Fixed Income Boutique

Omicron: An acid test for the markets


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In the wake of Omicron, markets immediately were rattled and plunged given low liquidity. The EU announced border closures and canceled all flights coming from Southern Africa, and travel bans have swiftly continued in various countries. So, what does this latest development mean for bond investors and what should they look out for?

The current macroeconomic context is specific, closer to unchartered territories than a cozy, cyclical pattern. Importantly, central banks’ guidance may appear difficult to read: Mr. Powell signaled this week his support for a quicker withdrawal of the Fed’s asset purchase program and is open to rate hikes. It’s all about inflation now and how it hurts households’ incomes and poses risks to growth.

High inflation at strong economic growth

Growth is decelerating, but from very high levels, and remains way above historical growth. Are we in the middle of a strong cycle, with many more quarters of respectable growth ahead of us? Or at the end of a short cycle, with a recession looming ahead? The truth is that from quarter to quarter economic change can be strong, as we saw in Q3 2021. Regarding inflation, it likely will be above the levels we had over the last decades. Is 3% inflation a problem if growth is above 3.0%? This is a plausible scenario for the US by the end of 2022. Corporate profits are linked to nominal growth, rather than to real ones. But the market worries only about inflation, without realizing that growth will also be strong. Short-term factors are leading long-term considerations. This is why markets are volatile.

The role of the Fed

This week, Mr. Powell suggested a faster taper, and the next FOMC will probably confirm it. In our view, by accelerating tapering, the aim is to augment the Fed’s room of maneuver for the medium run to be able to act in a scenario where the central bank would have to face a higher-than-expected structural inflation, fed, for example, by accelerating rents and wages. If Omicron becomes a new pandemic, the supply/demand imbalances would remain for longer, keeping prices higher for longer.

For the bond market, the immediate reaction has been higher yields in US Treasuries, and a flatter curve, as expected if one thinks the economy is going toward recession rather sooner than later. If the direction has not been a surprise, the move can be considered as relatively muted. This means a significant amount of rate hikes was already priced in, and the market remains healthy on this basis. The Fed’s timing may at the end not be bad, despite the downside risks for the economy if Omicron becomes serious.

Two possible scenarios

The emergence of Omicron added sizable uncertainty on the already complex dynamic and expected convergence toward a less volatile and more durable growth/inflation pattern. Depending on the scenario, significant pockets of value have already built up.

  1. If a new pandemic emerges, as the one we had in 2020, then a stagflationary environment is a quasi-certainty: inflation will not decelerate as expected in 2022, central banks will have to be more hawkish and rein in growth, which would report below expectations and potentially contract temporarily. Spread would widen further, curves flatten, equity shrink.
  2. On the other hand, the variant could prove to be less disturbing than the previous waves, thanks to short-lived lockdown measures and efficient vaccines. A lot of the negatives could already be priced in various asset classes, such as local currency emerging bonds, or high yield papers.

In any scenario, the capacity to remove unwanted macro risks and bond picking will matter, whatever the asset class. The market will probably oscillate between these two scenarios until we know more about the variant. Volatility is here to stay.


 

The views and opinions herein are those of the individuals mentioned above and do not reflect the opinions of Vontobel Asset Management or Vontobel Group as a whole. The views may change at any time and without notice. This document is for information purposes only and does not constitute an offer, solicitation or recommendation to buy or sell any investment instruments, to effect any transactions or to conclude any legal act of any kind whatsoever.