Omicron Shows Frothy Markets Who’s Boss
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What You Missed: A week of solid economic momentum unraveled quickly as a new covid variant sent investors headed toward the sidelines. Long-term interest rates and equities plummeted as the emergence of “Omicron” a new COVID-19 variant detected in South Africa, rattled markets. The yield on the US 10-year Treasury note traded in a wide range, rising to 1.65% on expectations of faster tapering by the Fed before sliding to 1.47% on Friday as investors sought safety on the coronavirus concerns. The entire Treasury yield curve shifted lower, as the 2,3, and 5-year joined their 10-year cousin in the move. Commodity markets weren’t spared the sweeping fears of what a highly contagious and vaccine resistant variant could do to the global economy: the price of a barrel of West Texas Intermediate crude oil fell to $71.25 from $75.50 while the US Dollar weakened, and Gold strengthened. Treasury yield volatility, a key driver of the cost of rate caps, swaptions and corridors, rose to levels not seen since March 2020.
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If you’re a floating rate borrower or lender that has ignored the impending death of LIBOR, the Federal Reserve’s recommendation that bank’s not enter into any new LIBOR contracts after December 31, 2021 should wake you up to the issue quickly. While the deadlines and nuances of LIBOR’s transition to a new index may change, it’s time to get up to speed on how the event will impact: 1) new and existing loans and 2) new and existing rate caps and swaps.
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New COVID-19 variant emerged. Omicron has sparked fresh worries among investors about travel restrictions and the possibility of fresh lockdowns and other nonpharmaceutical measures aimed at quelling a new outbreak. Friday saw a sell-off in stocks and other risky assets, as the yield on safe-haven Treasuries fell a whopping 18 basis points from Wednesday’s close. Stocks tied to the economy’s reopening, such as those in the travel and leisure sector, took a beating. While covered elsewhere extensively, the South African strain has a high number of mutations that experts believe may make it more transmissible and allow it to dodge some immune responses induced by past infection or immunization.
The news spurred bond traders around the world into action, who pushed out the date of the first post-pandemic Fed rate hike from June 2022 to September. The yield on the five-year US note, which has long been a gauge of future Fed moves, declined 18 basis points, while the 10-year slipped below 1.5%. The sharp drop in rates demonstrates how polarized opinion had grown, leaving the bond market vulnerable to a pandemic plot twist.
Our take: Boy, that was a quick and brutal move in yields, and one that will reset Fed tapering and rate hike expectations if the new COVID threat proves real. While the mutation’s impact on markets is difficult to predict, one thing is clear: markets can no longer view the pandemic as if it were in the rearview mirror. In the meantime, moves in yields like we saw last Friday will wreak havoc on the cost of rate caps and swaptions – driving them higher – as fixed income traders and the banks they work for struggle to figure out how to position themselves in the shifting sands that is now the new and improved COVID-19. Are you in the market for a rate cap, swap, swaption or corridor? Better check-in on its cost. No one likes surprises, especially when it comes to hedging interest rate risk.
Fed’s favorite inflation gauge increased odds of a faster taper. The Personal Consumption Expenditures Price Index (“PCE”) rose 5.0% on a year-on-year basis (vs 4.4% prior), matching our estimate but lower than the consensus of 5.1%. On a monthly basis, it accelerated to 0.6%, vs an upwardly revised 0.4% prior). Core was 4.1% (vs an upwardly revised 3.7% prior), matching consensus expectations. The gauge showed that spending by consumers was very robust, growing at an annualized rate of 4.5% relative to Q3, and outpaced income growth. This means that many households will likely accelerate their draw-down of built-up, excess savings in the months ahead.
Our take: After the dust kicked up by the latest worrying coronavirus variant news settles down, interest rates will still be driven by this: A Fed that’s laser focused on fighting inflation by getting more restrictive with monetary policy. Again, assuming Omicron is just a flash in the pan – and that’s a big assumption – resilient households, and high and rising inflation gives the Fed a green-light to accelerate the pace of tapering at its upcoming December meeting. Such a move would create options for the Fed to hike rates sooner than the current September hike priced in by markets.
