High Energy, High Drama

US investors will step out of the holiday and into a data vacuum in the week ahead. The only major US release is ISM services.

That leaves Fed speak to fill the void, and there’s plenty of it on offer. Traders will hear from Tom Barkin, Michael Barr, Lael Brainard, Charles Evans, Esther George, Loretta Mester and Chris Waller.

Oh, and somebody called “Jerome” will speak Thursday to the Cato Institute’s 40th Annual Monetary Conference. “With massive US debt and deficits, inflation at a 40-year high and popular/ political pressure for expanding the Fed’s mandate, it’s time to assess the Fed’s performance and future,” a preview posted to the think tank’s website reads.

If I were Powell (and I’m glad I’m not), I’d assiduously avoid these sorts of engagements. There’s an agenda. And I don’t just mean the schedule for the panel discussions, one of which (called “What Have We Learned?”) will feature Larry Summers, Mervyn King and Claudio Borio chatting with Wall Street Journal “Fed whisperer” Nick Timiraos.

Fed officials’ message will be more of the same: Inflation is the first (and, for now, only) priority, the Committee is committed to bringing it down and nothing will stand in their way. Well, nothing other than supply factors they can’t control. Like energy, which will garner all manner of headlines in the days ahead courtesy of an OPEC+ meeting and the possibility of more turmoil across the European energy complex following Gazprom’s announcement that flows won’t resume through the Nord Stream.

Last month, Prince Abdulaziz bin Salman suggested it may be necessary to cut crude supplies in order to fix what Pierre Andurand recently described as a “completely broken” oil futures market. Prices have gyrated wildly this year due in part to lackluster liquidity. “The paper and physical markets have become increasingly more disconnected,” the prince said, in remarks to Bloomberg. Oil is more than 20% off the highs (figure below).

On Sunday, the Wall Street Journal suggested Russia doesn’t back tighter supplies at this juncture. “Russia is concerned that a production cut would signal to oil buyers that crude supply is outstripping global demand — a position that would reduce its leverage with oil-consuming nations that are still buying its petroleum but at big discounts,” the Journal reported, citing the ubiquitous people familiar with the matter, who said that although Russia “has benefited from high oil prices since the Ukraine invasion, Moscow is more concerned about maintaining influence in negotiations with Asian buyers who bought its crude after Europeans and the US began shunning it this year.”

Late last week, G7 finance chiefs agreed to move ahead with plans to cap prices on Russian crude. Just hours later, Gazprom said gas flows through the Nord Stream wouldn’t resume, even at the diminished rate the link was running prior to a three-day stoppage. Germany on Sunday detailed a new €65 billion rescue package aimed at shielding households from the country’s energy crisis. Rationing is now seen as likely.

It’s against this exceptionally fraught backdrop that the ECB is poised to hike rates for only the second time in a decade. Inflation hit another record high last month, and it’s the furthest thing from clear that rate hikes will help. But, Christine Lagarde has little choice in the matter. If anything, the risks are skewed towards an ultra-hawkish outcome — a number of policymakers have argued for a 75bps hike, and markets increasingly see that as likely.

As the figure (above) makes clear, policy is so far detached from inflation realities that it no longer makes sense to compare the two.

Ostensibly, the ECB can help reduce inflation by curbing demand, but as is the case in the UK, demand destruction is inevitable anyway. The ECB and the Bank of England are condemned to push their respective economies over the ledge, into the abyss, with little hope of achieving their inflation goals anytime soon. Stagflation isn’t just the “base case,” it’s a virtual guarantee.

“We expect a recession in the euro area this winter due to surging energy prices,” Morgan Stanley, which sees a 75bps hike from the ECB this week, said. “From an inflation perspective, the key question is to what extent the expected growth slump will lower firms’ pricing power and thus slow the feed through of high input costs,” Jens Eisenschmidt, the bank’s chief European economist who spent 14 years at the ECB, said.

Although Eisenschmidt sees some scope for relief in 2023, he conceded that persistent pipeline pressure (figurative in the form of elevated factory-gate prices and literal vis-à-vis the Nord Stream) poses an ongoing upside risk to inflation outcomes.

The ECB abandoned forward guidance at its July meeting, and explicitly disavowed a prior commitment to a 50bps hike at the September gathering. Some market participants mistakenly assumed that meant the front-loading inherent in July’s half-point move reduced the odds of a large increment in September. I suggested at the time that was a misguided assumption.

The euro is beset (figure on the left, above), and a terms of trade shock will likely weigh on the common currency for the foreseeable future. I’d expect Lagarde to address that this week. The unfavorable trade balance could impair the ECB’s capacity to put a floor under the currency, which is trading near a two-decade low. Goldman, among others, sees the euro falling further below parity, which risks pass-through to prices, exacerbating inflation (figure on the right, above).

Complicating matters further for the ECB is the very real possibility that tightening the screws with higher rates could imperil periphery debt dynamics which, in a worst-case scenario, might boomerang back on Lagarde, forcing the ECB to activate the Transmission Protection Instrument, the new “anti-fragmentation” mechanism unveiled in July.

Also on deck in the new week: Expected additional rate hikes from the Bank of Canada and the RBA (moves which risk destabilizing enormous household debt burdens), Liz Truss’s expected ascension to prime minister, top-tier data out of China and, most importantly, an Apple launch.