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By Padhraic Garvey, CFA, Benjamin Schroeder, and Antoine Bouvet
The Omicron variant and the winter wave underway in many countries do not subtract from inflation worries – they add to them. Flatter curves are the logical consequence, and some real rates are moving higher too. The US front end continues to trade with a decent rate hike discount. Makes sense to us, especially as hikes are not expected till 2H 2022.
The US front end tells a story – hikes are still coming
The likely outcome for market rates in the coming days will likely be a digital reaction to what science has to say on Omicron. Good and bad news has been reacted to so far, with the move lower in yields and acknowledgement that circumstances have in net terms veered towards the worst. But we await a clearer vision on this. We have not, as yet, had confirmation that a follow-through lurch lower in market rates is required, but what we can say is any material break below 1.4% (there is a key technical point at 1.385%) on the US 10yr could quickly take us back to the 1.3% area that we plateaued at through much of the summer. That would be quite a setback for higher end-year yield aspirations.
Despite Omicron, USD OIS is pricing just over 2 hikes next year
At the same time, the US front end is not taking out any of the rate hike discounts. The 2yr remains in the 50-60bp area. Gearing for hikes still makes considerable sense. Remember the hikes are not expected to happen till the second half of 2022. By then, this latest Covid scare should be behind us. We don't have enough to suggest that that should change, and in fact, Chair Powell has intimated that a closer scrutiny of inflation risks is warranted. Indeed, the inflation story, while often ignored by the fixed income market in the past number of months, has a persistence about it. If it won't go away, and it looks like it won't (at least not easily), then market rates will have to be ultimately tempted higher.
Near-term risks to affect mostly long-end rates
A winter Covid-19 wave is an unwelcome news, and the wave of restrictions associated with them pose a threat to a near-term growth outlook that wasn’t brilliant to begin with in Europe. Travel restrictions imposed since the discovery of the Omicron variant add to these concerns, even if they might be reversed within a few weeks, or months. The bias towards pricing negative news was evident once again on Tuesday and we expect markets, through the volatility, to continue trading with a downbeat tone into year-end.
Curve flattening makes sense both on inflation and Covid-19 risk
In this context, the outperformance of long-dated rates makes sense, although they were probably lent a helping hand so far this week by month-end extension flows. More to the point, we would normally expect curves to bull-flatten on adverse developments. One could question if this applies at the onset of a tightening cycle where front-end rates could in theory price a more dovish path for policy rates on further Covid19-related worries. We think not.
While inflation fears keep front-end rates up
We are inclined to think of the near-term Covid risks to the outlook as factors that are transitory in nature, and that do not necessarily subtract from medium-term inflation fears. The surge in inflation on the other hand can no longer be described as transitory. Fed Chair Powell speaking in favour of faster tapering and yet another upside surprise in Eurozone inflation were clear reminders of that. In other words, it is entirely possible for both Covid-19 and inflation fears to be priced simultaneously by the market. This is most likely to occur via a flattening of the yield curve.
USD and EUR real rates have rebounded on the Omicron scare
Another takeaway is that despite very real near-term worries for the outlook, central banks are taking steps to prepare markets for less monetary support going forward. Powell's warning of a faster taper yesterday was the most conspicuous example, but we have documented in previous publications that the ECB is more than aware of upside risks to its inflation forecasts. It took more adverse Covid-19-related news for real rates to notice, tentatively so far, but this is a clear sign that unconditional monetary support can no longer be counted on.
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