ANDREAS STENO LARSEN: Hi, I'm Andreas Steno, and welcome to the Real Vision Daily Briefing. We are sending to you live, Wednesday, September 7th, on the back of an interesting day. In particular, in commodity markets, we've seen a landslide in the oil price over the past couple of hours here. And today, we're actually going to ask the question whether the world is upside down.
What will central banks do in response to all of the bailouts that we've seen announced in Europe this week? And to answer that question, together with me, I've invited Darius Dale, the founder of 42Macro. Darius, it's great to see you again.
DARIUS DALE: Likewise, Andreas, good to see you, man. How are you doing?
ANDREAS STENO LARSEN: All good, Darius. Let's have a look at the price action today. We've seen a material drop in the oil price over the past three, four hours here. What do you make of the price action in the commodity space right now?
DARIUS DALE: Yeah, I'd start by saying great question, because that to me seems to be what's driving the risk across broader asset markets in terms of the positive response we're seeing in fixed income. And as a function of that, a positive response we're seeing in equities and credit. This move in oil is largely technical from my perspective, just at least in terms of you have this, I forget what they call it, the death cross or whatever.
One of these, I guess, when the 50-day moving average breaks down below the 200-day moving average, you've seen a lot of investors de-risked their exposure in terms of taking down their position size, or just getting rid of the exposure altogether. In fact, it was something we flagged last week, WTI crude oil specifically broke down to bearish from the perspective of our volatility-adjusted momentum signal. Typically what happens in these big breakdowns of breakouts, volatility tends to be the leading indicator for price.
This is another example of the volatility signal a frontrunning what was very clearly a technically driven sell off. Is it sustainable? We've seen OPEC+ come out and try to push back against it in terms of trying to stabilize markets. We saw a pretty toke in supply production cut, targeted production cut a couple days ago, clearly it did not work. I think we're in a phase over the next couple of weeks to see their response. Is $80 the right price from their perspective, or do they want it more to close to $90, which is where they initially started targeting some intervention, verbal intervention?
ANDREAS STENO LARSEN: We've seen politicians across the European continent trying to contain the situation within the electricity and energy sector over the past four to five days with announcements on bailouts. We know that the European Commission will meet up on Friday to discuss the situation and potentially solve it, hopefully solve it I would say, but what do you make of the current string of announcement on bailouts in Europe? Is it something that matters for markets?
DARIUS DALE: Yeah, definitely. Let's play this forward. Typically, what happens when you have expansionary fiscal policy, you tend to wind up with higher levels of demand, both for the private sector, and as a function of that high level of demand, you wind up with exacerbating supply chains, et cetera, and you wind up with higher inflation. This type of intervention, however, from a fiscal authority perspective particularly in Europe, we got the new Prime Minister Liz Truss plan to curtail energy prices, there's talks of the European Council to do the same thing.
If we start to see that, then what we're going to see, we're going to wind up with a depressing influence over inflation because we have not seen the full brunt of electricity price hikes get pushed to European consumers, either in the UK or across the broader European Union. At the margin, that would be a positive element, because traditionally what happens the fiscal authority, it eases and has expansionary policy, whereas the monetary authority in these types of regimes tends to have contractionary policy to mop up some of the excess liquidity.
And I think, on the margin, you could wind up in a scenario relative to current market pricing, where both the fiscal authority and the monetary authority are easing at the margin, because again, we're addressing the energy price shock directly.
ANDREAS STENO LARSEN: If we look at the current policy mix, so bailouts being announced and presented by right about every prime minister in Europe right now. And interest rate hikes being on the table from the European Central Bank, from the Bank of England, from Bank of Canada, just again today, from the Federal Reserve. It seems as if the world is upside down compared to the 2010s, does it? It seems as if the central banks are now the tight part of the policy mix while the politicians are bailing out everyone.
DARIUS DALE: Plenty of other guests on this program and other programs on Real Vision have come on and talked about this, we have transition to an era of physical dominance in lieu of monetary dominance. Now, what's driving that transition at the ground rooted at the first principles level is a proliferation of a decline in working age population participation in the labor force, largely because a lot of the developed markets have shipped their jobs to lower cost manufacturing hubs like China, Mexico, et cetera. And then you've also seen a blowout of income inequality, not the least of which has been driven by the expansionary monetary policy we saw throughout the 2010s.
As a function of that, we've seen in the pandemic, the pandemic was very clearly a big lurch forward in this process for expansionary fiscal policy, but I would argue, at least in the US, in particular, it started with the tax cuts and Jobs Act five years ago. Now, we're in this new era where central banks are no longer the only game in town, if anything, they have to take out their mop and mop up the excess liquidity. But again, I don't know that the desire to mop up the excess liquidity will continue to rise at the same pace if in fact, we do see fiscal authorities address the energy crisis head on.
