for example, has been soft-pedaling moves to “taper” policy despite the highest inflation rates in Japan in 30 years. Since taking the job in April, Governor Kazuo Ueda has surprised traders betting on the BOJ exiting 23 years of quantitative easing. So far, Ueda has stayed the course, keeping record liquidity flowing and maintaining the “yield-curve control” policy.

    News last week that wage growth was slower than expected in August – rising just 1.1% year-on-year – seemed to reinforce the BOJ’s decision to slow-walk moves to normalize rates.

    Yet tight US labor markets and elevated Treasury debt yields are now colliding with an added burst of geopolitical chaos. The optimistic take is that this crisis will pass and the financial fallout will be temporary.

    As analyst Vivek Dhar at Commonwealth Bank puts it: “For this conflict to have a lasting and meaningful impact on oil markets, there must be a sustained reduction in oil supply or transport. Otherwise, and as history has shown, the positive oil price reaction tends to be temporary and easily trumped by other market forces.”

    Analyst Brian Martin at ANZ Group Holdings notes that the “key for markets is whether the conflict remains contained or spreads to involve other regions, particularly Saudi Arabia. Initially, at least, it seems markets will assume the situation will remain limited in scope, duration and oil-price consequences. But higher volatility can be expected.”

    Economist Ed Yardeni, president of Yardeni Research, says that “geopolitical crises in the Middle East have usually caused oil prices to rise and stock prices to fall.” But, he adds, “more often than not, they’ve also tended to be buying opportunities in the stock marke

    Yet the view that the Israel-Hamas conflict will not endanger major sources of oil supplies isn’t widely held. “There’s a risk of the conflict escalating regionally,” Eurasia Group analyst Henning Gloystein told CNBC. “If Iran is sucked into it, there could also be supply issues, though we’re not at that stage yet.”

    Stephen Innes, managing director at SPI Asset Management, warns that “historical analysis suggests that oil prices tend to experience sustained gains after the Middle East crises.”

    Strategist Helima Croft at RBC Capital Markets adds that “Iran remains a very big wild card and we will be watching how strongly Israeli Prime Minister Netanyahu blames Tehran for facilitating these attacks by providing Hamas with weapons and logistical support.”

    The many moving parts that might alter market dynamics are impossible to assess. As hedge fund manager Pierre Andurand of Andurand Capital views it, “over the last six months we have seen a very large increase in Iranian supply due to weak enforcement of sanctions.”

    Andurand says that “as Iran is also behind Hamas’ attacks on Israel, there is a good probability that the US administration will start enforcing those sanctions on Iranian oil exports more tightly. That would further tighten the oil market. Also, the probability that this will lead to direct conflict with Iran is not zero.

    The US dollar’s powerful rally is apt to continue as a flight-to-quality trade accelerates. Even before Hamas attacked Israel, economists at Barclays argued that stronger-than-expected jobs growth put US labor markets “significantly out of balance” and would make US Federal Reserve Chair Jerome Powell “skeptical” that monetary conditions are tight enough.

    The “dollar bid holds and the confusion over growth and inflation continues,” says strategist Bob Savage at BNY Mellon Capital Markets. “We are more likely to see an escalation of conflict than a resolution both at home and abroad, in markets and in economics, in monetary and fiscal policy.”

    All this is likely to add downward pressure on the yen, which is at the psychologically important 150 level (it’s down nearly 14% this year). The more the yen slides, the greater the risk Japan will import even more inflation via global energy and food prices. And the greater the threat Tokyo authorities might intervene.

    Until now, Ueda hoped to bide his time as a softer yen did more to boost Japanese exports and juice gross domestic product (GDP) than fan inflation. That wager might backfire as West Texas Intermediate oil jumped to over $86 per barrel on Monday.

    Thickening the plot, Powell’s team in Washington is now more likely than ever to continue tightening as the gap between US and Japanese rates widens. Though US monetary policy has limited influence over a “fear trade” bidding up oil prices or Saudi Arabia’s moves to reduce production, Powell may intensify efforts to tame inflation expectations.

    This complicates Ueda’s calculus greatly. If he refuses to narrow the yield gap with the US, 160 yen to the dollar was virtually assured. If Ueda moves to withdraw liquidity, Japanese yields could spike, putting the financial system at risk and scuttling economic recovery.

