US & Americas Political Macro Commentary – January 19, 2022

Nicholas Glinsman | January 19th, 2022

COMMENTARIES

  • When will tightening create tighter financial conditions?
  • New personnel at the Fed – what is the latest in the nomination process
  • A look at inflation and stock prices
  • Could we see $300 crude oil?
  • Are the Germans now trying to appease the Americans over Russia and Nord Stream 2?
  • Growth is Latin America’s big challenge

When will tightening create tighter financial conditions?

When and how will the pullback from ultra-stimulative monetary policies lead to a meaningful tightening of financial conditions and what will the spillover effects be for the global economy? Already, expectations have changed drastically for US monetary policy. Less than two months after Federal Reserve Chair Jerome Powell “retired” the “transitory” characterization of inflation, consensus for this year has shifted to include the end of large-scale asset purchases, at least three interest rate increases starting in March and the initiation of shrinking the central bank’s balance sheet.

We have seen this change occur as we get a 7% hit on CPI, combined with a steaming labour market. Indeed, this change has intensified in the past two weeks despite the increase in Covid-19 omicron cases, a slowdown in China’s economy and downside revisions to global growth projections, including by the World Bank. Furthermore, a few other developed countries, such as the UK, are more advanced than the US in reducing exceptional monetary policy stimulus. It is only a matter of time until others join the fray.

However, all this has not yet led to a significant tightening in overall financial conditions. Consequently, the real economy has not yet felt any contractionary impulses, markets have been relatively sanguine, even including yesterday’s price action, and developing countries have experienced few disruptive spillovers.

Several reasons have been proposed for the current disconnect between less dovish monetary policy and relatively unchanged financial conditions — some that are reinforcing and others less so:

  • One set of reasons relates to the willingness and ability of central banks to validate expectations for monetary policy tightening. Informed by the experience of several years, some feel that central banks will not have the stomach to go through with removing stimulus. Others believe they will be quickly forced into a U-turn as the economy, long conditioned by ultra-loose policies, struggles with a withdrawal of liquidity — and particularly so given that the Fed overly delayed its policy adjustments and now has to bunch together three contractionary measures.
  • A second set is based on the view that, given the relative magnitudes involved, it is the existing liquidity that matters rather than the reversal in flow. Financial conditions will continue to be governed by the enormous amount of liquidity sloshing around the system rather than the incremental policy changes. It is a view that is reinforced by the fact that, despite the anticipated measures, the 2022 monetary policy stance is likely to remain accommodative overall.
  • The third set is more behavioural in nature. Given the multiyear conditioning of markets by ultra-dovish central banks, it will take time to persuade investors to fully price the new policy realities. In this thinking — and especially given the deep anchoring provided by the combination of BTD/TINA/FOMO (Buy the Dip because There Is No Alternative to risk assets, especially given the Fear of Missing Out), markets would need unambiguous and overwhelming evidence of a durable change in policy before pricing it fully.

Almost regardless of the reason, the disconnect undermines the likelihood of a timely and orderly adjustment, thereby increasing the risk of a policy mistake. To assess this over the next few weeks and months, market participants would be well advised to:

  • Look more to developments in fixed income than in stocks in order to assess the degree to which financial conditions have started to tighten;
  • Focus on changes in yields on shorter-term bonds (up to five years) as reflective of effective policy expectations more than longer-term ones, which are influenced by a much bigger set of factors;
  • Recognize that the economic impact will take time and is likely to lag financial market developments;
  • Appreciate that the adverse implications for developing countries are more front-loaded, especially when, rather than if, the flow of capital to them reverses in earnest.

When some talk about the possibility of a new conundrum, it is important to recognize that the longer the disconnect persists, the more it may narrow what is already a small window for an orderly policy, market and economic adjustment. As the Fed was late to react to the pronounced change in the macroeconomic paradigm, from deficient aggregate demand to deficient aggregate supply caused by quite persistent supply chain disruptions and labour shortages, the global economy faces a bigger range of potential outcomes in 2022 and beyond. Now it also has to navigate a delayed and uncertain reaction of financial conditions

And while on the Fed…

New personnel at the Fed – what is the latest in the nomination process

The White House continues to progress with its effort to fill out the Fed Board by formally nominating Sarah Bloom-Raskin for Vice Chair of Supervision, as well as Lisa Cook and Philip Jefferson for the remaining open Board seats.  As expected, Republicans have begun to criticize Raskin’s climate policy views, even before she was formally nominated. Separately, trade associations representing small banks (e.g., ABA, ICBA) praised her nomination.