The biggest take-away from the PCE data? Just how much more widespread inflation is at present. Even though energy and used cars account for more than half of the monthly increase, a little more than a quarter (103) of the 400 or so PCE line components indicate a monthly inflation rate exceeding 1% (12% annualized), compared to zero in the two years prior to the pandemic and less than 75 lines exceeding that rate during July, August, and September of this year. While we’re still in the “inflation is transitory” camp, it’s becoming harder to stay here. Unless Omicron causes full shutdowns like we experienced 18 month ago, with financial conditions so loose and inflation continuing to surprise on the upside, the Fed has limited room to delay easing off the stimulus throttle. Tapping the breaks rather than slamming them may provide the Fed with the flexibility to better manage inflation.
Regardless of the continued rise in prices, or your doubts as to when and how much the Fed will pull back stimulus, the most vital ingredient to the continued economic recovery exists in abundance: consumer spending. In inflation-adjusted terms, personal consumption increased 0.7% in October; that’s 4.5% annualized for the quarter so far, significantly above the Q3 average. Product shortages and delivery delays may have pulled some buying forward ahead of the Christmas season, boosting real consumer spending. Nonetheless, the resilience of the consumer’s appetite to spend is promising.
Powell reloaded – what it means for Fed tapering and rate hikes. President Biden reappointed Fed Chair Jerome Powell to a second term and nominated the other contender for the position, Fed Governor Lael Brainard, to serve as vice chair. Following the news, 10-year Treasury note rates rose to 1.65%, partly due to speculation that Powell leans toward more aggressively tapering and hiking rates than Brainard.
Offering more clues into the Fed’s leanings, last week’s release of minutes from the Fed’s October policy meeting showed that many Fed members repeated their support for a speedier taper due to higher-than-expected inflation. From reading the minutes, many big Wall Street banks adjusted their forecasts, now predicting that the Fed would end its bond-buying program in March rather than June, and that rates would be hiked as soon as June, with subsequent rises expected in September and December. Of course, all that’s gone out the window now that Omicron has appeared on the scene.
Our take: Even prior to the Omicron variant showing up, we’ve always thought that expecting THREE, 0.25% rate hikes next year was an overreaction. The Omicron variant will likely help calm fears of inflation and move the market closer to expecting just two rate hikes next year, the first mid-year at soonest, the second near the end of 2022.
US coordinated release of oil reserves. To address rising oil prices, President Biden has arranged for the release of reserves from several big petroleum-consuming nations’ strategic stocks. Over the next several months, the US will sell up to 50 million barrels of crude oil from its Strategic Petroleum Reserve, while China, India, Japan, South Korea, and the United Kingdom will release lesser amounts. Given their small magnitude and worries that OPEC+ would balance the sales by reducing anticipated output rises, the sales are projected to have only a minor price impact.
Why you should care: In a textbook sense, any coordinated attempt to ease the pain of high gas prices on businesses and consumers helps to erode the need for Fed rate hikes down the road. However, the release of 50 million barrels of oil reserves is merely symbolic. To put things in perspective, the moves equate to only three days of national oil consumption.
US weekly jobless claims tumble, as durable goods data show CapEx is gaining momentum. Workers applying for unemployment benefits for the first time fell to a 52-year low of 199k, down from 270k the week before. While inspiring, many believe that seasonal modifications related to the looming holiday season may have skewed the results. Thus, we’ll have to wait for this week’s data for verification. Other US data released last week included a 0.1% drop in October durable goods orders, where core orders, which exclude military and aerospace, gained 0.6%. Elsewhere, existing home sales increased 0.8% last month, the highest level since January, while the median home price in the US increased 13.1k yoy to $353,900. In October, personal income increased by 0.5 percent, while consumer spending increased by 1.3 percent.
