Narrative Drift

Today it is more of the same
As energy traders proclaim
No price is too high
For NatGas, to buy
With policy blunders to blame

As such it is not too surprising
Inflation concerns keep on rising
Prepare for a shift
In narrative drift
Which right now CB’s are devising

Perhaps the most interesting feature of markets since the onset of the Covid-19 pandemic is the realization that prices for different things, be they equities, bonds, commodities, or currencies, can move so much faster and so much further than previously understood.  The simple truth is that markets as a price discovery mechanism are unparalleled in their brilliance.  Recall, for instance, back in April 2020, when crude oil traded at a negative price.  The implication was that crude oil holders were willing to pay someone to take it off their hands, something never before seen in a physical commodity market.  (Of course, in the interest rate markets, that had become old hat by then.)  Well, today European natural gas markets have gone the other way, rising 40% in both Amsterdam and London and taking prices to levels previously unseen.  Now, much to the chagrin of European policymakers, there is no upper limit on prices.  As winter approaches, with NatGas inventories currently just 74% of their long-term average, and with most of the EU reliant on Russia for its gas supplies, it is not hard to foresee that these prices will go higher still.

The first issue (a consequence of policy decisions) is that deciding to allow a geopolitical adversary to control your energy supply is looking to be a worse and worse decision every day.  Gazprom’s own data shows that they have reduced the flow of gas to Europe via Belarus and Poland by 70% and via Ukraine by 20% in the past week.  It cannot be surprising that prices in Europe continue to rise.  And the knock-on effects are growing.  You may recall two weeks ago when a fertilizer company in the UK shuttered two plants because the NatGas feedstock became so expensive it no longer made economic sense to produce fertilizer.  One consequence of that was there was a huge reduction in a byproduct of fertilizer production, pure CO2, which is used for refrigeration and has impaired the ability of food processors to ship food to supermarkets and stores.  Empty shelves are a result.  Just today, a major ammonia producer shuttered its plants as the feedstock is too expensive for profitable production as well.  The point is that NatGas is used as more than a heating fuel, it is a critical input for many industrial processes.  Shuttering these processes will have an immediate negative impact on economic activity as well as push prices higher.  If you are wondering why there are concerns over stagflation returning, look no further.

The bigger problem is that there is no reason to believe these prices will sell off anytime soon.  Arguably, we are witnessing the purest expression of supply and demand working itself out.  As a consequence of these earlier decisions, the EU will now be forced to respond by spending more money and reducing tax income in order to support their citizens and businesses who find themselves in more difficult financial straits due to the sharp rise in the price of NatGas.

Now, a trading truth is that nothing goes up (or down) in a straight line, so there will certainly be some type of pullback in prices in the short run.  However, the underlying supply-demand dynamic certainly appears to point to a supply shortage and consistently higher prices for a critical power source in Europe.  Slower economic growth and higher prices are very likely to follow, a combination that the ECB has never before had to address.  It is not clear that they will be very effective at doing so, quite frankly, so beware the euro as further weakness seems to be the base case.

The other main story of note
Concerns a new debt ceiling vote
Majority wailing
The other side’s failing
May yet, a default, soon promote

Alas, we cannot avoid a quick mention of the debt ceiling issue as the clock is certainly winding down toward a point where a technical default has become possible.  Political bickering continues and shows no sign of stopping as neither side wants to take responsibility for allowing more spending, but neither do they want to be responsible for a default.  (Perhaps that sums up politicians perfectly, they don’t want to take responsibility for anything!)  This is more than a technical issue though as financial markets are failing to see the humor in the situation and starting to respond.  Hence, today has seen a broad sell-off in virtually every asset, with equities down worldwide, bonds down worldwide and most commodities lower (NatGas excepted).  In fact, the only thing that has risen is the dollar, versus every one of its main counterparts.

The rundown in equities shows Asia (Nikkei -1.05%, Hang Seng -0.6%, Shanghai closed) failing to take heart from yesterday’s US price action.  European investors are very unhappy about the NatGas situation with the DAX (-2.2%), CAC (-2.15%) and FTSE 100 (-1.8%) all sharply lower.  It certainly hasn’t helped that German Factory Orders fell a much worse than expected -7.7% in August either.  US futures are currently lower by about 1.25% as risk is clearly not today’s flavor.

