At All Costs#

Ahead of the winter’s white frosts
The Chinese told firms, “at all costs”
Get oil and gas
And coal, so en masse
Our energy never exhausts

In Europe, as prices keep rising
For Nat Gas, most firms are revising
The prices they charge
Which has, by and large
Helped CPI keep on surprising

Ostensibly, the reason that the Fed, and any central bank, looks at prices on an -ex food & energy basis is because they realize that they have very little control over the prices of either one.  The only tool they have to control them is extremely blunt, that of interest rates.  After all, if they raise interest rates high enough to cause a recession, demand for food & energy is likely to decline, certainly that of energy, and so prices should fall.  Of course, precious few central bankers are willing to cause a recession as they know that their own job would be on the line.

And yet, central banks cannot ignore the impact of food & energy prices on the economy.  This is especially so for energy as it is used to make or provide everything else, so rising energy prices eventually feed into rising prices for non-energy products like computers and washing machines and haircuts.  As has become abundantly clear over the past months, energy prices continue to rise sharply and alongside them, we are seeing sharp rises in consumer prices as well.

Protestations by Lagarde and Powell that inflation is transitory do not detract from the fact that energy prices are exploding higher and that those charged with securing energy for their country or company are willing to continue to pay over the odds to do so.  Yesterday, an edict from the Chinese government to all its major companies exhorted them to get energy supplies for the winter “at all costs.”  This morning, they followed up by telling their coal mining companies to produce at maximum levels and ignore quotas.  Clearly, there is concern in Beijing that with winter coming, there will not be enough energy to heat homes and run factories, an unmitigated disaster.  But this price insensitive buying simply drives the price higher.  (see Federal Reserve impact on bonds via QE for an example.)

And higher these prices continue to go.  Nat Gas, which is the preferred form of fossil fuel, continues to rise dramatically in both Europe and Asia.  In both geographies, it has risen to nearly $35.00/mmBTU, almost 6x as expensive as US Nat Gas.  On an energy equivalent basis, that comes out to $190/bbl of oil.  And you wonder why the Chinese want to dig as much coal as possible.  The problem they are already having, which is adding to their overall economic concerns, is that they have run into an energy shortage and have been restricting power availability to the industrial sector in order to ensure that households have enough.  Of course, starving industry is going to have a pretty negative impact on the economy, hence the call for obtaining energy at all costs.  But that has its own problems, as driving prices higher will divert spending to energy from both investment and consumption.  In other words, as is often the case, there is no good answer to this problem.

If you are wondering how this impacts foreign exchange, let me explain.  First, energy is priced in dollars almost everywhere in the world, at least at a wholesale level.  So, buying energy requires having dollars to spend to do so.  I would contend one reason we have seen the dollar maintain its strength recently, and break out of a medium-term range, is because countries are panicking over their winter energy needs and need dollars to secure supplies.  Second, as energy prices rise, so too does inflation.  And while Mr Powell continues to refuse to accept that is the case, the market is not so stubborn on the issue.  We have seen the yield curve steepen sharply over the past several weeks, something which is historically a dollar positive, and with expectations for the taper firmly implanted into the market’s collective conscience, the strong view is interest rates in the US are going higher.  This, too, is very dollar supportive.  While I remain unconvinced that the Fed will ultimately be willing to tighten policy in any significant manner, that remains the current market narrative.  We shall see how things evolve, but for now, the dollar has legs alongside interest rates and energy prices.

Ok, to today’s price action.  The notable thing is the reduction in risk appetite that has been evident for the past several sessions.  For instance, yesterday we finally achieved a 5% correction in the S&P 500 for the first time in more than 200 sessions.  While prices remain extremely overvalued on traditional measures, it is not yet clear if the ‘buy the dip’ mentality will prevail as we enter a new fiscal quarter.  We shall see.

Overnight, Asia was mostly lower (Nikkei -2.3%, Hang Seng -0.4%) but Shanghai (+0.9%) managed to rally.  Of course, remember, Shanghai has been massively underperforming for quite a while.  Other than China, though, the rest of Asia was all red.  Europe, too, is bright red this morning (DAX -0.8%, CAC -0.8%, FTSE 100 -1.0%) as the broad risk-off sentiment combines with modestly weaker than expected PMI data and higher than expected Eurozone CPI data.  As to the latter, the 3.4% headline print is the highest since Sept 2008, right at the beginning of the GFC.  Yesterday, German CPI printed at 4.1%, which is the highest level since the wake of the reunification in 1993.  For a culture that still recalls the Weimar hyperinflation, things must be pretty uncomfortable there.  It is a good thing this inflation is transitory!

Not surprisingly, with risk being jettisoned, bonds are in demand this morning and although Treasuries are unchanged in this session, they did rally all day yesterday with yields declining nearly 5bps.  As to Europe, Bunds (-3.2bps) and OATs (-3.2bps) are firmly higher with the rest of the continent while Gilts (-1.5bps) are not seeing quite as much love despite an underperforming stock market.  I think one reason is that UK PMI data was actually better than expected and higher than last month, an outlier versus the continent.

Commodity prices are mixed this morning as despite my opening monologue, oil (WTI -0.9%) and Nat Gas (-0.7%) are both under pressure.  Of course, both have been rallying sharply for months, so nothing goes up in a straight line.  Precious metals are little changed on the day, but industrial metals are strong (Cu +1.6%, Al +0.5%, Sn +1.2%).  Ags, on the other hand, are mixed with no pattern whatsoever.

As to the dollar, it is under modest pressure this morning in what appears to be a consolidation at the end of the week.  The one noteworthy mover in the G10 is NOK (+0.75%) which is rallying despite oil’s decline as the market reacted to a surprisingly large decline in the Unemployment rate there to 2.4%.  But otherwise, GBP (+0.3%) is the next best performer and the rest of the bloc is +/-0.2%, with CAD (-0.2%) the laggard on weak oil prices.

EMG currencies have many more gainers than losers this morning with only RUB (-0.6%) on oil weakness, and KRW (-0.35%) on a smaller than expected trade surplus, declining of note, while THB (+0.6%), PLN (+0.6%) and HUF (+0.4%) all have shown some strength.  In Bangkok, the central bank vowed to monitor the baht, which has been falling steadily over the past 9 months to its weakest point in more than 4 years.  PLN saw higher than expected CPI data (5.8%) which has the market looking for higher rates from the central bank, while HUF was the beneficiary of central bank comments that the monetary tightening campaign was “far from the end.”

There is a veritable trove of data to be released this morning starting with Personal Income (exp 0.2%), Personal Spending (0.7%) and the Core PCE (3.5%) at 8:30.  Then at 10:00 we see ISM Manufacturing (59.5) and Prices Paid (78.5) as well as Michigan Sentiment (71.0).  If the PCE number prints on plan, the Fed will be crowing about how it, too, is falling and has peaked.  However, that is crow they will ultimately have to eat, as the peak is not nearly in.

The underlying picture for the dollar remains quite positive on both a technical and fundamental basis, but it appears today is a consolidation day.  Perhaps, a good time to buy dollars still needed to hedge.

Good luck, good weekend and stay safe
Adf