How the commodity crisis is changing the dial for the ECB and why payrolls could turn the dial for Fed policy
The end of Q1 gives us a chance to pause for breath and take stock of the epic move in markets, geopolitical ructions, the surge in global price pressures and the energy supply shock that has made Q1 of 2022 an historic quarter for markets. The dominance of the dollar can’t be denied, and although stock indices are likely to record declines for Q1 as a whole, their remarkable recovery since the Russian invasion of Ukraine and the surge in commodity prices is highlighting stock market resilience at a time of immense pressure. The question now is, can this last? As we embark on a new quarter, we will be looking at earnings season, which will be a key driver of stocks this quarter, what happens with commodity prices, and of course, if the Fed embarks on the aggressive rate-hiking cycle that the market is currently pricing in.
Biden buys time with oil reserve release
Yet again, commodity markets were the most volatile of all the asset classes on Thursday, but this time the volatility was driving the price lower, as brent crude tumbled more than 4%, soybean futures and oats were also lower while platinum and copper futures were also down a touch. The chief driver of the weakness in the oil price was the news that the US President would release 1 million barrels per day of oil from the US Strategic Petroleum Reserve for the next 6 months. This is huge news and is the largest release of its kind from the US oil reserves, however, we would argue that this merely buys us time. In 6 months, it will be the beginning of winter in the Northern hemisphere, and that will be when this release of oil will end. Thus, the supply problems that have been caused by 1, the Russian sanctions and 2, the delay in Opec+’s return to normal production levels, are still an issue for the market and many energy importing economies. The US oil reserves are not a viable alternative source of oil supply for the long term, thus without some new production coming on board from Western-friendly nations, the oil price is likely to remain elevated. Even with the recent declines in the oil price, the price of a barrel of brent crude oil was $109.40 at the time of writing. This is a huge amount, and a full $46 higher than the price a year ago, which stood at $63.50.
LNG wars begin
Things are even more stretched in the natural gas market, and Dutch TTF nat gas futures were up more than 5% on Thursday, above EUR 125.90 per megawatt hour. This is the highest level since March 14th, and it suggests that the Eurozone needs to buckle up for a prolonged period of high inflation after President Putin said that he would cut off supplies to any country that cannot settle their bills for gas in roubles. This is yet another sign of how Russia can hold the Eurozone authorities to ransom and is one reason why we are losing confidence in European assets as we move into the second quarter of the year. In comparison to the US, where we believe that the inflationary shock is caused by a demand push, the energy supply shock in Europe has pushed up inflation to record levels and this will have an extremely damaging impact on Eurozone growth and on stock prices. This is why we expect US and UK stock prices to outperform their European counterparts as we move through Q2.
There is also another spread to keep your eye on as we move into the new quarter: the spread between European and Japanese LNG prices. Both Europe and Japan are big natural gas importers and both are looking to diversify away from Russian supplies. They used to be good at “sharing” LNG supplies, however, this has gone to the wayside in the face of an unprecedented supply crunch. Japan and Europe will now be competing for LNG supplies, and for now Europe is paying a larger premium than Japan to ensure LNG supply. However, going forward this is likely to exacerbate Europe’s inflation shock. For example, German headline CPI was a massive 7.3% YoY for March, in Spain price increases were just below 10%, in France headline inflation rose to 5.1% YoY in March, which was a record, in Italy, consumer prices rose to 6.8%. So far, the inflation shock is not impacting the broader economic data, for example, unemployment in the Eurozone is still at a decent 6.8% for February and German retail sales rose at a strong 7% YoY last month. Howeverm, this data are lagging indicators, thus the full economic impact of the energy shock in Europe is yet to be felt, but we are sure that a sharp decline in activity and consumption is coming down the line. This was reflected in recent confidence indicators, business confidence, consumer confidence, industrial confidence and services sentiment all dipped for March.
Commodity prices and the ECB
This is the reason why we think that the main central bank to watch this quarter will actually be the ECB. On Wednesday the ECB’s Lagarde said that “Europe is entering a difficult phase”, however this seems something of an understatement, and recent data in Europe brings the sceptre of stagflation into the picture. On Thursday, ECB policy maker Peter Kazimir said that the ECB’s first-rate hike needs to come this year, while Robert Holzmann said that the ECB should adjust its forward guidance to raise interest rates in September and December as long as it stops its bond purchases before then. Yields in Europe fell on Thursday in line with US yields and also on the back of the decline in the oil price, however, the 10 -year German bond yield is up 53 bps in March, which is the biggest monthly increase since 2008. Added to this, with inflation surging and the prospect of sooner than expected rate hikes from the ECB, we expect further upside for European yields, and there is a risk that spreads between German and Italian and German and Spanish yields could widen, as these southern European economies struggle with rising inflation rates.
EUR at risk of further downside
The euro is once more turning lower and was down 0.8% vs. the dollar on Thursday at $1.1068. The inability of the euro to sustain a rally suggests that momentum is not on the upside, even if the ECB does hike rates earlier than currently expected. The reason why we think a return to the $1.08 lows and below could be on the cards is that if we start to see growth rates deteriorate then the prospect of stagflation becomes a reality, and stagflation is bad news for a currency. Added to this, there is also a political risk premium that may need to be added to the euro in the coming months, with the prospect of more ‘bilet jeune’ protests across the currency bloc as ordinary people start to get fed up with higher prices. Overall, this is not a good place for the euro or the ECB right now.
Will payrolls tip the scale for a 50 bp hike from the Fed?
Elsewhere, Friday’s payrolls report could determine if the Fed decides to hike by 50 bps in May. The market is expecting an increase of 485k, the unemployment rate is expected to fall to 3.8% YoY and wage growth is expected to have grown by 0.4% on the month. The lead employment indicators suggest that the March NFP figure could be around expectation, however, we would add that recent NFPs are highly unpredictable and difficult to forecast due to the recovery of the labour market from the pandemic, which is an unprecedented event in history, along with concerns about the war in Ukraine. The dollar was slightly stronger in March after a very strong February, however, a strong payrolls report could trigger a selloff in EUR/USD, as we mention above, while we think that USD/JPY could be at risk if the payrolls report is weaker than expected. In our next note we will dissect what this labour market report means for Fed rate hikes and if this NFP report justifies the 9 Fed hikes that are currently priced into the swaps market.