The Big Conversation
Episode 135: Will a Fed pivot pump prices?
This week Roger Hirst looks at the rising expectation of a pivot from the Fed. Growth indicators are rolling over and many in the market want the Fed to support growth and abandon its fight against rising prices. But, if the Fed pivots too soon, it could lead to another painful leg higher in inflation.
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Roger [00:00:00] Despite the Fed standing by its commitment to bring inflation under control by hiking rates regardless of the cost to growth, there are signs that the market is beginning to speculate over a potential pivot because so many growth indicators are rolling over, such as the S&P Global US Service PMI dropping into contraction territory below 50.
Roger [00:00:19] But with inflation making a new high and structural issues likely to persist, could an early reversal by the Fed risk recurrent upside price shocks... even if we see growth reset? That's The Big Conversation.
Roger [00:00:36] It seems that investors have shifted their focus from rising inflation to slowing growth in recent weeks.
Roger [00:00:43] Although consumer prices have reached a 40-year high and is nearing double digits, the market seems more concerned by the prospect of a recession. For most of the last 30 years, inflation was generally the product of growth overshooting to the upside and dragging prices higher... but today it's rather different.
Roger [00:01:00] A combination of rising input costs, supply chain shocks and higher rates have arrived at a point when demand is already heading lower, according to several key leading economic indicators. As these headwinds appear to have intensified recently, there are no signs of demand destruction potentially tipping the economy into recession.
Roger [00:01:19] Take, for example, the University of Michigan Consumer Sentiment Survey, which recently made an all-time low. Reading in the report, respondents have cited inflation as one of the main reasons for pessimism, impacting decisions to purchase housing and durable goods.
Roger [00:01:34] This is also reflected in the NFIB Small Business outlook for economic expectations, which reported a record level of pessimism for growth prospects over the next year. This particular report provides a good barometer for broader business conditions in the US economy, which is primarily comprised of small and mid-sized enterprises...
Roger [00:01:52] And big business is also now reporting a sharp drop-off in demand, with the ISM manufacturing New Orders index breaking below 50 - signalling contraction - whilst a rise in inventories imply that blue-chip clients have been overall ordering amidst the supply chain chaos of the last couple of years.
Roger [00:02:08] And the story here is that demand has essentially been pulled forward, leaving fewer marginal buyers remaining, particularly as businesses battle cost pressures and brace for an economic downturn...
Roger [00:02:19] Having been conditioned over many years to expect the Fed to capitulate at the first signs of economic equity market weakness, markets may now have to deal with policymakers who remain committed to hiking rates at the fastest pace since 1993, even as growth is faltering.
Roger [00:02:34] The Fed has made it clear for now that it's targeting price rather than growth, and officials have been pretty candid about achieving their inflation target even if it comes at the cost of a recession.
Roger [00:02:45] With the growth outlook really beginning to deteriorate, there are signs that bond investors are beginning to speculate on a Fed pivot. Last week there was considerable futures buying of the 5-year portion of the US government curve where yields could be in the process of making a topping formation, opening up the potential for significant further downside in yields.
Roger [00:03:04] With the US midterm elections later this year, the Fed may focus on the preservation of strong labour market conditions rather than the threat of inflation. Employment is however, a very backward looking indicator and would need to deteriorate rapidly to have any impact on policy decisions. Inflation, on the other hand, is a tax on everyone, whilst a weaker equity market impacts a much smaller subset of the population. Will the Fed fight for the few or for the many?
Roger [00:03:32] Whilst the probability of a pivot has now been raised significantly above zero, there are considerable structural issues that are likely to continue asserting upward pressure on prices.
Roger [00:03:42] Supply disruption and geopolitical uncertainty remain the key threat to growth via higher food prices and also higher energy prices, which are contributing to a cost-of-living crisis, particularly in Europe.
Roger [00:03:52] Although agricultural commodities, such as wheat, may have returned to levels seen before the Ukraine war began, significant uncertainty remains, given the potential for renewed political tensions. Having signed a deal to unblock grain exports from Ukraine, a missile attack on the seaport of Odessa almost immediately afterwards highlights the potential for volatility.
