The omicron strain will not steer the Federal Reserve’s focus away from inflation.
It feels like a déjà vu: another strain of covid pushes governments to increase travel restrictions sending the market into a panic. On Friday, investors flew to safety, although there is still little information regarding the new omicron strain. Nobody knows whether it is more contagious or deadlier than previous ones. Yet, on a day where many still enjoyed the Thanksgiving break, algos decided to sell now and ask questions later.
Government bond yields dropped dramatically, with 10-year US Treasury yields falling 17bps, below 1.5%, and 10-year German Bund yields plunging below -0.33%, deleting all November's gains as central banks shifted towards more hawkish monetary policies.
Interestingly enough, the yields of those sovereign bonds with a high beta, such as Italy, also dropped on Friday. It is a sign that the market is anticipating central banks to engage in accommodative monetary policies to save the economy once again. However, this time around, that bias might be wrong. Indeed, during the past few weeks, the White House and several FOMC members admitted that the surge in inflation has begun to be worrisome. After being nominated Fed's vice chair, the same Leal Brainard said that her number one priority would be fighting inflation. Another dove, Mary Daly, mentioned that she’s open in accelerating the pace of tapering.
Therefore, although a new wave of covid might lead governments to impose new lockdown measures, dismissing the central bank’s recent hawkish signs is erroneous. Covid is now coming into play in a moment in which inflationary pressures are at record high levels. New lockdown measures might exacerbate even stronger price pressures as they will further obstruct supply chains. Thus, although interest rate hikes expectations pared back on Friday, it's still safe to assume that the Federal Reserve will continue to taper its purchases, opening up for early rate hikes.
Additionally, if the White House decides on a new stimulus package, that would lead to more bond issuance, further lifting the front part of the yield curve. However, long-term rates will be pinned down by slower or even contracting growth expectations. That scenario matches our expectations that the yield curve will continue to flatten and could be even at the risk of inverting in the first half of 2022.
Regardless of how things will develop concerning the omicron variant, the market seems to agree that last week's bond rally was overdone. The yield curve is bear steepening this morning with 10-year yields back above 1.5%. Yet, the spread between 5s30s yields remains the flattest since February last year.
Job numbers will be in focus on Friday and could strengthen the case for faster tapering in December. Tomorrow and Wednesday, Powell will discuss the CARES act relief and the coronavirus stimulus in front of the Senate.