Key Highlights

• Energy prices now far above ECB baseline
• KRW cannot count on hedge unwinding
• MENA FX flows not repeating 2022 to 2023 pattern yet

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Natural gas curve upends ECB projections

EXHIBIT #1: NETHERLANDS TTF NATURAL GAS FUTURES CURVE EVOLUTION

_{Source: BNY}

Our take

The European Central Bank (ECB) is stepping up monitoring of inflation and inflation expectations in the Eurozone, while market participants coalesce around the view that supply disruptions from the Middle East conflict are unlikely to be resolved soon. We expect energy prices to remain volatile, but the ECB will need to prepare for all contingencies, especially given how liquefied natural gas prices feature directly in the baseline assumptions underpinning policy decisions.

Similar to the framework used for FX, the ECB maintains alternative assumptions that estimate the knock-on impact on inflation based on option-implied neutral densities for asset prices. The December staff projections were based on a market snapshot (for FX and energy) from November 26, 2025. We believe the snapshot used for the March staff projections has already been taken, using market prices from before the start of the conflict. Using futures curve pricing, figures last week showed a modest increase in prices through the next five quarters, which was already somewhat uncomfortable for the ECB, as its baseline forecast assumed lower natural gas prices this year. However, a 75th percentile move – which would trigger a 50bp rise in total CPI this year on top of baseline – would require a 20% increase, and the curve was only pricing about half that amount at best. As of Wednesday, the European natural gas benchmark curve has shifted to an average price baseline nearly 45% above last Friday’s figure and close to 60% above the original assumption. These levels are well into the high-90th percentiles, which could point to HICP running about 100bp above baseline assumptions.

Forward Look

ECB President Christine Lagarde stated that the central bank is carefully monitoring the situation and has already discussed the implications with EU leaders. The ECB’s absolute imperative is to be proactive and fully anchor inflation expectations, avoiding the catch-up that derailed policy throughout 2022 and 2023. Resilience is far stronger now, but all options should be on the table. Consequently, we understand the market’s willingness to price a material risk of rate hikes – well ahead of peers. However, doing so would recognize stagflation risk emerging in the Eurozone, and we doubt this will benefit local assets accordingly. If anything, the balance of risks is an overreaction on the fiscal front, thereby augmenting inflation risk and depressing local real rates.

KRW at risk of re-hedging, even if equity performance stabilizes

EXHIBIT #2: CROSS-BORDER HOLDINGS, KRW AND SOUTH KOREAN EQUITIES

_Source: BNY

Our take

South Korean equities registered a record 12% single-day drop on March 4 in response to the conflict in the Middle East. The country has unique energy-related exposures, with full import dependency on petroleum, up to 75% of which is transported through the Strait of Hormuz. We fully subscribe to the view that the scale of the move is attributable to ex-ante positioning and valuations. Even after the move, South Korean equities remain more than 20% up on the year, while Taiwanese equities are up 13% – still the best performers in the region and globally. Our data indicate cross-border client holdings are even more elevated, at close to 80% above the 12-month rolling average. Furthermore, these holdings appear concentrated in a handful of equities linked to semiconductor fabrication, so the move partly reflects an adjustment in elevated valuations tied to the global AI theme.

Forward look

The move in the KRW was not commensurate with equities; the currency even strengthened as risk appetite stabilized. However, near-term risks remain, especially if the duration of the crisis moves beyond current assessments. The currency was widely expected to perform well this year due to strong export balances, and there was even some risk of intervention. U.S. Treasury Secretary Scott Bessent highlighted that the mid-January move higher in USDKRW to 1,480 – around which the pair still sits – was “not in line with fundamentals.”

Expectations for strength led to gradual unwinding of currency hedges, and iFlow data show holdings shifted decisively net long in Q4 last year. This means cross-border investors are willing to take more currency risk on underlying equity positions, and any subsequent sell-off will not trigger hedge unwinds. Even if equity markets stabilize, the specter of fewer Fed cuts, irrespective of drivers, will likely push hedge ratios up again. Overall, KRW overheld positions have fallen by around a third but remain elevated by any iFlow standard.

EMEA FX carry trades wobble if labor markets normalize

EXHIBIT #3: SMOOTHED MONTHLY FLOW, SAR, AED AND EGP

_{Source: Bloomberg, BNY}

Our take

The current situation in the Middle East has drawn parallels with the energy supply shock of 2022 to 2023, but the reaction function for Middle East and North Africa (MENA) currencies is likely to be different. Our flow data indicate strong performance for AED and SAR during that particular period, but there were no supply disruptions for their mineral fuel products. EGP, in contrast, faced severe balance-of-payments challenges, like much of the emerging and frontier market space. It has taken several years, along with very painful fiscal and monetary adjustment, to recover the currency-based liability gap that opened at the time.

Forward look

The situation is fluid, but we observe that both upstream and downstream exports from the region are being affected. The nature of these industries means that once production is shut off, reactivation will take time. Therefore, high market prices will not translate into receipts, at least not in the near term. Timing is challenging for the affected currencies: SAR is now coming off its best flow period since 2022, whereas AED is only just recovering from its worst phase over the same period. Both currencies have solid holdings buffers, but the risk is broader outflows from assets or significant hedging while export earnings are affected. The EGP is also enjoying its best run in nearly two years. While it doesn’t face export stress due to product mix and geography, import challenges could also lead to balance-of-payments pressures quickly. After a difficult 2025 due to tariffs and weak terms of trade, the region was on its way to stabilizing currency flows. However, in the near term, any consolidation needs to be put on hold.

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