Switzerland Shows the Many Faces of Inflation

The 2021 UN Climate Change Conference, Cop26, took place in the British city of Glasgow, surrounded by the rolling, green and well-watered Scottish countryside. At the time, the autumn weather was surprisingly good for a country famous for its rain, perhaps ominous of the great changes on the horizon when it comes to global climate. This year, Scotland had a hot summer and much of the UK suffered droughts.

Cop27 will happen in a very different geography. Egypt is the host, and the event will begin in two months' time. In the run-up, the country is today preparing by convening a gathering in Cairo of African ministers of finance, economy and environment. Senior government representatives, such as US special presidential envoy John Kerry, are in attendance, as well as international organisations and banks – parties that will play a vital role in funding and managing responses to the climate crisis.

The topics that are up for discussion are crucial. But so is the location. Egypt has made clear that it wants this instalment of the conference to be for Africa, in addition to the wider goal of moving "from pledges to implementation".

At home, Egypt is demonstrating how to implement these promises. Speaking to The National, Egypt's Minister of International Co-operation Rania Al Mashat said "climate action has to be nationally motivated". In her mind, Egypt is making sure "climate and development come hand in hand".

Her case is strong. The country unveiled its "NWFE" programme, which stands for the nexus for water, food and energy. It involves pursuing ideas to safeguard these vital areas in the years ahead, which are particularly stressed in Africa and the Middle East.

An important part of getting such projects off the ground is securing funding. NWFE is a good template for doing so. The government is hoping to raise almost $15 billion to fund the project by November 2023. It is making progress. The European Bank of Reconstruction and Development is leading the energy strand, the African Development Bank on water and the International Fund for Agricultural Development food.

A focus on African issues will also raise awareness of today's unacceptable climate injustices. The continent is responsible for about 2 to 3 per cent of global emissions, and yet, according to the UN Environmental Programme, it is "disproportionately the most vulnerable region in the world".

Keeping focus on these issues will be important as even the richest countries grapple with severe economic troubles. If Cop26 was about keeping focus on ambitious targets during a pandemic, this year's is about doing so in a time of war, food and energy shortage and what seems to be a more general weakening of global diplomacy.

In a speech at the beginning of the forum, the president of Cop27 and Egypt's foreign minister, Sameh Shoukry, stressed that his country will address gaps in the implementation of the climate promises the world made in Paris in 2015.

Egypt is well-placed to be an advocate for climate issues in Africa, but, spanning the two regions, it is also in a good position to build momentum for the Middle East in the run-up to Cop28, which will be held in the Emirates next year. Mena is another region that is going to feel, indeed already does, a changing climate earliest and most severely. The next two years, then, are shaping up to be crucial for their futures.

Egypt has been working tirelessly to bolster its foothold across Africa by constructing dams and enhancing energy cooperation with other countries.

The effort comes amid a years-long dispute with Ethiopia over its mega dam project on the Blue Nile, a main tributary of the Nile River, which Egypt views as an existential threat to its water share.

On Aug. 29, Cairo hosted Djiboutian Minister of Energy and Natural Resources Yonis Ali Guedi for talks on enhancing bilateral cooperation in oil and gas.

Egyptian Minister of Petroleum and Mineral Resources Tarek el-Molla said Egypt is ready to support to Djibouti's oil and gas industry upon presidential directives to achieve rapprochement with Africa.

The two sides agreed to form working teams to determine Djibouti's needs in the oil industry. Guedi also held talks with Egyptian Minister of Electricity and Renewable Energy Mohamed Shaker to discuss establishing a potential electricity partnership between Djibouti and Egypt. Djibouti is a next-door neighbor to Ethiopia, from where the Nile River emanates.

In Eritrea, another next-door neighbor to Ethiopia, Egypt is building two solar power plants with a capacity of four megawatts to boost electricity production.

Cairo has also constructed a four-megawatt solar power plant in Uganda, where the Nile River flows from Lake Victoria. Egypt is also planning to increase the capacity of electric interconnection with its next-door neighbor Sudan, a downstream country, from 80 MW to 300 MW.

"Egypt has the potential to become a regional energy provider in Africa," Mohamed Salah al-Sobky, the former head of the New and Renewable Energy Authority, told Al-Monitor via phone.

