Aurelia Butler

Having badly misjudged the strength of inflation over the past year, central bankers are now anxious to convey the message that they are determined not to repeat the mistakes of the 1970s. So much the better, you might think, because that era told us that the long-term costs of allowing inflation to become entrenched far outweigh the short-term ones of bringing it under control.Yet while the current threat of stagflation rhymes with the 1970s, the wider economic and financial context when Federal Reserve chair Paul Volcker started tightening policy in 1979 differed notably from today. Inflation was much higher and the advanced economies looked very different. It is important, then, to ponder the likely new mistakes of the 2020s.The single most important difference, in terms of steering a course back to stable prices, relates to the huge accumulation of debt since that time. In the US, gross public debt as a percentage of gross domestic product rose from 34.3 per cent in 1982 to 127.0 per cent in 2021. A similar trend was apparent across the developed world. Debt levels in the corporate and household sectors were also on a rising trend during that period. But why?One fundamental cause was the supply-side shock whereby China, India and the eastern Europeans joined the world economy, cheapening labour relative to capital. This resulted in less investment and weaker demand in the advanced economies. Central banks compensated for this with looser monetary policy that distorted asset prices upwards relative to goods prices while securing debt dependent growth. Meantime, inflation remained quiescent, making it easy for central banks to keep within inflation targets introduced in the post-Volcker era.Morally hazardous low interest rates encouraged further borrowing — an effect that ratcheted up after the 2007-09 financial crisis on the back of ultra-low and negative interest rates across the world, along with the central banks’ asset purchasing programmes. And then fiscal support during the pandemic resulted in the largest one-year debt surge since the second world war. The IMF estimates that public plus non-financial private debt rose by 28 percentage points in 2020 to 256 per cent of global GDP.Such borrowing was relatively painless with ultra-low rates. It now becomes a debilitating vulnerability as pandemic-induced deficits rise and central banks raise interest rates and shrink their balance sheets to address burgeoning inflation. In the public sector borrowing costs naturally increase. Where central banks have engaged in large-scale asset purchases, higher interest rates will also reduce central bank remittances to governments.The central banks have in effect replaced long-term debt with debt pegged to the overnight interest rate — the rate on bank reserves that financed their asset buying. The Bank for International Settlements says that as a result, in the largest advanced economies, as much as 30-50 per cent of marketable government debt is in effect overnight. In the process, losses on the sale of assets as bond yields rise and prices fall could raise politically awkward questions around whether central bank balance sheets should be strengthened with taxpayers’ money.In the private sector, tighter policy brings rising debt servicing costs, with falling house and securities prices. The globalisation of capital flows since the 1980s also means that over-indebted emerging markets will be particularly hard hit by rising rates.Changes in financial structure since Volcker’s day point to looming financial instability. The growth of the opaque derivatives markets, the rise of under-regulated shadow banks and a post-crisis regulatory environment that constrains banks’ ability to take securities on to their balance sheet in times of stress are unnerving features of modern markets. As Michael Howell of CrossBorder Capital has pointed out, the chief role of the financial system is no longer to take deposits and make loans but to refinance the debt that sustains global growth and consumption. This complex system is increasingly dependent on shaky collateral.The successful control of inflation requires pre-emptive action. Yet central banks declare that they are data dependent and focus closely on inflation and employment numbers, which are lagging indicators. Fed chair Jay Powell, like most other central bankers, has minimal interest in money supply numbers, which are forward indicators. Tim Congdon of the University of Buckingham, whose forecasting record in relation to the current inflation is much better than that of the central banks, has noted that broad money growth in the US came to an almost complete halt in the six months to this July. We have here the perfect recipe for monetary overkill and liquidity crises. More

The writer is chief investment strategist at Charles Schwab It’s often been said that a key risk in a monetary policy tightening cycle is that the Federal Reserve hikes interest rates until something “breaks”. That raises questions of how far the Fed will now go to tackle surging inflation.Part of the reason that is cited for the central bank’s current aggressiveness is the strength of the US labour market and the potential for that to add to inflation. But a look under the hood highlights that there may already be some breakage in the labour market, not picked up by traditional headline indicators — including payroll growth and the unemployment rate.The “establishment survey” is what generates the headline payrolls number each month when the Bureau of Labor Statistics releases its US employment data. According to that survey, 315,000 jobs were added in August, which was strong, but well down from the prior month’s 526,000. Of course, counting payrolls only results in an estimate of the number of jobs created; it doesn’t measure unemployment.That’s where the US household survey comes in, from which the unemployment rate is calculated. It’s a survey of households’ members, so it counts people, and whether they’re employed or not.A recent trend picked up by the household survey is the increase in multiple job holders. If one person picks up a second or (God forbid) a third job for economic reasons, that is still counted as one employed person per the household survey. However, it’s possible those additional jobs get picked up as individual payroll jobs within the establishment survey.

