ROGER [00:00:00] After an initially tepid reaction to last week's FOMC meeting in which the Fed outlined a very basic strategy for a tapering of asset purchases, US and global bond yields have now jumped higher. In this week's Big Conversation, we look at whether this is a sign of economic strength, a readjustment of yields in anticipation of the reduction in bond purchases by the Fed, or a belated reaction to the ongoing concerns about inflation.
ROGER [00:00:28] For much of the summer months, bonds were remarkably well behaved with the US 10-year yield bouncing between 1.10 percent and 1.40 percent yields. In the last few sessions, it shot up to a high of 1.55 percent, prompting the usual cries of 'what is the bond market know that we don't?' In reality, very little so far. We're still within the range that's been set this year, which peaked around 1.75 percent. And when we look back at the long bond ETF, the TLT, we can see that the current price action is not unusual over a 20-year timeframe. Yes, yields have moved in a relatively sprightly pace by recent standards, but this is all taking place within existing tolerance limits. If we compare bond prices to spot inflation levels, then yields remain remarkably subdued with the difference between inflation and yields, the real yield, still deep into negative territory. There's a long way to go for yields to close that gap to current inflation levels. The bears will note that there's a reverse head and shoulders pattern forming. If the neckline is broken, that implies we could test the pre-pandemic highs and see yields move in excess of 3.25 percent. Now that number is derived as the mirror image of the differential between the neckline and the lows in yield. But it's very unlikely that we'll achieve those sorts of levels in the short term. Economic growth is not sufficient to sustain the current levels of debt at significantly higher levels of yields. Financial markets, especially in the US and Europe, have generally preferred weak economic growth, aligned with active monetary policy, rather than strong economic growth and higher interest rates. Now, back in 2018, there were two occasions where surging yields destabilised the equity market. The first was in the early part of that year, when growth expectations picked up, yields moved higher and equity volatility started to rise with the rising equity market. This eventually unbalanced markets leading to the 'volmageddon' event in early February that saw a short, sharp pullback in the US equity market and the explosion in the volatility of volatility. Now that event soon passed, but it was a foretaste of what was coming later in the year. As yields approached 3.25 percent, the US equity market also peaked and then it fell 10 percent before the Fed then raised interest rates again, in what turned out to be the last hike of that cycle. The markets couldn't cope with the rate increase. The S&P fell another 10 percent before the Fed had to reassure investors that they were done with tightening. Today, overall debt levels have increased. The economy will struggle if yields get anywhere near the levels of 2018. And obviously today we're used to policymakers providing more accommodation. But currently we're talking about them removing the punch bowl, not refilling it, even though right now QE is still at full blast. And even the famous taper tantrum of 2013 was relatively short-lived. At least there was widespread belief in growth back then. Today, very few believe that the economy is strong. Current levels of inflation are leading many investors to think that stagflation is likely. And that's certainly the concern sweeping the United Kingdom. But should we fear yields? The biggest risk for the bond market is a VAR shock in which the yields suddenly surge. Flash crashes and rallies have become increasingly familiar, such as a sudden drop in yields in 2014. And we can easily envisage an event in which investors suddenly head for the exit at the same time. A VAR shock in the bond market, however, would lead to a risk-off event across other assets like stocks. Therefore higher yields under that scenario would be very short-lived. And furthermore, the Fed will probably invoke yield curve control and target a cap on those yields. Another indication that the current move in yields will be short-lived is the response from the front end of the rates curve. Now if the Fed is going to taper, then the expectation is that rate hikes would soon follow. On Monday, the US 2-year yield finally broke out of its range, but this part of the curve is not yet showing many signs of life. The front end doesn't really believe the tapering, tightening narrative. If the Fed were really serious, then the front end should be much more aggressive in pricing for rate hikes. But even when we look at the relatively freely floating Eurodollar futures curve, we can see that the December 2023 contract hasn't even broken the levels achieved earlier in the year. Again, the market appears to be reluctant to push too hard on the rate hike narrative. Now, some of this may be due to the influence of the oil market. Over the long run, the US 10-year bond yields have generally followed the gyration of crude oil. The year-on-year change in the 10-year yield has followed a very similar path to the smooth year-on-year change in WTI crude oil prices. Crude oil has broken out in recent weeks, in part due to the global pressure on broad-based energy supply chains, which is particularly acute in Europe and the U.K. It may be that oil prices can squeeze higher still, given that the European benchmark Brent is testing a long-term downtrend. But unlike the period from 2009 to 2013, when higher oil prices led to huge investments in global energy infrastructure and a massive capex cycle, today's high prices are not being accompanied by investment and job growth. Therefore, higher oil prices today are a drag on the diversity of consumption. The ratio of the European Energy sector versus the European Basic Resource sector is an indication that this move in energy is not being accompanied by a move in other cyclical and growth-related names. Commodity prices may have been going up across the board, but volumes have been relatively poor. Recently, the European industrials