He said Egypt's electricity production is estimated at 60,000 MW, of which 35,000 MW are used for domestic consumption.

"The remaining surplus of 25,000 MW can be used to meet the electricity needs of other countries, including African neighbors," he added.

Egypt has emerged as a regional energy power in recent years. In 2019, the Arab country achieved natural gas self-sufficiency, and became a net energy exporter in the form of liquified natural gas (LNG), thanks to production from its large offshore natural gas deposits. It has also moved to develop renewable energy resources with plans to source 42% of its electricity from renewables by 2035.

According to the minister of electricity, the Egyptian electricity projects in Africa are worth over $3 billion, including the project to raise the capacity of the electrical interconnection line between Egypt and Sudan.

In Tanzania, a Nile basin country, Egypt is carrying out a mega dam project on the Rufiji River, a project that aims to double Tanzania's current energy production, control floods and improve agriculture.

The Egyptian government has also moved to boost its influence in South Sudan, another Nile basin nation. Cairo has built a number of underground water stations and river berths in South Sudan to link main cities with villages. Egypt is also carrying out feasibility studies for the multi-purpose Wau Dam, which could generate 10.4 MW of electricity and provide drinking water to thousands of people.

In a sign of warming relations between Cairo and Juba, Egyptian President Abdel-Fattah al-Sisi met Aug. 25 with South Sudan's presidential adviser for security affairs, Tut Gatluak, who conveyed a message from President Salva Kiir.

Sisi said Egypt is keen to bolster bilateral cooperation and help with a strategy for development in South Sudan, especially in urban planning, infrastructure, roads, and transportation.

"African countries look at Egypt now as a country that can help in achieving development," Abbas Sharaki, a professor of water resources and geology at Cairo University, told Al-Monitor. The Julius Nyerere dam in Tanzania "is an example of intra-African cooperation that will boost Egypt's image as a provider of development," he said. "If the dam project succeeds, it will be a gateway for Egypt to bolster its presence and influence across the African continent."

The Egyptian policy toward Africa began moving in a more positive direction in 2014, three years after Ethiopia began building its Nile dam, as priorities shifted and after memories faded of the failed assassination attempt on then-President Hosni Mubarak in Addis Ababa, Ethiopia, in 1995.

Egypt now seeks to protect its interests amid concerns that its water share from the Nile, Egypt's only source of freshwater, could be reduced by the Ethiopian dam project. Years of negotiations between Egypt, Ethiopia and Sudan have failed to make any breakthrough.

Signs of better news of inflation and foreign inflows are appearing for emerging Asia bonds, helping to prime the market for a recovery once the US Federal Reserve (Fed) turns less hawkish.

Goldman Sachs Group Inc said an improving inflation outlook would have a material impact at this stage. The latest consumer-price data for South Korea, Thailand and the Philippines came in below estimates, while some sovereign debt saw foreign money return. The repercussions of an aggressive Fed on some emerging Asia notes are also waning, analysis showed.

Any peak in inflation or rate expectations in the US may be the green light that Asia’s emerging debt markets need for a more sustained rally. An index of emerging Asia bonds has fallen about 1% in the third quarter so far, set for the smallest quarterly loss this year. That compares with a slump of 1.4% for US Treasuries.

“The local dynamics are much more important a driver than before” for Asian local-currency bonds, said Jin Yang Lee, an investment manager for sovereign debt at abrdn plc in Singapore. “We are generally quite comfortable with extending the duration on weakness in markets that have lower sensitivity to US Treasuries,” he added.

These three charts show how conditions are turning more supportive:

Analysts have been looking for signs of peak domestic inflation as one of the buy signals to return to bonds, with one catalyst a consistent trend of data undershooting estimates.

South Korea’s inflation is showing signs of topping out, with prices rising 5.7% in August from a year before, the first time in 10 months the figures have come in below economists’ projections. The Bank of Korea is the most advanced in the region in terms of rate hikes, and receding inflationary concerns mean it may be the first to conclude the cycle.

Similarly, August inflation in the Philippines was below estimates for the first time in six months, while data in Thailand came in below forecasts.