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An additional sign of underlying cracks in the labour market is the falling number of full-time jobs and the very sharp inflection higher in part-time employment. The gain of 442,000 jobs in the household survey in August appeared on the surface to be strong. But that was more than all accounted for by part-time workers, with full-time jobs actually shrinking by 242,000. It was the third month in a row of declines, totalling 465,000 over that period.Another fly in the ointment of labour market statistics is associated with job openings — the most common tracker coming from the Job Openings and Labor Turnover Survey (Jolts). A key measure of labour market tightness has been the relationship between job openings and the number of unemployed people; with the former outnumbering the latter by a ratio of 2.0 to one.

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The problem is that the Jolts statistics arguably overstate the number of actual individual job openings. One of the criteria for a job opening is that there is “active recruiting” for workers by an establishment. That may include advertising, internet notices, signs, word-of-mouth “announcements”, contact with employment agencies, or setting up at a job fair or similar source of possible applicants.In addition, the pool of labour available for those jobs spans beyond just individuals who are unemployed. Potential job switchers, included in the number of people employed, should also be considered as potentially competing for those job openings. This suggests that the labour market may be less tight than conventionally believed, confirmed by recent research by the St Louis Fed.The Fed has explicitly stated that its goal is to weaken job openings, without a significant rise in the unemployment rate — a narrow opening in the needle it’s trying to thread. But the Fed also cites the need for more restrained wage growth — which is elevated by historical standards, but remains below the rate of inflation. This means real wage growth is still in negative territory.

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There is another reflection of weakening demand for labour and that is the number of hours each week companies are asking of their workers.Notwithstanding the healthy reading on August payroll growth, there was yet another reduction in the workweek, which has been flat or down in five of the six months through August. At 34.5 hours, it is tied for the lowest reading since April 2020, when the pandemic lockdown was in full force. The decline in hours worked was so significant that it resulted in the first decline this year in the index of aggregate hours worked. With labour the highest input cost for many companies, and economic growth and demand weak, the hints of weakness in the labour market are likely to foreshadow further deterioration to come. As the Fed has been pointing out, it may be a necessary ingredient in the quest to quell the surge in inflation. More

The $24tn US Treasury market has been hit with its most severe bout of turbulence since the coronavirus crisis, underscoring how big swings in international bonds and currencies and jitters over US rate rises have spooked investors. The Ice BofA Move index, which tracks fixed income market volatility, has reached its highest level since March 2020, a time when deep uncertainty about how the pandemic would affect the world economy set off massive fluctuations in US government bonds. “Right now it is all about market volatility,” said Gennadiy Goldberg, a strategist at TD Securities. “You have investors staying away because of the volatility — and investors staying away increases volatility. It is a volatility vortex.” Fixed income investors’ nerves have been frayed by a series of events most commonly seen during market crises. Japan, the world’s third-biggest economy, last week stepped in to defend the yen after the currency rapidly tumbled to a 24-year low against the dollar. Just days later, plans for big tax cuts by the UK government ignited a historic sell-off in Britain’s currency and sovereign debt markets. These international events have added to a powerful pullback in the US Treasury market that accelerated after the Federal Reserve last week delivered its third-straight 0.75 percentage point rate rise and signalled significantly tighter monetary policy to come.The 10-year Treasury yield, a key benchmark for global borrowing costs, has surged to more than 4 per cent from 3.2 per cent at the end of August, leaving it set for the biggest monthly rise since 2003. It is on track for its sharpest ever annual rise. The two-year yield, more sensitive to fluctuations in US monetary policy, has leapt 3.55 percentage points this year, which would also mark a historic increase. The big price movements have left investors wary of trading in a market that acts as the bedrock of the global financial system and is typically considered a haven during times of stress. With investors on the sidelines, liquidity in the Treasury market — the ease with which traders buy and sell — has deteriorated to its worst level since March 2020, according to a Bloomberg index. Poor liquidity tends to exacerbate price swings, worsening volatility. In a sign of how the fraught conditions are keeping some fund managers away, the US has drawn lacklustre demand at sales this week for a combined $87bn in new debt. A two-year issuance on Monday priced at a high yield of 4.29 per cent, while a five-year deal one day later priced at 4.23 per cent — both marking the highest borrowing costs for the government since 2007. The two-year debt was sold with the widest difference — or “tail” — between what was expected just before the auction and where it actually priced since the 2020 Covid-induced market ructions, said Tom Simons, a money market economist at US investment bank Jefferies.The Treasury department will auction off $36bn in seven-year notes on Wednesday. The seven-year note has struggled to attract demand in less volatile moments, so the environment this week could pose a challenge. “Until there is more certainty I think we will continue to have this ‘buyers’ strike,’” Simons said. “The markets are so crazy that it’s hard to price any kind of new [longer-dated bonds] coming into the market.”A divergence between the Fed’s own outlook for interest rate and market expectations has added to the sense of uncertainty. According to their latest projections, most Fed officials now expect the federal funds rate to rise from its current target range of 3-3.25 per cent to 4.4 per cent by year-end. By the end of 2023, Fed officials expect interest rates to stand at 4.6 per cent. Meanwhile, investors are betting that the Fed will be forced to cut interest rates next year — with expectations in the futures market of a peak of 4.5 per cent in May of 2023, with a fall to 4.4 per cent by year-end. Given persistent and broad-based price pressures, there is significant uncertainty about whether that amount of monetary tightening will be sufficient to bring inflation back down to the Fed’s 2 per cent target. Recession risks have also risen markedly, further clouding the outlook.Strong rhetoric adopted by Fed officials about the central bank’s battle against inflation has stoked further angst in the market. Many officials now agree that interest rates need to rise to a level that actively constrains the economy and stay there for an extended period.“The only other time I have seen us this united was at the beginning of the pandemic, when we knew we had to act boldly to support the economy through the pandemic and through the downturn,” said Neel Kashkari, president of the Minneapolis branch of the Fed, in an interview with the Wall Street Journal on Tuesday. “We are all united in our job to get inflation back down to 2 per cent, and we are committed to doing what we need to do in order to make that happen.” More

