As energy prices ascend
More problems they seem to portend
Inflation won’t quit
While growth takes a hit
When will this bad dream ever end?
Another day, another new high in the price of oil. We have now reached price levels not seen in seven years and there is no indication this trend is going to end anytime soon. Rather, given the supply and demand characteristics in the marketplace, it is not hard to make a case that we will be seeing $100/bbl oil by Q1 2022, if not sooner. OPEC+ just met and, not surprisingly, decided that they were quite comfortable with rising oil prices thus saw no reason to increase production at this time. Meanwhile, Western governments continue to do everything in their power to prevent the expansion of energy production, at least the production of fossil fuels. This combination of policies seems likely to have some serious side effects, especially as we head into winter.
For instance, while I have highlighted the price of energy in Europe and Asia, which remains far higher than in the US, it is worth repeating the story. Natural gas in Europe is now trading at $37.28/mmBTU, compared with just under $6/mmBTU in the US. Storage levels are at 74% of capacity which means that any cold snap is going to put serious pressure on the Eurozone economy as NatGas prices will almost certainly rise further in response. In addition, Europe remains highly dependent on Russia as a supplier which seems to open them to some geopolitical risk. After all, Vladimir Putin may not be the friendliest supplier in times of crisis.
China, too, is having problems as not only has the price of oil risen sharply, but so, too, has the price of thermal coal (+5.25% today, +200% YTD). China still burns a significant amount of coal to produce electricity throughout the country with more than 1000 plants still operating and nearly 200 more under construction. It is this situation which causes many to question President Xi Jinping’s commitment to reining in carbon emissions. Unsurprisingly, the inherent conflicts in the desire to reduce carbon, thus capping coal production, while trying to generate enough electricity for a growing economy have resulted in the Chinese abandoning the carbon issues. Last week, Xi ordered coal mines to produce “all they can” rather than adhere to the strict quotas that had been put in place. Right now, there is a power crisis as utilities have cut back electricity production reducing service to both industrial and residential users. Again, winter is coming, and insufficient electricity is not going to be acceptable to President Xi. When push comes to shove, you can be sure that the primary goal is generating enough electricity for the economy not reducing carbon emissions.
Ultimately, this story is set to continue worldwide, with the tension between those focused on economic activity and growth continually at odds with those focused on carbon dioxide. Until nuclear power is accepted as the only possible way to create stable baseload power with no carbon emissions, nothing in this story will change. The implication is that energy prices have further, potentially much further, to run given the inelasticity of demand for power in the short-term. And this matters for all other markets as it will impact both growth and inflation for years to come.
Consider bond markets and interest rates. While the Fed and other central banks may choose to ignore energy prices in their policy decisions, the market does not ignore rising energy prices. The ongoing increase in inflation around the world is going to result in higher interest rates around the world. While central banks may cap the front end, absent YCC, back end yields will rally. A rising cost of capital is going to have a negative impact on equity markets as well, as both future earnings are likely to suffer and the discount factor for those who still consider DCF models as part of their equity analysis, is going to reduce the current value of those future cash flows. The dollar, however, seems likely to benefit from rising oil and energy prices, as most energy around the world (in wholesale markets) is priced in USD. Essentially, people will need to buy dollars to buy oil or gas. Adding all this up certainly has the appearance of a more substantial risk-off period coming soon. We shall see.
This morning, however, that is not entirely clear. While Asian equity markets saw more red than green (Nikkei -2.2%, Sydney -0.4%, Hang Seng +0.3%, Shanghai closed), Europe is feeling positively giddy with gains across the board (DAX +0.35%, CAC +0.8%, FTSE 100 +0.65%) as PMI data showed more winners than losers although it also showed the highest price pressures seen since 2008, pre GFC. US futures, after markets had a tough day yesterday, are pointing higher at this hour, with all three main indices higher by about 0.35%.
Bond markets are a bit schizophrenic this morning as Treasury (+1.9bps) and Gilt (+2.0bps) yields climb while we see modest declines in Europe (Bunds -0.2bps, OATs -0.3bps). While yields remain low on a historic basis, and real yields remain extremely negative, it certainly appears that the trend in yields is higher. There is every possibility that central banks blink when it comes to fighting inflation and ultimately do prevent yields from rising much further, but so far, they have not felt compelled to do so. This is something we will be watching closely going forward.
Turning to commodities, oil (WTI +1.05%) shows no signs of slowing down. Nor does NatGas (+3.0%) or coal (+5.25%). Energy remains in demand. Precious metals, on the other hand, continue to flounder with both gold (-0.85%) and silver (-0.7%) under pressure. Copper (-1.75%) too, is feeling it today along with the rest of the industrial metal space save aluminum (+0.6%). Ags are softer as well.
The dollar, however, is having a much better day, rallying against most of its major counterparts. For instance, JPY (-0.3%) continues to suffer as the market demonstrates a lack of excitement over the new PM and his team. Meanwhile, EUR (-0.2%) has reversed its consolidation gains and appears set to resume its recent downtrend. Technically, the euro looks pretty bad with a move toward 1.12 quite realistic before the end of the year. AUD (-0.2%) found no support from the RBA’s message last night as they continue to look toward 2024 before interest rates may start to rise. On the plus side, only NOK (+0.2%) on the back of oil’s gains, and GBP (+0.2%) on the back of a stronger than expected PMI release are in the green.
EMG currencies have also seen many more laggards than gainers led by HUF (-0.5%) and PLN (-0.3%) both high beta plays on the euro, and MXN (-0.2%) and RUB (-0.2%) both of which are somewhat surprising given oil’s continued rise. The bulk of the APAC currencies also slid, albeit only in the -0.1% to -0.2% range, with several simply adjusting after several days with local markets closed. ZAR (+0.35%) is the only gainer of note as the Services PMI data printed at a better than expected 50.7.
On the data front, the Trade Balance (exp -$70.8B) and ISM Services (59.9) are on the slate and we hear from Vice-Chair Quarles on LIBOR transition. In other words, not much of note here. While I believe oil prices remain the key driver right now, there is certainly some focus turning to Friday’s payroll data as that is the last big data point before the Fed’s November meeting.
The dollar’s trend remains higher and I see no reason for anything to halt that for now. My take is the modest correction we saw Friday and Monday is all there is for now, and a test of the recent highs is coming soon to a screen near you.
Good luck and stay safe