To The Moon

Updates throughout, changes dateline to March 2

By Vidya Ranganathan and Yoruk Bahceli

LONDON, March 2 (Reuters) - Conflict in the Middle East has moved from a fringe risk to a top worry for investors unsettled by the prospect of a power struggle in Iran and a protracted regional war, with ramifications for everything from global trade to inflation.

Oil prices shot higher on Monday, while gold rose alongside government borrowing costs as financial markets came to grips with U.S. and Israeli strikes on Iran at the weekend that killed Supreme Leader Ayatollah Ali Khamenei.

For now, investors were pricing in the conflict remaining relatively contained, analysts said, leaving plenty of scope for market volatility should it escalate further.

Iran has struck back at Gulf cities, with airlines halting flights and tankers carrying oil and other products suspending transit through the key Strait of Hormuz.

The first risk for markets is the uncertainty over what happens next in Iran, given the complexities of the Islamic Republic's ruling system.

That then complicates the outlook for oil prices which have gained for weeks and are now hostage to what oil-producing countries do and how the passage of tankers through the Middle East is affected, with big implications for inflation worldwide and even the safety of bonds.

Brent crude LCOc1 was up nearly 10% at $79 on Monday for a gain of nearly 30% so far this year, but remains far below the $100 level analysts reckon it would exceed in a prolonged conflict.

"This is a relatively moderate reaction considering that the Strait of Hormuz, through which around 20% of global oil consumption passes, is effectively closed," said Commerzbank's chief economist Joerg Kraemer.

"At the moment, market participants seem to be expecting a shorter war lasting only a few weeks," said Kraemer, who also sees this scenario as most likely.

The bigger risk, analysts said, may be complacency in markets that have assumed the fallout would be limited, like it was during last June's "12-Day War" in Iran or during Russia's numerous attacks on Ukraine.

"History argues strongly in favor of selling geopolitical risk premium when hostilities start," Barclays analysts said in a note on Saturday. "What worries us is that investors have now learned this pattern and might be underpricing a scenario where containment fails."

They point to other factors that could exacerbate a selloff should the conflict escalate, such as existing concerns around the artificial intelligence boom and private credit markets.

"We see further (market) downside in the coming days," said Jefferies economist Mohit Kumar, who had already derisked last week on concerns markets were complacent on geopolitics.

"At some point we would be ready to buy the dip, but that some point seems far for now."

SAFETY VERSUS INFLATION

In typical flight to safety, the dollar was broadly higher on Monday =USD, gold rose over 2% =XAU and European stocks dropped nearly 2%, with futures pointing to a similar open for U.S. stocks. The Swiss franc, a safe haven, rose to its highest since 2015 against the euro EURCHF=.

The yen, another safe haven, weakened against the dollar however.

Government bond yields, which initially dropped, then ticked higher as investors trimmed their rate cut bets across major central banks. That reflects more of a focus on the inflationary implications of the oil price.

William Jackson, chief emerging markets economist at Capital Economics, expects a prolonged conflict affecting supply could cause oil prices to jump to around $100, potentially adding 0.6-0.7 percentage points to global inflation.

"In my view, the market has already been overestimating inflationary forces, so I don’t think this will change much. There will be more impact on Europe than U.S. given the closer proximity of Hormuz oil and gas post-Russia," said Tariq Dennison, a wealth adviser at Zurich-based GFM Asset Management.

The euro was last down over 0.8% against the dollar at $1.17, with a surge in oil prices perhaps an unwelcome reminder of the energy-importing bloc's crisis at the start of Russia's invasion of Ukraine in 2022.

"Investors have been overweight the euro and European assets on the recovery story this year – a story that will naturally be challenged this week by higher energy prices," ING said.

Some analysts expect Iran will not be able to disrupt trade in the Gulf region and the impact on oil prices will be contained.

"We wouldn’t be surprised if any selloff in the S&P 500 on Monday morning turns into a rally, driven by expectations of lower oil prices once the latest Middle East war ends," said Ed Yardeni, president of New York-based Yardeni Research.

"The price of gold might also round-trip on Monday. Bond yields might fall due to both safe-haven demand and post-war prospects for lower oil prices," he said.

(Reporting by Suzanne McGee in New York, Gregor Stuart Hunter in Singapore, Alun John and Yoruk Bahceli in London; Writing by Vidya Ranganathan and Yoruk Bahceli; Editing by Christina Fincher, Dhara Ranasinghe and Sharon Singleton)

((vidya.ranganathan@thomsonreuters.com;))