Omicron fears take a back seat; inflation leads
Two weeks after global markets went into turmoil following the announcement of a new Covid-19 variant, most investors are now convinced that the economic recovery will be resilient to the new strain. UK’s Boris Johnson’s announcement yesterday that people in England will return to working from home if possible and wear face masks in most public places along with other stricter measures did little to alter global investors’ sentiment. The damage was limited to Sterling which tested a new 2021 low and UK’s travel and leisure stocks.
Most Asian stocks continued their rally for a third consecutive day as the S&P 500 recovered most of its losses and stands now less than 1% below its record high of 4,743. Brent crude rallied more than $10 in six days from a low of $65.72 reached on December 2. Meanwhile, the US Treasury yield curve steepened with 10-year yields rising back above 1.5% and 30-year yields flirting with 1.9%.
Commodity currencies benefited from the improved risk sentiment, with the Australian dollar bouncing 2.7% from the 2021 trough. Efforts to stimulate the Chinese economy and upbeat data on China’s trade were also factors supporting the Aussie.
As we continue to learn more about the Omicron virus strain, US inflation will be the next elephant in the room. Assumptions on how fast the Federal Reserve will tighten monetary policy and where interest rates would peak in the long run are key factors determining how equity, fixed income, and currency markets will behave in the medium term. And, of course, inflation will be the primary guide for monetary policy officials.
As of October 2021, there was a one-in-four chance of raising interest rates in June 2022 according to fed funds futures. Now, a June interest rate hike is a done deal, and more interestingly, markets expect a 39% chance of first interest rate hike occurring in March. That has led to a 400% rally in two-year US bond yields since June and are now hovering around 0.7%.
Looking at where markets stand now, investors do not seem worried about when the first interest rate hike occurs. Equity markets are relaxed with the idea of two to three rate hikes in 2022, which doesn’t seem to end the bull market. However, the next big question is, what if these rate hikes failed to drag inflation lower? Investors are still assuming that interest rates will be capped at 2% in the longer run, below the Federal Reserve’s target of 2.5%.
Next week’s FOMC meeting will provide new guidance on where policy officials expect interest rates to end over the next three years and in the longer run. An upward shift on the shorter end is expected, but what if the Fed sees neutral rate needs to be above 2.5% in the long run? And what if 2024 projections move beyond 2%? This is a risk that isn’t currently priced in markets.
Of course, these projections rely on inflation expectations. If the Fed believes they are falling behind the curve, and high inflation will persist for longer than previously anticipated, it will be problematic for financial markets. How the Fed tackles inflation will be the number one factor impacting US and global markets from now on. So, keep a close eye on inflation developments, and Friday’s US consumer prices will be critical.