Aurelia Butler

Good morning. This morning’s payroll report has the potential to move markets even more than usual. If it is anywhere near as hot as yesterday’s ADP employment report, the pervasive optimism of the past few weeks might get sucked right out of the air. A moderate report could keep the good vibes flowing. Deep breaths, everyone. Email us: [email protected] and [email protected] has changedIn the past week or two, something important seems to have happened in markets. As with any short-term move, the changes could be noise or a temporary byproduct of shifting investor positioning. But it feels more significant than that.The background to the market shift is economic data that has been coming in strong. We’ve discussed last week’s impressive durable goods and gross domestic product numbers. And just yesterday:The ISM services index popped to 54 in June, indicting expansion, up from a neutral 50 in May, and well above forecasts.The quits rate, which had been returning to a its pre-pandemic average of 2.3 per cent, ticked back up to 2.6 per cent.Job openings fell, but at a somewhat reserved pace. They remain more than 40 per cent above 2019 levels. There is lots of labour demand still out there.The ADP private payrolls report showed nearly half a million jobs added in June, suggesting today’s government payrolls data could come in hot too (ADP’s numbers are notoriously noisy, though).The crucial change in markets is in Treasury yields. Since early May, two-year yields have been rising steadily, as investors have slowly accepted the fact that the Federal Reserve will not cut its policy rate any time soon. Neither the debt ceiling set-to nor the meltdown of a few regional banks had an appreciable effect on the economy; inflation had declined but only at a stately pace; financial markets have churned higher, loosening financial conditions. The Fed doesn’t have room to cut.In the past few weeks, the increase in two-year yields has only accelerated. What has changed is that longer-term Treasury yields have started to rise too, and rise very quickly. See how the pink and light blue lines — 10- and 30-year bonds — have hooked up sharply after many weeks of running sideways:The rise in long rates is not surprising in itself. As expectations that the fed funds rate will remain high for longer become entrenched, it becomes harder for long rates to ignore them and stay low. Long rates are just a series of short rates, plus a variable term premium. What is a bit surprising is that this has occurred coincidentally with two other facts: inflation expectations have not risen, and stock prices have.Here is why that combination is surprising. If growth is still robust after 500 basis points of increases in the fed funds rate, the Fed probably is going to have to do quite a bit more tightening to cool the economy. This, presumably, increases the risk they will screw up the timing and tighten too much, causing a recession. But the rising stock market says this is not going to happen.Alternatively, maybe the Fed has overestimated how tight their policy is — maybe the inflation-neutral rate of interest is higher than the Fed thinks — and therefore will fail to tighten policy enough, allowing inflation to persist. But low and stable inflation break-evens are telling you that’s not going to happen, either. Break-even inflation rates (Treasury yields minus inflation-indexed Treasury yields) have been moving more or less sideways for two years. The recent increase in interest rates is therefore mostly an increase in real interest rates.The recent fast rise in long-term real rates is the concrete manifestation of the belief that the Fed will eventually pull off a soft landing — lower inflation without recession. This belief used to be abstract, a number in a probability matrix or a chart in a paper by a Fed official. As of this month, it’s a concrete fact, inscribed in market prices.Has the market become too optimistic? Yesterday’s trading featured rising rates and — for a change — falling stock prices. That combination suggests second thoughts, a twinge of fear about Fed-induced recession. And second thoughts are in order. Short term real interest rates are now higher than they have been since the great financial crisis:The chart above is enough to make a person doubt how long the good news on growth will continue — or wonder if monetary policy is no longer as effective as it was. [Armstrong and Wu]One good readFifteen years ago, the last time two-year interest rates were this high, Unhedged friend and rival John Authers wrote this analysis with another friend, Mike Mackenzie. Parts of it proved unpleasantly prescient about the crisis that was then less than a year away. Does it have lessons for today? We sure hope not. More

