Europe Struggles to Convert Ukraine Migration into Labor Boon

It may not thrill bulled-up bond investors, but a halt to central bank interest rate rises this year could be accompanied by stepped-up reduction of balance sheets, or QT - preventing markets running away with "peak rate" hopes.

"Quantitative tightening" - reversal of the massive central bank asset purchases undertaken to support bond markets as the coronavirus hit in 2020 and during the banking crash 15 years ago - has been quietly humming in the background for the past year, largely drowned out by the din of steep official interest rate rises to tackle high inflation.

As disinflation deepens, however, central banks will find it harder to justify many more policy rate hikes in the current cycle - not least as the lagged effects of the past year's campaign are still kicking in and the effects from here are now uncertain.

But in stopping the rate hikes they will have a hard job preventing investors from loading up further on bonds and driving down borrowing costs for the wider economy in the hope policy easing then follows - prematurely for many policymakers' liking if inflation still exceeds their 2% targets.

Rhetorically at least, the Federal Reserve has already been fighting this battle as it potentially hits what markets assume will be its "terminal rate" next week - and has been stressing a "higher-for-longer" policy rate right to the end of next year.

But management of central bank balance sheets could help - even if central bankers are keen to publicly disassociate the process from monetary policy goals per se.

Having fully unwound a temporary pop back higher around March's regional bank stress, the Fed's $8.26 trillion balance sheet was back at its lowest level in two years as of July 13 - almost three quarters of a trillion below pandemic highs. At just over 20% of outstanding Treasuries, that share is back close to early 2020 levels - and also levels of eight years ago.

While Fed policymakers reckon there's a high bar to tweaking the U.S. central bank's current runoff rate of $95 billion per month, they also see it as a 'backup' to interest rate policy.

But the U.S. central bank can be more comfortable nearing peak rates with inflation much closer to target than Europe's central banks - where future trade-offs may be more tempting.

For one, Bank of England Deputy Governor Dave Ramsden on Wednesday advocated allowing a likely increase in the pace of government bonds running off the central bank's remaining 800-billion-pound ($1 trillion) balance sheet - which had at its height more than doubled during the pandemic - over the year from September.

That's as markets now expect the BoE's main interest rate to peak below 6% by December - relieved as they were by this week's news that outlying UK inflation finally started to ebb back below 8% in June for the first time in a year.

It stands to reason that if the pain of even higher rates is hard for households and the wider economy to bear from here without seeding a deep recession, then an accelerated withdrawal of BoE support for the bond market may allow it to halt those hikes while keeping market conditions relatively tight.

Ramsden laced his comments with caution about not confusing the run-down of the BoE's "asset purchase facility" with its central policy task. He also emphasised the pace of unwinding would be allowed to go up naturally by continuing to not re-invest maturing securities - as a bigger amount come due next year - and not require the BoE to increase active selling of bonds.

He also detailed in-depth BoE analysis that showed the 100 billion pounds of gilts and corporate bonds offloaded in the year through the third quarter of 2023 had only a small added tightening effect on bond pricing or liquidity - some 10 basis point or so - beyond the effects of steep policy rate rises.

But even while he stressed that the process should remain "gradual and predictable" and in the "background" - and with new repurchase facilities to guard against any related excess rundown of commercial bank reserves - it will surely help to rein in any untimely animal spirits in the bond market.

The BoE's situation - indeed its haste to cut its balance sheet - may be complicated by its peculiar system of remunerating commercial bank reserves accumulated during bond purchases at its policy Bank Rate. Other central banks operate at different and variable reserve rates.

As the BoE jacks up policy rates, it also increases operating losses on a bond portfolio bought at far lower yields than its current policy rate - paying out more to the banks on reserves they've been credited with than the lower return it receives on bonds it bought from them in the first place.

The incentive for a speedy cut to the balance sheet is greater - even if Ramsden sees the Treasury-indemnified losses the BoE records as merely a flip side of years of hefty transferred profits on that switch.

But there's also growing talk that the European Central Bank, meeting next week in parallel with the Fed, may review its strategy as a "compromise" move.

With markets - and likely policymakers themselves - uncertain as to whether another rise in the ECB's benchmark interest rate after next week's expected quarter-percentage-point increase to 3.75% will be needed, use of the balance sheet may be seen as an alternative with inflation still at 5.5% in June.