Our take: Following the decline in investments of new equipment in September, October core durable goods orders signal, assuming Omicron is contained, a strong start for equipment expenditures in Q4. When compared to previous recessions and recoveries, the recovery from the Covid recession has been marked by a strong rise in equipment spending. Q3 GDP figures revealed the first pause in that trend, but we expect it to pick up again in the coming quarters as supply-chain constraints are beginning to ease.
While labor shortages remain, there are indications that supply chain disruptions have reached a nadir. Trans-Pacific freight prices are trending down, and the Baltic Dry Index, our favorite gauge of the state of supply chains, is at its lowest level since April. Confirming those reports, several major US retailers have stated that they are well-stocked for the holiday season.
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What to Watch This Week: The theme in interest rate markets this week is whether the Fed may taper faster and if rate hikes will show up sooner and occur more frequently than previously expected. While Omicron has thrown a monkey-wrench into everyone’s forecasts – including ours – for now we’re operating on the assumption that it won’t have a lasting impact on the US economy and, by extraction, interest rates.
Several Fed members who lean toward maintaining the status quo, that is, no rate hikes any time soon, have dropped hints of their growing inclination to speed up tapering at the December meeting -something that seemed unlikely before the shocking reading of inflation contained in October’s CPI data. A strong showing on the jobs front this week (payrolls, Friday; jobless claims, Thursday), together with an elevated consumer price reading (CPI) for November (a highly likely outcome given what we know about the cost of energy and housing prices) will cement policy makers’ decision to announce a speedier taper pace at the Fed’s December 15th meeting. Should the Fed speed up tapering, it will open the door to a rate hike around the middle of next year. This scenario favors the broad flattening in the yield curve, with any bouts of steepening likely to be brief. For some perspective, the difference between 5- and 30- year Treasury yields reached 70 basis points on Friday as short-term yields plummeted, a big jump from the 20-month low of 61 basis points set last Wednesday.
It’s ironic that the Fed could be leaning more heavily toward taking away the punch bowl faster than expected. It comes at a time when many of the variables that have driven prices up may be reaching their apex. After a long period of demand growth, supply-chain constraints appear to be easing (ISM manufacturing, construction spending, both Wednesday), while house price gains are slowing (Case-Shiller home price index, Tuesday).
Whether the Fed is making a policy error by accelerating the taper depends on whether the economy is now overheating or is already in the process of cooling (Fed Beige Book, Wednesday). So far, the reports are a bit of a mixed bag. In October, as stated previously, personal spending was surprisingly strong, indicating that consumers remain resistant to inflation. Now however, an increase in Covid cases and concerns about rising costs may negatively impact consumers’ confidence to keep spending (Conference Board measure, Tuesday, and unit motor vehicle sales, Wednesday).
Big Picture: One of the reasons that the first Covid crash, which occurred in March 2020, was so severe was froth had built up in markets before the virus’s arrival. While there are some distinctions for markets dealing with the latest Omicron-driven fears, there is also a lot in common.
Among the parallels is a general sense of security that investors found in decent economic statistics, strong earnings, and a happy-to-stimulate Fed. Nothing yet suggests that the markets will suffer a similar thrashing as they did in early 2020. With vaccinations and cures available and a larger population receiving doses, the globe seems to be in a better position to deal with the health danger.
The Omicron news is indeed concerning, but the major issue for the bond market right now is analyzing the path of what will likely be a tighter policy from the Fed next year, continuing the trend of higher rates and a flatter yield curve. In the meantime, get ready for more interest rate volatility as markets figure out if the Omicron threat is real. Greater rate volatility means more expensive rate caps and swaptions and solidifies the need for seasoned advisors to help you navigate your way through the obstacles that lie ahead.
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Source: Bloomberg Professional
Source: Bloomberg Professional