RPT-ROI-How oil shock and financial stress can feed each other: Mike Dolan

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By Mike Dolan

LONDON, March 10 (Reuters) - Central banks are clearly watching the Iran war oil shock like hawks. But even if inflation is their main concern, it's not the only one - and a worst case for some top policymakers is that the crude price surge proves a breaking point for multiple financial stress fractures.

The surge in oil prices, driven by supply disruption from more than a week of war in the Middle East, is already challenging central banks' stretched mandates.

An age-old question is whether oil spikes that lift inflation and inflation expectations ultimately crimp household and business finances so much that they depress demand and prices. And then there's the toxic scenario in which they do both, leaving policymakers with a conundrum of whether to prioritize taming inflation or supporting consumers and jobs.

Hawks say act quickly on prices and the hit to demand will lessen, particularly at central banks where price stability is the main or only goal. Others suggest "looking through" volatile inflation, much like central banks did post-pandemic - mistakenly, in hindsight.

A blizzard of "ifs" and "buts" informs all that - from how policy was positioned before the shock, to the scope for government subsidies or energy price caps, to the duration of the conflict and supply outage.

The weight of those uncertainties will likely argue for sitting tight and watching events and markets unfold for a bit before jumping to conclusions.

But there's another consideration under a third hat most major central banks now wear - financial stability.

BOND MARKET TERMITES

Senior officials fear that some of the excesses and behavioural trends they have been monitoring in financial markets for several years could be exposed by a mega-macro disturbance in energy, inflation, interest rates, currencies and generalised volatility.

The risk of a perfect storm is keeping some awake at night.

Of the many issues watchdogs have put on their radars in recent years, four stand out - and they typically involve "shadow banks" outside the traditional banking system and their growing role in lending to firms and governments.

This includes the sharp rise in private credit funds - which have topped $3 trillion globally - where asset managers effectively lend directly to businesses. Without the public glare of bond market pricing or traditional bank lending norms, what happens under the bonnet of these vehicles during a shock still unnerves many.

Regulators fear that this lack of transparency could trigger sudden investor rushes to exit these funds, with ripple effects for borrowers and, ultimately, for the banks that still help finance or manage many of these vehicles.

Arguably a bigger source of anxiety is the rising share of government debt now financed by highly leveraged hedge funds. Unease has been building for years about the scale of their activity in vital securities repurchase, or repo, markets and in today's gigantic U.S. government bond arbitrage trades, which exploit small gaps between cash and futures pricing with huge leveraged bets.

While these players may help smooth government financing, they also create significant vulnerabilities to shocks - and, once again, the stress ultimately feeds back to the real economy via the sizeable exposure of traditional banks that lend to these funds.

In January, for example, the G20's Financial Stability Board homed in on repos and flagged the potential hit to sovereign bonds from a sudden deleveraging by cash borrowers. It also warned of inadequately priced counterparty risk, often with zero haircuts on sovereign bonds for repos, and highlighted cross-border spillover risks. More than $16 trillion in repo backed by government bonds was outstanding last year, with some 60% of that in America.

Two other areas of concern have been the build-up of so-called stablecoins - crypto tokens pegged to the dollar or other currencies using assets in reserve - and their emergence as major holders of sovereign debt.

With the $300 billion market set to rise further, any disturbance to that ecosystem - or run on these tokens - could force an unwind of the bonds and assets backing them. In the meantime, there's a risk they rob banks of deposits.

And that's not to mention a long-standing concern among savers, investors and lenders about the overvalued and hugely concentrated artificial intelligence universe.

How might all those fragilities be affected by the war in the Middle East? One obvious area is the behaviour of giant regional oil-wealth and sovereign funds; another is a more traditional dash for the liquidity of dollar cash rather than paper or physical assets.

But the two main routes would be a surge in volatility in equity and debt and a dramatic change to the interest rate outlook from an inflationary energy price surge.

We have already seen rumblings of the latter over the past week with rising government borrowing rates and jolts to central banks' interest rate horizons. But the disturbance doesn't yet appear to be at destabilising levels.

Yet since this sort of financial stability is now part of all central banks' remit, it raises a question over how well they could cope with a shocking, even viral, disturbance from a geopolitical event like this.

A further question is whether consideration of these financial risks might work against a firm and decisive central bank response to any inflation threat.

While the Ukraine invasion and the related inflation and interest rate jolts back then did pass without too much incident - at least beyond a dire year or two for asset price returns - there was also the tremor of the U.S. regional bank shakeout in 2023.

No two shocks are identical, however, and triple-digit oil and the pressure for a central bank response are unlikely to pass without impact.

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

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(by Mike Dolan; Editing by Marguerita Choy)

((mike.dolan@thomsonreuters.com; +44 207 542 8488; Reuters Messaging: mike.dolan.reuters.com@thomsonreuters.net/ @))