"With the policy rate having been raised by a record amount in a short period of time ... discussion around faster balance sheet reduction could gain momentum," Deutsche Bank said this month, adding that divisions on the likely terminal ECB rate may see 'compromise solutions' around the balance sheet become "live".

And they reckoned an increase in the volume of QT should theoretically lead to higher term premia in euro bond markets.

Increased supplies of liquefied natural gas (LNG) from Russia's Novatek mean the company is close to overtaking Kremlin-controlled Gazprom as the country's leading fuel supplier to Europe, Reuters calculations show.

Novatek's rise towards the coveted top spot underlines how much the Ukraine conflict has disrupted Russia's and the world's energy industry as Europe turns to LNG and away from Gazprom's network of pipelines that dominated European supply for decades.

Russia's gas, in contrast to its oil, is not subject to Western sanctions, although Brussels is considering extending its embargo on Russian fuel.

The European Union has already sought to cut its reliance on Russian supplies and aspires to replace gas with renewable energy as it strives to curb its emissions. In the immediate term, it has increased its LNG imports.

Novatek, founded almost 29 years ago, secured Russian state support to expand in the LNG market following the launch of its vast Yamal LNG plant in northwest Siberia in 2017.

Reuters calculations, based on figures from Refinitiv Eikon data, showed that Gazprom's total exports of LNG and pipeline gas supplies to Europe were around 13.8 billion cubic metres (bcm) between January 1 and July 15.

Novatek's exports to the region in the same period amounted to 12.34 bcm.

Gazprom and Novatek have not replied to Reuters' requests for comment.

"Gazprom has likely forever lost 65%-75% of its historical share of the European market," Ronald Smith of Moscow-based brokerage BCS said.

However, he added it would be "very difficult" for Novatek to completely replace Gazprom in Europe, as Gazprom's remaining customers have limited infrastructure to import LNG.

Gazprom's gas exports, mainly to Europe, almost halved last year because of the political crisis over Ukraine and after undersea Nord Stream pipelines were damaged by unexplained blasts last September.

Germany and Italy remain among Gazprom's largest customers in Europe.

Russia aims to secure a fifth of the global LNG market by 2035 from around 8% in 2022, while Russia's pipeline exports, exclusively provided by Gazprom through a Soviet-built network, are steadily declining.

Natural gas is frozen to minus 163 Celsius (-261.4 Fahrenheit) to convert it to a liquid that can be shipped to any regasification terminal in the world, making it more flexible than pipeline gas.

To defend its position, Gazprom in 2006 secured a law that enabled it to become Russia's sole exporter of natural gas via pipelines and sea-borne liquefied natural gas.

But Russia has since liberalised LNG trading to support projects by Novatek.

Novatek, meanwhile, has ramped up output from its Yamal LNG plant in the Arctic and plans to further boost LNG production at its new projects, which are due to come onstream in the coming years.

The leaderships of both Novatek and Gazprom have close ties with President Vladimir Putin and have publicly clashed over Novatek's rising profile on the European gas market, which used to account for two thirds of Gazprom's total gas sales.

Alexei Miller, Gazprom's CEO, has been an ally of Putin since they worked together in the early 1990s in the mayor's office in St Petersburg, Russia's former imperial capital.

Miller moved to Moscow in 2000 when Putin was first elected Russian president. A year later, he was appointed chief executive of Gazprom.

Gennady Timchenko, also a long-time ally of Putin, resigned from Novatek's board in March 2022 after he was targeted by sanctions.

Timchenko has said he owned a few trading companies in and near St Petersburg in the 1990s, when Putin worked in the office of the city's mayor. He had been listed among Novatek's largest shareholders, before the company stopped disclosing them several years ago.

Timchenko had long challenged Gazprom's monopoly on Russian gas exports, saying in 2012 that Europeans wanted to have an alternative to Gazprom.

At the time, he also criticised Gazprom's policy in Europe, which, he said, had contributed to a decline in market share.

"I believe that Gazprom Export's marketing campaign led to its European share decrease ... Liquefied natural gas has already come to the market. In essence, a new, cheaper gas market is emerging; one has to see such things," Timchenko told the Forbes magazine in 2012.

As markets blew the froth off this year's extraordinary rally in Big Tech stocks on Thursday, the dollar clocked its best day - and likely its best week - for more than two months.

