European Central Bank Tightening Meets an Energy Shock It Cannot Fix

Markets have moved to price further tightening from the European Central Bank, and the trigger is an energy shock the bank has no tools to reverse. Sustained high oil prices and natural gas prices near their highs for the year are feeding directly into European inflation, in a region that imports much of the energy it consumes. That leaves policymakers responding to a supply disruption with a demand side instrument, which is an uncomfortable position for equity markets. European and U.S. indices have already turned defensive as investors work through what that combination means.

Fawad Razaqzada is a Market Analyst for StoneX Media, with more than twelve years of trading and analysis experience spanning foreign exchange, equity indices, and commodities. He works across macroeconomics, technical analysis, and price action, which is the same set of markets now transmitting the energy shock into European rate expectations.

Key Themes

• Markets are pricing further European Central Bank rate increases as high energy prices lift inflation expectations.
• Europe's dependency on imported energy makes the region unusually exposed to a prolonged supply disruption.
• Rising bond yields raise the opportunity cost of holding growth stocks and technology shares.

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European Central Bank Rate Expectations Climb on Imported Energy Costs

European Central Bank rate expectations have risen because energy costs, not domestic demand, are driving the inflation impulse. As Razaqzada puts it, "high energy prices are also boosting expectations for the European Central Bank to hike interest rates", with markets increasingly pricing further tightening ahead. That is a difficult sequence for equities, because policy tightening is not typically a good sign for equity markets, and the underlying cause sits outside the central bank's control. The energy backdrop shows little sign of resolving on its own, with Donald Trump having rejected an extension of the truce and Iran stating that the Strait of Hormuz will remain closed until the blockade and embargo are both lifted. Consequently, European equities are absorbing an inflation shock and a policy response to it at the same time.

Rising Bond Yields Raise the Cost of Owning European Growth Stocks

Government bond yields have climbed across major markets, and that move changes the arithmetic for equity valuations before any earnings figure is published. Yields on long dated United States government bonds have reached their highest levels in almost two decades, with Japanese and eurozone yields also sitting at multi year highs. The mechanism is straightforward, and it hits the German DAX index harder than most given the nation's reliance on imported energy and the large technology names inside the index. "Higher bond yields increase the opportunity cost of holding assets that come with high risk and low yields, for example, growth stocks and the technology sector", Razaqzada explains. For now the move still reads as a pullback rather than a reversal, though the balance of risk is shifting.

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--- Written by Frédéric Guétin, StoneX Media Producer

--- Expert: Fawad Razaqzada, StoneX Media Market Analyst