Six more women have alleged that financier Crispin Odey sexually assaulted or harassed them, expanding the timeline of his alleged abuse across five decades and raising further questions as to the extent his behaviour was tolerated by senior colleagues.The women came forward after the Financial Times last month published the accounts of 13 women who said they had been abused by Odey. Since that article, the hedge fund manager has been ousted from Odey Asset Management and the UK’s Financial Conduct Authority has come under scrutiny over its handling of a long-running probe into the firm.The six women include two former receptionists and an intern at Odey Asset Management, with the earliest of the new allegations dating back to 1985 when an interior designer, then 26, said she was violently assaulted at Odey’s home in London.The new accounts have been corroborated through documents seen by the FT as well as through interviews with friends and family members the women confided in. Odey’s lawyers previously told the FT that he strenuously disputed the first set of allegations.Odey and Odey Asset Management did not respond to requests for comment regarding the new allegations.Here’s what else I’m keeping tabs on today and over the weekend:Canada employment: Economists forecast that Canada’s economy added 20,000 jobs in June, following a decrease of 17,300 jobs in May. The unemployment rate is expected to have risen to 5.3 per cent, up from 5.1 per cent.US employment data: Non-farm payroll figures for June are expected today after data on Thursday did little to dispel the notion the US labour market remains in solid shape. Economists expect the US economy to have added 225,000 jobs in June, down from 339,000 in May. The unemployment rate in June is forecast to have slightly decreased to 3.6 per cent, down from 3.7 per cent in May.Biden in Europe: US president Joe Biden is due to start a two-day visit to the UK on Sunday, which will include meetings with Prime Minister Rishi Sunak and King Charles III, before he travels to Lithuania for a Nato summit.Companies: Hydrogen company Thyssenkrupp Nucera makes its stock market debut in Frankfurt today, while Liontrust Asset Management shareholders vote on its acquisition of Swiss rival GAM.Five more top stories1. US borrowing costs touched a 16-year high yesterday, prompting a global sell-off in stocks and bonds. Europe’s Stoxx 600 index closed down 2.3 per cent, its biggest one-day drop since March, as strong jobs data in the US intensified expectations of further interest rate increases by the Federal Reserve. Read the full story.2. Twitter has threatened to sue Meta over Threads, alleging it stole the company’s trade secrets when creating the new rival social media app. Meta chief Mark Zuckerberg said yesterday that more than 30mn people had signed up less than 24 hours after Threads’ launch. Here’s what Twitter’s lawyer wrote in a letter to Zuckerberg.Opinion: It feels like 2006 all over again, writes Tim Bradshaw. A new social network has set the internet alight with chatter about the possibilities.3. Brazil’s tax reform has won approval in the lower house of Congress. The legislation, which will amend the constitution, now faces two more votes in the Senate. Finance minister Fernando Haddad said: “After decades, we passed a tax reform. It seemed impossible. It was worth fighting for.”4. Treasury secretary Janet Yellen defended US companies against Chinese pressure during her trip to Beijing, saying “I am communicating the concerns that I’ve heard from the US business community.”5. A top Federal Reserve official has signalled her support for a July interest rate rise to tame the US’s ‘hot’ economy. Dallas Fed president Lorie Logan has called on the central bank to resume raising rates after forgoing an increase last month. Read the full story.How well did you keep up with the news this week? Take our quiz. The Big Read

An artisanal miner holds a cobalt stone at a mine near Kolwezi, Democratic Republic of Congo © Junior Kannah/AFP/Getty Images

Cobalt, the silver metal so abundant in the Democratic Republic of Congo that miners can dig it out with basic tools, is essential for the world’s clean energy transition. Demand is expected to triple by 2035, mainly for electric-vehicle batteries. But the small-scale miners fuelling this transition through “artisanal mining” — a name that belies a rudimentary and hazardous practice — face extreme danger and exploitation.We’re also reading . . . Wagner fallout: The Kremlin’s relatively lenient approach to Yevgeny Prigozhin reflects its weakness and has turned Russia “into a banana republic”, says one former official.Wellness packages for tech founders: Venture capital firm Balderton is to provide nutrition, sleep and mental health advice to entrepreneurs at risk of burnout, writes Tim Bradshaw.Stars on LinkedIn: Emma Jacobs asks why celebrities such as Ryan Reynolds are joining a site known for its humblebraggers and “thought leaders”.Chart of the dayThe riots in France, sparked by the death of a teenager of North African descent shot dead by police during a traffic stop, show just how entrenched inequalities have become between immigrants and those born in the country, writes chief data reporter John Burn-Murdoch. Despite claims that France is race-blind, the data tells a different story.Take a break from the newsFind out how a patents expert, a music professor and a software engineer set about cracking a 445-year-old code to reveal the secrets of Mary Queen of Scots.

