Omicron takes center stage with the Federal Reserve on standby

COVID-19 omicron variant

Unfortunately, the world knows little about omicron. Many formed opinions and educated guesses over the past week, but below are the facts we know to date:

• Researchers in South Africa identified omicron as a new COVID-19 variant.
• The World Health Organization deemed omicron a “variant of concern”, due to early evidence suggesting it poses a higher reinfection risk.
• South Africa averaged 200-300 daily infections before omicron was identified in early November. By December 1, that number had risen to 8,561 identified cases. By December 3, the daily case count had increased to 16,055.
• Omicron has been detected in at least 38 countries and 17 U.S. states.
• Dr. Fauci said it could take up to two weeks to gain more insight into how easily the variant spreads and its relative deadliness.
• The Biden administration has not imposed any widespread lockdowns or mask mandates, but is encouraging all citizens to get vaccinated, obtain a booster, and wear masks.
• Current vaccine manufacturers have expressed a range of views on the level of protection offered by current vaccines and the amount of time it would take to determine efficacy against the new variant.
• If a new vaccine is needed, Moderna expects it to take months to develop. With this timeframe in mind, Johnson & Johnson announced they have already started working on a new vaccine for the omicron variant.

The Federal Reserve

Excluding the announcement of omicron, the U.S. economic condition has dramatically improved. Below are recent highlights:

• Weekly jobless claims fell to a 52-year low as of November 24. On December 2, the figure was 222,000, which was only a 23,000-claim increase above the previous week’s record.
• The official unemployment rate fell to 4.2% on Friday, and the U.S. expects to achieve full employment in the coming months.
• There is currently 0.66 unemployed individuals for every 1 job opening in the U.S., the lowest on record since 2006.
• Nominal hourly wages have increased 3.2% since April 2020 to $31.03 per hour, which is the highest level on record.
• Q4 2021 gross domestic product (GDP) is expected to increase 9.7%, based on the Atlanta Fed’s GDPNow forecast.
• As of July, the IMF projected 7% annual GDP growth for the United States in 2021. If accurate, this would represent the best annual GDP growth since 1984.
• As of Q3 2021, GDP was 6.9% higher than it was pre-pandemic (Q4 2019). Over the same period, real GDP, which is adjusted for inflation, increased 1.4%.

Despite these strong macro-level economic measurements, consumer sentiment (which was recorded prior to omicron’s announcement) in November hit a 10-year low, based on the University of Michigan’s consumer sentiment survey. According to the report, one in four respondents cited erosions of their living standards, and complaints about falling living standards quintupled in the past year. Despite the positive macroeconomic figures, the average American’s real hourly earnings have been steadily falling since April 2020.

With full employment on the horizon and the highest inflation in recent memory, the Fed is preparing to begin increasing interest rates to cool the economy. Lower inflation is expected to help avoid additional wage erosion.

On Tuesday, Jerome Powell said, “The economy is very strong and inflationary pressures are higher, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases… perhaps sooner than expected.” Powell also suggested that the “transitory” definition be retired when describing inflation. The Fed now expects higher inflation to persist until mid-2022.

Since the Fed previously stated it would not raise rates before tapering is complete, the Fed can hike interest rates more quickly by tapering asset purchases sooner than expected. However, if the new omicron variant causes higher unemployment and persistent inflation, the Fed will be in a precarious situation. If the Fed waits to taper and increase rates, it could risk further eroding wages and overheating the economy. If it hikes rates too quickly, the Fed could stunt the economic recovery. The world will know more on the Fed’s official strategy after the next FOMC in mid-December.

Financial market developments

With a lack of information on the omicron variant and a potentially faster taper and rate hike announcement from the Fed, markets were volatile this week.

As of Friday, the S&P 500 index fell 4.33% since it set an all time high on November 22. Intraday swings averaged 2.07% for the week and the VIX index, a broad measure of equity volatility, hit its highest level since Jan 29, 2021 last Wednesday.

Commodity prices fell last week with oil dominating headlines. The price of crude WTI fell 21% to $66.26 on Friday’s close relative to its 52-week high of $84.15 set on November 9. The U.S. and other oil consuming nations releasing oil reserves combined with omicron fears led to the drop. The last time crude was in the $60-$70 range was in August.

Long-term treasuries broadly kept falling over the last week due to omicron fears. Since November 23, the 10-year treasury rate fell 32 basis points to finish Friday at 1.35%. It was the largest fall in treasuries over a seven-day trading period since March 2020. Aside from omicron and the Fed, a catalyst that could cause rates to increase is the looming government default. Secretary Yellen stated Tuesday that if the debt ceiling is not raised, the treasury would default soon after December 15.

Short-term rates, however, increased on Powell’s hawkish comments. As a result, the 2-year/10-year treasury spread flattened to 0.75 basis points on Friday. The last time the spread was that flat was December 1, 2020.

The flattened curve provides corporations an opportunity to utilize pre-issuance hedges via T-locks and forward-starting interest rate swaps for any upcoming debt issuance.

The week ahead

The market will be actively monitoring omicron, Fed tapering, and the U.S. government debt ceiling.

(Related insight: Register for the December webinar, "Treasury 2022: Opportunities, Priorities, and Trends")