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The Big Conversation

Episode 112: Is the fed at peak policy?

This week we look at the rapid repricing of interest rate expectations. The US is expecting around six hikes and even the ECB is being priced at two. Has the hiking hysteria now reached a peak? In the chatter, Real Vision’s Roger Hirst talks to Refinitiv’s Anders Nordeng about the rising price of the European carbon market. This is the system that other policymakers are using as a blueprint for their own markets, and the speed of the price gain is being watched closely.

  • Roger [00:00:00] Over the last couple of weeks, we've seen an intense repricing of interest rate expectations, with up to 6 US hikes being priced for the end of 2022 and up to two priced for the European Central Bank after a pivot from President Legarde. But are we now reaching peak hawkishness? That's The Big Conversation.

    Roger [00:00:22] Perhaps the biggest surprise over the last few weeks was the about-turn from the ECB. For most of the last 12 months, President Lagarde had refused to be drawn into discussions about inflation and rate expectations. But all of that changed recently with her comments about 'the normalisation of our monetary policy'. Rate expectations rapidly repriced, here using the Euribor short-term interest rate future and converting it into an implied funding rate. Even though we're only talking about 60 basis points of potential tightening, this is a big change for Eurozone Markets. Now to put that in perspective, the ECB's deposit facility has been below zero since the middle of 2014. A couple of hikes in 2022 would take the deposit rate back to zero. And this repricing of interest rate expectations has had knock-on effects across the yield curve. German 2-year yields at the highest level since 2015. Whilst the German 10-year yield has moved back into positive territory for the first time since 2019. Even Japan's government yields have jumped on the bandwagon; 10-year yields have risen to their highest level since 2016, which was a year when the BOJ initiated a policy of yield curve control, in order to stabilise the bond markets. But of course, for Europe, higher interest rates are a double-edged sword. Banks want higher yields to improve their net interest margins and therefore profitability, which in turn helps to pay down some of their debts. But for many banks, their debts are so large the gains in profitability could be more than offset by the rise in financing costs implied by higher interest rates. And that's one of the reasons why investors thought that the ECB could never meaningfully raise interest rates and hence the surprise at Lagarde's sudden change of heart. And if the ECB is aiming to tackle inflation with higher rates, then Europe really has the wrong mix of inflation for this to be successful. Food and in particular energy are the main culprits for higher eurozone inflation. Eurozone core inflation is still under 3 percent, 2 percent below the all-item inflation. This is a supply-side issue, rather than rampant demand. And the breakdown in Europe is a very different type of breakdown from the one in the US. There it's all about used vehicles, rental cars, transportation and new vehicles, which are 4 of the top 8 inflationary items in the US. US wages are, however, starting to be impacted. Average hourly earnings in the non-farm payrolls report are now just under 6 percent, with US workers demanding more flexibility. European workers have already experienced many of these workplace changes, meaning there should be less upward pressure on European wages. And despite the latest US CPI print easily beating expectations in January, when it came in at 7.5 percent versus 7.3 percent forecast, many of the comparisons will get a lot easier from here. Firstly, base effects across much of the commodity complex will place downward pressure on future CPI prints. Now, that doesn't mean prices are falling, but they won't be rising as quickly. Secondly, the pandemic surge in goods consumption has likely peaked, and will probably subside as restrictions are lifted and consumers substitute goods spending, that accelerated when consumers were forced to stay at home, with the services spending of going out to restaurants or taking vacations. Economist Andreas Steno Larsen also highlights an additional accelerator in the US of this dynamic. The US CPI basket has changed; with the weighting of stay-at-home items increasing, at the expense of going out items. Therefore, when the substitution effects of consuming services, instead of goods kicks in, it will amplify the decline in inflation because prices will be falling on a large component of that CPI basket. Additionally, we may already have experienced peak US growth expectations. The consensus is for higher inflation, higher interest rates, stronger economic growth and higher earnings. But the flattening US yield curve, however, is hinting the best may be behind us. The commonly used US 10-year versus 2-year portion of a government curve, has recently dipped under 40 basis points. An inversion has preceded all recessions since the 1980s, although the inversion usually takes place many months before a recession actually occurs. So could the yield curve really be flashing a warning? It could be a false warning, but there are two other possibilities. Firstly, the pandemic and the policy response, may have distorted the final months of the previous economic cycle, which lasted from 2009 until 2020 and was already the longest expansion in history. Maybe the cycle still has unfinished business. Secondly, the policy response and a subsequent bout of inflation, may have now created a far more volatile economic cycle, much more like the 1970s when we saw shorter periods of expansion and contraction. But no one really knows, but what does matter is that expectations have become very one-sided. When the consensus has shifted this dramatically towards higher growth, it becomes much harder for those expectations to be beaten, and much easier for those expectations to miss. Long-dated yields have nudged higher, but they remain incredibly low given the levels of inflation. Real yields, which is actual yields minus inflation, are still incredibly subdued. U.S. earnings have been robust and guidance has been almost universally positive. But if those earnings were based on consumption of goods, which is now peaking, then those expectations may not be met. Michigan consumer sentiment is lower today, than it was during the depths of the pandemic, and that's largely because of the price surge in large ticket items. And at the same time, it's hard to see how policymakers step back from their current path. The Fed is now fighting against price, rather than supporting growth. Inflation, which is high, and employment, which is tight, are both backward-looking data points that will remain sticky even as the Fed tightens. The underlying economy has proven again and again, that it can't take significantly higher interest rates and yields, and the yield curve is already indicating that level of intolerance once more. We should therefore, expect greater volatility across asset classes and economic data. But the speed with which rate expectations have moved higher in Europe and the US suggests that we are probably at peak policy hawkishness for this cycle.