India and Indonesia recorded net foreign bond inflows in August, their first addition in at least six months, while global funds poured into Thai debt for the first time since May.

While the bulk was mainly after the dovish July Fed decision, the trend suggests that global funds see positives in the region, such as light foreign bond positioning and more moderate policy tightening. This hints at more significant inflows if the Fed dials back.

Thai, Malaysian and Indonesian 10-year yields proved to be less vulnerable to hawkish US expectations in August. The correlation with two-year Treasury yields fell, even as the shorter-tenor US yields surged to a near 15-year high, following last month’s Jackson Hole symposium.

Liz Truss has been formally sworn in as the UK's new prime minister and it looks like her first act will be to cap energy prices for both households and some businesses. Press reports vary on the finer details, but most suggest that electricity and gas costs could be fixed around their current level of £2,000 for the average household per year. That would avoid the planned increase to £3,500 in October and potentially well over £5,000 next April, on an annualised basis.

There's plenty to debate about a blanket price cap, but the obvious benefit is it's clear and straightforward for consumers and should have a material impact on confidence. It should reduce the depth of a winter recession, and would also mean inflation has already more-or-less peaked; January's inflation rate would be roughly six percentage points lower.

As we see it, there are three main criticisms. The first is that fixing unit prices does little to incentivise consumers to reduce energy demand this winter (albeit there's only a limited amount many households can do in this respect).

Secondly, it's not targeted, though admittedly channelling support in an efficient manner in the time available is not a straightforward task. The sheer scale of the energy price shock means that most households will be paying more than 10% of their disposable incomes on energy without government intervention, which means some form of blanket support was always going to be required. Even within income brackets, energy usage can vary considerably depending on household size, making a targeted package harder to implement.

But that does mean it's going to be very expensive. Energy providers will need to cover the shortfall between the capped price and wholesale costs, which we estimate will amount to roughly £70bn (or 3% of GDP) over the next year. That's based on our expectations for Ofgem's energy price cap, which in turn is based on futures prices.

That estimate falls to around £30bn if the government were to fix costs after October, once the planned 80% increase in household bills has taken place. Add to that the cost of supporting businesses, which Bloomberg News reports could amount to around £40bn.

But the key point is that these are just estimates – they aren't fixed. They are based on futures prices today, and depending on the scheme's final design, risk leaving the UK Treasury with an open-ended liability should wholesale energy prices surge once again.

Add to that the potential for additional tax cuts for households and corporates, and gilt markets are unsurprisingly nervous.

A large portion of the move in UK rates this summer can be explained by investors ramping up rate hike expectations. The sheer scale of the government support being mooted is clearly influencing how hawkish rates market participants expect the BoE to be. The Gilt 2s10s curve inverting in August and the overnight swap curve pricing a terminal rate of nearly 4.5% are both indications that investors expect a robust monetary policy response to a new government support package.

We tend to agree with that assessment – even if we disagree with the scale of tightening being priced, not least because the introduction of a price cap is a double-edged sword for the Bank of England.

The fact that headline inflation will potentially be much lower in the near term should reduce fears about inflation expectations (at least among households) becoming less anchored. The YouGov/Citi measure of long-term expectations has risen to just shy of 5%, up from a pre-virus range of 3-3.5%. These surveys have a history of being closely linked to actual inflation.

But the Bank of England has also recently forecast a sharp rise in unemployment and a prolonged recession, helping to lower wage pressure and pricing power by 2024/5. All of that is less likely to happen under an energy price cap, and in theory that could lead to more tightening. That doesn't necessarily mean a dramatically higher terminal rate but does mean that the BoE is less likely to start the firing gun on rate cuts in early/mid-2023, unlike some other central banks.

We expect the Bank Rate to peak around 3% or a little below (from 1.75% now), and we're still inclined to say policymakers will opt for a 50bp rate hike next week over a more aggressive, 75bp move. Until August, the Bank had shown itself reluctant to move in larger increments. As other central banks have found, accelerating rate hikes sets a precedent for expected future moves, something we suspect the BoE won't want to do. It's also not clear yet how much of the energy plan will be announced before the next meeting, and the Bank typically operates based on whatever is formal government policy at the time of a decision.

