I’m From The Government, And I’m Here To Help

If fighting determined central banks is a fool’s errand, what is fighting panicked governments?

That’s a question market participants need to ask themselves as UK and EU officials, elected and otherwise, gear up to combat an existential energy crisis with heavy-handed market intervention, sweeping industrial policy and a willingness to deploy the fiscal bazooka to prevent citizens from freezing, starving or preemptively rioting to protest conditions conducive to freezing and starving.

There’s some dark humor in there, but I’m being serious. And it isn’t actually funny. The Kremlin’s decision to halt all flows through the Nord Stream and the prospect of more escalations as G7 nations “poke the bear” with a planned price cap on Russian crude, mean Europe is now compelled to confront its dire predicament head-on. It’s no longer possible to persist in any sort of delusions. A war footing is in order. Because this is, after all, a war. An economic war, yes. But a shooting war too. For now, the shooting is confined to Ukraine. For now.

For traders, successfully navigating these extremely choppy waters entails assessing both the near-term and long-term implications of price caps, subsidies, handouts and liquidity backstops of unimaginable scale.

Germany’s new €65 billion rescue package brought the total under the Scholz government to €100 billion, but as discussed here Monday, that’s a relative pittance. Expect to see more (much more), including massive liquidity guarantees to guard against a Lehman-like domino effect across the European energy complex.

Sweden and Finland are already set to establish backstops for utilities amid extreme volatility in power markets, and Norway’s Equinor on Tuesday said $1.5 trillion is needed to help ameliorate the increasingly untenable cost of managing derivatives positions. In simple terms: The margin requirements are now so large that they pose operational and market function risks. “This is just capital that is dead and tied up,” Helge Haugane, Equinor’s senior vice president for gas and power, told Bloomberg, during an interview from a conference in Milan. “If the companies need to put up that much money, that means liquidity… dries up and this is not good.”

Haugane went on to say that although caps might work to shield Europeans from spiraling power costs, the global nature of the natural gas market will complicate efforts to put a ceiling on prices. Only more supply will help, and Russia is keen to perpetuate artificial scarcity. The Kremlin would doubtlessly say that if you’re looking to assign blame, a good place to start would be sanctions that effectively make Russia’s energy contraband. To which the West would invariably respond: “Yes, but you invaded a country that isn’t in the Middle East and, as you know, that isn’t allowed on the Risk board we used to share with you.”

In any event, the point is that momentum is clearly moving in the direction of massive state intervention. Liz Truss’s first priority as UK prime minister is preventing a planned escalation of household energy bills. Specifically, she intends to cap those bills, and according to an internal document seen by Bloomberg, the plan, as envisioned initially, could turn into an uncapped liability for the government.

But, in a testament to how difficult and complex the tradeoffs really are in 2022, not capping energy bills would likely be terrible for public finances too because as inflation spirals, so does the cost of index-linked debt and welfare expenditures. Additionally, the lower inflation is, the less upward pressure on wages, which in turn lessens the odds of the dreaded wage-price spiral becoming embedded across the economy. And then there’s the (very real) prospect that freezing energy bills at current levels (instead of allowing them to jump another 80%, as planned) could avert, or at least shorten, the long-lasting malaise forecast by the Bank of England. A better economy means more tax revenue (unless you cut taxes, as Truss also wants to do). Less joblessness means less government transfers. And better business outcomes reduce the risk of defaults on what Bloomberg noted are £50 billion in taxpayer-guaranteed pandemic loans. Finally, capping energy prices (and thereby inflation) could reduce pressure on the BoE to raise rates further, which would also save the government money.

However, forestalling demand destruction in the face of soaring inflation is a textbook economic mistake. Truss doesn’t so much want to drag the UK economy out of recession as much as she wants to tie it to an Acme rocket and light the fuse. That could prove extraordinarily perilous. As one person who spoke to Bloomberg put it, the UK needs to “avoid perverse outcomes” and think about “how costs will be eventually repaid.”

For market participants, the near-term risk is clear, even if the longer-term outlook is more murky than ever. It’s possible Truss can engineer a dramatic drop in short run inflation — a game changer. The problem is what happens later. “This is when you get out of the way of governments, because the ‘left-tail scenario’ odds get slashed by moving the goalposts, kicking the can and re-writing the rules mid-game, despite likely unintended and second-order consequences,” Nomura’s Charlie McElligott said Tuesday.

“How does one handicap the market impact of Truss’s reported fiscal package,” he wondered, before running through the possible implications. “On one hand, the government is planning to somehow cut taxes while simultaneously and violently expanding their deficit,” McElligott wrote. “But on the other, the outlook for CPI inflation will dramatically shift if the UK government does indeed freeze energy prices, which then seemingly risks downside to the current BoE hike trajectory.”

Of course, it would also risk embedding inflation (lower inflation, but still above-target inflation) in the economy for longer. The BoE, while no longer obliged to hike to infinity in a hopeless attempt to bring down energy bills with harsh language and a scary-looking Bank Rate chart, would nevertheless need to be exceptionally cautious about pouring gas on the demand fire by pretending not to understand that solutions (and especially fiscal solutions) which seem too good to be true usually are.

“Being realistic regarding the eventual ‘footing the bill’ for this largesse, it always boomerangs back to the central banks and quasi-monetization,” McElligott went on to say, adding that “nearly all of the response from governments and authorities has been in the form of solutions which perversely create demand construction, contributing to a higher likelihood of further shortages.”

Meanwhile, Goldman expects European household energy bills to be €2 trillion higher when they peak next year. Markets, Goldman suggested, may be too sanguine about “the depth, the breadth and the structural repercussions” of the shock which, on the bank’s view, “will be even deeper than the 1970s oil crisis.”

“Truss is adamantly backing tax cuts for high earners and businesses, despite all the evidence that this is the worst possible way to run MMT or boost the supply-side, and she may also introduce COVID-scale price subsidies to keep energy lower,” Rabobank’s Michael Every wrote. That approach “will artificially suppress supply shocks while juicing demand, and [do] nothing to restructure supply chains defensively or reallocate physically scarce resources,” he warned. “Nobody wins an economic war that way.”

The ultimate irony in all of this is that Truss is an avowed small government libertarian.