in order to be confirmed, the Fed nominees need 50+ Senate votes, and given Raskin, Cook, and Jefferson’s progressive orientation, they will need to rely primarily, if not exclusively, on Democratic votes to get to the 50+ mark.  Unless controversial prior or new statements emerge from Cook and/or Jefferson, it appears that Raskin will be the most controversial of the nominees.  Her assertions that the Fed should get involved in climate policy are of very significant concern to Republicans, and they will argue that not only is this an inappropriate role for the Fed in the abstract, but that it threatens jobs in the oil and gas sector.  To the degree that argument begins to resonate, it could create concern for Democrats who represent states with an oil and gas industry presence (for example, Senators Tester, Manchin, and others.)  Whatever support Raskin receives from some moderate Republicans, which is a possibility given her prior unanimous confirmation by the Senate during the Obama administration, could offset any dissent among Democrats.  The praise she has received from small banks is a major positive for her confirmation, as they are a very powerful stakeholder group in Congress and any objections from them can be very damaging to both parties. 

Given the above, it is hard to predict her prospects for getting through the Senate, given the reasonable assumption that some uncertainty will emerge among moderate Democrats, thereby slowing the process and not resulting in her confirmation by the full Senate before the latter part of Q1 or sometime in Q2.  As a result, significant action on Raskin’s policy agenda, which will likely focus on SLR and climate, as well as possibly crypto, Volcker, stress tests, and other issues, will not get underway until she is both confirmed and has an opportunity to assess these issues, and as such, this takes the timeframe into Q2 or possibly Q3 for initial action.  Given that Cook and Philips are not well known, some time will be required for vetting among Senate Democrats, which will result in their confirmation not occurring until about the same time. 

We will be looking for comments about Raskin from moderate Democrats on the Banking Committee (such as Senators Tester and Warner) and those representing oil and gas states (Joe Manchin)  We are not likely to get clear comments from them until Raskin’s confirmation hearing or later.  It will also be important to see if controversy surrounding climate policy emerges for the Cook and Jefferson nominations, as well as how they are perceived by small banks, which as noted, is a key source of influence on the views of moderate Democrats.

Elsewhere, there has been no formal announcement as to when the Senate Banking Committee plans to vote on the nominations of Jay Powell to serve another term as Fed Chair and Lael Brainard as Vice Chair.  Powell’s term as Chair expires on February 5th.  There was no unusual controversy surrounding either nominee at last week’s confirmation hearing.

Republicans questioned Brainard about climate policy at last week’s hearing and she was effective in avoiding controversy by saying it is not the Fed’s job to tell banks what sectors to lend to and by avoiding any comments about going beyond climate scenario analysis, including to a more aggressive approach of integrating climate into stress tests, as progressives would like to see.  As expected, the trading and ethics controversies at the Fed do not appear to be having a materially negative impact on Powell’s confirmation.  However, criticism from Elizabeth Warren and general discontent from progressives about Fed regulatory policy will likely reduce support for him from Democrats.  While Powell and Brainard are likely to have lower levels of support than is typical for Fed nominees, there is no indication they are at risk.

Expect comments soon from Senator Brown, Chair of the Banking Committee, and Majority Leader Schumer as to when votes will be held on Powell and Brainard’s confirmations.  The delay in their confirmations until the point at which Powell’s term is expiring is a function of broader Senate scheduling issues and the White House’s slow pace in making the nominations.  It is likely that they will receive a Banking Committee vote this week, and with the Senate floor dominated by other issues this week and the Senate out of session next, they are unlikely to be confirmed by the full Senate until early February.  Democrats would like to avoid going beyond expiration of Powell’s term as Chair, but there is precedent for this occurring, Alan Greenspan being one such.

A look at inflation and stock prices

In the following chart, I’ve put the real S&P 500 (divided by the Consumer Price Index) on the right scale, and the annual change in CPI on the left. None of the first four times when yields started rising signaled an attractive opportunity to buy stock in real terms, and this was because inflation was generally high and rising. In the last three decades, with inflation under control, buying when yields started to rise generated good real returns each time — but this generally also involved buying at the bottom after a financial accident. It’s hard to say that the current situation is much like the Covid implosion of March 2020, for example, or the end of the post-Lehman collapse in 2008, or the Long-Term Capital Management meltdown in 1998. In all those cases, yields were rising but there was ample support for markets from monetary policy, thanks in part to low inflation. If inflation doesn’t burn itself out in short order, what are the chances that this will happen again this time?