Mary Stuart — ‘famously tall, auburn-haired, impeccably dressed and dangerously Roman Catholic’ © Royal Collection Trust / © His Majesty King Charles III, 2023 / Bridgeman Images

Additional contributions by Tee Zhuo More

The conditions for the greatest bond bull market in modern history were set in the 1970s, when inflation hit runaway levels. Central banks, led by the US Federal Reserve, launched a draconian response, pushing interest rates sky-high. Over the 40 deflationary years to the end of 2021, the annualised real return on bonds in the world bond index was 6.3 per cent, not far short of the 7.4 per cent return on global equities over the same period. So says the invaluable Credit Suisse Global Investment Returns Yearbook prepared by economists Elroy Dimson, Paul Marsh and Mike Staunton. As today’s central bankers doggedly pursue interest rate policies dubbed “higher for longer”, many investors have taken a bet, so far unrewarding, on history repeating itself.Yet it is important to bear in mind that the equity-like returns on government bonds in this golden period were a mixed blessing for investors. Moreover, this spectacular 40-year run created a new mythology of bond investing, along with a perversely misleading vocabulary. Academic economists and actuarial consultants declared government bonds were “safe” assets that delivered a risk-free interest rate. They also claimed that bonds offered diversification against risky equities, an argument that provided the rationale for the hallowed 60/40 portfolio split between equities and bonds.But in much of the developed world the yield on many government bonds before 2022 was negative in both nominal and real terms, which is a curious kind of risk-free rate. Such bonds offered the certainty to investors of a guaranteed loss on maturity. As for safety, global bonds offered a real return in 2022 of minus 27 per cent, with UK gilts performing even worse than that. The reality is that nothing in capital markets is ever risk-free. This collision of myth with reality has serious implications not only for governments and regulators. It affects individual investors, who are contemplating how they should respond to the new landscape of bonds; the UK’s fixed-term mortgage borrowers, whose home loan rates are heavily influenced by the path of gilt yields; and pension savers looking to reduce the volatility in their pension investments as they approach retirement.The illusion of protectionParadoxically, investors in longer-dated index-linked bonds last year saw their investment decline by one-third or more in value on a mark-to-market basis.Many bought on the erroneous assumption that they were acquiring protection against rising inflation. Yet the protection only operates if the index-linked bond is held to maturity. In fact index-linked gilt prices are driven by relative real yields, not inflation. So if nominal gilt yields rise, index-linked gilt yields have to rise to offer a competitive return, which destroys capital value regardless of what is happening to the general price level, since rising yields mean falling prices.This is particularly disastrous for people in UK defined contribution pension schemes where the great majority take a default option that involves switching into supposedly safe assets such as fixed interest and index-linked gilts as retirement approaches. Investment consultants call this process “de-risking”, a phrase of outrageous terminological inexactitude (to borrow Churchill’s memorable coinage). Such switching exposed people to big capital losses. To make matters worse, bond prices fell in tandem with equities in 2022. So much for diversification. Earlier equity-like returns came with equity-like volatility.The good news today is that bonds no longer offer terrible value as they did before 2022. But do not expect them to deliver anything like the return of the 40-year golden age. While central bankers tend to attribute low inflation during this period to their sagacity, the real driver of disinflation was globalisation. The global labour market shock resulting from China and eastern European countries joining the global trading system eroded the bargaining power of labour in the developed world. Increasingly complex cross-border supply chains added further disinflationary impetus.This has now gone into reverse due to the Russian invasion of Ukraine and geopolitical friction between China and the West. At the same time, stagnant real incomes in advanced countries, resulting from global labour market pressure, have spawned populist politics and a retreat into protectionism. And as academics Manoj Pradhan and Charles Goodhart have argued in a recent book the ageing of populations in the developed world will cause labour markets to shrink, so re-empowering workers. How, then, given these renewed inflationary pressures, can a