Rates Spark: Energy policy goldilocks

The European Union’s proposed energy market reforms and consumption curbs managed to draw a line under the continued climb in both traded gas and electricity prices. The impact has been nothing short of spectacular, especially as it occurred in the midst of a gas supply worst-case scenario, a total cut-off of the Nord Stream flow. We’ve highlighted recently that a continued fall in energy prices constitutes a key downside risk to European rates, in EUR and GBP. That downside is growing.

From the point of view of rates markets, the (tentative) reaction has been as close as one would expect from energy policy goldilocks: not too effective economically that it provides cover for central banks to hike further, but effective enough that it does allow energy prices to drop. Of course, between the two effects, the drop in energy prices may well be the one that impacts rates the most, but this is far from a foregone conclusion. Central banks are now overtly worried about second-round effects, a de-anchoring of inflation expectations, and a broadening of inflation – all of which could justify a continued hawkish tone.

The main takeaway from last week’s European Central Bank meeting for EUR rates markets is an updated, more hawkish, ECB reaction function. The ECB seemed to have taken, indeed ripped, more than a few pages out of the Fed’s book. The upshot is that markets should, and have to a large extent already, concluded that euro for euro, the central bank will deliver more monetary tightening if energy prices rise further. We’ll leave it to our economics colleagues to discuss whether this is the right approach going into a recession but we share their scepticism.

The upshot is that a jump in energy prices has so far impacted rates to the upside, but not to the downside. Nothing is set in stone and the further they drop, the more likely they are to take rates with them. For now, we stick to our view, also motivated by the strength of the US economy, that upside risk dominates for bonds. This is particularly true in an environment of fragile investor sentiment and rising supply, as is customary in September and October. If confirmed, however, the milder inflation picture would precipitate the rally in government bonds we expect for late 2022/early 2023, through 1% in the case of 10Y Bunds.