Central Banks Have a Diesel Problem

Tresmark: We now have a remarkable combination.
– Oil > $100
– G10 bond yields on the rise
– Fed hiking
– ECB hiking
– BOJ hiking
– RBI & BoE expected to hike
– Dollar strengthening

That is a pretty hostile macro cocktail for emerging markets. Yet something potentially more dangerous is happening underneath.

Central banks have a diesel problem

They can raise interest rates. They can drain liquidity. They can support currencies. What they cannot do is produce another barrel of diesel.

Asian 10ppm diesel refining margins reached just over $87/barrel this week, versus roughly $22 before the war. That is an all-time high. SocGen estimates current US diesel prices are economically more consistent with Brent around $190 rather than where crude is actually trading today.

And diesel sits deep inside the productive economy.
– Trucking → food distribution
– Agriculture → tractors, harvesters, tube wells
– Construction → machinery and freight
– Industry → generators and logistics

So unlike petrol, diesel doesn’t stop at the pump. It slowly finds its way into the price of almost everything.

Even SBP’s unusually specific reference to El Niño in its latest MPC points to the same problem: some of the biggest inflation risks now sit outside the reach of interest rates.

The price of money is going up too

The Fed raised rates by 25 basis points this week and has signalled another hike this year. BoJ and ECB have also raised rates, with further tightening increasingly on the table. Their problem is increasingly the same: inflation.

But perhaps the more worrying signal is coming from the bond market.

The US 10-year Treasury crossed 5% this week, its highest level since 2007. The 2-year has also moved sharply higher, while bond yields across major economies have risen.

Central banks are saying: we are tightening to control inflation. Bond markets appear to be saying: you may need to do more.

Money is getting more expensive again.

Everybody else’s inflation problem

Last week we wrote: “Pakistan’s interest-rate outlook may no longer be about Pakistan’s inflation. It may be about everybody else’s inflation problems.”

A week later, that argument has become stronger.

If US and other global rates continue moving higher, Pakistan’s interest-rate differential keeps narrowing. At some point, that pressure becomes increasingly difficult for SBP to ignore, even if Pakistan’s own inflation picture does not deteriorate dramatically.

India is already moving in that direction. With oil above $100, INR around 96 and global yields rising, expectations of an RBI hike have increased sharply.

Anyone who thinks there will be no hike at the next MPC should probably restart reading from the top.

So why is the Rupee still at 277?

With almost everything above working against emerging markets, Pakistan’s currency has barely moved.

Total FX reserves are at an all-time high of over $26bn, remittances remain strong and the CAD was minimal. Importantly, Pakistan has been building financing buffers proactively.

Pakistan raised $3bn in one go, even as the global price of money was beginning to rise. That looks considerably better today than having raised the typical $1bn and returning to international markets for subsequent tranches at potentially higher yields.

There is also China. Pakistan has already experimented with Panda Bonds, opening another potentially important funding market. China’s 10-year government bond is trading around 1.7%, while the US 10-year has crossed 5%.

And bonds are only part of the defence. The government’s fuel austerity measures should also help contain consumption and take some pressure off the import bill. Every barrel saved matters more when Oil is above $100.

Ultimately though, the biggest variable may simply be time.

Pakistan can absorb expensive Oil for a while. It has reserves, financing buffers, strong remittances and a stable Rupee.

The price of Oil matters. The duration of the war may matter more.