That said, there's little doubt the hawks will be worried about sterling weakness over recent weeks, so a more aggressive move shouldn't be ruled out. Another 50bp hike in November is also likely.

Away from the Bank of England, the secondary but almost equally important aspect of the upcoming support package is how it is financed. News reports are mixed on this, so we'll consider two extreme scenarios here, with the understanding that the ultimate financing of it will probably entail a mixed financing strategy.

In one extreme, the additional support could translate pound for pound into an equal about of gilt issuance. In the alternative, the treasury manages to shift the entire borrowing burden onto energy companies, for instance by guaranteeing loans granted by other lenders such as banks.

From the point of view of gilt investors, any additional debt issuance would come on top of the planned deficit, on top of the cost of any additional tax cut, and on top of the extra amount of debt released into the hands of private investors by the BoE through Quantitative Tightening (QT). The cost of the energy package is still subject to much uncertainty but assuming £110bn (£70bn for households and £40bn for companies) spread equally between this and the next fiscal year, private investors will be asked to increase their exposure to gilts by a record amount (the black line on the chart above): around £120bn this year, and £210bn next.

Another consequence is that funding through gilt issuance is likely to have a much longer average maturity from the start. For instance, the average maturity of existing gilts is almost 15 years. Should energy companies borrow from banks, it is unlikely this will be at such an average maturity, and that banks will finance it with equally long liabilities, so the overall market impact on interest rates will be much lower.

Suffice it to say that the gilt market's preference is for the energy package to be financed through other forms of funding. The question is whether lenders will be able to stump up such a sum in a short period of time, even helped by government guarantees. The re-steepening of the gilt curve suggests anticipated long-dated issuance, and the cheapening of gilts relative to swaps suggests markets are braced for at least some extra direct financing by the Treasury.

This in turn raises the issue of who in the private sector would be willing to increase their gilt issuance by such an amount. Inevitably, questions will be asked about the UK's reliance on the 'kindness of strangers' as its twin deficits widen.

Markets are already pricing in some increase in gilt supply. But don't underestimate the gilt markets' ability to absorb more debt. At the start of FY 2020-21, the Debt Management Office planned to issue £156bn in gilts, it ended up selling £486bn. However, the more relevant metric here is the increase in net private investor exposure to gilts, which increased only £107bn that year, compared to £117bn and £210bn this and next year according to our forecast.

10Y gilts are already trading more than 150bp above 10Y Bund to reflect this possibility. In the event where the majority of it is financed through issuance, we would expect this to rise to 200bp putting gilts above 3.5% in the coming weeks with both domestic and foreign investors spooked at the sharp increase in gilts outstanding, but also in foreign capital needs. We doubt this will be sustainable, however, and a decline to 2.5% in 2023 is still possible even in that scenario assuming the tone at the BoE turns progressively less hawkish.

Sterling has been grabbing the headlines for all the wrong reasons over recent weeks. Since early August, it has been under pressure not only against the mighty dollar but also against most of the currencies with which the UK trades. That puts the Bank of England's broad trade-weighted sterling index back to the lows last seen in late 2020 and down nearly 4% on the month.

That sterling decline seemed to go hand-in-hand with the sell-off in the UK gilt market and also the relatively sharp widening in the UK's sovereign Credit Default Swap (CDS). This is the cost of insuring against UK sovereign default. It is hard to avoid the conclusion that a UK sovereign risk premium has been going into the pound – presumably on doubts about at what price investors would be prepared to fund future UK borrowing plans.

That the hawkish BoE policy has had little effect on supporting the pound can be seen by some of the betas in our Financial Fair Value (FFV) model. 12 months ago two-year rate spreads were the most important driver of EUR/GBP short-term valuation. Today it is global risk appetite and the relative performance of Eurozone versus UK equities.

And that should serve as a reminder that sterling can be considered a 'pro-cyclical' or 'growth' currency. Its correlation with global equity markets is more akin to the commodity currencies in the G10 space than to the more defensive currencies of the yen and Swiss franc. Driving that relationship is the UK's large current account deficit (probably an overstated 8% of GDP in 1Q22) and the relatively large share of the financial sector in the UK economy.