Funnily enough, bond markets are also under pressure today, with Treasuries (+1.6bps), Bunds (+1.6bps), OATs (+2.2bps) and Gilts (+3.0bps) all seeing heavy selling.  It seems that inflation concerns are a more important determinant than risk concerns as the evidence of rising prices being persistent continues to grow.

In the commodity space, pretty much everything, except NatGas (+0.6% to $6.33/mmBTU) is lower as well, although this appears to be consolidation rather than the beginning of a new trend.  So, oil (-0.6%), gold (-0.5%), copper (-1.0%) and aluminum (-0.85%) are all under pressure.  Given the dollar’s strength, this should not be that surprising, although overall, I continue to expect a rising dollar and rising commodity prices.

As to the dollar, it is king today, rising 1.1% vs NZD, despite a 0.25% interest rate increase by the RBNZ last night, 1.0% vs. NOK and 0.85% vs SEK with the latter seeing a negative monthly GDP outcome in a huge surprise, thus marking down growth expectations significantly for the year.  But the rest of the G10 is much softer save JPY, which is essentially unchanged on the day.  Meanwhile, the euro has fallen a further 0.5% and is now approaching modest support at 1.1500.  Look for further declines there.

As to emerging market currencies, all that were open last night or today are lower with MXN (-1.2%) leading the way on a combination of lower oil and higher inflation, but HUF (-0.9%), ZAR (-0.8%) and CZK (-0.8%) all suffering on either weaker commodity prices are concerns over insufficient monetary tightening in an inflationary economy.  Even INR (-0.7%) is feeling the heat from rising inflationary pressures.  It is universal.

On the data front, only ADP Employment (exp 430K) is due this morning and there are no Fed speakers scheduled.  Right now, it feels like the dollar is primed to continue to move higher regardless of the data, or anything else.  Fear is growing among investors and they are searching for the safest vehicles they can find.  The steepening of the yield curve indicates the demand is in the 2yr, not the 10yr space, which makes sense, as in an inflationary environment, you want to hold the shortest duration possible.  Beware the FAANG stocks as they are very long duration equivalents.  Instead, it feels like the dollar is a good place to hang out.

Good luck and stay safe

The Ceiling for Debt

To traders, the ceiling for debt
Is starting to grow as a threat
As Yellen explained
She’ll soon be constrained
From paying our bills, just not yet

Some folks claim an alternate way
Exists which could help save the day
To quickly influx
A cool trillion bucks
Just mint a new coin to help pay

In addition to all the Congressional drama over the Biden spending agenda, the US is also being buffeted by the debt ceiling drama.  We’ve all seen this movie before, where US law requires Congress to approve the amount of debt that can be issued by the Treasury in order to pay for the spending that Congress mandates.  (A little-known fact is that the debt ceiling was not enacted to impose discipline on Congress, in fact it was the opposite.  Prior to the debt ceiling’s implementation, Congress was required to vote on the funding for each spending bill they enacted on an individual basis.  The debt ceiling was created to allow Treasury to fund the Congressional spending mandates in a smoother and more efficient manner.  My how things have changed!)  But back to our story… the current situation is that the debt ceiling has been reached and the Treasury is not empowered to issue any new debt (it can roll over maturing debt) in the current situation.  While the Treasury does have some cash on hand, and can move funds around in its various accounts, by most measures, it appears that there are about 2 weeks of funding left before the government will have to default on paying some bills on a timely basis.

Now default was never contemplated by the Founding Fathers, with them going so far as to explain in Section 4 of the 14th Amendment of the Constitution:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void. [author’s emphasis]

It is this confluence of events which has led to a somewhat creative thought regarding how the government can overcome their problem, minting a trillion-dollar platinum coin.  One thing that is clear is that the Treasury has the legal right to mint coinage, which is why despite the talk of the Fed printing money, the actual money printer is the Treasury department.  Those $20 bills in your wallet are printed at the US Mint, a part of the Treasury.  And the right to print money is fiercely protected by every nation as it is a good source of revenue (known as seignorage).  Consider, they print money and can use it to buy real stuff, whether tanks, or medicines or anything else.  All of those things cost far more than the paper that money is printed on.  As well, paper money is considered part of the Treasury’s coinage capability.