ANDREAS STENO LARSEN: The European Central Bank will meet tomorrow. And I think the consensus is slowly but surely moving towards 75 basis points among sell side analysts, the market is a bit less certain on the 75 basis points. But given this backdrop of massive bailouts being presented across the European continent, what do you make of the European Central Bank's reaction function in relation to this series of bailouts being presented?
DARIUS DALE: Well, to me, I think it's less about-- in my opinion, I think it's less about the central bank's reaction function, and more about the market's reaction function. Because this expansion of fiscal budget deficits effectively, which is what this is going to equate to, has to get capitalized by someone or some entity. We're used to the ECB expanding its balance sheet, the Fed expanding its balance sheet, and effectively capitalizing the European governments and the US governments as a function of that process.
But now, we're very clearly in a state where, at least on the US side, balance sheet is contracting, on the European side, balance sheet is probably stable, if you will, over the next-- at least the current outlook is probably support stability and so it's pushing more of the onus in terms of capitalizing the governments back towards the private sector. Now, that's not the end of the world if you're talking about Europe, because it's a current account, at least for now, current account surplus of the nation with excess savings on its balance sheet.
The US on the other hand is a current account deficit nation. Again, we've seen that spread narrow in terms of trade shock, but we need to capitalize the fiscal authority to the extent we do see an incremental lurch forward in fiscal policy in the US which we are experiencing. We talked about that if over the last few weeks. We're seeing student to loan debt relief, we're seeing things like cash and gas prices, et cetera.
There was one more thing but yeah, there's three things the Biden administration has done, inclusive of the inflation Reduction Act, to basically take up incremental fiscal spending to effectively offset inflation, which historically is not the smartest idea.
ANDREAS STENO LARSEN: True. But we've actually seen markets calming down a little bit after the announcements of the bailout packages in Europe. And I want to bring up a chart on the so-called Clean Spark Spread. And now, I'm getting thrown into the deep end here, because I'm not an electricity expert. But I've spent most of my week in telcos with power trading desks in Europe, because electricity is basically what's driving everything right now in the European landscape.
And what this measures is basically the input spread between the natural gas price and the electricity price that a utility can sell forward on. And the interesting thing here is that the spread between the electricity price in forward terms and the input price of the natural gas used to create the electricity basically blew up throughout last week. And it went all the way above 400 euros per megawatt hour, which is a level that we've never seen before. And this was the exact spread that triggered this story about 1.5 trillion worth of margin calls across the European continent in the energy sector.
We've actually seen a sharp retracement in this spread after the government stepped in to calm down markets with these bailout announcements. I think we can take that margin call story at least partly off the table again. It's still bad, but it's not as bad as it was reported last week. So quite interesting that we see these developments in the European electricity markets. But I also wanted to ask you, Darius, is the electricity market a hot topic in the US as well right now?
DARIUS DALE: No. We still have electricity. I do have one thing to add at the expense of sounding like a complete uninformed fool on this subject matter. I thought when I saw the story on the 1.5 trillion of margin calls, that was actually positive. It's like the only time where margin calls are broadly positive. Because what it probably ultimately means is that a lot of traders and speculators who've driven up the price of forward gas prices in Europe have to basically cut close those positions-- about those positions, and I think that's one of the outcrops of that is that it's getting too expensive from a risk budgeting perspective to maintain the position sizes.
We've seen those positions cut, and as a function of that, the outlook for European energy prices at the margins relative to that condition had actually improved. This is something we're-- not this specific thing, but we're picking all these different dynamics up in our nowcast models for things like Eurozone CPI. In fact, Brian, just pull up that chart, our model is suggesting that European inflation is likely to peak sometime in September and October timeframe.
And that's relative to the draconian, the worst-case scenario, which is we continue to see ongoing price depreciation in energy and electricity prices, which would have been picked up by our nowcast model, it's the purple line in the charts. That's a better dynamic than I think the consensus view on Europe, and you talk about this all the time. The consensus view on Europe is that inflation is going to just go through the roof. Europe's going to go through the abyss economically.
And I think over the last few weeks, we've gotten enough datapoints from the perspective of policy and the perspective of price in the markets to tell you that those things are less true.
ANDREAS STENO LARSEN: I tend to agree with your assessment. By the way, I think we will have a material spike in the CPI index in Europe over the next one to two months before a sharp retracement low. And that's also what's being indicated by the future pricing right now in the natural gas space for example.
I also find it interesting that given that Putin actually decided to cut the flows to zero in the Nord Stream I pipeline, we haven't seen new highs in the European nat gas futures. Which is interesting, because if the flow is already zero, it's impossible to surprise to the downside on the float. I think the worst-case scenario is more or less priced in buy now.
DARIUS DALE: Sell the news, and exactly, yeah. Who's buying European nat gas today on the view that Putin might cut off the spice, the positions were already put on. That's one of these classic dynamics where markets are forward looking. And very clearly, they priced in already the furthest left tail of the distribution of outcomes. And I would argue at the margins, we're probably cutting off that tail, just based on the policy response.
