How Bad is the Fear Factor in Markets?

The fear factor across markets is moderately elevated - we're nowhere near an apocalypse

Since war erupted in the Middle East two weeks ago, markets have gone from extreme complacency to all-out panic and back again. As I noted in yesterday’s post, we’re on our way back to all-out panic currently. Growing anxiety over the closure of the Strait of Hormuz has pushed Brent to $103, a big risk premium given that this is 42 percent above where oil was before this war began. For the first time, it looks like uncertainty in global oil supply is spilling over into other markets. This has prompted all kinds of apocalyptic talk, when - in reality - key risk gauges look only moderately elevated. Of course that doesn’t mean things can’t get worse. Of course they can. But it does mean you can ignore some of the shriller commentary out there.

Before I get into it, let me explain a few things. First, the war with Iran is an unusual shock. It combines geopolitical uncertainty with the possibility of disruption to global oil supply. That’s a lot for markets to digest, so you want to compare what’s happening now to a similar shock and - ideally - one markets came through in one piece. Russia’s invasion of Ukraine is such a shock, so I’ll look at what’s happening now through that lens. Second, I’ll look at what’s happening in spot and options markets. The former is where directional views are expressed, so - if you’re certain oil is going to rise - you’ll go long oil in this market. If, in contrast, you’re worried about rising uncertainty and tail risk, you’ll want to hedge that in options markets. Hedging often runs well ahead of directional views, so the swings in options markets are usually more violent than in spot markets. Thus, if options markets look more or less in line with 2022 - an episode markets navigated successfully - this bodes well for where we are now.

• Spot markets: the four charts below show the evolution of the Brent oil price (top left), the S&P 500 (top right), the Dollar versus its G10 peers (bottom left) and the Dollar versus emerging markets (bottom right). The blue line is what’s happening now and the black line is what went on in 2022. In both cases, I’ve indexed things to be 100 the day before war began, which is Feb. 23, 2022, for Ukraine and Feb. 27, 2026, for Iran. The risk premium in Brent is slightly above where it was at this point in 2022 and the S&P 500 is slightly weaker. The Dollar is completely in line with where it was in 2022. Overall, given that the Strait of Hormuz is three times as important as Russia for global oil supply, markets are very well behaved.

• Options markets: the four charts below show 30-day ahead implied volatility for crude oil prices (top left), S&P 500 (top right), the bond market (bottom left) and the high yield corporate debt (bottom right). The picture is quite reassuring here as well. We know uncertainty in oil markets is high, so no surprise option-implied volatility is elevated (though not massively so versus 2022). We also know that credit markets in the US are under strain, so - again - no surprise that high yield is above where it was in 2022. However, broadly speaking, hedging activity doesn’t look like it’s an order of magnitude different from 2022, which is remarkable given how much bigger this shock is than Ukraine.

The bottom line is that markets are holding together remarkably well when you consider how much bigger this shock is than Russia’s invasion of Ukraine. On any given day before this war, 20 million barrels of oil transited the Strait of Hormuz, which is roughly three times Russia’s daily oil exports. This shock is therefore at least three time as big 2022. Taking this into consideration, markets are certainly pricing some stress, but we’re nowhere near an apocalypse.