By Elwin de Groot, Head of Macro Strategy at Rabobank

We’ve been warning for persistent inflation in this Global Daily for quite some time and although the recent declines in headline inflation –largely driven by energy and thawing supply chains– have been viewed by markets in a positive perspective, there is still considerable risk hidden below the surface. Climate change certainly belongs to the tally of such risks. Reuters reported yesterday that the Spanish spring was the hottest and second-driest in Spain since records began in 1961. That harvests are being affected is as clear-cut. Last week, the Panama Canal authority said it is forecasting a July 31 water level of 78.2 feet, far below the 5 year average of 84.9 feet, and also a touch below its all-time low of 78.3 feet set in May 2016 (ZH: it appears the icebergs are not melting?). Lower water levels means higher costs for cargo through surcharge fees and the need to reduce loads on ships. Adding insult to injury, the evidence is piling up that an El Niño weather system is now forming rapidly, which could have significant consequences for weather conditions as well. This is quite complicated stuff, but generally it does not bode well for global temperatures...

Climate change and drought are increasing the prevalence of e.g. wildfires, such as the ones currently in Canada. The impact is being felt far beyond the border, with New Yorkers forced to wear face masks and limit the time spent outside because of the poor air quality.

Meanwhile, temperatures in China are rising as well and this time we don’t mean the geopolitical tensions with the US, but the weather. An early heatwave is putting both livestock and power supplies at risk which could lead to yet another factor disrupting global and more particularly Asian food supplies. Last week Shanghai already saw a 150 year old record being broken for the highest ever temperature recorded in May. With the heat killing rabbits, the price of spicy rabbit heads (a popular street food) has been on the rise. Additionally, hundreds of pigs have been reported dying in the Jiangsu province. A prolonged heatwave could result in rising inflation, something China has been able to avoid so far, unlike many other countries around the globe.

As these risks to future inflation pile up, this also includes man-made disasters such as the blowing up of the Kakhovka dam in Ukraine, which has already deprived hundred thousands of people of clean drinking water according to experts and is expected to have a huge impact on farming in the region and to be an ecological disaster more broadly. That climate, ecology and biodiversity risks are no longer outside the realm of economics and even monetary policy making was underscored by an FT interview with ECB’s Frank Elderson, who warns that 72% of Eurozone companies and 75% of bank loans were exposed to loss of biodiversity.

New inflation surprises could fuel the old familiar pattern that so much drove markets during the best part of 2022, seem to be returning. And it’s already hitting the policy front as well. The Bank of Canada took markets by surprise by hiking its main policy rate by 25bp to 4.75% and governor Tiff Macklem warned in the BoC’s statement that “overall, excess demand in the economy looks to be more persistent than anticipate”. The pick-up in Canadian headline inflation had already pushed market expectations into ‘hiking territory’ over the course of May, but a 25bp was far from fully priced in for the June policy meeting.

Although the pink sunglasses brigade would probably argue that “this is a country with a GDP as big as Italy’s” (well, yes, both were almost exactly equal in 2022 when measured in USD) or “one swallow doesn’t make a summer”, this BoC hike actually came on the heels of a surprise RBA hike the other day. But more important, we’d argue, is the backdrop and time-frame of previous hikes against which this hike took place. For, the BoC had already been on hold since its last January hike and has thus effectively re-started its tightening cycle. After all, hiking just 25bp after a long pause doesn’t seem like a plausible scenario, especially not when you have just identified persistent inflation risks… As such it may also be a warning signal for other central banks, either for those that have just entered or are contemplating a ‘pause’ (such as the Fed), or for those that have been much later to the rate hike party, so those that basically had their lunch pause before breakfast started (such as the ECB).

Turning to markets, a huge slide in the Turkish lira was one of the eye-catching events yesterday. After trading at around 21.57 against the dollar during the European session, it started to slide in the evening and by the time European markets reopened it had already pierced 22.50. This morning it stood at 23.35. According to reports citing traders, the country’s state banks –who regularly intervene in the fx market– have given up those interventions.

However, the underlying rationale for that development may not only be the (negative) fact that the central bank’s reserve coffers are close to their lowest point (as measured in terms of imports cover) in nearly 30 years, but also a (potentially) more positive development on the policy front. In particular, the re-appointment of Mehmet Simsek as Treasury and Finance minister could be a sign that there is a policy shift in the making that would return Turkiye to a more conventional policy framework that would – over time – rein in rampant inflation. Although that is easier said than done (if pigs could fly, you know...), the fact that this slide in the currency went hand in hand with a positive performance of the Turkish stock market and its $-bonds (but not local currency bonds) provides some evidence that the market’s verdict is that this developments gives hope for the future, but likely with near-term pain to come.

Over in Europe, German production staged a small recovery in April after an (upwardly revised) slump in March. Non-durable consumer goods and branches such as food, chemicals and metals were largely responsible for the better tone in the production report. The rise in output in the latter suggest that lower energy prices are having a positive effect on production (i.e., fewer businesses being forced to hold back output). Further downstream, however, things were not as positive, with computer, engineering and auto sector output declining in April. This gels with the overall impression of weaker global demand – as also pointed out by recent survey data.