Europe, Russia & Energy – Simulating the Market Impact of Price Caps and the Cost of War
Stress Tests play an important role in improving financial stability by enhancing market discipline and transparency. Clients leverage TS Imagine’s flexible and powerful risk engine to stress test a variety of specific scenarios.
Since the start of the war in Ukraine, Western nations have imposed sanctions on many Russian individuals, businesses and state-run enterprises. Moscow has shut its key Nord Stream 1 gas pipeline to Germany, owing to technical issues, but also made it clear that unless sanctions are dropped, no gas will ever flow through Nord Stream 1 again.
For Europe, on top of these disruptive supply chain issues, OPEC+ recently agreed on a token 100,000 barrel a day cut to production based off an Iran supply deal. Iran also stated that there would be no nuclear deals unless the International Atomic Energy Agency (IAEA) backs off from investigating any prior breaches of the last nuclear deal they struck.
Assuming that Europe cannot retreat from its current position on Russia, this would tend to lead to a severe recession with higher inflation. Borrowing or printing money to pay for imported energy (in dollars), while running rising twin deficits will likely lead to currency devaluation and price inflation.
Across Europe, multiple countries are already feeling this strain. Moreover, Russia recently stated that it would not sell oil to countries with a price cap in place. A G7 ‘price cap coalition’ would not likely be broad enough to make the cap work. Arguably, Russia cannot afford to stop selling oil to these countries; however, Russia has already raked in much higher-than-normal revenues from its oil and gas exports since Western sanctions were enforced.
Whatever the solution that is applied, the stark reality is that Europe can’t produce more natural gas, oil or coal, so one way or another, it will have to offset the surge in costs. First in commodities, then in all downstream chains, which in the very near future may mean governments could soon be subsidizing Europe’s cost of living as the alternative to a potential revolution.
From a stress testing point of view, if price caps are incorporated, there are several possible outcomes:
- The ECB will incorporate Yield Curve Control (YCC) to keep sovereign yields intact.
- Printing through YCC could cause the Dollar (DXY) Index to explode higher given the large weighting of the Euro within the index.
- Emerging markets could potentially start to default on debt, which may force them to sell their US bonds to attain US Dollars to defend their currencies. US Bond Yields could then expect to explode higher.
Stress Test Input Factors:
- Euro decreasing by 20% (“EUR” global shift)
- US Bond Yields Rise (100bps) (“USD-GOVT”, predictive)
- Commodities (Crude Oil, NatGas) rising by 20% (“CLc1”, predictive)
The Dollar Milkshake Theory – Stress Testing the Potential Impact of a Sovereign Debt and Currency Crisis
Stress Tests play an important role in improving financial stability by enhancing market discipline and transparency. Here we consider the third example of these stresses based on current market conditions and show how the risk factors can be generated along with their relevant shock examples.
Stress Tests play an important role in improving financial stability by enhancing market discipline and transparency. Clients leverage TS Imagine’s flexible and powerful risk engine to stress test a variety of specific scenarios. With Americans set to commence voting early next week, markets around the globe are watching carefully. Will the midterms disrupt the Democratic legislative agenda or tip in their favor? We ran two scenarios through our stress-testing engine, gaming the potential market impacts. Please note that these are hypothetical shocks and are not a prediction of any forthcoming events.
Historical VaR (HVaR) has become a standard measurement of risk. Many firms now require a full twelve years of prices (plus data from further back such as the Great Recession of 2008–2009). However, this requirement introduces a conundrum: what do we do when a company has not been around for a full twelve years?