The most important part of the bet that markets are now making is that inflation will indeed come down without too much coaxing. There are definitely technical pressures that should tend to push it downward in the next few months (along with some others that push upward), and the market is sensibly positioned for this outcome. But a lot is riding on this. It’s four decades since the Fed last started to raise rates with inflation this high — and the stock market of the last two decades is very different from the pre-Volcker world of the 1960s and 1970s, when high price rises seemed to be a fact of life. 

Markets are probably right to accept that things are different and that rates will really rise this time. The much harder question is whether they’re right that things aren’t so different when it comes to inflation. 

Could we see $300 crude oil?

Have I got your attention? The answer is unlikely, as even adjusting for inflation, it’s never been at that level before, and in any case, as yesterday’s energy source, condemned by the demands of climate change to terminal decline, isn’t it meant to be all over for fossil fuels? However, in Europe and parts of Asia at least, we have already seen natural gas prices spike up to the oil price equivalent of $350 a barrel, so it is not altogether impossible that the black stuff might follow suit.

Of course, if it does, it’s going to shake the global economy to its core, in much the same way as the oil price shocks of the 1970s. Analysis by Doomberg, a US-based newsletter published on Substack, makes a plausible case for it. “In a world where US oil production tapers off, spare Opec+ pumping capacity fails to materialize, financing for new exploration and development continues to shrink, and demand for oil in the West continues to grow while exploding higher in the emerging economies, what happens to price?”, Doomberg asks. It scarcely requires an answer.

Not that you’ll feel the effects in your pocket for a long time to come, at least in my home country, the UK. There, the price cap is a lag restraint, which allows suppliers to continue charging high retail prices even after the wholesale cost has collapsed back down again. Coming up fast in the wings now, however, are levitating oil prices.

Even at current, slightly more subdued wholesale gas prices, there is a big mismatch between the price of natural gas and that of oil, the latter of which today trades at around $88 a barrel as measured by the Brent benchmark. This in turn presents plenty of opportunities for arbitrage. Electricity generating plants in the US and Japan that can have swapped their feedstock from natural gas to oil to take advantage. There is unfortunately little such flexibility in the UK and Europe, where the fallback energy source amid eye-wateringly high natural gas prices has tended to be coal.

The effect of this arbitrage is to progressively narrow the difference between the two prices. Since the start of the year, natural gas prices have been falling, but oil prices have been rising. The gap nonetheless remains a wide one. Unlike oil, natural gas is not yet a global commodity; it remains substantially trapped in local markets. Where exported, the quantities are constrained by limited LNG capacity. The problem is particularly acute in Europe, where the fracking revolution that has provided the US with plentiful domestic supply is either banned or discouraged. Climate change goals have meanwhile starved more traditional sources of fossil fuel supply, such as the North Sea, of the capital needed for further development. The lack of foresight is breathtaking. Yesterday’s fuel they may be, but for now, fossil fuels remain the very lifeblood of a thriving economy.

Despite all the starry-eyed talk of an accelerating energy transition, we are still a long way from the promised land of boundless and cheap green energy; for now, the world remains overwhelmingly dependent on fossil fuels for transport, heating and baseload electricity generation – and will remain so for years to come. Traditional sources of energy are being dialled down before green grids are ready to take their place.

When the pandemic hit, demand plummeted and virtually all except already committed investment in fossil fuels ceased. What’s happened since is that the demand has come roaring back, but supply hasn’t, even in the US. That shortfall has caused prices to skyrocket. Now that we can see omicron for what it is – something of a false alarm – the situation is set to get worse still. Opec could up production to compensate, but quite how much capacity it has for doing so is open to question. Three hundred dollar oil? Perhaps not that high, but something much higher than now is certainly plausible.

Oil price spikes tend to be self-correcting, in that they both incentivise higher investment in the sector and press down hard on demand, eventually bringing the two back into balance. But they can do an awful lot of damage in the meantime. And if we continue to discourage the required fossil fuel investment, then prices will remain high for a long time to come. Today’s energy crisis has been many years in the making, yet we have failed to take evasive action and carried on regardless. What we are seeing is a massive, politically destabilising failure in energy policy, for which the bottom half of the economic ladder will pay a heavy price in lost disposable income.