After the first real edgy day on financial markets in weeks, returning calm on Friday suggests that sudden burst of activity - a stock and bond market recoil and loud dollar pop higher - was more a re-set than a rethink.

Many put the moves down to traders jockeying for position ahead of next week's Federal Reserve meeting - which may well deliver the last interest rate hike of the cycle. Another unexpectedly tight weekly reading from the U.S. labour market sowed some lingering doubts that we're on the cusp of 'peak Fed' just yet.

Grouch-like disappointment at forecast-beating profits at Tesla and Netflix saw the supercharged FANG-plus index of the 10 leading tech and digital mega cap stocks record its worst day of an otherwise spectacular year so far - losing more than 4% as Netflix and Tesla shares were almost decimated.

And yet, that index remains up 76% for the year to date.

The tech wobble saw the Nasdaq recoil 2% in its biggest drop since March. But the S&P500 lost a more modest 0.6% and the Dow Jones industrials ploughed on regardless to notch its ninth straight daily gain, aided by upbeat Johnson & Johnson.

What's more, Nasdaq and S&P500 futures are up again ahead of the bell on Friday. A quieter earnings schedule is topped by American Express - but nearly all the other banks have been impressive over the past week.

The optimists suggest a combination of ongoing jobs market strength and some rotation of sectoral stock holdings underlines 'soft landing' hopes and marks a healthy broadening of what has been a very narrow-led market gain so far this year.

Pessimists think the Fed is not done tightening yet and any further rate hikes after next week will just hasten a downturn in 2024. That has sobered up the Treasury market a touch after a couple of weeks of disinflation relief.

Futures are fully priced for a quarter-point rate rise next week, but indicated less than a 50-50 chance of another hike by November and 75 basis points of cuts from the peak by this time next year. Two-year Treasury yields nudged 12 bps higher to 4.88% on Thursday, but have settled back to 4.85% since.

The backup in yields saw the dollar put in its best showing since early May - helped additionally by growing doubts about the willingness of other major central banks to keep tightening their policy rates once the Fed stops.

The Bank of Japan is leaning toward keeping its yield control policy unchanged at its policy meeting next week, according to Reuters sources, as policymakers prefer to scrutinise more data to ensure wages and inflation keep rising.

With inflation having exceeded the BOJ's target for more than a year, markets had been simmering with speculation the BOJ could tweak yield curve control as early as this month.

Dollar/yen surged above 141 on Friday for the first time in 10 days.

China's markets remained in a funk, meantime, with anxiety growing over the lack of a major fresh stimulus for the struggling economic recovery as geopolitical tensions bite.

Authorities on Friday announced measures to boost consumption of auto and electronic items as part of a broader drive to shore up the country's faltering economy.

But all eyes are now on the annual Politburo meeting, which is expected to take place before the end of July and where China's leaders chart a policy course for the rest of the year.

* U.S. corporate earnings: American Express, Huntington Bancshares, Schlumberger, Comerica, Regions Financial, Roper Technologies, Interpublic,

* Canada June house prices, May retail sales

* US Treasury Secretary Janet Yellen speaks in Hanoi

The highlight for the week will be the second quarter CPI release in Australia on Wednesday. The inflation outlook will help determine whether the Reserve Bank of Australia (RBA) hikes rates again in the second half of the year. The unemployment data released earlier today showed that the unemployment in June stood at 3.5%, slightly lower than the consensus of 3.6%. The improvement in the labour market could point to solid economic activity despite the recent string of tightening. As such, CPI for the second quarter is likely to remain elevated but lower compared to the first quarter.

Korea's GDP growth in the second quarter is expected to accelerate to 0.5% quarter-on-quarter seasonally-adjusted compared to the first quarter's 0.3%. The improvement in net export contributions is likely to have driven overall growth on the back of a sharp decline in imports, while private consumption growth will probably remain flat. Monthly activity data should stay soft with construction and service activity declining in June.

The Bank of Japan (BoJ) will meet on Friday and we believe that recent swings in the FX and Japanese government bond markets reflect market expectations for policy adjustment. It is a close call, but we still think yield curve control (YCC) tweaks are possible, given that recent data support steady inflation growth and a sustained economic recovery.

