“But it's all right now, in fact, it's a gas”
Rolling Stones, Jumpin’ Jack Flash
In our last piece, we discussed a number of events in what continues to be a very complicated and uncertain backdrop for the global economy: (i) in the UK, we discussed the new PM (and thus new Cabinet and new policy agenda - not least the estimated £150 billion plan to cap energy prices) (ii) in the US, the increasing focus from policy makers on both the global activity slowdown and the lag between rate hikes and the full effects of policy tightening and (iii) the ECB’s monetary activism to rein in inflation (and inflation expectations) and anchor the EUR. All points that, perhaps, merit in expanding upon this week.
The UK energy price cap has a number of faults, that will, I'm sure, be long debated - though it is not entirely clear that there was any alternative, due to the acute dislocations of the energy market (as a direct function of German reliance on cheap Russian gas for many years) and the direct pressure that was about to be placed on the consumer, as we move into the colder months. I heard it referred to as “a terrible idea, but the only option”. The biggest issue, of course, is that there is no demand response to the price shock, no demand destruction, and thus the problem is not solved, just hidden.
There is, however, another way of looking at the issue. The UK, or probably more directly, the Prime Minister, has effectively just initiated a (Very Big) short position in (UK-delivered) natural gas (or its direct and interchangeable substitutes) to the tune of £150 billion, or 5% of UK GDP. Indeed, it is likely that there is ultimately an equivalent package put in place by the EU. If we are to assume a similar level of intervention, then this essentially amounts to a trillion-dollar natural gas short! It is possible that some may, in the future, look to freely interchange Prime Minister and Portfolio Manager. One outcome in the energy markets could make the move look inspired and courageous, another ill-considered and foolish. Time will tell.
The big event of the week, however, was undoubtedly the US inflation print. Expectations were for the headline number to fall to 8.1% y/y in August, from 8.5% in July and 9.1% in June. The number came out at 8.3% (or 8.26% to be precise). In the core measure, where markets were expecting a rise to 6.1% y/y from 5.9% in July, the release also disappointed at 6.3% y/y. On the face of it, the misses seem moderate. On a headline basis, prices are starting to moderate (albeit a little slower than expected in August), but there are clearly some positive factors in the data - on the supply side, there are more clear signs of relief in goods, as supply chains continue to improve and base effects start to become more favourable across the commodity space. However, there were also some clear disappointments in the data - notably from the demand side. With broader resilience in price pressure across shelter, medical, food ‘out’ and education components of the basket, markets were quick to reprice rates to a higher, yet sooner, terminal rate in the US.
For me however, it is not that clear, if we take into account the rhetoric that we discussed last week in relation to the global economic trajectory (or increasing fragility - notably in Europe and China), and also the fact that the very aggressive front loading of interest rates from the Fed that has already happened has had little or no time to impact anything but the most rate sensitive parts of the US economy. When I started in financial markets, many moons ago, it was generally accepted that the full impact of a rate rise would not be felt until around 13 months later. If we overlay this notion with the current stubborn shelter component of the CPI (around one third of the total index is allocated to rents and owner equivalent rents), then we can expect that the increased housing starts and falling house prices will, over coming months, arrest, or even reverse, the rising rents - especially if, as expected, growth is going to continue to moderate. In that scenario, the Fed is raising rates most aggressively now when the biggest impact of those hikes is likely to be felt when the economy is weaker (as the stimulus effects continue to wane) and prices are significantly lower (not least due to base effects).
Indeed, just overnight the World Bank warned that Global Central Banks risk sending the global economy into devastating recession next year if policy makers raise rates too high in the months ahead – Meanwhile in the aftermath of a retail sales print that had a better-than-expected headline figure (but a much weaker breakdown and back revisions) markets continue to price in higher terminal rates across global central banks!
Now, I am aware that it is not as simple as that, and that there is a significant role for the Fed to play in convincing markets that they are in control of inflation, and that there will not be wage price spirals that threaten to undermine economic progress; that inflation expectations do not become unanchored.
When we look at the US curve movement relative to breakevens, 5y nominal yields rallied 20bps initially on the data release; 5y breakevens rallied 5bps. I would argue that this is suggestive of a market that is comfortable that the Fed will do what is necessary on the inflation front at the expense of growth, if needed. By extension, in a world where we are fully pricing a Fed reaction function that offers downside risks to growth, then longer end yields should look attractive at these levels - especially if we continue to see inflation back to target at or around the forecast horizon and current yields remain above the long run equilibrium level (at least as per the June SEP’s) of 2.50%. Thus, I am increasingly of the opinion that at the long end of the curve, US Treasuries are a very attractive proposition both on price and duration basis.
In Europe, the situation (as per global inflation pressures) is also hostage to the energy situation and thus the Russia situation. The market reacted positively at the start of the week, as Ukrainian forces’ progress was seen as increasing the likelihood of a ceasefire - likely a very significant event for energy prices and the EUR. However, for the EUR at least, this was trumped on Tuesday by the disappointing US CPI figure, which drove EUR back towards the lows.
Last week, I emphasised my perspective that “it is likely that the ECB have done enough for now to stabilise the EUR.” Following their 75bp hike. This still feels about right. Two-year rate differentials have moved very little, following the US CPI print, and the spread is still way off the wide levels that accompanied the EUR move to parity in July. Indeed, the suggestion from ECB members this week is that they will keep pace with the Fed for the remainder of the year, with 75 and 50 now expected from Fed and ECB in the last two meetings of 2022.
There is a long way to go in 2022, and a wide array of significant factors that likely keep volatility elevated throughout. However, there are also a number of positive prospects: in the UK, the change of leadership and new policy impetus potentially gives the Truss UK a direction, and thus a productivity upside that had lost its way under Boris Johnson. In the US, while the Fed rhetoric likely remains tough, there are still reasons to think that a soft(ish) landing is still possible; and in Europe, with zero Russian gas flows and a +2.0% policy rate fully priced, risk reward and capital flows may even begin to favour the EUR more clearly – just look at bank deposits at the ECB over the course of the last few days as a possible pre-curser. It is certainly good value at these levels.
To paraphrase the Rolling Stones, in many ways the global macro backdrop has been something of a “crossfire hurricane”, but you can make a case that increasingly “its all right now” .. on one condition … “gas, gas, gas”!
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