How oil shocks affect markets: consider the five most recent scenarios.

• Author: Kubarych, Roger

The five major oil shocks that have rattled the global economy since 1973 also had powerful effects on financial markets. But just as the economic impact of successive oil shocks has become progressively less destructive to growth, so too have the financial market effects become milder. Indeed, the latest surge in oil prices has been largely taken in stride within the financial markets, in contrast to past responses. In part that is because moderately higher crude oil prices no longer have a decisive effect on overall inflationary developments. In part, it is because rightly or wrongly market participants have been conditioned to expect the oil price to retreat after a temporary overshoot. And in part it is because a sharp rise in energy costs has differential effects on different sectors of the economy--some industries do worse, such as automakers, but others do better, such as energy developers. Here is a brief review of how the main financial sectors have responded to successive oil shocks since the big one in 1973.

The Five Shocks

[1] 1973-75: OPEC SQUEEZES THE WEST

The proximate cause was the Yom Kippur War in the fall of 1973, followed by the Arab boycott of countries judged to be supporting Israel against Egypt. But in the background was a long period of OPEC frustration that relatively constant oil prices, against a backdrop of rising global inflation, were resulting in a steady decline in real oil revenues. The geopolitical disturbance provided just the fight degree of cover to slip through a new policy of using its latent market power to push up prices. Over the next year and a half, the price of Saudi light crude oil soared from $2 per barrel to over $13 per barrel. The price subsequently leveled off to trade in a narrow range just under $15 per barrel until the next geopolitical shock in 1979, the Iranian revolution.

FINANCIAL MARKET RESPONSES

Bonds: The U.S. Treasury ten-year constant maturity bond posted a yield of 6.81 percent on October 18, 1973, the day before the oil embargo began. Initially the ten-year yield actually declined, reaching a low of 6.67 percent two months later. Over subsequent months, bond markets gradually sold off as the oil price hike began to be viewed as permanent, with serious inflationary consequences. But the bond market continued to trade in an orderly fashion. There were no sudden, sharp yield spikes. By March 18, 1974, when the oil embargo ended, ten-year Treasuries were up to a yield of just 7.24 percent. However, when prices continued upward even after the end of the embargo, bond yields resumed an upward path, topping 8 percent in the fall of 1974 and rising further to a peak of 8.5 percent a year later. All told, the first oil shock produced a cumulative increase of almost 2 percentage points in long-term U.S. Treasury yields.

Stock markets: The U.S. equity market, as measured by the S&P 500 index, was badly shaken by the events in the Middle East and the Arab oil embargo. From just before its imposition until oil prices began to stabilize in early 1975, average stock prices nearly halved. The value of U.S. equities dropped by 50 percent or $600 billion, about 40 percent of GDP. By comparison, that plunge was only slightly less severe than the collapse of the high tech bubble of 2000-03.

Currencies: The Japanese yen, which had been allowed to appreciate against the U.S. dollar after the 1971 collapse of the Bretton Woods system, weakened significantly in the aftermath of the oil shock. The Japanese economy was viewed as more vulnerable to a contraction in oil supplies. The currency traded at about 265 to the dollar just before the oil embargo. It weakened to about 300 by the middle of 1974 and then fluctuated narrowly around that level until 1977, when the Carter Administration took office with a mandate to deal with the growing Japanese trade...