We do not think that sterling is particularly cheap at these levels based on our medium-term fair values. Indeed EUR/GBP looks around fair value. That means sterling would be vulnerable should some of the more extreme outcomes materialise for gilts, as we discuss above.

Our baseline forecasts see both GBP/USD and EUR/GBP trading around current levels into the end of the year. But the risks are skewed to the downside for sterling – perhaps for another 5% of independent sterling weakness.

Markets have had good reason for dramatic and sometimes violent repricing due to serial economic shocks over the past two years - but there's a gnawing sense of overstretch in many areas and a feeling that a lot of upheaval is already priced.

It's always risky calling turns that never materialize, and markets routinely overshoot - or undershoot - fair values for long periods. FX markets are a great case in point - they often reflect temporary divergences between otherwise highly integrated economies, and are a magnet for huge speculative capital flows.

Look at the dollar's parabolic rally against the yen.

The dollar has soared to a 24-year high above 144.00 yen. It has strengthened more than 25% this year - on course for its biggest annual rise ever - as U.S.-Japanese yield spreads have blown out to their widest in favor of the greenback since 2007.

Zoom out a little, and the move is even more astonishing. The dollar has strengthened more than 40% since the start of last year. Dollar/yen is a G3 currency pair, not an illiquid emerging market prone to wild and unpredictable price swings.

A reversal must surely be imminent, right? Yes, says JP Morgan analysts, but not before new highs are reached.

"If policy/rhetoric around the (Japanese) currency remains unchanged, a move toward 150 does not look impossible," they wrote on Monday.

There have been notable moves and wide regional differences in other markets recently.

The Bloomberg Global Aggregate Bond Index has slumped as much as 24% from its peak, a record fall. The ICE BoFA U.S. Treasury Index, meanwhile, is on track for its worst annual performance on record too, but is down 'only' 11% this year.

The plunge in non-U.S. bonds is reflected in the spread of two-year U.S. yields over euro and UK yields. This widening gap had helped propel the dollar to a 20-year high, but it is now shrinking as European Central Bank and Bank of England rate expectations shift.

The two-year U.S.-euro zone spread has narrowed 40 basis points in the last month, and the comparable U.S.-UK spread has tightened 100 bps. If the euro and sterling do fall further against the dollar from here, it may not be by much.

"Our baseline assumption is ... that the most rapid phase of sterling underperformance is now behind us," Goldman Sachs's currency strategy team reckons, adding: "We see few barriers to dollar/yen continuing to press higher."

Societe Generale's Kit Juckes believes the euro, back below dollar parity, will remain anchored at "very low levels" for the rest of this year. "But we are not sure that we will see much lower levels."

Europe is at the heart of many of these extreme pricing and flow divergences. Take equities.

According to Bank of America, a net 34% of fund managers were underweight euro zone equities in August. That is 2.0 standard deviations below the long-term average, and similar to July's net 35% underweight, the most bearish position in a decade.

Investors are gloomier on euro zone equities than any other region, sector, or asset class. The only region on the global equities map where investors are bullish is the United States, with a net 10% overweight position.

Fund flows reflect the divergence. Goldman Sachs' equity strategists note that investors have pulled money out of Western European funds for 29 straight weeks, with total redemptions of $90 billion. U.S. equity inflows in the same period are around $100 billion, and are around $300 billion since July last year.

The charts are striking.

The dim view investors have on European stocks has made them significantly cheaper. European equities' 12-month forward P/E ratio is just above 11.5, according to Morgan Stanley, indicating that they are the cheapest since 2014.

Perhaps they may need to cheapen more before investors buy them again. Morgan Stanley sees a "plausible" risk that the P/E ratio will fall to 10.0, significantly lower than the S&P 500 P/E - it is currently 16.5, and Morgan Stanley reckons it will stay above 16.0 for the next 12 months.

"While sentiment and positioning can prompt short-term tactical bounces from time to time, the negative fundamental backdrop (in Europe) suggests that these should be viewed in the context of 'selling the rally' (in contrast to 'buying the dip')," Morgan Stanley analysts wrote on Sunday.

Both Morgan Stanley and Goldman see European stocks significantly underperforming Wall Street over the next six months before re-aligning next year.