sector, which has been one of the best performing in Europe, has also been on the back foot. Higher yields today are not reflecting higher growth. We've also noted recently that China is no longer playing the same hand in global demand that she has during much of the last two decades. There's also a possibility that something far less exciting than growth or inflation is at work in the bond market today. Quarter end asset allocation may be having a significant impact on bond yields. The end of September is one of the quarterly rebalancing periods for asset allocators. We've noted before that this year's high-end bond yields was achieved on March the 31st, which was also coinciding with the end of Japan's financial year, as well as the end of the first quarter. Japanese asset allocators were part of the driving force behind yields rising into the end of that month and then declining during much of the summer period. Today, yields are rising just as we approach the final stages of the third quarter. Now we'd need to see higher yields show significant follow through to be sure that this wasn't just the impact of asset allocation rather than a repricing of inflation or growth. So overall, the recent move in yields doesn't feel like it's a delayed reaction to inflation. Yields could and should have reacted a long time ago unless you believe all bond market participants had swallowed that transient narrative. The move could have been a late reaction to the Fed's September meeting, where a vague outline for tapering was discussed. But we all know that the Fed will reverse course at the first sign of trouble. If anything, a taper should take some of the inflation expectations out of the market. Whilst the recent resignation of two key FOMC members should have made the Fed's voting committee slightly more dovish. And Bonds are certainly not reacting to a sudden spurt in growth. If anything, growth is probably peaking. The year-on-year performance of FedEx versus the ISM New Orders Index suggests that a slowdown is coming, whilst currently high energy prices could be an additional strain during the winter months. And for many regions, energy prices have been surging due to a shortfall in natural gas. In the next section Wayne Bryan Refinitiv's Director of European Gas Research, outlines the key issues Europe is experiencing in the gas market and runs through the factors that could define whether prices remain painfully elevated through those winter months.
ROGER [00:08:09] The U.K. power market has been experiencing a series of significant disruptions in recent weeks, perhaps the biggest issue has been the soaring price of natural gas. For the UK it's had a knock-on effect across other major industries and these issues have been grabbing the headlines. But the problems in the gas market are not confined to the UK. Europe and many parts of Asia are also struggling.
Wayne [00:08:31] Well, at the moment, the U.K. gas market is experiencing a lot of issues, prices along the front month contract, which is for delivery in October, are at levels we've never seen before. Even today, it's up another about 12 percent. The main thing, what we've got here this year compared to last year, it's a complete paradox really is, main thing is storage. European gas storages are at multi-year lows at the bottom of the five-year range. Typically, we go into the winter with storages at an ample level. For example, this time last year, total EU storages were around 94 percent. At the moment, they're about 73. So you can see already a big 20 percent difference. Now, what that does, it creates a lot of risk if we have a very cold winter, normally we have the buffer of storages that will help us, you know, get through a particularly cold winter. On the back of that as well, we've also got problems with in terms of supply into Europe. At the moment, LNG supply, we're in competition with Asia. Asia also have a lot of concerns in terms of big growth in Chinese gas demand, huge demand in general in Asia and South America. They're competing for these LNG cargoes. This is dragging prices even higher. Last winter, we had an extreme cold snap in China and in Asia, and we also had some cold weather in Europe. What that did in November, December and to some degree middle of January was drag away all the LNG cargoes that should have come to North West Europe, went to Asia. That then lifted the prices. We started using our storages even more, as we got to the start of this summer, which is the first of April, in terms of the gas season, European storages are at multi-year lows. This was compounded by exceptionally cold weather in the end of March and April, which saw us drain storages even more. This summer we've had extensive maintenance work in the UK and in Norway, who one of the largest gas suppliers. This maintenance has basically meant gas wasn't flowing as much as usual this summer. Now, just the reason why that was is because in Covid-19 restrictions last summer, they couldn't do all the maintenance, so they rolled it over to the summer. So that meant even less supply. I think people are a bit scared of getting caught out like they did last winter, so we saw Asian restocking start earlier. We also saw huge demand from South America, notably Brazil. Main reason there is that they've had hydro reserves drought, so they've had to import additional gas to generate electricity. So that's added another twist to it. And then there's Russian supply. I mean, it's been in the news quite a lot. But the main thing with Russia is we've got this Nord Stream 2 pipeline. This pipeline is now being complete. It was actually completed and all documents sent to the regulator on September the 8th. Gazprom obviously want to get commercial flows going through this pipeline as soon as possible. Europe needs the gas, the problem is now, this is now with the German regulator. The German regulator, with some input from the EU Commission, this process could take up to six months now, way longer than people were expecting, which means the likelihood of any start-up of commercial flows by Nord Stream 2 are very limited in terms of Q4 this year. So we've got this huge now sort of supply concern going into the winter, and it's exacerbated by this situation with Nord Stream 2.
