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What does China’s coal shortage mean for trade?



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Hello from Hong Kong, where quarantine restrictions have been eased for senior directors of big listed companies. But rather than flows of people, our main piece today is about flows of energy in an age of environmental transformation. Few would predict a future where the role of coal has not declined dramatically. But for now, the outlook is, to put it mildly, blurred.

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The link between trade and the price of coal

Tackling record commodity prices is on the minds of the Chinese Communist party’s top brass. And that raises questions over the production and trade of the country’s prime energy source: coal.

At a state meeting chaired by Chinese premier Li Keqiang last month, one line in particular will have jumped out to environmentally minded observers: the idea of tapping the country’s “rich coal resources”.

In September last year, China declared its commitment to reach net zero carbon emissions by 2060. But it still relies on coal for its electricity generation and, for now, it needs more of it.

“Almost all energy prices including coal, oil and gas have been rising rapidly in the past few months, prompting the Chinese government to prioritise energy security over decarbonisation concerns and reduction of fossil fuels like coal and gas,” said Cindy Liang, an analyst at S&P Global Platts, in late May.

Like many other commodities, prices for coal have recently soared. The wider raw material price rally has fuelled fears over inflation in China, with the same state council meeting emphasising the need to avoid them feeding through into consumer prices.

One of the main reasons why coal prices have shot up is a shortage in China, which is the world’s largest consumer of it. Analysts at Morgan Stanley point to a surge in power consumption, which in April rose 14 per cent year on year on the back of the country’s rapid recovery. 

Coal production is up too, by 16 per cent in the first quarter compared with the same period last year, though mines were closed in early 2020 owing to the pandemic. But despite rising production, there are still pressures on supply to keep up with higher demand.

At the same time, domestic producers must comply with a tighter environmental backdrop, even if long-term targets are many decades away. Morgan Stanley notes that “domestic coal supply is under continued pressure from safety and environmental inspections”. Analysts at Argus, who anticipate higher coal consumption in the future, make a similar point.

“Market participants do not expect the government to allow significant production increases until after the celebration of the 100th anniversary of the Chinese Communist party on 1 July,” they wrote last Friday. “In fact, strict environmental and safety curbs are likely to stay in place as longer-term rules, even after the celebration.” The state council meeting emphasised not only coal production, but also wind, solar, hydro and nuclear capacity.

How does trade fit into this dynamic? Despite shortages, Chinese imports of thermal coal, which operate under a quota system and are only a fraction of total consumption, have plummeted by almost a quarter so far this year. That’s in part due to constraints on Australian coal amid worsening geopolitical relations between the two countries.

Line chart of thermal coal imports (millions of tonnes)  showing Chinese coal imports have slumped of late, despite high demand

While prices are on the up the world over, foreign coal is far cheaper. In Australia, the active futures contract for thermal coal cut in Newcastle is $115.6 a tonne. In May, thermal coal futures on the Zhengzhou exchange surpassed the Rmb900 ($141) mark for the first time. As the chart below shows, this price discrepancy has gone on for years.

Line chart of  showing Chinese coal is pricier than foreign substitutes

Against that backdrop, it might seem tempting for China to import more coal or at least avoid cutting imports further. The quota restricts imports to just 300m metric tonnes a year, compared with production of 3.81bn tonnes last year, according to S&P Global Platts. But another related dynamic is its push to reduce its reliance on other countries, which may explain the emphasis on its own resources.

Matthew Boyle, head of coal and Asia power at S&P Global Platts Analytics, expects coal production in China to peak in 2023. He says that China has continued to source coal from other countries, such as South Africa, but that the country is transitioning towards greater energy independence.

That ambition, which is also playing a role in gas, could point to a clearer trajectory for the trade of coal long before its consumption in China is significantly cut back. “As China moves towards self-sufficiency for its coal requirements,” he says, “its need for seaborne coal will become less.”