    “The risk is higher oil prices, a slump in equities and a surge in volatility that supports the dollar and yen, and undermines ‘risk’ currencies,” wrote analysts at the Commonwealth Bank of Australia.

    In recent days, Japan’s Financial Services Agency unveiled plans to stress-test at least 20 pivotal Japanese banks. The concern: as the BOJ steps toward dismantling QE policies that have been part of the global filament since 2000, Japan risks a Silicon Valley Bank-like blowup or two.

    Southeast Asia, meantime, doesn’t tend to thrive amid powerful dollar rallies, from the region’s 1997-98 crisis to today. The Thai baht, for example, is already down more than 7% this year, denoting a lack of confidence in the nation’s economic trajectory.

    For the PBOC, surging oil prices are a decidedly unwelcome development. China, too, has seen the yuan slide this year at a moment when Riyadh is reducing oil supplies. Until now, Beijing has been able to limit energy risks thanks to its Russian connection. Yet war in the Middle East upends that workaround, as does Moscow’s asking for higher prices for power exports.

    On Friday, China will release its latest inflation data, which will likely see consumer prices in September “rise a little more than they did in August as stimulus measures and higher commodity prices wash through,” says economist Denise Cheok at Moody’s Analytics.

    Already, though, economists wonder what October data will bring. On the one hand, rising prices could end the Chinese deflation narrative that has spooked global markets in recent months. On the other hand, they could limit PBOC Governor Pan Gongsheng’s options to stabilize mainland demand.

    It hardly helps that Asia’s post-Covid-19 debt surge now leaves the region’s governments in harm’s way as global turmoil intensifies. The good news is that general government debt to GDP ratios in the Asia-Pacific region are seen falling between 2023 to 2025, says Thomas Rookmaaker at Fitch Ratings.

    “However,” he notes, “the scale of the decline appears modest in the context of strong regional economic growth and the large increase in government debt in most economies during the Covid-19 pandemic.”

    Asia-region sovereigns, Rookmaaker says, “face headwinds in the near term from continued weak external demand.” China and India, for example, are among emerging markets in which Fitch analysts “expect debt/GDP will continue to rise in 2023-2025, building on increases which were already big during the pandemic.”

    The combination of the highest US yields in nearly 20 years and high Asian debt levels leaves the region increasingly vulnerable to surging oiling prices. Nor does it help that the Organization of the Petroleum Exporting Countries (OPEC) cartel seems to be in no mood to cap prices.

    “The implication of losing this supply would be that the global oil balance would be tighter throughout 2024,” says economist Warren Patterson at ING Bank. “At the moment, we are assuming Iranian supply remains in the region of 3 million barrels per day through next year, but clearly, there is downside risk to this given recent developments.”

    If this loss materializes, Patterson says, “the surplus we currently forecast in the first quarter of 2024 would largely disappear, leaving the market roughly in balance early next year. For the remainder of 2024, we would see deeper deficits, particularly over the second half of 2024.”

    Under this scenario, Patterson adds, “there would be some upside risk to our current Brent forecast of $90 per barrel for next year.” For now, Patterson says, “we don’t expect OPEC+ to adjust their output policy as a result of recent developments. However, if we were to see significant strength in prices, i.e. Brent trading above $100 per barrel, there is a possibility that Saudi Arabia would start to unwind their additional voluntary supply cut.”

    There are indeed, he adds, “levels where the Saudis would start to become increasingly concerned over the potential for demand destruction.”

    What’s more, says economist Richard Martin at advisory IMA Asia, all this adds to the list of forces already contributing to high global inflation. As Martin sees it, “the origins of structural inflation lie in big stimulus spending during Covid-19, Russia’s invasion of Ukraine, an emerging El Nino weather event, a wave of populist politicians with tariffs and nationalist industry policies, and unexpectedly tight labor markets.”

    In other words, Martin adds, “many things are going wrong at the same time, with the structural rise in inflation being the symptom not the cause. Higher interest rates are one of the biggest weapons central banks have for curbing inflation, but they are a blunt tool that has little to do with the causes. Those causes are thriving, and they may be joined by others in the next year.”