Bank Indonesia (BI) is set to extend its pause, keeping policy rates at 5.75%. Inflation has returned to target but pressure on the Indonesian rupiah (IDR) of late may give Governor Perry Warjiyo reason to keep rates steady. We expect BI to stay on hold for a couple more meetings and only consider a potential rate cut once the IDR stabilises.

Favourable base effects and moderating commodity prices could help both headline and core inflation dip in Singapore. Headline inflation may edge lower to 4.6% YoY with core inflation also expected to slow. The Monetary Authority of Singapore will be weighing the upside GDP growth surprise alongside the improving price outlook for its meeting later this year.

British Prime Minister Rishi Sunak's governing Conservatives lost two strategically important parliamentary seats on Friday but unexpectedly retained Boris Johnson's old constituency in a setback for the opposition Labour Party.

The Conservatives' narrow victory in Johnson's seat gave Sunak some breathing space to try to narrow Labour's large lead in the polls by aiming to reduce high inflation and ease a cost-of-living crisis before a national election expected next year.

But the problems he faces were highlighted by the loss of the formerly safe Conservative parliamentary seat of Selby and Ainsty in northeast England, where Labour overturned the biggest Conservative majority at a by-election since World War Two.

Labour leader Keir Starmer said the victory showed "just how powerful the demand for change is".

The Conservatives also suffered a crushing loss in another vote but retained Johnson's former seat of Uxbridge and South Ruislip by fewer than 500 votes to ensure Sunak avoided becoming the first British leader to lose three by-elections on a single day in more than half a century.

Greg Hands, chair of the Conservative Party, said while disappointed by the two losses, the overall results, in his opinion, had shown that "the electorate don't like Labour being in power and running things badly" - a reference to the Labour London mayor's decision to expand vehicle charges to regions around the capital.

Conservative former minister David Jones told Reuters the results showed "there is everything to play for at the next general election".

"We now need to put forward economic policies that will recover support in traditional Conservative areas ... With up to 18 months until the election, there is time to do it," he said.

Sunak, a former finance minister and investment banker, has tried to use his technocratic leadership to restore the Conservatives' credibility after a series of scandals last year forced Johnson to resign, and economic turmoil prompted his successor, Liz Truss, to quit after just six weeks.

He is expected to reshuffle his senior ministers soon to pick his team to fight the next general election.

With stubbornly high inflation, economic stagnation, rising mortgages rates, industrial unrest and long waiting times to use the state-run health service, the Conservatives had been braced for the possibility of losing all three seats.

Sunak's Conservatives are trailing Labour by about 20 points in national opinion polls, which suggests the governing party will struggle to win a fifth consecutive national election.

But Labour's loss in Uxbridge shows its lead in the polls may not translate into to a clear parliamentary majority at the next election.

John Curtice, Britain's best-known pollster, said based on Labour's performance in Uxbridge, the most likely outcome at the next national vote is a hung parliament and Starmer might see more debate within the party about his "safety first, ming vase strategy".

Starmer has been criticised by some in his party for sticking to a disciplined stance on public finances, refusing to make any uncosted offerings and sometimes dropping policies he believes a Labour government could not afford.

"The tide is still a long way out for the Conservatives and they still have an awful long way to go before they look as though they might have a chance of being able to retain power after the next general election," Curtice told the BBC.

The Uxbridge by-election was called after Johnson's shock decision to quit parliament last month after he was found to have made misleading statements over parties held in Downing Street during the coronavirus pandemic. Johnson denied misleading parliament.

The winning Conservative candidate, Steve Tuckwell, said his party's victory was because of local rather national factors, pointing to the issue of London's Labour mayor extending the ultra-low emission zone (ULEZ) to include suburban areas such as Uxbridge meaning some voters had to pay more for their cars.

One Conservative lawmaker said the opposition to ULEZ was a winner for the party and could help its candidate in the London mayoral election in May.

The other results exposed the Conservatives' vulnerabilities on two fronts: the loss of the rural Selby seat in the north of England, and one in the southwest, a traditional stronghold. The Conservatives had won large majorities in both in the 2019 general election.

Labour won Selby and Ainsty in Yorkshire by 4,000 votes with the Conservatives unable to defend a majority of 20,137. The seat was vacated after an ally of Johnson resigned in solidarity with the former prime minister.

In Somerton and Frome in southwest England, the centrist Liberal Democrats managed to overturn a Conservative majority of 19,213 after a third member of parliament quit over allegations of sexual harassment and cocaine use.