Roger [00:04:11] And even more pressing, particularly for Europe, given her reliance on energy imports. Is the price of natural gas. Now unlike wheat, European Endex natural gas futures are once again heading higher, trading at a significant premium to the equivalent US benchmark.
Roger [00:04:26] It was hoped that the reopening of the Nord Stream 1 pipeline after 10 days of maintenance would see supply resumed at the same 40% capacity as before, but a dispute over sanctioned parts has resulted in flows being limited more than was previously expected... and that's something that we're going to cover in the next section.
Roger [00:04:43] But this further reduction in supply of natural gas has seen the European Union become increasingly concerned about the potential for the energy crisis to worsen over the winter. German baseload power is trading right at the top of a wide range set over the last 15 months, and may remain elevated if the supply constraints on the European energy market persist...
Roger [00:05:02] So, whilst investors have begun to speculate over the possibility of a Fed pivot, there are clearly major factors at play when it comes to the global stickiness of high consumer and producer prices. And although the US isn't as reliant as Europe on energy imports, it is likely that we've seen a "peak in cheap energy" and this may constrain the ability for prices to reset to a sustainably lower level.
Roger [00:05:25] US CPI needs to pull back and not just to peak. The month on month change was 1.3%. This needs to drop significantly if we are to get anywhere near the Fed's target levels and even if an economic slowdown materialises, one of the biggest risks to higher prices is an early pivot by the Fed that supports growth and price... Before prices have been properly brought under control.
Roger [00:05:50] And as we've mentioned, the ongoing energy crisis is at the very heart of this dilemma. I spoke to Wayne Bryan about the crisis facing Europe, which has been hit hardest by its reliance on Russia. This is very much a fast moving and volatile situation and the outlook for Russian supplies has shifted yet again since we recorded the interview on Monday. Wayne talks about these issues which have been taken out of the hands of Europe's policy makers, which in turn highlights the limitations of ECB monetary policy.
Roger [00:06:22] Wayne, great to have you back again. And a there's a hell of a lot going on in the European energy markets, in particular around natural gas and a lot of the issues, I mean, they were building over a long period of time even before the war in Ukraine. So before we talk about things like Nordstrom, can you just give us a background on what's been going on in the European energy market and with natural gas?
Wayne [00:06:39] Yes. Good to see you again, too and it's been it's been like a soap opera or pantomime of late. I mean, as you said, things were already in terms of Russian gas flows were already falling even before the war started, as basically in the Kremlin or should we say Gazprom tried to get Nord Stream 2 in operation and bypass Ukraine. So volumes were already falling and their actual transit contracts started to fall already. Fast forward to obviously the war happened and then all the political ramifications of that in terms of sanctions, etc.. Then we had a situation where gas flows actually started to fall, when Gazprom introduced the Rubles for gas payment scheme. This scheme basically said that those European buyers need to pay via a system that enables them to deposit into Euros, that get transferred into Rubles, Gazprom get paid. Several countries didn't abide by this, gas flow to them countries, were cut. And then what we saw was Nord Stream 1 flow started to fall. Now, Gazprom cited a couple of reasons for this. First, we mentioned this Rubles for gas scheme. Then, of course, they mentioned that there was problems with some of the compressors at the pumping station for Nord Stream 1. Now these compressors, help, help basically get the gas through the pipeline at the right temperature, the right temperature and capacity. So the Gazprom side to turn the flows down via Nord Stream 1. This really, really put the sort of frighteners up to Europe because basically we need Russian gas to fill our storage levels. Without Russian gas through Nord Stream 1 and various other routes, we won't be getting European gas storages build to the mandatory requirement. So this already started to set the alarm bells ringing. We saw flows at about 40% of normal capacity, so a 60% drop in flows via the pipeline. This caused prices to spike. And of course, Gazprom cited sanctions. They citied repairs to the turbine. They cited a number of reasons as to why gas was not flowing at the required level. Then we started to approach the maintenance period, now, typically every year Nord Stream 1 goes under maintenance, so around in July normally 11th, to around 21st, 22nd. As the maintenance starts, its prices start to rise further. A lot of comments whether it from Russia, whether it from European politicians around the capitals of Europe, all concerned about would Nord Stream flows restart and at what level? Most in the market thought they wouldn't start restart all that would see a complete cessation of flows and that Gazprom was using Nord Stream 1 flows, sort of weaponizing, sort of hold Europe hostage, and to be fair as I mentioned, without those flows we'd find it very difficult to refill our storage levels. So in the build up to Nord Stream 1 restarting on the 21st, every day there was a different comment. There was constant volatility in the markets as participants grappled to wonder whether we would get supplies. The day before, Gazprom said that flows will resume. They didn't give a number at all, most people then started to think, okay, we won't see flows, at least back to previous levels. The next day flows started to ramp up, we saw nominations and of course these flows then returned, but only to the pre-maintenance level. So the pipeline is still operating at 40% of its capacity and again they're citing turbine issues as the reason why. So this is now an ongoing good story.
