From Russia, with love…
Commodity prices have been at the front of investors’ minds in recent weeks, as the price of natural gas futures has exploded in the UK and Europe in recent months and has dragged up the price of crude oil in recent days. Surging natural gas prices eased off on Thursday after Russia took steps to boost its natural gas supplies to Europe, which could help to avert a full-blown energy crisis as we head into the winter months. This was cheered by stock investors across the world, with all major European and US bourses rising on Thursday and the vix volatility index falling sharply. Interestingly, the 10-year Treasury yield rose to 1.57%, its highest level since June as we wait for the important US labour market report to be released on Friday. At the time of writing, market momentum is to the upside as we wait for the US payrolls report, and support for safe havens has drifted away.
Commodity price inflation is here to stay
Commodity prices have gripped the headlines for weeks, which has no doubt helped to push speculative interest into commodities such as natural gas where upside momentum has been strong. The news that state-owned Gazprom would boost supplies to Europe to avoid an energy crisis later in the year, helped natural gas prices to fall, although they remain extremely high by historical standards. Russian President Vladimir Putin said that the “speculative craze” in energy markets won’t do any good for Russia. While this may be true in the long term, in the short term, rising prices is extremely good for Russia and other gas producers from a commercial perspective. While the news that Russia would boost its gas supplies to Europe and re-fill its storage facilities in the Continenthas calmed the market for now, there is still a lot more inflation in the pipeline than there was at the start of the year. To put the move in natural gas prices into perspective, even after Russia’s conciliatory move earlier this week, UK gas prices for delivery in November are now 242p per therm, having started the year below 50p per therm.
Thus, do not expect any shift in interest rate expectations or a significant drop in Western governments’ sovereign bond yields in the short to medium term. The inflation story is not just about gas prices, other commodities such as coffee and cotton have also surged this year, and tight supplies are being met with record demand for goods, which is also triggering fears that central banks are behind the curve when it comes to inflation. Thus, it will take more than soothing words from Russia to get the world’s major central banks to stop worrying about price pressures in their economies.
The Bank of England and the pound
One central bank that could grab the inflationary “bull” by the horns is the Bank of England. The new chief economist at the Bank of England, Huw Pill, said that he had “great concern” about the inflation outlook, and firmly placed himself on the hawkish side of the BOE’s Monetary Policy Committee. There has been an increasing number of bets that the first rate rise from the BOE could come in December, right now the market is priced for 15 basis points of tightening by February 2022. This has boosted the pound, with GBP/USD rising above $1.36, although it scaled back some previous gains as we progressed further into the trading day. Further EUR/GBP weakness looks almost certain at the end of this week, after a poor set of PMI reports for the currency bloc and weaker German industrial production data hurt sentiment towards the single currency. We expect a build-up of euro shorts in the short term, especially if we see a stronger than expected NFP report on Friday. This could weigh on EUR/GBP, especially now that UK Gilt yields seem to have stabilised around 1.8%. Earlier this week, rising Gilt yields started to weigh on the pound, however, some stable economic data has helped to break that link, and we think a moderate rise in UK yields from here could be supportive of the pound. EUR/GBP is currently below 0.8500, with a big test around the corner at 0.8450, the low from 10TH August. If this level is breached, then we could see a significant shift to the downside.
NFPs: why the bar is low for the Fed to taper next month
We have mentioned above that the Federal Reserve will not only be relying on Vladimir Putin to dampen global inflationary pressures, its next move to start tapering asset purchases in November could be signed, sealed and (almost) delivered come Friday lunchtime. The Fed said at its September meeting that it wanted to see another payrolls report before it committed to tapering, however the Fed chair said that it wouldn’t take a knock-out number for them to start tapering asset purchases next month. The market expects a reading of 490k for payrolls, however, we think that a reading of 150-200k would be enough for the Fed to start tapering in November. The US has had some strong economic data this week, including the ISM services index that surged to 61.9 last month, with new orders rising to 63.5 and the employment index falling slightly to 53, from 53.7 in August. We believe that jobs data on the service sector will be the most important component to watch on Friday. Consumer spending is shifting towards services, and away from goods, thus services have the ability to drive the US economic recovery forward in the coming months, but that will depend on the extent that the labour supply is available. Thus, tomorrow’s report could tell us two things: 1, virtual confirmation that the Fed will start tapering asset purchases next month and 2, whether or not the service sector can turbo charge US growth in Q4.
NFP trade ideas
The trade we like leading up to payrolls is EUR/USD, where we think the bias is lower. The dip below $1.16 earlier this week was a negative sign for this pair and it is close to its lowest level of the year. This opens the way for a move back to $1.1520 and then $1.1475. From an equity perspective, a decent payrolls figure that makes a taper announcement from the Fed in November likely, could trigger a move higher in US bank stocks. Although some of the bigger names are already at multi-month highs, we still prefer blue chip banks with strong fundamentals, as they should benefit the most from the higher US yields and rising interest rate expectations. There is some room on the upside for Citi, which could try and return to its June high. We also think that JP Morgan could make fresh all-time highs, if US economic data remains strong at the same time as Fed interest rate expectations for 2022 rise.