“Omicron + taper = volatility,” read the title of one note on Wednesday.
Weary and wary, markets entered the final month of a banner year for equities pondering a Fed Chair plainly bent on restoring the FOMC’s inflation-fighting credentials at a time when uncertainty around a new COVID strain poses a significant threat to growth.
It’s still premature to speculate about the extent to which Omicron will imperil the global recovery, but what we can say is that a more transmissible variant is particularly vexing for Europe, and especially Germany, where ICU beds are filling up. “We have to protect our staff and prevent our clinics from collapsing under the pressure,” an official from a German intensive-care medicine lobby said.
Incoming chancellor Olaf Scholz is in favor of mandatory vaccines. A decision could be made by the end of the year. A technical recession in Germany isn’t out of the question. And although much of the spike is down to one-offs and other aberrations, inflation is running the hottest since 1992.
Inflation is similarly elevated in the US, of course, and Jerome Powell is apparently keen to tackle it — despite knowing that monetary policy may prove feeble in the face of price pressures driven by supply-side factors.
If anyone was curious as to whether Omicron might compel the Fed to put inflation concerns to the side until we have more information around the potential impact on the economy (and, specifically, the labor market), the answer is “no.” Or at least for now.
“In effect, he helped to settle a debate for traders, who were earlier torn between deciding whether the central narrative of the day was still-dominant inflation or the fallout from Omicron,” Bloomberg’s Ven Ram wrote, of Powell’s Congressional testimony, during which he officially “retired” the “transitory” characterization of inflation.
“The key revelation was that Powell views the economic impact of the Omicron variant in an entirely different and opposite light than the market’s view,” JonesTrading’s Mike O’Rourke said. “The market reaction of the past several days involves a fear of economic slowing, indicating longer policy accommodation is needed,” he added, noting that “Powell, on the other hand, believes the variant may be a potential source of inflation in an already inflationary environment.”
10-year US yields rose to 1.50% ahead of the US open Wednesday. European shares rebounded from a seven week low, with volatility perched near 13-month highs (figure below).
It goes without saying — or it should — that things will remain choppy, at least until the December Fed meeting. As Wells Fargo’s Chris Harvey put it, “panic doesn’t disappear overnight.” “When the market decides to ‘shoot first, aim later,’ the sharp reaction suggests stress levels will take at least 1-2 weeks to decay,” he wrote, earlier this week.
Nomura’s Chetan Seth and Amit Phillips suggested investors exercise caution around any dip-buying impulses. Elevated inflation means the bar is higher for central banks to tamp down volatility, even if Omicron ends up being a material threat.
With the caveat that central banks are always predisposed to rescuing risk assets in a bind, Powell’s hawkish tilt certainly suggested the Fed won’t blink as quickly as expected. Vol of vol hit 140 twice in three sessions (figure below).
Note that the persistence of daily 1% swings in equities leaves the door open to ongoing de-leveraging from the vol-control universe. That could be a latent headwind for stocks.
As for the Fed, it’s worth asking if Powell is setting markets (and himself) up for an Andrew Bailey moment. Recall that in October, Bailey plainly telegraphed an imminent rate hike only for the BoE to wrong-foot markets at the November meeting with a fairly convincing hold.
“Does this mean that an accelerated taper is now all but a given? Or did Powell make a BoE-like faux pas, where it turns out in December that the FOMC doesn’t want to follow through with a faster taper?,” Rabobank wondered, noting that “the market surely seems to think the former.”
The bank went on to ask if the Fed is “embarking on a policy error by tightening into a potential economic slowdown.” We were asking the same questions in October. The curve may have an answer.