ROGER [00:11:49] Now, there's been a confluence of factors that have created these bottlenecks. Some of these are expected to dissipate, but there's still significant concern that these issues could persist well into winter, where many of these factors will be beyond the control of governments.
Wayne [00:12:01] The first thing to think about here is the cold scenario. If we have a cold winter in both Asian, Asia and Europe, so the Atlantic and Pacific basins, if we have a very cold winter, we're going to be in trouble. Today's price will look cheap. If we have a cold winter with no additional supply, we've already got obviously a good supply from Norway, we've got a good supply hopefully from Qatar with LNG. But what the main problem will be, is if we have an exceptionally cold winter, the competition will intensify between Asia and between Europe to attract these cargoes, which is what we've seen in the last couple of days, Asian prices have gone through the roof the last few days and European prices have followed. So an exceptionally cold winter puts us in severe problems. I wouldn't even want to hazard a guess how high these prices go, because it depends how cold the weather is and how strong the heating demand is. So that’s scenario 1. Scenario, 2, if, for example, we did have a milder winter and got some gas via Nord Stream in this quarter, so by the end of the year, that would have a real downside effect on prices. The main concern of people here, storages are so low, how cold will it be, how much demand will there be? Could we run out of gas? I don't think we're going to run out of gas, but we're going to push it very close. If it was a 'beast from the east' scenario, then I would even be a lot more concerned. But the main thing is a mild winter with some additional flows from Russia would see prices start to soften. Prices today are now trading at multi-year highs. We've gone past the highs we saw last week. This also translates into the power market as well. Input fuels for power are very high. You've got gas is really high. We've actually maxed out gas. We're now using a lot of coal, which isn't good for the environment. So coal fired generation, if you look at the four curves, it's maxed out for the winter, which is, which is a real, real concern environmentally. Also as well, another thing we need to think about this winter is renewables. Renewables have been very weak. We all talk about renewables are great. They're intermittent. The wind doesn't blow every day. The sun doesn't shine every day. We've seen that this year with gas for power generation is really, really, really increased due to lower renewables. So renewables strength as well will be key this winter. So we really are in a, in a sticky spot at the moment in terms of, it's hard to forecast because we're waiting for the weather. Longer-term forecast kind of tell you what's going to be mildish, but we all know longer-term forecast don't really hold too much weight. If you look at what happened last year, cold weather came, no one really predicted it. It was very cold in the Pacific and Atlantic basins. This market got a bit complacent. They didn't have enough gas in storage in Asia. Their storage capacity is limited as well. They didn't buy enough, so they just started bidding, bidding, bidding. Prices went through the roof. Absolutely through the roof. We saw record prices for Asian LNG and now we're creeping up towards them levels again, which kind of indicates how nervous the market is. We're talking about big percentages on consumers bills. We're talking about businesses stopping production. We've seen Yara, a huge zinc producer stop producing. We saw the fertiliser in the UK two the largest fertiliser producers, or sorry two plants, they stopped producing. And that had a by product of ammonia, which fed into quite a few concerns which the UK government stepped in to top up. We've also seen several small suppliers go under. These small suppliers typically buy gas a lot closer to delivery, so they'll probably be buying for the next six months. Prices got so high they were always going to go out of business. The Big Six are a bit more insulated because they actually hedged their domestic consumption probably by two or three years in advance. So these effects of this rippling throughout Europe, and this is why we're seeing not only gas prices at multi-year highs, power prices are breaking records. Carbon is also at yearly high, and the coal market is also at really multi-year highs. So it's like a commodities boom at the moment, driven by uncertainty and gas. We've created a perfect storm. And the only way out of that is, is if we see these flows from Gazprom either this quarter or very early in Q1 22 or we see a very mild winter. If not, we will be facing these problems again next year for sure.
ROGER [00:16:16] Many factors are behind the problems in the global gas market, including regulation, redirection of investments and the impact of the pandemic. Some of these were bad luck and some were bad decisions. A few of the structural issues can be resolved relatively easily, but Europe will be hoping that the winter weather remains mild in order to prevent the gas crisis from extending into next year and piling up the costs for consumers. And as ever if you have any questions about today's episode, or about the economy or financial markets in general, please put your questions in the comments section or send them to TBC@Refinitiv.com
