Energy Shocks and How Markets Absorb Them

An energy shock is a sudden change in the supply or price of oil or gas, usually caused by a disruption to production or transport. The first move is in the energy price itself. The effects that follow spread through currencies, bonds, indices and policy over weeks, and a trader who knows the sequence can anticipate the second and third moves rather than only reacting to the first.

The immediate reaction

Oil or gas jumps, often with a gap. Energy-exporting currencies rise and energy-importing currencies fall; the Canadian dollar and the yen are the clearest examples at each end. Equity indices fall, led by airlines, transport and consumer sectors that face higher costs, while energy producers rise. Gold often rises on the uncertainty.

The second phase

Within days, the market begins to price the inflation effect. Higher energy prices feed into headline inflation, bond yields rise, and traders bring forward expectations of central bank tightening. The currencies of central banks most likely to respond with higher rates tend to firm, which can reverse some of the first-phase currency moves.

The third phase

Over weeks, the growth effect arrives. Higher energy costs act like a tax on consumers and businesses, slowing demand. Growth surveys soften, the yield curve flattens, and the market begins to weigh whether the slowdown will force central banks to look through the inflation. This is when the energy price itself often peaks, because demand destruction has begun.

What absorbs the shock

• Strategic reserve releases by governments, which add supply quickly
• Increased output from producers with spare capacity
• Demand reduction as high prices change behaviour
• Substitution, slow but real, between fuels

The speed of absorption decides how long the shock lasts. A disruption with spare capacity elsewhere is absorbed in weeks; one without can last a season.

In the first phase, trends in energy and energy currencies extend and pullbacks are shallow; size should be small because gaps are frequent. In the second phase, rate-sensitive assets suffer and the trade shifts to the currencies of the central banks most likely to act. In the third phase, the energy price becomes vulnerable and growth-sensitive assets have usually priced the worst.

What to watch

Watch the energy price against the spare capacity available, the reaction of bond yields, the shift in central bank language, and the growth surveys. The peak in the energy price has usually come when the growth data turn, not when the supply news improves.