EC Omicron Flattens The Yield Curve

Apart from soul-searching on the endgame for COVID-19, the arrival of the Omicron variant seems to have had two relatively predictable effects on financial markets. Volatility has shot higher, and the yield curve has flattened. Put differently, stocks have sold off, and the long bond has rallied.

The MSCI World is down just under 4% from its peak at the start of November, and the U.S. 10-year yield is off some 25 bps. Neither of these numbers are dramatic, but they’re eye-catching, all the same.

I suspect these shifts are driven by both fears of Omicron—despite little hard evidence that it is the vaccine-evading super-bug everyone has feared—and the fact that monetary policymakers so far have had little interest in changing their stance. More specifically, Fed officials have said nothing to shift expectations that it is expected to taper QE to zero by the middle of next year, and start raising rates shortly thereafter.

In Europe, I also detect little evidence that the ECB is shifting its message that its emergency QE program, PEPP, will end in March. I won’t pass judgement on that story, though, until I see the new forecasts later this month. It’s interesting that many commentators have latched on to the idea that a new virus panic will be inflationary.

This makes sense, to an extent. Our collective response to the virus has been to support demand, while being comparatively helpless to alleviate the damage wrought on the supply side. Specifically, as Dom White articulated well recently, the policy response to COVID-19 has lifted demand for goods in the West, while stinging the supply of goods in the East.

We have seen this story play out with our own eyes, but I’d be more interested in an inflationary impulse from Omicron if the curve wasn’t doing what it is doing. Specifically, markets are now signalling that if the Fed pushes ahead with higher rates next year— after ending QE—it will be a short-lived hiking cycle.

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