Powell Drops the Mic as Omicron Rages
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What You Missed: Long-term interest rates and equities both declined following the rapid spread of the Omicron variant of the coronavirus to much of the world, including the US. The yield on the US 10-year Treasury note fell to 1.34% from 1.48%, while short-term rates, like the 2- and 3-year Treasury yields, rose, flattening the yield curve. Elsewhere, the price of a barrel of West Texas Intermediate crude oil declined to $67.63 from $68.17, while the US Dollar weakened, and Gold traded flat. Treasury yield volatility, a key driver of the cost of rate caps and swaptions, fell to a two-week low, but remains near highs not seen since March 2020.
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“Weak” jobs report masked underlying strengths. On the surface, America’s job creation engine seemed to sputter in November, with nonfarm payrolls number increasing just 210k, significantly below expectations of 550k. October jobs were also revised up to 546k from 531k, following a trend of upward revisions this year. In sharp contrast, the household survey – which gauges responses from individuals as opposed to only businesses – showed the labor market improved significantly last month. The unemployment rate fell to 4.2% (vs. 4.6% prior), below consensus (4.5%) and expectations (4.4%); 1.136 million more people reported to be working, while the number of unemployed declined by 542k. Finally, growth in average hourly earnings, aka wages, was stable at 4.8%, a brisk pace that importantly exceeds productivity growth.
Our take: The jobs data – the most impactful piece of economic data on interest rates – wasn’t as bad as the lower-than-expected headline payroll figure suggested. The labor force participation rate increased, while the unemployment rate dropped notably. Many minority groups also saw a decrease in joblessness. These are the indicators of improvement that the Fed has been hoping for.
Powell warned on US economy. Fed Chair Powell believes that the Omicron variant and a recent uptick in coronavirus cases pose a threat to the US economy and muddle an already-uncertain inflation outlook. He also said that worries over the variant could reduce people’s willingness to work in person, which would slow progress in the labor market and intensify supply chain disruptions. He added that the central bank could consider speeding up its taper, a topic that he expects to discuss at the bank’s December meeting.
Our take: Powell’s speech to the Senate Banking Committee was peppered with signals that fighting inflation was a priority, especially given that the jobs picture – the other half of the Fed’s mandate – is solid. Powell was speaking in front of a bipartisan group of senators, which should come as no surprise. He needs them to confirm him for a second term, but their own political fortunes are tied to the state of the US economy, particularly inflation.
Don’t be fooled by the fact that the Fed has shifted the goalposts on ‘transitory’ inflation. It’s concerned, which is why it’s considering accelerating asset purchases to give itself some breathing room if it’s mistaken about inflation’s stickiness. However, while the knee-jerk reaction might be to expect higher long-term yields as a result of the Fed’s pivot, the risk is to the downside for the economy, and therefore, for long-term yields as well. More on this later.
Omicron variant spreading fast as markets brace themselves. Is it an overreaction? According to the World Health Organization, the Omicron variant is likely to spread further and poses a very high worldwide risk due to the possibility of catastrophic repercussions from outbreaks in specific locations. More than 38 nations around the world have discovered the new type, up from 23 only 48 hours before. Early evidence suggests it is spreading faster than prior versions.
According to the Financial Times, Moderna CEO Stéphane Bancel believes that existing vaccinations will be less effective this time around, stating that developing and shipping a vaccine that precisely targets Omicron might take months. According to the European Union’s medical body, a vaccine against the variation might be approved in three to four months.
As a direct response, financial markets have now returned to the old financial crisis days of “risk-on” and “risk-off” where all assets would move according to the perception of whether the environment had grown safer or more dangerous. Here are the key questions going forward as we see them:
- Omicron is more contagious than its predecessors. That implies, like the delta variant before it, Omicron has the potential to hasten the pandemic’s progression once more. It offers grounds to suspect that the epidemic will last longer than previously anticipated, and that fresh restrictions on the movement of people would be required.
- There is currently no indication that Omicron is more lethal than prior variants. However, it’s unclear whether it would place those who are more vulnerable at greater risk.
- Omicron may be more adept at evading existing Covid vaccines. As many will have read, the degree to which this strain has mutated suggests that there could be more breakthrough infections beyond Delta. But for the time being, this is only speculation. As with prior strains, early anecdotes seem to indicate a mild disease profile for the vaccinated with Omicron. If this variant turns out to be more able to pierce both prior-infection and vaccine immunity, we’re in for a long and tense winter as governments try to persuade people to limit their travels once more.
One thing is for certain. Buckle up; rates volatility, especially on the short end of the yield curve, will be with us for a while as the medical professionals and the arm-chair epidemiologists (you know who you are) take weeks to figure it out. However, at present, there is no evidence that Omicron is particularly more harmful than Delta or the original Wuhan strain.
Regardless, the scenario creates a dangerous situation for the Fed. A slew of recent economic gauges has given Americans, as well as the Fed, plenty to be thankful for. Whatever has been gumming up improvements on the jobs market seems to clearing; things appear to be moving in the right direction now. Then there’s the continuing news about high and rising inflation. The Fed’s favorite inflation gauge recently showed inflation to be broadening and less “transitory” than previously believed, and should the Omicron threat prove real, further restrictions will compound supply-chain challenges while worsening labor shortages elsewhere as people are hesitant to return to work. These fresh, pandemic-driven delays and stoppages would likely translate into higher goods inflation, already at its highest in four decades.