Trade links

Tensions between Washington and Beijing rose another notch this morning, after the Biden administration said it was considering whether to launch a probe into imports of rare earth neodymium magnets from China. The probe would investigate whether tariffs could be introduced on security concerns. As those of you who read Ed White’s brief from Seoul last week will recall, China dominates the processing of minerals and rare earths vital for the production of goods such as mobile phones and electric vehicle batteries.

Relations between the EU and the UK over the Northern Ireland Protocol also look decidedly shaky, with Brussels now threatening to intensify action.

There are a couple of interesting reads on semiconductor chips. A big issue post-pandemic is going to be whether the automakers reduce reliance on just-in-time production, which left them with little to no chip inventory when the shortage hit. Bosch, Europe’s largest auto supplier, thinks the industry has to change tack and has warned carmakers must put “money on the table” and make a “rock solid” commitment to orders if they are to avoid a repeat of the events of the past year. There may be more trouble ahead for the likes of Europe’s automakers too, following an outbreak of Covid-19 in Taiwan, home to many of the chipmaking industry’s biggest participants. As Kathrin Hille writes, it is unlikely that this will affect the likes of larger manufacturers such as TSMC directly, but it may impact the smaller groups responsible for packaging their products. Nikkei also has an interesting take ($, requires subscription) on the vaccination crisis that has resulted from the latest surge in cases.

Industry groups from Japan and Finland, meanwhile, will conduct joint research and development of sixth-generation communications technology, looking to lead the creation of 6G standards in a field increasingly influenced by Chinese companies. (Nikkei, $)

Chad Bown of the Peterson Institute and Chris Rogers of S&P Global Market Intelligence have a new blog out, which posits that there was no US export ban on vaccines to India. However, they argue that the kerfuffle highlights exactly why a well-thought out global vaccine supply chain is so important. The post is summarised in a Twitter thread here too. Claire Jones

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Bond spreads collapse as investors rush into corporate debt




The premium above super-safe US Treasuries that investors are demanding to buy corporate debt has dropped to its lowest level in more than a decade.

The collapse in the difference between yields — or spread — is a sign that investors are growing increasingly confident that recent rises in inflation will not hinder the booming economic recovery.

The spreads between US Treasury and corporate bond yields have tightened markedly this year, as investors gained confidence and clamoured to own even marginally higher yielding assets in a low return world.

That spread compression, which indicates the level of risk investors see in lending to companies compared to the US government, had come under pressure from the spectre of higher inflation from mid-April to May.

However, an increasing number of investors are coming around to the Fed’s mantra that price rises will prove transitory as the economy reopens after the pandemic, pushing measures of expected inflation lower.

“The Fed has been controlling the transitory narrative which has provided confidence to corporate bond investors,” said Adrian Miller, chief market strategist at Concise Capital Management. “After all, corporate bond investors are more focused on the expected strong growth path.”

Line chart of Spread on US corporate bonds, by rating (percentage points) showing Investors are demanding less yield to lend to US companies

Confidence in the economic recovery was further bolstered on Wednesday as Fed officials signalled a shift toward the eventual repeal of crisis policy measures, embracing a more optimistic outlook of America’s rebound. The more hawkish tone from Fed chair Jay Powell — including comments that “price stability is half of our mandate” at the Fed — has helped to mollify concerns that inflation could run out of control, forcing a more abrupt response from the central bank.

The spread between US Treasury yields and investment grade corporate bond yields fell 0.02 percentage points to 0.87 per cent on Wednesday, according to ICE BofA Indices, its lowest level since 2007, and was unchanged on Thursday. For lower rated — and therefore riskier — high-yield bonds, the spread fell 0.05 percentage points to 3.12 per cent, below a post-crisis low last set in October 2018. It widened modestly to 3.15 per cent on Thursday.

The slide in spreads has been buoyed by the central bank’s accommodative policies through the pandemic crisis as well as the federal government’s multitrillion-dollar pandemic aid package. Financial conditions in the US are close to their easiest on record, according to a popular index run by Goldman Sachs, which has spurred a wave of corporate borrowing by riskier junk-rated businesses.