Roger [00:10:15] And so this is also, I mean, you know, it's there's a fragility in here because obviously there's not a lot of alternative ways that that we can source natural gas. So what are the ongoing issues? Because this sounds like a very, very volatile scenario, going forward are there any solutions to this?
Wayne [00:10:33] Well, at the moment, again, where we've had a few, it's kind of like smoke and mirrors going on you hear from Siemens, you hear from Canada, you hear from the Kremlin. And there's a whole lot of stories. But in a nutshell, basically these turbines typically built by Siemens go to Canada for repair, routine maintenance in Canada. Due to sanctions, Canada couldn't return this turbine. They made an exemption. Of course, it that could be, that could be changed but to allow this turbine to be sent to Germany, documentation was received. The turbine then made its way to Germany. It got to Germany, it would typically, then it would make its way to Russia via Helsinki. Then we have the situation last week where the actual operators, Siemens, said, well, we've got the turbine, but we need Gazprom to tell us what location to send it to, and we need necessary documentation, Gazprom came out and said, well, we don't need to provide documentation, you need to give us documentation showing us that this turbine is exempt from sanctions. More to-ing and fro-ing, then you have Vladimir Putin speaking, which only added to the concern. So he started saying that, yeah, we've got problems with this repair. We're very concerned about the quality of repair. We're also concerned because additional turbines need to go into service. And if we don't receive the repaired turbine on July 26 or around that date, we're going to cut the flows further. So instead of at 40%, they're talking about from tomorrow, it being at only 20%. So again, that's caused even more consternations, but what's transpired over the last two days, the turbine now is supposedly on its way to Russia. The Kremlin spokesman, Dimitry Peskov, literally just said the turbine is on its way. We will get that turbine install it and then we'll start looking at gas flows again. But there's still no firm indication at what level, apparently will take 3 or 4 days for this turbine to be installed. Then you've got additional turbines that need to go and get refurbished. And if you listen to what Vladimir Putin said last week in a in an interview in Tehran, he was saying that it will fall to 30mcm tomorrow from 60mcm today. So there's still a lot of concern the markets are still trading higher even on the news that the turbine is making it. So in terms of the options, we've got a couple of options on the table. Reducing gas demand: EU has already come out with a proposal, rejected by many that we cut gas demand by 15% using various methods. Germany's already diming street lighting, banning the heating of indoor pools this winter, so there's lots of different factors in play. Also LNG, we're importing a lot of LNG from America and thanks to falling Chinese demand, we're able to import a lot more than we typically would this time of year. Asian demand is still suppressed, so what we're seeing now is a lot of energy is coming to Europe. So that is still kind of helping, but, take a step back, whatever happens, if these flows by Nord Stream don't go back above 60% in the next couple of months, we won't reach the mandated storage requirements, which actually the German government just lifted by 5% points now. And they already came out this morning and said if you slow down increase, we won't be meeting our storage target. So a huge risk ahead for this coming winter, especially when we don't know what temperatures will be like yet.
