Wholesale gas prices have trebled since the summer and this threatens to lead to a sharp jump in energy bills in the months to come. In a country like the UK, which is heavily dependent on gas for electricity generation, this could be particularly problematic – especially since the UK has lacked the ability to store gas in large quantity since the closure of the Rough storage site under the North Sea in 2017.
Gas inventories across Europe are particularly low, putting Moscow in a strong position vis a vis the rest of Europe. This could raise interesting geopolitical questions, but in the near term, the bigger issue facing a number of countries is the impetus that recent energy price moves may give to inflation indices over the coming months.
Price pressures within many economies have been elevated due to supply shortages. High shipping costs and ongoing disruption in China – which manufactures one-third of global output – suggests that ‘transitory’ effects may persist for at least another six months, if not longer.
An energy price shock on top of this could see UK inflation rise above 6% in the next few months, which is well above central bank projections that have seen a CPI inflation peak closer to 4%. There is a question of whether higher inflation will act as a tax hike and thus depress consumption, and it is certainly possible to view higher utility bills in this light.
Elsewhere, consumer balance sheets remain healthy and savings have increased during the pandemic. This could suggest that consumers can continue spending even as prices rise. Moreover, consumption can be expected to trend with growth in incomes and with economies posting solid job gains on the back of strong demand for labour and with wages also showing signs of picking up, it still seems appropriate to look for robust economic growth in the months ahead.
Indeed, higher inflation may act as an incentive to spend in the near term, if cash is seen losing value in real terms and consumers decide they had better spend today, rather than waiting for higher prices.
Overshooting inflation risks lifting inflation expectations. In this context, a survey by the New York Federal Reserve this week showed respondents now expect US prices to rise by 4% in the year ahead – a marked pick-up from the prior survey. Moreover, prevailing inflation rates may appear very disconnected from bond yields, with central banks effectively sustaining bond prices based on their QE purchases.
Yet there is a sense that as these purchases recede, fixed income assets may need to establish a new clearing level – biasing yields to the upside. In this context, European yields have nudged higher in the past week, with the ECB announcing plans to reduce the pace of its balance sheet expansion in the coming months.
However, we believe that euro government bonds should be better supported than US Treasuries or UK Gilts as this process unfolds. Eurozone inflation has been undershooting on the downside for a number of years and is likely to remain at levels well below the US or UK.
On the back of this, we have been adding to short positions in Gilts relative to Bunds over the past week as Bunds have sold off.
US yields have been little changed over the week. The August CPI report was relatively benign, yet we believe that it may be too complacent to think that US inflation has peaked and will trend lower as transitory factors drop out. Indeed, for the factors outlined above, we would not be surprised to see a new peak in inflation in the next few months and for CPI to remain close to 5% until Easter.
With the economy appearing to regain momentum after being sidelined by the rise of the Delta variant in August, we think we can see robust data as we move towards Q4, with the Empire business survey pointing to a healthy bounce in September from August weakness, and retail sales yesterday surprising to the upside.
Credit markets remain rangebound against the backdrop of low volatility. New issuance has been well absorbed during the past several weeks, but it seems that there is little impetus to drive spreads materially tighter.
In the eurozone, periphery yields have rallied modestly as Bunds have sold off. Seasonal factors should also turn more constructive for spreads over the next few months. Meanwhile, moves by Greece, Spain and Italy to cut taxes to alleviate the impact of higher energy costs don’t appear to have troubled fixed income investors. However, we would expect increased fiscal scrutiny from the hawks in Northern Europe as the eurozone economy recovers.
FX markets have also been broadly rangebound, though the Norwegian krone has been a strong performer, helped by a rally in oil prices plus expectations for an upcoming rate hike from the Norges Bank.
The Federal Reserve monetary policy meeting should provide the focus for markets in the week ahead. We believe that the Fed may formally announce its taper plans, with a reduction in purchases starting in November. It is possible that this announcement will be pushed back to the next meeting if Fed participants remain uncertain in the face of Delta and other cross-winds in the economy.
But our sense has been that Powell has wanted to give markets plenty of advance warning of upcoming policy steps, so as to try to mitigate the risk of a taper tantrum in markets. Ultimately, the Fed taper has been well flagged and widely discussed for much of the past six months and so it should not be a big shock when it comes.
However, the powerful technical of the Fed absorbing USD120 billion per month of Treasury supply will start to disappear and so it would be very surprising if there was not some reaction in yields as this commences – even if an improving economy helps shrink the government deficit and issuance requirement.
After all, the point of QE in the first place was to drive longer-dated yields lower. Given that this was largely effective, it stands to reason that this should reverse once QE comes to an end.
Returning to the topic of inflation and energy prices, it would seem wrong to draw any parallels with the 1970s. Yet higher gas prices should continue to be underpinned by robust demand and green policies, which have seen Europe turn-off from coal and run-down nuclear ever since the Fukushima disaster in Japan five years ago.
With renewables struggling to fill the gap – especially if the sun isn’t shining and the wind isn’t blowing hard enough, it seems that we may need to get used to higher prices.
Of course, it could be possible to turn some coal generation back on, but in the example of the UK, this is very difficult to square with Johnson hosting the COP26 summit and wanting to portray the UK as an emerging green superpower.
The risk is of a winter of discontent, only compounded by bare shelves on the back of Brexit supply disruptions and a shortage of workers in key sectors exacerbating supply chain issues already prevalent in the wider global economy. With UK energy supply also affected by an upcoming loss in the ability to import power from France due to nuclear shutdowns and a cable fire creating damage in the past week, there has even been discussion relating to power outages in the months to come.
Energy poverty at a national level, as well as at a personal level, could represent a stagflationary risk. We can hope that this doesn’t come to pass, though looked at from another angle, this only seems to underpin the need for further substantial infrastructure investment in green technologies.