Winter is coming: Europe skates on thin ice as energy proxy war heats up

By the OFX team | 7 September 2022 | 6 minute read

Key points in this article

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While the invasion of Ukraine bogs down into a grinding war of attrition, the geopolitical battle is heating up – and the global economy is in the crossfire.

When Russia invaded Ukraine in February 2022, a number of countries applied sanctions on Russia, cutting down on Russian imports including oil and gas to exert financial and political pressure. It was at this point that Europe’s high dependence on Russian energy imports was exposed. Given this dependence, Europe has been unable to ban imports completely, recognising that doing so would cause almost as much economic hardship on its own member states as it would on Russia.

Over the months since, a proxy war has been waged between Russia and Europe over fuel – testing how long can Europe hold out in resisting Russia’s energy squeeze.

Supply pressures escalate

On September 2, hours after the Group of Seven nations agreed to an oil price cap for Russian crude, the Kremlin-controlled energy company Gazprom said it would suspend supplies of gas to Germany via the Nord Stream natural-gas pipeline until further notice¹, piling pressure on Europe’s ability to withstand the fast-approaching Northern winter.

Russia’s move came as energy prices in Europe were finally beginning to moderate from eye-wateringly high levels. Dutch natural gas prices had dropped back to €250 from as high as €320 in late August² which, in turn, pushed 1-year inflation expectations sharply lower. The reason for the decline in energy prices was the positive news that the German gas reserve — a policy to safeguard supply ahead of winter — had reached 85% of capacity, or two months supply³. Despite the drop in prices in the Netherlands, Dutch natural gas prices are up over 1000% for the year.
So the news that a key source of European gas may be cut off indefinitely is causing more uncertainty for an already volatile market. When news of the Nord Stream shutdown broke, rattled investors drove natural gas prices up 35% on Monday September 5. The euro fell below 99 cents for the first time in 20 years⁴ and European equities plunged, as markets digested the likelihood of not just higher inflation, which means higher interest rates, but also significant economic upheaval as Europe heads into winter⁵.

Energy woes sap Europe’s economy, as inflation soars

The energy squeeze is cruelling European businesses. ArcelorMittal, one of the world’s largest steelmakers, said it plans to close two of its plants in Germany amid soaring electricity costs, and a further plant in Spain due to low demand. Those plants produce nearly 4 million tonnes of steel a year. In August, Norway’s Norsk Hydro said it would halt primary production of aluminum at a smelter in Slovakia due to high electricity costs, while BASF, one of the world’s largest chemicals companies, said it would reduce production of the fertiliser ingredient ammonia. High gas prices caused an ammonia plant in the UK to close as well⁶.

That puts central bankers — European ones particularly — in an unenviable position, as they try to avoid a steep recession while driving down soaring inflation running at 9.1% (up from 3% the previous year). The biggest driver: energy prices that rose by a whopping 38%⁷.

The European Central Bank (ECB) is under no illusions that it needs to get inflation under control, and that getting prices down will be painful. Speaking at an economic summit in late August, ECB board member Isabel Schnabel warned that the populations could again be facing the sacrifices endured during the inflation shocks of the 1970s and early 1980s. She warned that if banks didn’t anchor inflation expectations to a reasonable level, citizens would lose faith in central banks as institutions; 

Regaining and preserving trust requires us to bring inflation back to target quickly. The longer inflation stays high, the greater the risk that the public will lose confidence in our determination and ability to preserve purchasing power.⁸

That is the view of one ECB board member, and a very hawkish one at that, but it does set the scene for continued interest rate rises, even in the face of a slowing European economy.

US ‘pivots’ toward a harder landing

At the same conference, US Federal Reserve Chairman Jerome Powell also struck a hawkish tone.

Powell warned that fighting inflation is now the Fed’s top priority, even if some “pain” is required. He foreshadowed that the central bank would continue raising interest rates and shrinking its balance sheet “for some time⁹.”

Markets had hoped that Powell might start to moderate interest rate rises as the economy started to slow, so investors were thrown into a tailspin by those remarks with the US S&P500 shedding over 5% in the week since the August 26th speech. The tech-heavy NASDAQ fell 8%.

The August jobs report, released a week after Powell’s speech, validated the Fed’s stance, suggesting that the US economy is taking longer to cool than expected. 315,000 jobs were added in August — still growing, but at its slowest pace for more than a year. Wages also rose, up more than 5% for the year, but less than economists predicted¹⁰. In short, not enough to divert the Fed from its interest rate tightening course.

As the US continues to raise interest rates faster than the ECB, its dollar should see continued demand and retain strength relative to the euro as money markets seek a higher return in the US.

What next for Europe and the euro?

From a currency perspective, the euro was already struggling. Now, with the currency falling below 99 US cents for the first time in 20 years, markets are now staring at a prolonged period of weakness for the currency. The pound, which is already down 15% against the USD so far this year, also slid on energy fears and the impact of slowing European growth¹¹.

The question now is how long Europe and the UK can weather the weaponisation of energy, with the Northern hemisphere only just entering autumn and rationing of energy already on the cards.

A cold winter would severely test European’s resolve, and force countries to choose energy consumption for heating over production. That would put more factories at risk of being shuttered, leaving Europe facing the nightmare scenario of stagflation, when interest rates rise to control inflation but soaring costs send output plummeting.

Perhaps an even worse scenario would be European disunity as member countries react to internal pressures and pursue self interest over a common front. Greece, Italy, Spain and Portugal are highly indebted and very reliant on EU/ECB support to prevent bond yields (and therefore interest payments) in those countries shooting up¹². Those debt levels might also rise if governments borrow to subsidise energy costs for consumers and business, so currency markets may be particularly wary of both geopolitical uncertainty in Europe and unsustainable debt levels.

Expect the euro, and the pound, to continue to struggle against the US dollar. 

Impact on the global economy

The Conference Board, one of the US’s most respected economic institutions, thinks the United States should still manage to avoid a recession despite the harder landing, and they are optimistic that China can navigate its rolling COVID lockdowns and avoid negative growth.

On Europe, they tip a ‘technical recession’ (two quarters of negative growth) later this year, and their survey of German sentiment supports that¹³.

The global energy crisis, against a background of stubborn inflation, interest rate hikes and slowing growth, is contributing to huge uncertainty for the global economy, and with recent commentary from central banks this looks set to continue in the coming months. With nervous investors looking for safer investments, the currencies of economies that appear better-positioned to withstand forceful rate hikes and slowing growth should benefit. With change to the broader macro picture looking unlikely, demand for the US dollar looks set to continue, particularly against the euro.