case be made for a bond bull market?An uncertain outlookOne obvious starting point is that if you believe central banks will ultimately bring inflation down close to their targets of around 2 per cent then current yields of 4 to 5 per cent on UK gilts and US Treasuries represent good value, especially relative to equities, where earnings estimates look unduly optimistic in the US and, perhaps also, the UK.There is, in addition, a serious possibility of monetary overkill. Central bankers are steering policy using backward-looking data. In the US, the UK and the eurozone they are not much interested in forecasting the money supply. The reason is that soon after monetarism became fashionable in the 1980s the correlation between broad money and consumer price inflation had broken down.Chris Watling, chief executive at research company Longview Economics, sees the breakdown as a consequence of financialisation. That is, most newly created money since governments started to deregulate finance in the early 1980s fed into asset prices rather than goods and services in the real economy. A notable example of this was the growth of mortgage debt which has gone from around 10-20 per cent of gross domestic product to more than 100 per cent in many countries. In the UK it peaked at just short of 80 per cent in 2010.More recently, money creation since the 2007-09 financial crisis has been driven by the central banks’ asset purchasing programmes, known as quantitative easing. This, too, has gone into asset price inflation, mainly in government bond markets.Watling argues that this pattern has now been broken and that the latest bout of inflation stems from money creation during the pandemic going into households’ and businesses’ bank accounts in the form of emergency grants, furlough payments and other support. This was then spent, leading to old-style inflation, in which too much money chased too few goods and services.Lending support to the argument is the fact that monetarist economists such as Tim Congdon in the UK and Steve Hanke in the US were making prescient forecasts about an inflationary surge back in 2021 when central bankers, relying on complex but unhelpful economic models with no money supply input, were declaring that inflation would be transient. Both economists are now forecasting incipient recession in the light of the contraction in broad money in the US and the eurozone and very low money growth in the UK, where banks are adjusting their balance sheets in line with tougher capital requirements.So far the falls in real money balances have not done too much damage, according to Congdon, because they have only offset the overhang of money from excessive monetary growth in 2020 and 2021. But ratios of money to GDP are declining fast.Recession brings the risk of deflation which is, of course, good for bonds as weak demand in the economy causes interest rates to fall and bond prices to rise. The recent weakness of commodity prices further highlights the potential in the short term for deflation.The case againstWhat are the counterarguments to bond bulls? The first might be the enormous uncertainty surrounding the outcome of the monetary experiment conducted by central banks since the financial crisis. Having expanded their balance sheets hugely they are now keen to shrink them in the interests of preserving their anti-inflationary credentials — a process known as quantitative tightening. This is uncharted territory in monetary policy. The big question is, with central banks selling, who will buy government IOUs at a time of great public spending pressure?Apart from the increase in spending because of the pandemic there will be big demands on the public purse not only for a continuing rise in healthcare bills but for infrastructure investment in the transition to low carbon. Ageing populations mean bigger pension bills. The war in Ukraine and wider geopolitical friction make higher defence spending necessary.This is happening against the background of a pressing increase in global indebtedness. The Institute of International Finance, a trade body, estimates that global debt at $305tn is now $45tn higher than its pre-pandemic level. In the UK public sector net debt stood at 100.1 per cent of GDP in May, topping 100 per cent for the first time in 62 years. This raises questions about the potential conflict between central banks’ objectives — price stability and financial stability. Higher for longer means many households and corporations will be at greater risk of default. That in turn is potentially destabilising for the banking system. So, too, is the fall in bond prices as monetary policy has tightened. The bonds in bank balance sheets have fallen in value. This has tilted some regional banks in the US such as Silicon Valley Bank into insolvency. The same could happen in Europe, especially on the