Now, in economic terms, $20 bills are actually zero-coupon perpetual bonds.  A claim on a fixed notional of assets with no interest rate paid and no maturity date.  The same is true with quarters and dimes and nickels, no maturity date, no interest rate, some ascribed value.  This has led to the idea that the Treasury can mint a coin with a notional value of $1 trillion (made of platinum to denote its high value), deliver it to the Fed and get $1 trillion of spending power in their general account.  This idea was first mooted in 2011 as a similar split in Congress brought the US government very close to an actual default.  Ten years later, as the concept of MMT has become more widely accepted as a viable path forward (it’s NOT), the idea is once again gaining traction.  It certainly solves some problems, notably it prevents a default, but more importantly to the Democrats in Congress, it prevents a distasteful political vote that can be used as a cudgel by Republican opponents in the next election.

Of course, my question is, why would they stop at $1 trillion?  After all, if current spending plans are for $5 trillion, why not mint five coins, or ten so they have some spare change?  You can see the danger of this slippery slope, especially in the current economic environment where inflation is already running rampant.  The addition of $1 trillion or $5 trillion more into the economy without the creation of new products or services would really turbocharge inflation.

While thus far, it seems this idea remains at the margin, given the dysfunctionality of Congress these days, and the shrinking timeline for action, it cannot be ruled out.  My sense is that while it could have a short-term positive impact on the dollar and markets, it would relatively quickly be understood to be a massively inflationary action with both bonds and the dollar suffering accordingly.

OK, with that food for thought, let us take a look at market activity today.  The first thing to note is that China is in the midst of its Golden Week holidays, which means there are no markets there until next week.  Hong Kong (-2.2%) and Tokyo (-1.1%), however, were both open, although neither had a very positive session.  Hong Kong suffered as they halted trading in Evergrande shares and other real estate companies fell sharply.  Europe, on the other hand has edged slightly higher this morning, (DAX +0.0%, CAC +0.2%, FTSE 100 +0.2%) although it is hard to get too excited over the movement.  US futures, on the other hand, are all pointing a bit lower, on the order of -0.4% at this hour.

Bond markets are seeing some selling this morning with 10-year Treasury yields higher by 3.5bps, although since the very sharp move last week, they have been consolidating either side of 1.50% yields.  European sovereigns are also under some pressure with yields there moving up (Bunds +1.8bps, OATs +1.6bps, Gilts +2.0bps), although there has been precious little news on which to trade.

In the commodity market, oil prices continue to trade higher (WTI +0.3%) as does Nat Gas (+2.3%).  While precious metals are under some pressure (Au -0.6%), industrial metals are firm this morning (Cu +1.35%, Al +0.6%) and agricultural prices are mixed in slow trading.

As to the FX market, the dollar is definitely under some pressure this morning with CHF (+0.45%) leading the way higher in the G10 with NOK (+0.4%) and GBP (+0.4%) next in line.  The only laggard today is JPY (-0.15%) which is confusing given the Swiss franc’s performance as otherwise, one could consider this a somewhat risk-on day.  But US equity futures are not helping that story either.  In the EMG space, things are a little clearer as the CE4 (HUF +0.75%, PLN +0.6%, CZK +0.3%) are the top performers as all of them continue to get supported by central bank comments regarding tighter monetary policy.  On the downside, MXN (-0.45%) is suffering the opposite as Banxico comments indicated that there would be no 50 basis point rate hikes anytime soon, something the market was beginning to price in.  Net, the dollar is probably slightly softer, but the recent uptrend remains intact.

Data this week is fairly slow up until Friday’s payroll report:

Today Factory Orders 1.0%
Tuesday Trade Balance -$70.6B
ISM Services 59.9
Wednesday ADP Employment 430K
Thursday Initial Claims 350K
Continuing Claims 2770K
Consumer Credit $17.5B
Friday Nonfarm Payrolls 470K
Private Payrolls 450K
Manufacturing Payrolls 25K
Unemployment Rate 5.1%
Average Hourly Earnings 0.4% (4.6% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.7%

Source: Bloomberg

A couple of things worth mentioning are that last week, the NFP forecast was 535K, so starting to slip.  Also, we continue to hear that there is no wage inflation, yet 4.6% Y/Y will be the highest non-Covid related level since before the GFC.  On the Fed speaker circuit, this week is far less noisy with only 4 speakers, none of whom are going to change the narrative.

As to the dollar overall, I believe we are in an uptrend for now, having broken through previous strong resistance, and I expect that we are likely to see this trend continue.  Use pullbacks to hedge, but they will not be large in my view.

Good luck and stay safe