Central banks' worst nightmare: inflation and a new Covid strain

This morning, the market was caught by surprise with the news of a new Covid variant coming from South Africa. Investors flew to safety in a typical “sell now, make questions later" fashion, pushing down bond yields, together with oil prices and the stock market.

The big question remains whether today’s flight to safety is justified or not. However, nobody can answer this question because there is too little information at hand. What we can do is to work with what we already know: central banks are concerned about inflation and are getting ready to tighten the economy. However, can they continue with their hawkish plans despite a new wave of infection that might cause countries to impose restrictions and lockdowns? The short answer to that question is yes. They will need to because a lockdown can further exacerbate inflationary pressures by worsening supply-chain bottlenecks. Easing the demand looks like the most sensible thing to do not to overheat the economy further.

Yet, in a day where liquidity is so thin, one has to be careful to overreact with what the market is “saying”. That’s why we believe that the deep drop of yields, especially in the belly of the curve, might be overdone, especially under the prospect that the Federal Reserve will accelerate the pace of tapering in December. At the same time, the market pushed back on interest rate hikes expectations. While yesterday it was expecting almost three hikes in 2022, today it is pricing only two. Yet, provided that a new wave of Covid will be temporary, it’s safe to assume that rate hikes will accelerate once that market sentiment normalizes.

Therefore, the front part of the yield curve might soon resume its rise. However,  there is a chance that long-term yields will stabilize or even fall amid growth concerns. Hence, we are heading toward the risk to see the yield curve inverting.

The spread between 30-years and 5-year US Treasuries is well below 100bps. However, the spread between 30-year yields and 10-year yields it's even tighter -just 36bps. The spread between 10-years and the 7-years yields it's just 8bps. It means that we are not far off from an inversion scenario, which is often seen as a solid recessionary predictor.

There is plenty of reasons to remain cautious, especially in a day where thin liquidity might provide a distorting view on events. Next week, we will gain a better picture when the American market has digested the Thanksgiving turkey and liquidity is restored.