After a positive start to the New Year, valuations of risk assets fell as markets priced a more hawkish policy from the US Federal Reserve.
Covid-19 infection rates soar as Omicron spreads rapidly
Since mid-December, infection rates have skyrocketed in the US and most western European countries as the Omicron variant continues spreading worldwide. This development has had negative consequences for mobility (as some governments impose travel restrictions) and labour availability as infected workers self-isolate.
The GISAID tracking of variants platform indicates that the share of Delta cases has continued to fall across regions, while the Omicron share is rising, suggesting that the latest variant could outcompete and displace Delta globally. Omicron has already become dominant in the US and a number of European countries.
Crucially, Omicron-related deaths have (so far) remained contained. Initial evidence suggest that Omicron may cause milder disease and is less efficient at entering lung cells. While the data is still patchy and many unknowns remain, investors appear to remain optimistic that the trajectory of a reflationary recovery in the global economy is not jeopardised.
Under these circumstances, disruption to supply chains is likely to continue. However, a new measure of global supply chain pressure by the New York Federal Reserve suggests that pressure may be beginning to moderate (see Exhibit 1).
Omicron in China – A known unknown
Despite the recent re-imposition of restrictions in some countries (e.g. a nationwide lockdown in the Netherlands), political appetite for pragmatic measures adapted to the specificities of the Omicron variant has been apparent. A growing number of countries are shortening mandatory Covid isolation times (e.g. Germany, Spain, the US, the UK) notably to limit any disruptions that staff shortages could cause.
China, however, remains an exception as authorities are set to maintain their zero-tolerance approach ahead of the Beijing Winter Olympic Games in February and the 20th National Party Congress in November. Infection rates in China therefore represent a significant risk of further supply chain disruption and local labour market tightness.
In an interview this week, German virologist Christian Drosten noted that Omicron might test the efficacy of China’s Covid vaccines (there is some speculation that as inactivated vaccines, China’s vaccines may be less effective against Omicron than mRNA vaccines).
With strict lockdowns and closed borders in China likely to continue throughout the year, the consequences for global markets could be significant. For example, if China’s zero-COVID policy inhibits domestic consumption/imports and contributes to trade surpluses, these may in turn be recycled in the form of purchases of government debt in the US and/or Europe.
FOMC minutes – A sting in the tail
The US Federal Reserve’s Federal Open Market Committee last met to consider monetary policy on 15 December and delivered what financial markets interpreted as a benign set of measures (see our post here for a full account of their decisions). However, the publication on 5 January of the minutes of that meeting did not go down well, triggering a sharp rise in bond yields and a sell-off in stocks.
In the view of our fixed income team, these minutes highlight the fact that most committee members think it appropriate to begin rolling off the balance sheet shortly after commencing interest rate rises.
The market was manifestly surprised to learn that ‘almost all’ FOMC participants believe that the Fed should reduce the size of its balance sheet (that is, start to sell off the bond holdings acquired through quantitative easing) once there has been an increase in its main policy rate.
All things being equal, an earlier-than-expected balance sheet reduction should raise bond yields. Markets were generally not prepared for simultaneous balance sheet roll-off and rate rises.
Rolling off the Fed’s balance sheet would limit the number of rate rises required. In our view, that reduces the flattening impact such rate rises would have on the US bond yield curve. We now anticipate a steepening of the curve.
Overall, we see these minutes as signalling a hawkish shift by the FOMC. The fact that the notion of a simultaneous balance sheet roll-off and rate rises was not evoked by Chairman Powell during the question & answer session after December’s FOMC meeting suggests to us that the Fed is seeking to ‘drip-feed’ a hawkish pivot to investors.
Market reaction to FOMC minutes
The perception that the Fed is shifting towards a more hawkish policy stance caused the Nasdaq Composite to fall by 3.3%, marking its biggest decline in almost a year. Higher bond yields raise the discount rate for equities, challenging elevated multiples.
The yield of the 2-year US Treasury note rose after the release of the minutes to 0.82%, its highest level since March 2020. The yield on the benchmark 10-year Treasury note rose to 1.72%, up from 1.5% on 31 December. The S&P 500 equity index fell by 1.9%.
European government bonds were also caught up in the sell-off. Germany’s 10-year bond yield climbed to minus 0.05%, its highest since May 2019. Italy’s 10-year yield rose to above 1.3% for the first time since July 2020.
In Asia, Japan’s Nikkei 225 share index closed down by 2.9% lower and mainland China’s CSI 300 fell by 1%.
Our multi-asset portfolios are positioned for higher US and European government bond yields. We continue to favour equities, but focus on regions we consider to be less sensitive to real yield moves at current valuations and with strong cash flows expected for 2022 and 2023 in both absolute and relative terms.