“Who Is On The Other Side Of Those $1.5 Trillion In Energy Derivative Margin Calls Which Europe Is Bailing Out”

By Michael Every of Rabobank

Today is the key US CPI release for August. All eyes will be on that number, and more so given markets have spent the past two trading sessions generously pricing in “Transitory! Again!” Woe betide them if we get m-o-m prints above the -0.1% headline and 0.3% core expected, which still equals 8.1% and 6.1% y/y respectively.

The odds favor of a soft print today for a few reasons. Helped by a one-off release from the Strategic Petroleum Reserve (SPR) that ends soon, US gasoline prices at the pump are back under $3 in places when they had been at $5. Lower energy prices flow through to many other items, including air fares. Moreover, reports are food prices could dip, particularly meat, as ranchers slaughtered earlier this year, temporarily boosting supply. You could see that simple logic at work in the New York Fed’s 1-year ahead consumer inflation expectations survey yesterday, which dipped from 6.2% to a 10-month low of 5.7%, while the 3-year expectation dropped from 3.2% to the lowest in nearly two years at 2.8%. Note none of this is 2%, or likely to shift the Fed from whatever it is locked and loaded to do in September – but it won’t stop the market screaming ahead with another leg in the “transitory” trade.

Indeed, there are several core reasons why markets always think inflation is transitory.

First, it was very much so for a very long time.

Second, it is self-serving: lower inflation means lower rates, which means higher asset prices, which makes the people saying “transitory” richer or able to attract more fund inflows. You cannot discount that uncomfortable truth any more than you would from a scientist peddling a new discovery that they have shares in – follow the money as well as the science.

Third, economics is not a science. The we-always-trend-back-to-2%-inflation predictions it spits out are DSGE&DSGE (or Advanced DSGE&DSGE), a game of fantasy and imagination where a huge inflation dragon can be easily killed with a +25 rate hike. Its dynamic stochastic general equilibrium models, based on concepts debunked by economics itself(!), are mean-reverting: they have to show inflation comes back to 2% again! They are incapable of showing other results unless you tell them what long-run inflation trends are going to be. Yet as the market gets ready to scoop up all the transitory treasure the inflation dragon had been guarding, things are happening in the world of ‘Dungeons and Draghis’.

The vast cavern holding the US SPR can’t keep being drained for long, even if it isn’t then refilled immediately. There are also drums in the deep from places people who play DSGE&DSGE in air-conditioned offices and homes never go. We could get a US railroad strike as soon as September 16, which would cripple distribution of agricultural and industrial goods such as fertilizers, chemicals, grains, coal, and steel, etc., and even risk backlogging US ports again. Those in the know underline even a short strike would send major ripple effects through supply chains.

Moreover, strikes may only be avoided by loss of treasure. Freight Waves reports three railroad unions just struck new tentative wage agreements which include a 24% increase from 2020-2024, 14.1% immediately, and five annual $1,000 lump sum payments, partly retroactive. Yes, a Wall Street giant is firing a slew of its expensive deal-makers as pipelines dry up: but if you want to track wage inflation among those with the highest marginal propensity to consume, and who hold the whip hand over physical pipelines, look to the railroads not the ‘railroaders’.

Central banks boast they slew the inflation dragon in the 1980s and can do so again with rate hikes. However, anyone who played 80’s edition D&D knows there is nothing more annoying than a party member who contributes little during a battle against a big monster, watching his companions take all the damage, and then steps in to deliver the final blow, as the rules dictated they alone gained all the requisite experience points for the kill.

The 70’s/80’s inflation dragon was NOT slain by high interest rates alone: others took huge damage via de-unionisation, deregulation, privatization, and globalization to kill it. Nobody in the current party, or any Western political party, is willing to see more of the same pain today: quite the opposite. There are no more technocratic NPC Draghis out there, even in Italy if opinion polls are accurate. Rather, the Financial Times today carries an op-ed asking, ‘Who will pay for the shift from efficiency to resilience?’, with the sub-heading ‘Western politicians want companies to foot the bill for post-neoliberal economics.’

Then factor in lower immigration, work-force losses from Covid deaths, the many suffering from Long Covid, hard-core cryptonites trading at home, lifestyle changers, early retirees, and ‘quiet quitters’ together, and you could get a much tighter, less productive labour market.

Then add in deglobalisation / onshoring, which by its nature is the opposite of what we saw in the 80s; and mix in military spending across the West which *will* match what was being seen in 80s. As noted yesterday, and warned of many times before that, 2% of GDP on defence is not enough: as Germany says it must assume a leading military role in Europe, Poland is aiming for over 4%.

Yet markets are playing the same always-mean-reverting-to-2%-inflation game of DSGE&DSGE.

Meanwhile, it’s a whole different fantasy role playing game in Europe, as Bloomberg reports the EU will push for 10% power reductions going forward. I was one of several voices pointing out the simple logic that if you won’t ration energy by price then you have to ration by diktat: EU month-to-date September natural gas demand is 16% below the 5-year average, but still needs to be more than double that to achieve the EU’s targeted 15% goal, according to some estimates. What diktat is to be seen then, as aluminium, steel, fertilizer, and greenhouse agriculture are turned off? Which unlucky firms, households, or public services, are to be shuttered or limited for the foreseeable future? And who decides – the Dungeon Master? These are pressing questions.

So are those around reported requests for $1.5 trillion to cover margin calls in the derivatives market Europe is being asked to stump up for energy firms – so far. Who is on the other side of those trades? Are central banks (and taxpayers) on the hook for it given this crisis is structural, not cyclical? How large are the liabilities in the worst case? Is this the most efficient way to deal with this energy crisis? Will said energy derivatives market be shut down too, as some suggest? Playing DSGE&DSGE against that kind of real-world volatility really is escapism.

At least Western energy traders don’t have to worry about accidentally mysteriously falling out of windows, like they do in Russia, or off of their yachts, as they do if they are Russian. But that doesn’t mean there aren’t hidden traps around, because there are.

Anyway, let’s wait for inflation and roll those dice.