The risk to any economy is over tightening. There are only so many rate hikes the economy can withstand before investors shift from unprofitable or debt laden and speculative ventures toward solid cash flows. As the Fed eases off the stimulus throttle, it needs to avoid that switch happening aggressively and head off any sudden, reduced lending appetite in credit markets.
Bottom line? Markets have now scaled back the timing and frequency of Fed rate hikes – rates traders had priced in close to three rate hikes in 2022 before the omicron news – as any major infection wave and subsequent lockdowns would make rate hikes unpopular. However, it appears that there is a new inflation problem – on top of the one we’re all already experiencing – that a new infection wave would intensify. The public and political outcry over strong and broad-based inflation has increased pressure on the Fed to do something about it. Though it’s still a toss-up – and the Omicron variant only adds to the uncertainty – the advantages of speeding up the pace of the Fed’s taper outweigh the drawbacks.
On the upside, while the Fed has missed its inflation forecasts over the past year, they have been more accurate about the virus’s impact on economic growth: the virus’s negative influence on growth seems to shrink with each subsequent infection wave. This suggests that both financial markets and the economy are likely strong enough to weather a faster taper.
Should a faster taper come to pass, the spotlight then moves to the timing and pace of rate hikes. Pretty much everyone agrees that the Fed must conclude its tapering actions before it would hike rates. A faster taper means that the process would end sooner – say in March 2022 as opposed to June 2022 under its current tapering pace – and would create more room, optionality if you will, to the Fed’s decision on when and how much to hike rates next year. More options are always good, especially when it comes to managing an economy.
On the downside, one of the Fed’s concerns is a replay of the 2013 taper tantrum, when it fumbled the communication of its tightening stance, resulting in a selloff in Treasury markets and a severe tightening of financial conditions. The chances of that happening again have decreased, as seen by the limited global market spillover from the recent jump in short-term Treasury yields. To put it another way, financial conditions are still very loose, giving the Fed lots of room to soak up some of the slack.
A disturbance to the Fed’s maximum-employment mandate is also a risk. Despite increasing prices, demand – both consumption and investment – has remained strong. Even though the jobs market recovery could hit a speed bump over the next few months as a result of Omicron, it won’t take much to bring the unemployment rate down to 4% by mid-2022 if the Fed adopts the view that many of the recent job departures are permanent.
As such, assuming the economy doesn’t fall apart in December, we expect that, starting in January, the taper will likely increase in speed, with the process ending in March. If upside inflation threats materialize, this opens the door to a possible rate hike as early as March, but we seriously doubt that will happen, given the Fed’s slow response to easing off the stimulus throttle. Instead, we suspect that we’ll see the first hike until June or September.
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What to Watch This Week: The only questions now are whether Omicron hurts the economy or increases supply-chain bottlenecks and whether inflation remains sticky. In the meantime, with the November jobs report corroborating the Fed’s assessment of a tight labor market, two variables might derail what we believe would be a probable announcement of a speedier taper at the Fed’s December 15th policy meeting: consumer price data (Friday) and clinical findings on the Omicron variant.
Hang on to your hat; we expect that November’s consumer price index (CPI) data (Friday) to reflect the highest rate of inflation since 1982. The psychological impact of this milestone, as well as the heightened public pressure that such news will produce, will make the Fed’s recent leanings toward less stimulus make sense.
The outlook for interest rates from here on is heavily contingent on virus developments. As such, evolving news on Omicron’s lethality and resistance to vaccines will be front and center. If Omicron proves as powerful as the delta variant, supply-chain bottlenecks will reappear after a recent peak, labor shortages will last longer, and wages will rise further. Inflationary pressures are likely to worsen consumer morale (Friday).
Big Picture: The combination of increasing inflation, a strong economy, and a tightening Fed should result in a steepening of the yield curve. And it did at first, with short-term yields anchored at record lows, held there by pedal-to-the-metal Fed stimulus, and long-term yields rising, on the back of the positive growth outlook as investors sought higher returns elsewhere.
While Omicron has rattled markets, the positive macro picture remains unchanged, with high inflation and central banks terrified of the implications. To deal with today’s scenario, the Fed clearly requires flexibility. That means an announcement of accelerated tapering will come mid-month, followed by earlier than expected rate hikes if inflation remains sticky this winter, which would then raise the risk of a growth slowdown or recession further down the road.
That’s a recipe for flattening yield curves if we’ve ever seen one, as short-term rates, like the 2 and 3-year Treasury yields, rise in response to anticipated rate hikes, and longer-term yields, like the 5 and 10-year Treasury, stay low as investors seek safety on expectations of a growth slowdown. In fact, the flattening has already begun, as evidenced by the spreads between 2-year Treasury yields and other, longer-term yields, like the 10-year:
When the Fed does finally hike next year, it won’t just be the short end of the yield curve that notches higher. More likely, the entire curve will shift higher. This dynamic likely leads the 10-year Treasury yield to trade in a 1.40-1.65% range through year’s end, while short-term rates continue rising.
The evolving yield environment equates to more expensive rate caps and swaptions, and an opportunity to use other, option-based vehicles for interest rate hedges that may offer more advantages over plain ol’ interest rate swaps.
It’s times like these that beg for a seasoned, independent, market-savvy advisor to identify favorable hedging opportunities, while guiding you past the expensive potholes that lie ahead. Do you have one?
Rate Cap & Swap Pricing:
Source: Bloomberg Professional
Source: Bloomberg Professional