Posted 13 November 2023
Overview: Back-pedalling central bankers
The turnaround rally in stock and bond markets – prompted by dovish central bank comments – petered out towards the end of last week, with central bankers at pains to reverse their messaging, or at least reaffirm their commitment to keeping rates high for as long as it takes to get inflation back to their 2% target.
This comes against the backdrop of seemingly having passed through the peak in nominal growth (real growth + inflation) and are now heading back down to more normal levels. In most cycles we would expect to see real growth become negative for a time while inflation starts to undershoot central bank targets. That normally means contraction of economic activity (aka a recession). What matters for capital markets is the depth and pace of the downswing. The increased uncertainty heightens the likelihood that banks, investors and other intermediaries in the financial system respond to rising risks and uncertainty by pulling their liquidity prematurely. This in itself creates the downswing in both markets and economies (of course, if it happens, no bank or investor would say they were premature).
This therefore constitutes the point of greatest danger for a policy error by central banks. Indeed, because we start from such elevated inflation levels, there is a lot more uncertainty about where we are in this trajectory. But despite most central bank policymakers reiterating that rates will remain restrictive, investors now think the tail risks of higher rates and therefore a policy error have diminished. Whether it’s the US Federal Reserve (Fed), the European Central Bank (ECB) or the Bank of England (BoE), the discussions are acknowledging that rate rises are almost certainly over for now and that cuts are on the cards.
This week brings the release of provisional inflation data, which feels even more important in the current environment. UK consumer prices rises are expected to have fallen back to 4.7% year-on-year, which should allow Prime Minister Rishi Sunak to claim a victory in his inflation pledge (to halve inflation from December 2022’s +10.5%). That will be less important than the signal it might send about the chances of rate cuts in the second half of 2024.
Bank of England giving and receiving mixed messages
When the BoE kept interest rates on hold last week, Governor Andrew Bailey told reporters it was too early to talk about cutting rates. But last Tuesday, BoE chief economist and fellow Monetary Policy Committee (MPC) member Huw Pill was quoted saying market expectations of an interest rate cut next year are not “unreasonable”. Bailey and Pill are realistically outlining the same view on the economy, but tone can make a world of difference to avid central bank watchers. In fairness to the MPC though, if their policy guidance is confusing, it is probably because the UK economy appears rather fickle – with growth oscillating from slight positive to slight negative, while prices continue to rise.
Markets tend to dislike the uncertainty of mixed messages but rather like the prospect of easier monetary policy. However, the labour market situation is more complicated than it appears. The MPC’s estimates of how jobs might respond to their policies are hampered by the fact that the reliability of the available data has become less than ideal for making that call. For the headline unemployment rate published by the Office for National Statistics (ONS), this is well known, since it only comes out after a significant delay and so offers at best an indication of how things were five or six months ago. But the household, company and tax data used for the more up to date job market assessment has since the pandemic also become far less reliable than it used to be.
UK year-on-year inflation is still high in both absolute and relative terms, so it makes sense for Bailey to silence any dovish noises, but of course the Governor has had to bear the brunt of the public’s ire over the cost-of-living crisis. No doubt, his speeches will continue to insist that the BoE decisions are dependent on incoming data. The problem is that being dependent on the data from the main official sources means “behind the curve”. We think they will not be so hidebound.
Europe’s natural gas on a bumpy road down
European gas supplies officially reached 100% of storage capacity at the beginning of November. This is a far cry from the fears of last year, when Russia’s war in Ukraine decimated Europe’s energy supplies and policymakers planned for rolling blackouts. Policy choices have obviously played a big part. The immediate priority was finding other short-term sources, exemplified by the massive increase in imports of liquified natural gas (LNG), but structural changes for the medium and long term have been aggressively pursued too. Strict storage build targets are part of it, helped by moves to limit household and business energy consumption – particularly in Germany – thanks in part to an unusually mild winter. Less remarked on has been the increase in storage capacity itself, although this slow process has not yet had a massive impact at the aggregate supply level.
The biggest structural push, over the longer term at least, has been to ween Europe off natural gas altogether. But even if the EU’s long-term energy security and environmental ambitions both point towards renewables, politicians are well aware that gas will be needed for the foreseeable future. Pipelines to alternative suppliers are being built, and there has been a marked increase in LNG inflows. Recognition of this need is perhaps why wholesale gas prices have not fallen further. Reserves were still above a reassuring 60% of capacity at the start of spring – the seasonal low point for reserves – and the build has been ahead of schedule ever since, but European gas and energy prices are still high by historical levels. This is despite weak demand on the continent, both current and projected.
Even with abundant supplies, the technologies for transporting or using them are not very flexible. This is fine if we can plan for periods of supply-demand imbalance, but the last few years have shown that the best laid plans go awry. For example, even with gas supplies filling up all available tanks, Europe is estimated to have at most two months of required gas for the winter. Two months spare should be more than enough, but further complications could always come about. The brittle nature of energy markets means that prices will likely remain volatility, even if the general trend is downward.
Still, a slow downward path will be good for European businesses and households. But unfortunately, this improvement in absolute terms is unlikely to give much benefit in relative terms. For one thing, the current oversupply is largely down to weak economic demand – hardly a good sign for the near future.