Omicron uncertainty remains but Powell signaled clearly that the Fed is moving in a more hawkish direction, an important shift at a time when the US economy is strengthening.
Uncertainty remains elevated as we await more conclusive data about the Omicron variant specifically its severity. This uncertainty manifested itself as extremely volatile market conditions last week. 10 day realized volatility in the S&P has risen almost 4 fold from before the Thanksgiving holiday to this week, and 10 day annualized oil volatility has risen to 85, the highest level since May of 2020.
In terms of directional movers, idiosyncratic themes played a key role. Argentine bonds had a 1.9 weekly stdev move higher following positive developments relating to the potential for an IMF deal; in contrast, in Turkey, the lira fell by another 10% a 2 weekly stdev move despite several FX interventions by the Turkish central bank. Ukrainian bonds had a 2.7 weekly stdev move higher as risk premium fell in the region following ongoing discussions between the US and Russia (even as tensions remained high).
Aside from the heightened uncertainty and these idiosyncratic stories, there were a few important macro developments last week.
Chair Powell in the first public testimony to Congress since being renominated to Fed Chair was clearly hawkish. Among a series of comments, he stated that it may be appropriate to conclude asset purchases “a few months sooner” and that it may be time to retire the “transitory” term in discussing inflation. These were not throwaway comments, the entire tone and content of his testimony was clearly hawkish, and a shift from recent communication.
The timing and venue are commentable. Inflation is now a political issue, and it is logical that Chair Powell’s nomination over Lael Brainard comes with an implicit mandate to ensure that price stability is given appropriate weight in policymaking. These comments support this viewpoint, and certainly indicate that the Fed has shifted more hawkish in quite a short period of time.
This is in large part due to the broadening strength of the US economy. Last week’s ISM services data hit an all-time high in November, construction spending was higher than expected, and high frequency card spending data shows robust consumer demand despite low levels of consumer sentiment. The US employment data was also strong. Despite a weaker than expected headline, the household survey showed more than 1mm jobs added, bringing the unemployment rate to 4.2%. Furthermore, the participation rate, wages and hours worked all rose, pointing to an increasingly tight labor market.
The US unemployment rate is now only 0.2% above the Fed’s estimate of NAIRU, and with this week’s inflation print expected to show yoy inflation at 6.7% (with upside risks to that number), one can clearly see the rationale for the Fed accelerating their taper timeline. The fact, however, that they have shifted so soon after the taper announcement is indicative of a more responsive and hawkish Fed. This all happened against a backdrop of heightened uncertainty due to the Omicron variant and resulted in sharp bull flattening across the US curve. Curves have been flattening since the June FOMC, but we are now at levels that price a policy “error” type move.
The spread between 2y and 10y interest rates, 2 year forward is at levels that have only been seen at the end of hiking cycles.
The implications of a more hawkish and responsive Fed (with an economy that justifies this) will be a key driver of the macro environment into next year. Tightening liquidity conditions is a clear headwind to high growth tech, as evidenced by ARKK’s 12.7% fall last week, and adds to headwinds faced by EM tech. As we have previously noted, it reinforces the divergence between the Fed and ECB, which will help support the USD on a broad basis. It will require early cycle EMs to keep hiking, but for late cycle EMs (like Brazil and Russia), the global growth and inflation outlook will be priced lower, allowing deeper rate cuts to be priced.
Obviously, the Fed’s policy outlook is subject to the outcome of the Omicron variant. However, while uncertainty remains high, we remain focused on where the macro trends remain clear. We are long US homebuilders beta hedged, we are received Russian 2y rates against paid Polish 2y rates, have added a long Ruble basket against USD, EUR and NOK and remain in flatteners in Poland and South Africa. This is an alpha orientated book, reflective of both the current uncertainty, but also the environment of divergence we expect to play out next year.
COVID Pandemic
Omicron-related risks remained a key focus this week, with new data over the last week providing some additional clarity, but still leaving some key questions about the variant unanswered. Omicron cases were identified in dozens of countries across the world last week, with many countries now seeing case levels consistent with domestic community transmission. South African cases rapidly increased with daily cases and positivity rates of 11,125 and 23.8% on Saturday, up significantly from last Saturday’s 2,858 and 9.8%, respectively. The high growth rate in South African Omicron cases is consistent with some combination of high transmissibility and immune erosion, although high confidence estimates of Omicron’s transmissibility edge are not yet known.
Over the last week, there has been some increased insight into Omicron's immune evasion. A recent preprint shows a 3.36x greater risk of reinfection from Omicron than the reinfection risk seen with prior variants. The preprint, which looks at the level of protection against immunity provided by prior natural infection, confirms some concerns around the immune evading potential of the Omicron's mutations. While the study did not focus on vaccine recipients, the natural immunity evasion observed highlights the potential risk to vaccine-induced immunity. The chart from the preprint below shows estimates on the number of primary infections, the population at risk of reinfection, and the estimated number of reinfections in South Africa.
While severity data on Omicron remains limited, some notable trends in the preliminary data from Tshwane District hospitals show some changes relative to prior South African waves. First, as the chart below shows, the COVID admissions profile during this wave have skewed young relative to prior waves with an unusual increase in pediatric admissions (an increase that has raised new concerns about potential risks to toddlers). Second, those patients admitted in recent weeks have shown some signs of lower severity relative to prior waves. For instance, most COVID patients at the time of admission did not know they had COVID and were admitted for another condition (an unusual new development). Furthermore, the average length of stay for patients hospitalized for COVID has been notably shorter (2.8 day average for admissions in the last two weeks vs. 8.5 day average for admissions over the previous eighteen months). In-hospital death rates have also been lower at 6.6%, relative to 23% in previous waves. In summary, there are signs of potentially decreased severity, but the data remains uncertain due to still small and early sample size and an unusual age-skew that biases the data. It will be important to see how South African patients' severity and age profiles change in the coming weeks, as recent cases increasingly feed into new hospitalizations.
Globally cases rose last week, with cases rising for the week in Europe and the United States, while falling CEEMA, Latin America, and Asia. In Europe, case growth in Eastern Europe slowed, with cases falling nearly -39% from their recent highs in Austria and slowing in the Czech Republic, Hungary, Poland, and Germany. Case growth remained elevated in Western and Southern Europe, with COVID waves rising for the week in France, Italy, and Spain. In the US, cases and test positivity rates rose for the week, with last week’s Thanksgiving-related distortions falling out of the US data. As the chart below of Massachusetts COVID wastewater shows, COVID RNA concentrations suggest the US Northwest is likely to face a similar-sized outbreak to the winter wave seen last year.
Calvion’s View: We continue to see Omicron risks as uncertain and varied. While last week has confirmed initial concerns about Omicron’s natural immune evasion, the degree of Omicron’s vaccine erosion and disease severity is unknown. We continue to see two-sided risks to Omicron severity and will closely follow reports on how South African hospitalizations develop, with a focus on changes in hospitalization levels, severity, and age profile. We see winter Delta waves converging between Europe and the US, slowing European case growth and accelerating case growth in the US. In Asia, we continue to see potential tail-risks from China's zero tolerance approach to COVID risks.