Roger [00:13:51] So so it sounds like, you know, we've got this real shortfall in what we need for our storage in the whole of Europe, and we're kind of reliant on Asia being sort of in quasi lockdown at the moment. Obviously, that could come back to come back and they could go back to their normal demand, and obviously these are all offsetting, we're already hearing of certain countries which are desperately short of energy requirements themselves because they're being diverted to places like Asia and Europe. So going forward, just focussing back on Europe, what I mean, potentially, will we end up with rationing? You know will we, people may remember things like the three day weeks in the UK back in the 1970s. What sort of scenarios, what are the sort of scenarios of the blue sky optimistic scenario all the way through to the beary scenario? What sort of things can you see as being that potentially kind of list of what could transpire over the next 12 months?
Wayne [00:14:34] Well, on an optimistic front, you're looking at a warm winter, a warm winter in both Asia and Europe, which where actually, you know, we've had a couple of mild winters, so we're due a cold one, so an additional, a really cold snap I'm talking about akin to the beast of the East of 2018 puts us in a perilous situation. Gas storage is would be rapidly emptied. And this is, of course, on the assumption that Russian gas loads continue to be at 40% levels. We're going to be in trouble on on the flip side, in terms of gas rationing, we won't come to that, especially in the UK as supply side, whether that's interruptible demand is cut, certain big producers get their supply cut automatically and they've already got cheaper gas at the moment as an incentive for them to be allowed to cut. The UK now is also exploring the possibility of reopening rough storage. This is the biggest storage facility. So we're now this is meant to be mothballed. But now due to the price dynamics that's being brought back online, the decision is still to be made but that be back online this winter giving more supply security to the UK. Europe's on the other hand is a little bit different, but UK prices are a lot cheaper than European gas prices due to the UK not being as reliant on Russian gas. So in terms of Europe, the danger is a lot stronger. You've got low hydro levels across Europe, very, very poor rainfall. So hydro generation is low. You've got French nuclear concerns again linked to the hot temperatures and also to an aging fleet. So that is another factor. So what we seeing here is, lower Russian flows, stronger demand from the power sector, a potentially colder winter in tandem with a reduction in LNG flows. We're in we're in quite a lot of trouble. I mean, you see a lot of these measures from Europe. I think these measures would definitely be coming into place. So you'd see cuts to large scale industrials; your ceramics, your bricks, your paper, plastic, all these sort of industries are going to have to cut. Now, in the case of Germany, it would be catastrophic for their industry; there's already, if you look at it, if the storage is not full, gas doesn't continue, we're going to see inflationary, we've already seen inflation rise. This would probably put another 3 to 4, knock 3 to 4 percentage of German GDP, which probably equates to run out of 180 billion on their economy, which they don't really need. And another what we've seen recently as well is the Euro trading against the Dollar, close to parity. That raises the import costs of LNG, which is another factor this market doesn't need at the moment. So a lot of the risk is skewed to the upside. And if you look at the way the market is priced, that shows you that, and if you look at the spreads for next year, summer is trading above winter, which really tells you that, you know, we're far from out of the woods and we're at the mercy of quite a few things at the moment, which goes to show how sort of overreliant we have been on Russian gas over these years and now it's really coming back to bite.
Roger [00:17:25] So they basically sort of summarising what we're saying here is that it's a very, very tight situation. It's all down to effectively potential exogenous shocks over which Europe has no control. And I mean, Germany is already talking you know, Germany is clearly already flirting with recession, but it sounds like for the next at least through winter, we're going to be consciously saying we're in a we're out of recession with potentially the recessionary downside more likely in this current environment.
Wayne [00:17:48] Correct? Yeah. It's just again, though, that we've left ourselves in this situation with the overreliance on Russian gas and of course, with the with the ongoing geopolitical situation, the tit for tat sanctions, at any moment they could just turn that gas off. It really is as you highlighted a perilous situation as we head into sort of the most demand intensive period of the gas year that being the winter period starting 1st October.
Roger [00:18:13] So as you can see, this is a very volatile situation to say the least. The German IFO data suggests the economy could already be in recession. The rest of Europe is on equally uncertain ground, although not all countries are as reliant on Russian Gas exports, but this is likely to weigh on the Euro through winter even if the Fed does do a dovish pivot.
Roger [00:18:35] And if you want to see more videos like these, please subscribe to the LSEG channel here on YouTube.