Freezing winter weather seems a remote concern as Europe swelters, but traders and strategists got a reminder last week of the continent’s fragile energy security and bond-market risks.
Spot natural gas prices leapt almost 30% in one day after strike threats in Australia jolted investors.
ING Groep NV, Rabobank and Saxo Bank A/S recommend positioning for a hawkish pivot from the European Central Bank as energy prices rise again, saying officials will look to stop long-term inflation expectations from drifting ever higher.
“Suddenly some inflation alarms are ringing again,” said Benjamin Schroeder, senior rates strategist at ING. “Recent swings in the price for natural gas highlight the lingering risk of supply disruptions to the more benign inflation dynamics of late.”
The next big focus for the market is the ECB’s own inflation expectations survey due Monday. But energy prices are ailing a host of markets including the UK, which lacks natural gas storage. The nation reports inflation data on Wednesday.
While Europe’s cold-weather supplies are plentiful, the region is still paying four times more than the US and about double what it was before the pandemic. As energy prices jumped, a market gauge of long-term inflation expectations tested the highest level since 2010 last week, which traders say will make it hard for the ECB to justify an end to its tightening cycle.
ING’s Schroeder cautioned that ECB hawkishness could escalate to contain the price-growth risks. He warned against jumping into curve-steepening trades — bets that yields on longer-dated bonds will rise faster than shorter notes. Markets should not underestimate the central bank’s “resolve and persistence,” he said.
Read more: Europe’s Rising Inflation-Risk Gauge Is a Headache for ECB
Europe’s reliance on liquefied natural gas imports was turbocharged by Russia’s invasion of Ukraine. Weaning itself off Russian energy supplies fed the bout of inflation that started last year and risks fanning future price pressure as the region remains highly vulnerable to any disruption to global energy markets.
Money-markets currently price a 40% chance of a 25 basis point hike from the ECB in September, with a further 66 basis points of cuts priced for next year. Rabobank echoed the likelihood that the ECB will need to show “more determination” to deal with inflation given the risk of further upward energy shocks.
“Energy is a really important crux for the ECB,” said Lyn Graham-Taylor, a senior rates strategist at Rabobank. He prefers European bond-steepening trades focused on the less policy-sensitive five- and 30-year curves — in contrast to the two- and 10-year curves.
Winter on the Way
Saxo Bank A/S blamed traders building higher energy prices into their positions for the steady rise of market-based inflation measures.
“Energy is the component that is going to keep inflation elevated and above the central bank target,” said Althea Spinozzi, senior fixed income strategist at Saxo Bank. “Winter is coming, natural gas is going to be more in demand.”
Rather than additional rate hikes, Spinozzi expects the ECB to stay on hold for longer. She favors the policy sensitive short-end of the yield curve, expecting the yield curve to flatten until October.
For State Street & Trust Co. the jump in prices is unlikely to result in a dramatic change to the ECB’s policy outlook, as the moves were not as dramatic as the ones seen last year and inflationary pressures continue to cool down elsewhere.
“If this is solely an energy price shock, it should not force too broad of a rethink in the market pricing for policy rates,” said Tim Graf head of EMEA macro strategy.
But factor in squeezed global food-supply chains, extreme weather events and WTI crude near a nine-month high — and a whole host of factors threatens to fan the pace of inflation.
“Parts of the market are saying the ECB needs to hike in September,” said Orla Garvey senior fixed income portfolio manager at Federated Hermes.
“A jump in headline inflation is an underpriced risk.”
--With assistance from Greg Ritchie and James Hirai.