Some 373 junk-rated companies have borrowed through the nearly $11tn US corporate debt market so far this year, including companies hard hit by the pandemic like American Airlines and cruise operator Carnival. Collectively the risky cohort has raised $277bn, a record pace and up 60 per cent from year ago levels, according to data provider Refinitiv.

Column chart of Annual proceeds from high-yield US corporate bond sales ($bn) showing Risky junk-rated US companies are issung debt at a record pace

However the fall in spreads and investors’ perception of risk has not been enough to outweigh an overall rise in yields, which have been jolted higher by the prospect of rising interest rates as investors adjusted to a quicker pace of policy tightening from the Fed.

Higher rated debt, which is safer but offers less of a spread to cushion investors against a jump in Treasury yields, tends to suffer more in high growth, rising interest rate environments. High-yield bonds on the other hand tend to benefit, with the booming economy making it less likely that companies will go bust.

“For the time being people are not at all fearing the price action of a move higher in yields,” said Andrzej Skiba, head of US credit at BlueBay Asset Management. “Companies are doing really well and we are seeing a meaningful recovery in earnings.”

Investment-grade bond yields have moved 0.3 percentage points higher to 2.08 per cent since the start of the year, compared with a decline of 0.27 percentage points to 3.97 per cent for high-yield bonds.

Bank of America analysts expect the two markets to keep coming closer together, projecting that investment-grade spreads will widen to 1.25 per cent and high-yield bond spreads will continue to decline to 3.00 per cent in the coming months.

However, while optimism about the US recovery abounds the continued zeal for lower-quality corporate debt has caused consternation in some quarters. Investors worry that precarious companies are being offered credit at interest rates that don’t account for the high levels of risk involved.

“It’s very important for us that the yield we receive on a high-yield bond offers an appropriate level of compensation for the credit risks of investing. When yields are as low as this, that naturally becomes harder to say,” said Rhys Davies, a high yield portfolio manager at Invesco. “It’s quite simple — the lower the yield on the high yield market, the more carefully investors need to navigate the market.”

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Global stocks slip and bonds weaken after Fed signals tighter policy




Global stock markets dipped, European government bonds dropped and the dollar strengthened sharply after US central bank officials brought forward the anticipated timing of the Federal Reserve’s first post-pandemic interest rate rise.

The FTSE All-World index of developed and emerging market stocks, which hit a closing record on Monday, headed for its third session of losses on Thursday, falling 0.6 per cent.

The Federal Reserve said on Wednesday that most of its officials expected a rate rise in 2023, against earlier predictions of 2024, as the US economy recovered strongly from the pandemic and consumer price inflation hit an annual rate of 5 per cent in May.

Fed chair Jay Powell also said the world’s most influential central bank was “talking about talking about” reducing the Fed’s $120bn-a-month asset-buying programme that has boosted financial markets since March last year.

The announcement rattled the US Treasury market on Wednesday, as the prospect of higher interest rates on cash lowered expected returns from fixed interest securities such as bonds, with traders in Europe following those moves in the next session.

“It was a hawkish surprise,” said Keith Balmer, multi-asset portfolio manager at BMO Global Asset Management. “Markets now see the Fed as stepping in to control inflation earlier than expected,” he added, following previous comments from Powell that suggested price rises above the central bank’s long-term 2 per cent target would be temporary.

Line chart of FTSE All-World index  showing Global stocks dip from record high

The dollar index, which measures the greenback against trading partners’ currencies, jumped 0.7 per cent after gaining a similar amount on Wednesday as traders anticipated higher returns from holding the world’s reserve currency. The euro lost 0.5 per cent against the dollar to $1.193.

The yield on the benchmark 10-year Treasury note, which jumped 0.09 per cent on Wednesday evening to 1.58 per cent following the decision from the US central bank, moderated slightly in European trading hours to 1.558 per cent.

European bond yields, which move inversely to prices, raced higher as traders bet on other central banks following the Fed to rein in their crisis-era stimulus spending. The UK’s 10-year gilt yield rose 0.09 percentage points to 0.828 per cent. Germany’s equivalent Bund yield added 0.04 percentage points to minus 0.164 per cent.

