Omicron and the Shifting Fed Landscape

As I wrote this month’s commentary with various financial news networks on in the background, I continually heard the words “probably” and “highly” with regards to the COVID-19 Omicron variant. That seems to be the main issue as markets continue to digest a new strain’s possible impact on the global economy.

Media headlines about Omicron’s emergence shook financial markets the day after Thanksgiving – a half-day trading session that is historically known for light volume. The high level of uncertainty around the new variant (and future variants) impacted financial markets as one would expect – Treasuries rallied hard and risk assets sold off. By the next market opening, Treasuries were selling off and equity markets were rallying as the world implemented new travel restrictions but scoffed at the notion of new lockdowns. It was almost an attitude of, “Hey, we’ve done this before and we know how to manage things in a pandemic.” The major difference between the initial days of the pandemic, as well as the Delta variant surge last summer, and now is that we’ve seen this movie before, and as tragic as it may be, the world is better prepared to handle another surge.

The unknown aspects of Omicron (e.g., more contagious? deadlier? vaccine resistant? much ado about nothing?) spooked markets that day and dominated headlines through the weekend. By the time markets opened in Asia on Sunday evening, and in the US on Monday morning, the rebound was well in hand. Replicating the unpredictability of the ongoing battle against COVID, markets reversed course on the final day of the month as uncertainty shifted sentiment to a risk-off posture.

Exhibit 1: Market Index Returns (%)

Source: Bloomberg.

As markets adjusted to the prospect of travel restrictions and another strange holiday season, attention turned to the Federal Reserve and how it might react to the potential growing Omicron shadow. Expectations for an initial rate hike (or two) in 2022 remain, but as markets wrapped up the penultimate month of the year, those expectations pushed further out. What markets price in and what the Fed does are potentially two different things, and events and outlooks shift daily. Let’s look at the expected probability of interest rate hikes in 2022 using Federal Fund futures. Exhibit 2 illustrates the shift in expectations that occurred the last week of November.

• November 24–The model estimated a 100% chance of one hike, as well as an 8.3% chance of an additional hike by the June 15 meeting next year.
• November 26–With Omicron’s emergence, market expectations shifted the initial rate hike from June (77.8%) to late July (100.6%).
• November 29–Rate hike expectations pushed out once again (61% chance of an initial hike by mid-June, 83.6% by late-July) as Federal Reserve Chair Jerome Powell’s prepared testimony to the Senate Committee on Banking, Housing and Urban Affairs indicated his concerns about the negative impact on the economic recovery from Omicron.
• November 30–Overnight concerns from Moderna and Pfizer executives regarding current vaccines’ efficacy against Omicron and the development timeline for Omicron-focused boosters created additional angst in the market.

Offsetting the impact on the short end of the curve was Powell’s response to questions from the Senate Committee on Banking, Housing and Urban Affairs, which created a shift in expectations as Powell offered an expectation on accelerating the balance sheet tapering schedule and the retirement of the notion of transitory inflation. The FOMC has made it clear that rate hikes won’t occur until the tapering has been completed, and an increase in the monthly tapering amount to bring the bond purchase program to a close sooner would indicate an acceleration in the timing of rate hikes. By the time the market closed on the final day of November, expectations completed a one-week roller coaster ride.

Exhibit 2: Expectations for Rate Hikes (% chance)

Source: Bloomberg.

If nothing else, November’s final days are illustrative of not only the times we live in but the hazards of trying to predict market movements when so many external factors can deliver significant impacts. While the Omicron variant can’t be deemed a Black Swan event, since we know variants are a real risk to the global economy and our overall well-being, Omicron reminds us that the battle against the virus is ongoing and there will be future episodes of (hopefully) short-term disruption. It’s too early to truly understand the new variant’s potential impact on the global economy as we don’t have the data to know if this is a game changer like Delta or something less benign.

As we turned the calendar to December, we’re faced with an abnormally high level of market uncertainty due to multiple factors. How dangerous is Omicron and how will it impact the global economy? We should have more data on Omicron around the middle of the month, which is also when the Federal Reserve will conduct its final meeting of the year. If the Federal Reserve accelerates balance sheet tapering, what does that look like and will additional information on Omicron throw a wrench into its plans? Does the Fed provide additional insight into the future path of interest rates? Will the debt ceiling debacle force another government shutdown? It’s been a difficult year (or two) for financial markets and the global population, and the final month of 2021 doesn’t appear as though its going to give us any reprieve.

Happy holidays to everyone and buckle up for what could be a potential roller coaster conclusion to 2021!