continent, where banks have often been pressed into holding large quantities of their governments’ paper.A particular difficulty arises because of the migration of risk from the conventional banking system to the dangerously opaque non-bank financial sector. It is difficult for financial regulators to keep track of the related risks.An indication of this came with the liquidity crisis in the UK gilt market last autumn, in the wake of a Budget under Liz Truss’s government that wrongfooted many pension funds which pursued so-called “liability driven investment strategies”. They were unable to meet calls for more collateral as gilt yields rose and prices fell. The Bank of England moved swiftly to act as a last resort buyer of long-dated gilts and postponed quantitative tightening, thereby forestalling a potentially systemic financial collapse. But will future crises in the non-bank financial area be so swiftly and readily managed?This is a world in which financial stability may take priority over inflation fighting. Indeed, some economists argue that it should. Willem Buiter, former chief economist of Citigroup and a former member of the Bank of England’s monetary policy committee, believes financial stability has to come first because it is a precondition for the effective pursuit of price stability. That would not be good news for bond investors in the short term, since loosening policy to address financial instability reopens the possibility of inflation through money creation.Will central banks keep calm and carry on? Above all there is a question whether central banks will hold their nerve if they confront political pressures when overborrowed companies and homeowners plunge into default in a recession. Their much-vaunted independence will be at risk. That highlights the existence of another potential conflict in central banks’ objectives — that between inflation fighting and career risk. Politicians rarely thank central bankers for curbing inflation if it comes at the cost of higher unemployment. The logic of inflicting a short, shallow recession to avoid having a longer, deeper one later has no purchase in the political market place.Policymakers are also conscious that inflation is actually a solution to outsized public sector debt at levels that have hitherto only been seen in wartime. The key to reducing wartime debt has always been a combination of economic growth, fiscal restraint (meaning austerity), artificial restraints on interest rates (known as financial repression) or surprise inflation. That said, we are in a much lower growth world than in the three decades after 1945 and financial repression is harder to pull off now that capital flows across national borders. It is not hard to envisage circumstances in which central banks choose to stretch out the period over which they seek to return inflation to target, so facilitating a reduction in the real value of the debt. Or, again, governments could raise inflation targets, say, to three per cent while arguing that this is more realistic given the structurally higher inflation that we face in the 2020s. But this option would only be available in countries where monetary policy is perceived to have been effective. The Bank of England’s much poorer performance on inflation control when compared with the Federal Reserve and the European Central Bank has so damaged its credibility that a move to a higher target might cause market turmoil.A final difficulty with the bullish case for bonds is simply that it might take higher policy rates than the market now anticipates to curb the second-round effects of inflation in labour and other markets as people try to recoup income that has badly shrunk in real terms. This distributional struggle could last longer than generally expected. And in financial markets there always lurk what Donald Rumsfeld, when US Secretary of Defense, called unknown unknowns.If investors believe that it will take a recession to bring inflation back to target, then it makes sense for them to allocate more money to bonds. Some may feel gold is a better option in current circumstances where inflation is proving more sticky than expected. Yet gold is a bet on monetary policy failure. If you believe central banks will fulfil their anti-inflationary mission, the opportunity cost of holding the yellow metal that yields no income when interest rates are rising is unacceptably high.The hope must be that the central banks achieve a smooth reconciliation between financial stability and price stability. Resorting once again to the liquidity tap when markets take the next big tumble will simply propel the debt mountain higher through another morally hazardous reduction in borrowing costs. That way lies potentially uncontrollable inflationary consequences, resulting in more populist politics and wholesale destruction of savings. More