Red Sea Quagmire Unlikely to Stop Fed Pivot

Summary

• Shipping through the Red Sea has been disrupted by attacks that have raised shipping costs and that could persist.
• Beyond the initial $1-2 spike in oil, we see little further upside (relating to the rerouting). We watch for attacks on local tankers from warships in the region but do not see a ’70s-style embargo as a probable scenario.
• US inflation has limited exposure to the Red Sea quagmire as most US imports do not transit through the Red Sea, the impact of US shipping costs on import prices is limited, and the passthrough from import prices to inflation is small.

Market Implications

• Oil demand could rise marginally but is unlikely to boost the oil price beyond the initial $1-2/bbl spike.
• I still expect a 50bp cut in March, against market pricing only 20bp.

Goods Price Deflation Supported Fed Pivot

The Fed’s December policy pivot has been enabled by last year’s fast disinflation, supported by easing supply constraints (Chart 1).

But normalization of global supply chains could be at risk from regionalization of the Israel-Hamas conflict. In late December, attacks by Houthi militants on shipping through the Red Sea Bab El-Mandeb straight intensified (Chart 2). And while the international community has increased naval patrols, whether this will be enough to quickly restore normal shipping conditions is unclear.

Here, we argue that even if shipping through the Red Sea remains disrupted, the impact on US inflation – and therefore on Fed policy – will likely be negligible.

The main transmission channels from disrupted shipping to US inflation are oil and import prices.

Limited Impact on Oil Supply or Demand

The initial reaction following the news that Maersk Tankers, Hapag Lloyd, and BP would look to re-route ships via the Cape of Good Hope was higher oil prices: Brent rose $2 from $74 to $76/bbl.

However, the medium-term impact on oil prices should be no larger than this $2 spike.

We can think about the impact in two ways.

First, oil demand could rise. Global bunker fuel demand in 2023 was around 4mn b/d – this includes all sorts of containers and fuel tankers.

Meanwhile, the Suez accounted for 10-20% of global trade, while re-routing via the Cape of Good Hope is estimated to add about 40% to a ship’s journey time. If all ships were to re-route (which we know is not happening – many oil tankers are still operating in the Suez), oil demand would rise 0.25mn b/d.

Second, on the supply side, a delay of 10-15 days in arrival time for vessels will increase oil on water while reducing onshore inventories. The reduction in onshore inventories will likely persist until trade routes normalize – however, the impact is likely marginal.

Beyond this, we see no further upside risks to prices. However, we continue to watch closely for risks stemming from attacks by warships on local tankers (leading to oil spills).

In addition, we reject calls from those who see a ’70s-style oil embargo on countries supporting Israel. For one, the US purchases very little crude from GCC nations anymore – and is now a net exporter. Iran, which is widely known to be Hamas’ biggest supporter, relies almost solely on China to consume its oil, while other countries in the regions export more to EM economies such as India and South Korea. Enforcing embargoes would do little at this stage to help, instead accelerating shifts away from oil toward other sources.

Upside Risks to US Shipping Costs

Besides oil prices, the other transmission channel for shipping disruptions is higher shipping costs and inflation.

Direct US exposure to disrupted Red Sea shipping is limited. Most US imports do not transit through the Red Sea as they are mainly from NAFTA, i.e., North-South (29%); the Pacific Rim, i.e., trans-Pacific (32%); or from Europe, i.e., trans-Atlantic (22%). Imports from Europe to the US West Coast or from the Pacific Rim to the US East Coast tend to transit through the Panama Canal. Also, only about half of US imports are shipped – a quarter each arrives to the US by air or road transportation.

The main risk to US shipping costs is therefore through a spillover from Red Sea to global shipping costs. So far, the increase in global shipping indices, except the Baltic Dry Index, has been relatively contained. For instance, the Freightos global index is up 30% from the lows of October 2023, compared with an 835% increase during March 2020-September 2021.

By contrast, the Baltic Dry Index is up 194% relative to lows in September 2023. These large increases partly reflect the volatility of the indices: when expressed in Z-scores, the values of global shipping indices have barely changed, except for the Baltic Dry Index (Chart 3).

Global shipping indices likely have more upside as brokers are reporting rising shipping costs. That said, a repeat of the pandemic-linked multifold increases is unlikely as the disruptions are confined to the Red Sea and since the pandemic shippers have been adding capacity.

Limited Impact of Shipping Costs on US Inflation

Shipping costs impact inflation through import prices and their passthrough to CPI and PPI. Academic studies, however, suggest limited impact of higher shipping costs on US inflation.

A St Louis Fed study found a limited passthrough from shipping costs to US import price inflation. It estimated that a 1% increase in shipping costs increased import prices 0.06%.

An IMF multi-country study over 1985-22 found higher shipping costs had a statistically significant impact on headline, core inflation, PPI and import prices. The impact was smaller in countries where imports represented a smaller share of consumption, inflation expectations were better anchored, and monetary policy followed an inflation-targeting framework. Since the US has a relatively small share of imports in consumption and has well anchored inflation expectations and inflation targeting, the IMF study is not inconsistent with the St Louis Fed.

The most recent data is consistent with these studies. The Baltic Dry Index has a positive but small relation with import prices and most importantly tends to lead them. This suggests that the recent recovery in import prices has further to go (Chart 4).

The data also shows greater passthrough from import prices to the CPI than the PPI (Chart 5). Until the late 1990s, core goods CPI tended to track the PPI. From the late 1990s, following a decade of rising imports, the CPI decoupled from the PPI and instead started to track import prices.

During the pandemic, with few imports available, the goods CPI again tracked the PPI. But with the normalization of supply conditions, the CPI is back to tracking import prices. The recovery in import prices therefore suggests forthcoming goods price stabilization from the current deflation.

That said, even a stabilization of goods price inflation is unlikely to impact core inflation, which remains largely driven by services inflation (Chart 6).

Market Consequences

Beyond the initial $1-2 spike in oil, we see little further upside (relating to the rerouting). We watch for attacks on local tankers from warships in the region but do not see a ’70s-style embargo as a probable scenario.

US inflation, and therefore Fed cuts, do not appear at risk from the Red Sea quagmire. I therefore continue to expect a 50bp cut at the March FOMC, based on 6m monthly average inflation remaining between 20bp and 25bp and on the Fed pivot to supporting growth and asset prices. This compares with market pricing only about a 20bp cut.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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Viresh Kanabar is an investment strategist with 8+ years of experience, notably contributing to portfolio construction and risk management at CCLA Investment Management, a £12 billion fund. Viresh was also a voting member of the Investment Committee and ran the private asset valuation process.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)