Typical. You take care of one cost of living shock and another turns up to take its place.The extreme gilt market reaction to UK chancellor Kwasi Kwarteng’s “fiscal event” last week, which came on the back of a package to tackle soaring energy costs, has triggered mayhem in the mortgage market. A clutch of lenders, including Virgin Money, Skipton Building Society and Halifax, stopped offering new mortgages or withdrew certain products on Monday in response to the soaring cost of funding.This isn’t 2008. The market isn’t just slamming shut because lenders lack funds. But the impact will be painful and unequally felt.Banks have been caught with products on offer that are just bad business after the surge in funding costs. The two-year swap rate, which mortgages are priced off, has jumped from under 4 per cent a few weeks ago to north of 5.5 per cent. Business that looked decent very recently is now uneconomic, particularly for those with the keenest pricing in the market.The shock has jarred some banks more than others. The biggest lenders are more likely to have hedged their funding several weeks ahead. HSBC and Santander suspended new deals on Tuesday, in part because they were inundated by demand. Halifax only pulled certain mortgages with fees, where the upfront payment has to compensate for a lower interest rate. Others, mostly challenger banks and building societies, froze everything.Make no mistake: all banks will be hiking their mortgage rates over the coming weeks. But the urgency is greater for some. Big high street names, like Barclays or NatWest, have more sticky, low-cost deposits in their funding mix. Challengers and building societies tend to be more reliant on higher-cost savings deposits and hot money that moves more frequently. That has been becoming more expensive: on Monday, the average 2-year bond rate on offer was 2.8 per cent from building societies and 3.2 per cent from challenger banks, according to Omar Keenan at Credit Suisse. For the big banks, it was just 1.6 per cent. Similarly, the Big Five banks have a loan to deposit ratio of about 80 per cent, notes Keenan. Other specialist lenders are more likely to be reliant on other sources of funding, such as the market for mortgage-backed securities.The hit to households won’t be immediate. UK borrowers are now overwhelmingly on two to five-year fixed-rate deals. There are 600,000 fixed-rate deals due to expire in the second half of this year and 1.8mn next year, according to UK Finance. If mortgage rates go up to 6 per cent, the average household refinancing a two-year deal would see monthly repayments jump over 70 per cent from £863 to £1,490, according to Pantheon Macroeconomics.More households than ever are insulated from this market shock. Outright home ownership has been steadily rising since 1990, with owner-occupiers without a mortgage outnumbering borrowers since about 2014. But those protected from the mortgage ructions are concentrated in the older age groups: 62 per cent of outright owners (roughly a third of the market) are 65 or over; 58 per cent of owners with a mortgage (another third) are aged 35 to 54. Private renters could suffer as landlords seek to pass on higher mortgage costs.Younger people, many already shut out of buying, are likely to be those who increasingly struggle to get a mortgage on affordability grounds. First-time buyers, who last year borrowed on an average income ratio of 3.58 times based on UK Finance numbers, are likely to be most affected by higher rates and tightened lending criteria, followed by home movers on 2.96 times and those remortgaging on 2.8 times.And just as with energy, poorer households will suffer most. UK Finance earlier this month looked at household “wiggle room”, or the proportion of disposable income left after mortgage repayments and basic expenditure. A 100 basis point rise in mortgage rates (and the market is pricing in close to triple that by the end of the year) left the picture for richest households barely changed, but meant a substantial deterioration in the position of those in the lowest income brackets. Even for this modest rise in rates, the trade body estimated that three in 10 could struggle to pay their bills after refinancing this year.Needless to say, these are also among the households set to benefit least from the tax cuts that helped spark this [email protected]@helentbiz More