Curtice said Labour's loss in Uxbridge shows the "potential fragility" of the party's lead in the polls while the Conservatives continue to lose voters in southern areas.

He said the two main "political party leaders have been left with something to think about in the wake of these results".

Stocks and bonds in the U.S. fell yesterday. Stocks fell, sent down by a nearly 10% plunge in Tesla and more than an 8% dive in Netflix. Chip stocks fell as well around the world as TSM cut its annual outlook for revenue due to geopolitical tensions and weak global demand, and announced that its Arizona production plant will be delayed due to shortage of qualified labour that could build the plant. TSM shares fell 5% to below $100 a share in NYSE, while Nvidia lost more than 3% as investors started wondering whether the chipmaker will be able to deliver the $11bn revenue estimate that it announced last quarter! All in all, the S&P500 retreated 0.68% and Nasdaq 100 lost 2.28%.

Bonds, on the other hand, fell as well yesterday, as unemployment claims unexpectedly fell in the U.S.. That strengthened the Federal Reserve (Fed) hawks' hand yesterday on the reasoning that the U.S. jobs market just won't loosen and challenge the latest expectation where investors and economists, including the ex-Fed Chair Ben Bernanke, think that the Fed's next week rate hike will also be its last in this tightening cycle due to easing price pressures. There is no expectation of another hike in September, while some 20% predict that there could be another hike in November. The rising question is, when will the Fed start cutting rates, in January, or in March? It will depend on inflation, really. The rising geopolitical tensions between Russia and Ukraine in the Black Sea, where Ukraine also said that ships going to Russian ports may be military targets threatens the crop trade. Wheat futures jumped past their 200-DMA yesterday and are up by more than 20% since last week. If that's not enough, India bans shipments of non-basmati rice to contain domestic prices and rice futures are also upbeat right now. While succeed in crude tests the 200-DMA to the upside, and technicals hint that the bulls could succeed breaking the resistance this time, as trend and momentum indicators are positive, and we are not in the overbought market just yet. So, there is room for further recovery. And the European nat gas futures gained nearly 4% yesterday. So, all these jumps in commodity prices will certainly show up in next inflation figures as the favourable base effect will also gently fade away.

The U.S. dollar index is better bid after hitting the lowest levels since April earlier this week. The U.S. dollar index is up from its recent lows but is still at the lowest levels seen this year, the EUR/USD is down below the 1.12 mark, on the back of a broadly stronger U.S. dollar, and a lack of consensus. In one hand, the European Central Bank (ECB) members said that a 2nd rate hike following the next ECB hike is not guaranteed. On the other hand, the higher-than-expected core inflation and the positive revision in growth figures leave the ECB enough space to stay on a hawkish policy path. We will likely see a rangebound EUR/USD between the 1.10-1.12 range into next week's policy meeting. Gold is upbeat on the back of rising geopolitical tensions as the price of an ounce stands around the $1970 this morning, while the USD/JPY tests the 140 mark and the 50-DMA, after inflation in Japan came in higher than last month but softer than the expectations, and kept investors pricing the persistent divergence between dovish Bank of Japan (BoJ) and sufficiently hawkish Fed expectations.

One place where the doves are also very persistent is Turkey. The Central Bank of Turkey (CBT) increased its policy rate by 250bp at yesterday's policy meeting, versus 500bp hike expected by analysts. This is Turkey's new economic team's – who was supposed to normalize policy and regain investor confidence – second policy meeting and it's the second time the rate hike is well below expectations. Inflation on Turkey on the other hand will be skyrocketing in the coming releases as the lira took a dive since May. Official inflation, which fell below 40% in June, will likely spike above 50% in the coming readings, and if the CBT normalizes policy at the current speed, the divergence between where the Turkish policy rates will be, and where they should be will keep the lira under further pressure. And of course, the softer than expected action from the CBT's new team will hardly restore investor confidence and remedy worries that the CBT decisions remain highly influenced by political pressure. The USD/TRY rallied by around 40% since May and risks remain comfortably tilted to the upside with the next targets sitting at 28, and 30 levels. Note that the USD/TRY is expected to jump by chunks as the CBT relaxes FX interventions from time to time to let the lira find a fair market valuation after a year-and-a-half long heavy FX purchases. Therefore, the timing of price moves is unknown, but there is little doubt about the direction.