The ECB meeting today will be key for interest rates. We have already laid out our thinking that the 75bp hike that markets are now bracing for would set the stage for EUR curves to invert, first the swap curve and eventually also the German Bund curve, as it becomes clear that the ECB's hawks have won the front-loading argument and are willing to take more economic pain down the road. As front-end rates are pushed higher, the longer end would increasingly have to account for more severe economic outcomes. While the ECB has officially moved away from rates forward guidance towards a meeting-by-meeting policy setting approach, the market will still extrapolate a new reaction function from the size of the move and other elements of today's communication, such as the forecasts.

Irrespective of the size of today's interest rate hike, it will be another milestone on the ECB's path to normalising monetary policy. The negative interest rates policy (NIRP) has already ended, but after this hike also zero interest rate policies (ZIRP) will be left behind. Many will be taking particular note of the plumbing in money and repo markets when this threshold is passed. After many years of negative interest rates, the market structure has adapted to these extraordinary policy circumstances - the question is how easily can that be flipped back.

Markets are leaning towards a 75bp hike, pricing a 65% probability of such an outcome. The next logical step then would be to price in another 75bp hike in October. The Fed experience has shown it can be difficult to revert back to smaller steps. Currently markets have in total 125bp priced over the next two meetings. Given the looming energy crunch our economists still see good arguments for a more measured approach, leaning towards a 50bp hike today.

The new forecast will play an important role in gauging the ECB's new reaction function. ECB's Schnabel had called for a 'forceful' response even at the risk of lower growth and higher unemployment. Our economists highlight two key points: How negative or positive will the ECB be on the eurozone's growth outlook for the winter and what are the inflation projections for 2024. Larger downward projections in both regards would point to a less aggressive rate hike trajectory.

Hints have been dropped – subtly so in the ECB accounts and less subtly by some hawkish council members - to at least start discussing the forward guidance on reinvestments after the rates forward guidance has already been abandoned. While a logical next step in the policy normalisation process, the counterargument is that it could still pull the rug under sovereign spreads also with crucial elections in Italy just a few weeks away. The aim to eventually reduce the balance sheet could be counteracted if this that meant that the Transmission Protection Instrument would have to be activated – buying bonds again.

The move into positive policy rates will lay bare some changed incentives for market players that may not be entirely desirable also in the eyes of the ECB. Think of the TLTRO remuneration, where the large hikes now create an arbitrage opportunity for banks. As potential remedy the ECB had floated a trial balloon a while ago of tweaking the tiered deposit rate or changing the operations conditions retroactively, but the discussion has died down since.

More pressing may be another issue highlighted by the decision of two government debt management offices (DMOs) to no longer lend out their securities against cash, the reason being the 0% remuneration cap on government deposits at the central bank. But the effect is that the collateral scarcity created by the ECB's vast buying programmes is only becoming more severe. The ECB may be propmpted to intervene in this case. After all it was the one to introduce the cap when it entered negative interest rates. While it will have to weigh the prohibition of monetary financing it could consider loosening the limits and makingg a larger portion than currently eligible for a market-rate remuneration - maybe less controversial than lifting the 0% cap itself, affecting the entirety of government deposits. It could also dodge the politically loaded bullet of government deposits by tweaking the terms of its existing securities lending programme to more effectively address the severity of collateral scarcity issues in some markets, particularly German bonds.

The ECB hawks have managed to push the market towards expecting a 75bp hike today. Backing down may send the wrong signal given the greater weight that has been given to current inflation dynamics. But delivering on expetctations would also be a clear signal to markets that more is still to come. The front-end end could price in even further tightening for this year and next. The longer end may also still move higher, even if lagging.

That however is the near-term view. Even if some of the government interventions on energy prices may delay the time of reckoning, the economic outlook is already clouding over as we move towards winter. We struggle to see Bund yields remaining at current, or indeed higher, levels in the midst of a recession, and as we think the ECB will eventually fail to deliver on the hikes priced by the curve.

Away from the ECB today's other main event will be Fed Chair Powell's comments at a conference on monetary policy. With the Fed's "quiet period" ahead of the 21 September FOMC meeting kicking in on the weekend, it is the last opportunity to steer market expectations. Other speakers later in the day are the Fed's Evans and Kashkari. Data will see the release of the weekly jobless claims.