Now, with regard to OPEC specifically, there was an interesting exclusive from Reuters, the following is of note:

“As demand recovers, OPEC+ has been aiming to raise output by 400,000 bpd per month, but the actual monthly production increases are coming in lower, as many producers can’t pump more and those that can are sticking to quotas. “OPEC+ has difficulty producing at its target level because the necessary investment in the oil industry has not been made in the last two years, and the effect of Omicron on short-term oil demand was mild,” the source added, adding these are the two major factors fuelling the rally. In November, the latest full month available, OPEC+ production was 650,000 bpd below target, according to International Energy Agency (IEA) figures.”

And then you have this from the Wall Street Journal, in an article entitled Oil Demand to Exceed Pre-Covid Levels in 2022, IEA Says:

“Global oil demand will exceed pre-pandemic levels this year thanks to growing Covid-19 immunization rates and as recent virus waves haven’t proved severe enough to warrant a return to strict lockdown measures, the International Energy Agency said Wednesday. In its monthly oil market report, the IEA hiked its oil demand growth forecast for the coming year by 200,000 barrels a day, to 3.3 million barrels a day. The Paris-based agency also raised its demand growth forecasts for 2021 by 200,000 barrels a day to 5.5 million barrels a day…

… Total demand this year should stand at 99.7 million barrels a day, around 200,000 barrels a day more than 2019 levels, the IEA said. Last month the IEA was expecting this year’s oil demand to be broadly on par with pre-pandemic levels… While the IEA’s view on demand has grown stronger, the body still expects supply to exceed demand by a narrow margin throughout 2022, despite signs that major producers were struggling to increase their output at agreed-upon levels…

The combination of robust demand and tepid supply hikes are helping to push crude stockpiles lower, something which analysts broadly think will keep oil prices supported this year. The IEA said that stocks in the wealthier nations that make up the Organization for Economic Cooperation and Development fell by 6.1 million barrels in November to a seven-year low of 2.76 billion barrels. Preliminary data showed a further decline of 45 million barrels in December.”

Are the Germans now trying to appease the Americans over Russia and Nord Stream 2?

It is not really a big deal for Olaf Scholz to say that Nord Stream 2 needs to be discussed if Vladimir Putin were to attack or invade Ukraine. Of course it will be discussed. It already is. What he didn’t say is that Germany would agree to block the pipeline. It is possible that the pipeline’s output might be calibrated to ensure that gas continues to flow through Ukraine. Or that the regulatory process might be delayed further. There are intermediate options. But, as yet, there are no indications of a policy shift in Berlin.

Also consider that Nord Stream 2 is not yet operational. Nothing would need to be switched off. Regulatory approval is not expected until the summer. The European Commission will, presumably, also have a go at this afterwards, so it might take a few more months until the gas actually starts to flow.

The US would almost certainly impose sanctions on Nord Stream 2 if the project were to go ahead after an invasion. What Scholz is trying to do now is appease the Biden administration while simultaneously appeasing the Russians. This is an old German foreign policy game. Willy Brandt, Helmut Kohl and Gerhard Schröder were most successful at it over the years. Until recently, we would have classified the German-Russian relationship as the most strategic bilateral relationship in western part of the Eurasian continent. The Franco-German relationship is heavier on symbols, and obviously takes place inside the EU. An long-standing German political saying has it that from the perspective of Berlin, Warsaw was the nearest neighbour, and Moscow the nearest city: politically, not geographically. Paris, London and Washington were out of sight. Such a view appears to be shared by a surprisingly large number of Germans.

The Greens’ opposition to Nord Stream 2 is unbroken, but has more to do with gas as a fossil fuel than with Russia. If Russia cuts off the gas, Europe will suffer energy shortages that it cannot plug by switching to alternative sources. The energy dependence is not a hypothetical scenario. Without Russian gas, Germany would need to increase coal production, and keep its last three remaining nuclear power plants switched on for a little while longer. The Greens may come to realise that without Nord Stream 2, the energy transition would be delayed.