    Roger [00:06:28] Energy transition is one of the investment megatrends, a key element of that transition will be a robust market for pricing carbon. Carbon markets are being developed in every major region. Though it's the European market that's developed the greatest depth and liquidity. Prices have soared, but should we equate higher prices with success? I chatted to Refinitiv's Anders Nordeng, about the outlook for carbon markets in general and the impact that the European experience is having on developments in this sector.

    Roger [00:06:56] Anders thanks very much for joining us on The Big Conversation. And could you just give a brief overview again of the sort of intention and the main purpose of the carbon markets?

    Anders [00:07:06] That is basically a policy instrument I would say more than a market. It's a way to price carbon emissions, and it's one of several possible ways you could have taxation, you could have direct regulation, or you could have emission trading.

    Roger [00:07:23] What are the big regions that we have these? What are the major areas where these carbon markets exist, and which are the biggest ones?

    Anders [00:07:28] By far the most dominant one is in Europe, the EU ETS, the European Union Emission Trading System. With recently a new standalone version in the UK since the UK left the European Union, but you have also elsewhere in the world, you have for example, two systems in North America; the Western Climate Initiative, which is basically California plus Quebec; and then the second smaller one in the northeastern part of the U.S. And then interestingly, in the recent years, you've seen South Korea coming online, I think they launched theirs properly in 2015. And obviously, last year, China launched a national, a nationwide emission trading system.

    Roger [00:08:12] Can you maybe just outline how that European system has been going over the last couple of years? Maybe just outline the very basics of how that system works and how that's been progressing over this maybe last two year period, particularly since the pandemic?

    Anders [00:08:24] It was launched in back in 2005, and it's been a little bit of a rollercoaster since then. Ups and downs and a lot of learning by doing, it entered its third trading period as it was called in 2013 and with some new revisions now from 2020. But it's broadly it's along the same lines as we've seen since 2013. But what is, has been interesting over the last 2 years, is really we've seen the skyrocketing prices, after some years in you know, of prices around 5 euros per ton of CO2, from 2018 onwards, we've seen a quite, quite stable and at times very steep price rise, which I mean, there are several reasons behind that, but we would argue that the main one is a new sense of commitment from European policymakers, that this is really intended to be the flagship climate policy instrument.

    Roger [00:09:28] Has it been almost too successful and is that a problem? Does that create barriers to companies thinking of potentially locating within the European area?

    Anders [00:09:36] I'm not sure if it has really come to that point yet, but but certainly we have seen inflow of new types of stakeholders that weren't very active before. And this again, you could see the development of prices since 2018 and the increased share of positions held by hedge funds, for example, pension funds. And then the question of whether this creates barriers. I mean, we interestingly, maybe we have a survey every year called the Carbon Market Survey, where we ask also that category of respondents, compliance companies, so the industries and the power companies; to what extent the price is, is becoming detrimental for their competitiveness? And maybe no big surprise, as prices have risen, we have seen a higher share, saying that it is, or can be detrimental. But so far, we see a relatively small share saying that they have moved abroad or are thinking of moving production to, to locations outside of the European Union.

    Roger [00:10:42] Do you think the regulators will have to maybe tweak the system again in order to make sure that prices don't move so quickly, that it actually becomes incredibly detrimental?

    Anders [00:10:49] We do see signs of that, actually. And I mean, we are in the middle of a huge new reform. It's only 2 or 3 years since the previous big, big reform of the EU ETS. And now we because of the new 2030 climate target to reduce emissions by 55 percent, I mean, that basically requires the whole system to be recalibrated to meet that target. So we're in the middle of that process and in the EU ETS directives of the centerpiece of the legislation, so to say, there is a clause that might allow for intervention to curb prices in the event of, I can't remember exactly the wording, but it basically says, if it's excessive, if it's enduring and if it's not caused by fundamental factors, so those 3 criteria need to be met. And many, of course, would argue that we have been in such a situation for a long time already. But so far the Commission, The European Commission has you know said that it's it's because of fundamentals so there is no reason to intervene by adding extra supply. But last week, the lead, the rapporteurs of the MEP in charge of shepherding this process through the European Parliament, he argued that we might now need to look at that article again and simply by saying so, he instantly caused a tiny crash of the price from 96 to 90 euros.

    Roger [00:12:19] Ultimately, it still feels like this is potentially the sort of the pioneer system globally. And is that going to be the case? Do you think people are still really watching what Europe does?

    Anders [00:12:27] I think so, especially the new markets in Asia. You know, they are very much modeled on the experiences from the European system, both in Korea and in China.

    Roger [00:12:37] The European market has generally been considered a success by policy-makers, but that doesn't mean it's been plain sailing. Regional regulators are closely watching developments in the European market, which is still the blueprint for many newcomers. European regulators will continue to tweak their market structure, so those short-term costs don't start to outweigh the long-term benefits across this accelerating megatrend of energy transition. And if you've got any questions about this episode, the economy or financial markets in general, please put those questions in the comments section or send them to tbc@refinitiv.com