But after the dust kicked up by the latest worrying coronavirus variant news settles down, Treasuries look most likely to be driven by this: the central bank fighting inflation in 2022 by getting more restrictive with monetary policy.
The Omicron virus strain’s emergence sparked a dramatic Treasuries rally on Friday. Traders rushed to push back the timing of a 2022 rate hike to September from June. There was an 18-basis-point yield drop in five-year U.S. debt, which has long been a barometer of future Fed shifts, and the 10-year fell below 1.5 per cent. The abrupt slide in yields was a testament to how one-sided sentiment had become, leaving the bond market at the mercy of a sudden pandemic plot twist.
Inflation remains an insidious threat, something Fed officials have been fairly open about. Chairman Jay Powell and Lael Brainard, the prospective Fed vice chair, focused on stemming inflation in their remarks after they were nominated by President Joe Biden to helm the central bank next year. The bond market has also heard from a growing number of Fed officials before Thanksgiving that a faster pace of tapering the central bank’s asset purchases may be warranted in the months ahead.
“With the likes of the Fed and Bank of England already behind the curve, it is unlikely that the new variant will change their direction of travel at this stage,” said Leandro Galli, senior portfolio manager at Amundi Asset Management. “Financial conditions remain easy and inflation continues to surprise on the upside, giving the Fed limited room to delay the withdrawal of unprecedented monetary support.”
BloombergHeading into December, the market can expect no easing in volatility as more details about the Covid variant emerge. However, the current macro story will also dictate sentiment. Next week, attention will focus squarely on the latest job data for November and whether wage gains suggest inflationary pressure remains pertinent. Markets will also be on watch for clues from Powell, who is set to testify before Congress in the coming week, and a slew of other central bank speakers.
The shifting inflation discourse from the Fed from its prior stance of tolerating the economy running hot for an extended period has the bond market primed for an accelerated pace of asset-purchase tapering from January.
An employment report that surpasses a forecast median projection of 530,000 new jobs in November — versus 531,000 in October — and shows wage growth running beyond an expected 5 per cent for the past year will add fuel to that fire.
Also looming ahead are the next consumer price index report and the central bank’s meeting in mid-December, when officials will update forecasts for the economy and rate hikes in 2022.
“The market and the Fed are very data dependent, and if the next few inflation reports show no sign of significant moderation” then Powell and Brainard have “the job of bringing the Fed towards the bond market in 2022,” said Kevin Flanagan, head of fixed income strategy at Wisdom Tree Investments. “The first step is to get more aggressive with tapering, and January is on the table for reducing more of their current extraordinary policy accommodation.”
Quickening the pace of bond-purchase tapering early next year is seen providing the Fed with a window to begin raising overnight interest rates from around the middle of 2022, with economists at Goldman Sachs Group Inc. in that camp.
Such a policy stance favors the broad flattening in the yield curve, with any bouts of steepening seen as amounting to brief countertrend episodes. The difference between 5- and 30-year Treasury yields got to 70 basis points on Friday, a big jump from the 20-month low of 61 basis points set Wednesday.
Moment Has Passed
“The narrative for a steeper curve was the story at the start of this year when the Fed was telling investors they would let inflation run hot,” said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. “The moment for the steepener has passed by. Now the Fed is focused on maintaining its inflation credibility, and you trade that by flattening the curve.”
A flatter yield curve also looms should economic data show signs of moderation, with concern in some quarters that the U.S. economy may endure a renewed wave of Covid infections during the winter months. That may intensify inflationary pressure by disrupting already-stressed supply chains even further, requiring restrictive Fed policy to help ease demand, rather than overheat the economy.
“The Federal Reserve may remain hawkish as stimulating demand can produce stronger price pressures,” Althea Spinozzi, fixed income strategist at Saxo Bank, wrote in a research note. That will maintain upward pressure on short-dated yields, while any hit to growth prospects likely pulls long-dated yields lower, and accelerates the flattening trend.
The latest pandemic news is certainly a worry, but for now assessing the trajectory of tighter policy next year and sticking with the broad trends of rising yields and a flatter curve is the main story for the bond market.