Stock markets were less affected by the rate increase forecast as investors focused on the strength of the post-pandemic economic recovery and bought up shares in businesses expected to benefit from higher borrowing costs.

The Stoxx Europe 600 index, which rallied to an all-time high on Wednesday, fell 0.3 per cent on Thursday. Shares in European banks, which benefit from higher interest rates that enable lenders to make wider profit margins, gained 1.2 per cent.

The next US rate rise “will be happening at a time when the [global] economy is able to stand on its feet”, said Zehrid Osmani, manager of Martin Currie’s global portfolio trust.

Futures markets signalled the S&P 500 index would slip just 0.2 per cent at the New York opening bell after declining 0.5 per cent on Wednesday, while the top 100 stocks on the technology-focused Nasdaq Composite would lose 0.3 per cent.

Elsewhere in markets, the Norwegian krona rose 0.1 per cent against the euro to €0.984 despite the Norges Bank saying it was likely to raise interest rates in September. Some traders had expected an increase on Thursday.

Brent crude, the international oil benchmark, rose 0.1 per cent to $74.48 a barrel.

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Hawkish Federal Reserve forecasts jolt Treasury market




US equities slid and Treasury yields surged after policymakers at the Federal Reserve signalled that they expected to lift interest rates in 2023, a year earlier than previously thought.

The benchmark S&P 500 fell 0.6 per cent, led by a decline in the shares of technology companies including Oracle, Microsoft and Facebook. The Nasdaq Composite was also down 0.6 per cent.

The equity market decline accompanied a sell-off in the $21tn Treasury market, where the yield on the benchmark 10-year note rose 0.06 per cent to 1.56 per cent.

Among shorter-dated government bonds most sensitive to interest rate policy, there were even larger moves. The yield on the five-year note climbed 0.09 percentage points to 0.88 per cent, while the yield on the two-year note briefly hit its highest level in a year at 0.19 per cent.

“Just as the market was getting comfortable with a patient Fed and inflation considerably above target, the dot plot has shifted,” said Seema Shah, the chief strategist of Principal Global Investors, referring to the graph showing Fed officials’ interest rate predictions.

“Now it will be up to [Fed chair Jay] Powell and other Fed speakers to once again reassure markets that tightening in 2023 doesn’t need to be disruptive.”

The equity market rally over the past year has been in part predicated on rock-bottom interest rates, which the Fed has anchored near zero since the crisis began in March last year.

While policymakers at the US central bank showed that they could raise rates sooner than previously thought, they did not yet signal changes to the Fed’s $120bn-a-month asset buying programme, which investors are starting to expect will be tapered soon.

But markets have worried that signs of higher inflation, which Fed policymakers acknowledged in their economic projections published on Wednesday, could force the central bank’s hand.

“Given that the only takeaways from the Fed update involved higher rates, it follows intuitively that Treasuries are trading lower,” said Ian Lyngen, the head US interest rate strategist at BMO Capital Markets.

Ian Shepherdson, the chief economist at Pantheon Macroeconomics, added that the forecast for higher rates in 2023 meant that members of the Fed’s policy-setting committee “now are ready to talk tapering, so chair Powell is not going to be able to repeat his March/April stonewalling . . . We expect him just to acknowledge that the discussion is under way, but that a firm decision is a way off.”

The US dollar index climbed 0.4 per cent along with the uptick in Treasury yields. The pound fell 0.4 per cent against the dollar, while the euro slipped 0.7 per cent to $1.20.

European stocks finished at new records before the release of the Fed decision. The Stoxx Europe closed up 0.2 per cent for another all-time peak, the region-wide benchmark’s ninth session of back-to-back rises.

Frankfurt’s Xetra Dax rose 0.1 per cent, while both the CAC 40 in Paris and London’s FTSE 100 climbed 0.2 per cent.

Additional reporting by Siddharth Venkataramakrishnan in London

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