Much was also made yesterday about Annalena Baerbock’s visit to Moscow. The German foreign minister has turned into a formidable operator, potentially the first political heavy-hitter in this job since the days of Hans-Dietrich Genscher. What was interesting yesterday was her highly symbolic refusal to shake hands with Sergei Lavrov, Russia’s foreign minister. After a joint press conference, in which the two expressed their different views, she left and walked past him right to the door. Interpret this as you like. What matters perhaps more is that Russia is no longer looking at Germany in the way it did in the past. The really important meeting for Lavrov this week is with Anthony Blinken, the US secretary of state. Unfortunately, there are no predictions that can be made now about what might be the latest diplomatic effort to prevent a Russian attack on Ukraine, although Blinken has yet to prove himself capable of pulling the proverbial rabbit out of the hat.

The German defence ministry, meanwhile, denied that it rejected a UK request to fly over German air space to Ukraine. The Frankfurter Allgemeine notes that west European and US military air planes do not usually require permission to use air space, but rely instead on what is known as diplomatic clearance, a fast-track clearance procedure among Nato members, that gives countries the opportunity to refuse it in theory, but not in practice. This still does not explain why UK air planes avoided German air space. There may be a technical, or security-related reason for this. It might also be that Germany might have raised objections to the UK decision, prompting the UK authorities not to seek diplomatic clearance in the first place.

. It is also interesting that Ben Wallace, the UK defence secretary, gave the most coherent assessment by any western politician yet of what is behind Russia’s possible aggression against Ukraine, and why the west needs to act forcefully. The UK, however, also made clear it will not engage militarily in any conflict.

Clearly, Russia is well prepared for western sanctions. A prolonged military campaign carries political risks for Putin, hence the massive troop mobilisation near the border with Ukraine and in Belarus. But it would be a big mistake for us to think that this is a war in which everybody ends up as a loser. The EU certainly will. But Putin might not.

Growth is Latin America’s big challenge

It may seem hard to believe today but Brazil and Mexico were once the envy of the world. Their economies grew more than 6 per cent a year from 1951-80, almost as fast as postwar growth paragons South Korea and Japan.

Since the debt crisis of the 1980s, Latin America has fallen badly behind. In recent years it has sunk to the bottom of the emerging market class, underperforming the Middle East or subSaharan Africa. Latin America’s inability to grow generates much hand-wringing and many theories. Low productivity, poor infrastructure, corruption and political instability are recurrent themes. Criticisms are levelled at the leftwing governments of the early 2000s for not investing enough wealth from the commodity boom in building competitive infrastructure or delivering high-quality education and health. The right is faulted for doing too little to tackle entrenched inequality, promote effective competition or make taxation fairer.

Coronavirus cruelly exposed Latin America’s limitations; the combined health and economic impact from the pandemic was the worst in the world. Now change is in the air. In a series of important elections, voters in the region have turned on incumbents and picked radical newcomers. Peru and Chile have swung far to the left, Ecuador, Uruguay and Argentina have tilted back to the right. Brazil and Colombia vote this year.

Fortunately, Latin America’s plentiful natural resources mean that opportunities abound. The region is rich in two key metals for electrification: copper and lithium. Home to some of the world’s sunniest and windiest areas, it could generate gigawatts of ultra-low-cost electricity to produce and export green hydrogen. The region is in the middle of a tech boom so big that it attracted more private capital in the first half of last year than south-east Asia. The world’s biggest standalone digital bank, Nubank, is Brazilian. Tiny Uruguay is a leading software exporter. A push by the US to bring production closer to its shores could give manufacturing in Mexico and Central America a fillip. Brazil has fostered the development of globally competitive high-tech agriculture.

To exploit these opportunities to the full, Latin America needs to adopt pragmatic solutions that leave behind ideological debate. This should begin with the axiom that wealth must first be created to be shared. A flourishing private sector, a fully functioning state, quality public services, the rule of law and foreign investment are all essential ingredients. Taxation in some nations is too low but raising it will only help if the proceeds deliver healthier, better educated and more productive citizens, and competitive economies. Too often in Latin America, higher government spending has meant padded payrolls and increased corruption, rather than better outcomes. Citizens across Latin America are growing restive. Tolerance for governments of any stripe that fail to deliver is minimal. Their faith in elected presidents is being sorely tested.

During the last growth spurt, Mexico was a one-party state and Brazil mostly a military dictatorship. If the region is to avoid sliding back into populist authoritarianism, its new leaders urgently need to show that democracy can deliver strong, sustainable growth and shared prosperity. That means abandoning dogma and seeking consensus around long-term policies to build effective states, strengthen the rule of law and create globally competitive economies.

Unfortunately, time is running out and I am not holding my breath.