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“…Im only happy when its complicated”

Garbage, Only Happy When It Rains

Last week we discussed the evolving financial market backdrop, as the focus continues to shift away from inflation and towards the implications of prices and the autonomous monetary response on the prospects for global growth. In particular, we highlighted the rising significance of the deepening energy crisis in Europe - above and beyond the threat of inflation and or the resultant tightening in financial conditions. This week, as EUR trades (briefly so far) below parity with the USD, some of those risks for the eurozone appear to be coming to fruition. There is an old British saying: “It never rains but it pours” - in reference to the fact that misfortunes or difficult situations tend to follow each other in rapid succession or to arrive all at the same time. In Europe, in the midst of a heatwave, it is (at least metaphorically) pouring!

This week marked the start of the ten day Nordstream 1 gas pipeline maintenance period. A factor that has been at the heart of the recent acute energy concerns in the region and from my perspective the dominant factor in the EUR lurch from 1.05 towards (and marginally through) parity. Indeed, each of the three recent moves in EUR below 1.05 have come as a result of the threat of curtailment or the curtailment of Russian gas supply to Europe.

The debate now is clearly what the supply looks like at the end of the maintenance period and there are two schools of thought: the first is that Russia does not turn on the gas at the end of next week - or at least does so such that the supply is so unreliable or in sufficiently low volumes that Russia keeps maximum economic pressure on Europe (especially if this extends into the Winter). The second, is more optimistic. That Russia does not have an alternative pipeline, storage capacity or liquefaction capacity and therefore will reopen the taps to Europe - albeit perhaps not at the level that Europe may desire in order to fill its winter storage tanks. I would err on the more positive side as I would imagine a maximally unreliable supply chain is too similar to no supply chain that there is a possibility the pipeline never returns to use if it does not do so after ‘scheduled maintenance’.

The question now is what the return of the flow looks like relative to the risks priced into the market - I would also suggest this offers a modestly positive trade-off.

The recent uptick in global inflation and the Fed-led further hawkish pivot to regain control of the inflation narrative has, as we have discussed, intensified market fears of recession. While we remain more positive than the consensus on both Chinese and US growth dynamics, global growth is clearly slowing from its reopening rebound pace. The global slowdown amid high energy and commodity prices has damped sentiment towards the energy consuming global export model of Germany - and by extension Europe.

Indeed, Covid related supply chain disruption and more recently slowing Chinese economic activity have also played a part in the slowdown of German (and European) exports to the point that the monthly current account surplus for Germany was just EUR 2.5 billion (down from above EUR 30 billion at the peak, 2017-2021).

At the same time Inflation in the eurozone has been sufficient to warrant a normalisation of monetary policy, or at least the removal of emergency monetary settings (QE, negative deposit rate, favourable TLTRO borrowing). However, there is no agreement on the backstop tool for the monetary transmission mechanism or mechanism by which the European Central Bank (ECB) can address or even counteract the widening of peripheral spreads as monetary policy tightens.The difficulty comes due to the fact that monetary financing is illegal within the treaties and widening spreads as a function of credit and debt affordability changes are also central to the proper functioning of financial markets. We will be very keen to see how the ECB squares this circle at its policy meeting next week.

Even this itself is threatened to be made more complex this week by the prospect of instability in the Italian unity government that has until now brought calm to global markets. And the narrative from the German GC rep are far from suggestive of the likelihood of greater fiscal cooperation going forward - especially as the economic model of Germany is being so severely tested by the cost and reliability of the Russian energy supply upon which the German industrial prowess is built
In short, Europe remains most sensitive to the global and idiosyncratic growth risks of recent events.

In the US, this week we have seen a further jump in the inflation data as headline CPI for June rose to 9.1% - many analysts continue to be concerned by the broadening of contributors to the headline with 42% of the basket now showing an annualised inflation rate of above 6%.

I have a couple of thoughts: Firstly, I continue to believe that the current inflation backdrop must be looked at through the lens of the pandemic response - the unprecedented fiscal stimulus. In much the same way that US retailers extrapolated consumer demand for goods into the post pandemic world (and then capitulated and sold off excessive inventories as demand shifted back to services upon reopening), there is a danger that this demand shock is being extrapolated in analyst inflation expectations. This demand has also spread, like the ripples of a wave into broader service sectors but I would argue that this is not a self sustaining inflation change, but a one off demand shock working its way through the system (People may be willing to pay $1000 for a hotel room that cost $500 last year because they have been locked up due to Covid. Their ability or desire to pay $2000 next year, however, is much less clear).

It could also be argued that this demand shock is generating heightened recessionary fears as markets are unable to differentiate slowing activity from a stimulus induced one off demand shock, back to longer term equilibrium levels (which remain healthy), and a more sinister demand destruction leading to recession.

In the near term, the factors seem to be conspiring against the EUR {energy security, recession fears, interest rate differentials, risk aversion...} and in the very short term the risks likely remain biased towards the downside for EURUSD. However, from our viewpoint selling EURUSD at these levels is likely a low Sharpe ratio trade.

In the longer term, while we are not negative on the US growth trajectory - certainly not relative to current expectations, we are increasingly sympathetic to the prospect of a more structural decline in the USD - albeit one that is likely not ready to start just yet. In this regard it is important to put the recent stimulus driven demand surge into context (the stimulus and the ripple effects on goods and then into services as global economies reopened) - This has implications for US and global growth prospects and for rate differentials.

Furthermore, with core inflation continuing to edge lower, and with rate markets maximally pricing a Fed reaction function that pushes US rates deep into restrictive territory, it is possible - as was suggested by Fed Waller this week - that markets are getting ahead of themselves. In short, a fully priced Fed, an overpriced recession risk, and a maximally priced European energy disruption risk likely overemphasise the medium downside risks for the EUR - admittedly the short term is more vulnerable to knee jerk reactions to unhelpful headlines.

In the bigger picture, to paraphrase Garbage, the USD, at these levels, is only likely happy when it’s complicated… only happy when it rains. Our outlook may not see uninterrupted sunshine for Europe, but a passing of the dark clouds might be enough for the EUR.

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    FOMC Meeting, June 2022 - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20220615.htm

    Semiannual Monetary Policy Report to the Congress 22, June 2022 - https://www.federalreserve.gov/newsevents/testimony/powell20220622a.htm


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