ANDREAS STENO LARSEN: If we look at the European Central Bank ahead of tomorrow, I think we can bring up a chart on the pricing of the European Central Bank over the coming couple of years here. The Euribor curve peaked just south of 2.5%. What do you make of a level of 2.5% on the policy rate in comparison to inflation levels close to 10% or even above?
DARIUS DALE: Yeah, so there's a couple of things I'll say, obviously, relative to history, that's usually not going to cut it historically speaking when you analyze tightening cycles, you tend to have to get the policy rate above the observed level of inflation in order for it to see that big disinflationary process take hold and have it be self-sustaining. This time might be a little different, though, famous last words are the most dangerous words.
But if, Brian, if you pull up that chart, Slide 98, where we show the ISM manufacturing in services indices, there's a sub-index within those reports called the percentage of respondents reporting slower supplier delivery times. And this is a good proxy for supply chain disruptions so when that chart spikes, that's telling you a very high and large percent of respondents are saying, hey, it's harder to get goods, harder to get services, because there are supply chain disruptions.
Well, we're basically seeing the opposite take place in the most recent months. For all the talk of supply chain disruptions that we had throughout 2021 and into the early part of this year, they're basically moving in the opposite direction with the same degree of expediency that they move to the upside. There is some element of inflation that we all understand, or at least most of us should understand by now, that was in fact transitory and that transitory inflation is receding at the margins and may make the European inflation story and even the US inflation story look a lot better in the coming months than I think probably the most ardent bears are willing to admit.
ANDREAS STENO LARSEN: If we look at the FX developments over the past three to four months, it's quite clear that the release valve when we have a situation with an energy crisis in Europe and in Japan, and central banks are hesitant to react to it by a tighter policy in the FX channel versus the dollar. We've seen new lows during the day in the pound sterling versus the dollar. I think we need to go back three and a half decades to find as low levels in the cables of the pound sterling versus the dollar. What do you make of the FX development right now and the spillovers to Central Bank reaction functions in Europe and in the US?
DARIUS DALE: Very clearly, what's driving the currency market right now, it's much bigger than the traditional interest rate differential story that's the, I would argue, the base case scenario. Right now, what's driving the FX channel largely is this terms of trade shock we're seeing between the US and Europe. Europe is swinging from largely, if you'd look at the Eurozone continent in aggregate, a very large current account surplus of the country or not a country, a region or an economy rather, that looks a lot closer to more neutral.
And then on the other side of that reduction, that narrowing of the current account surplus, we're having our current account deficit narrow. And that's really what's driving those flows, that term of trade shock is really showing up in flows. It's also showing up in the capital account as well. Don't forget that the US, if you aggregate the last few years, we're tracking it like plus $7 trillion, $8 trillion in terms of the change in our net international investment positioning to the downside, which means we're importing all that capital into the US.
And obviously, there's been a variety of reasons for why that's happened throughout the pandemic era, not the least of which is we issued a lot more debt than most people. Because of the issuance of debt, we had a massive fiscal expansion that turned into a massive outperformance in growth, massive outperformance in earnings growth, corporate profits, and ultimately massive outperformance in asset markets.
And so all that capital is, I would argue just in terms of the relative performance of indices and the relative valuations of indices, is still trapped here. But obviously, if you look forward ahead, maybe six, nine months from now, that dynamics are likely to reverse once we get towards the lows of the global growth cycle, and we started to see some of those flows abate and going the other direction.
ANDREAS STENO LARSEN: In relation to this debate on debt levels in Europe, I wanted to play a soundbite for you. It's from an interview I did with Emil Kalinowski, the host of the Eurodollar University podcast, by the way, a very good podcast. He's talking about the fundamental risks underlying the situation in Europe because Europe basically headed into this energy crisis with very high levels of debt, both privately and public debt. Let's listen to Emil's point here and get back to that debate.
EMIL KALINOWSKI: As Jeff and I often talk about on the show, we're not fans of central bank quantitative easing in terms of generating economic activity or inflation. We don't believe it creates either. We believe that they create bank reserves that then sit idle on bank balance sheets, because the banks think that it is too risky to lend out there. And right now, it does seem absolutely too risky to do.
That's why I believe it would take politicians strong arming these banks, commandeering them, informing them that they must, as a national security issue, as an emergency to the cost-of-living issue, that they must issue the credit and the loans into the private sector. And that's what will get liquidity into the system.
Quantitative easing isn't really liquidity for the economy, it's liquidity for the banking system that doesn't want anymore. If you want liquidity for the economy, you've got to get banks to lend they won't, because it's too risky. The politicians have to step in and guarantee the lending.
ANDREAS STENO LARSEN: The entire interview between Emil Kalinowski and me will be available today for subscribers on the Real Vision platform. But back to you, Darius. Emil's point is obviously that Europe entered this energy crisis with a massive private debt load already. And that to ensure that banks will keep lending to