Global equities had a solid run last week and we’ll see if the goodwill lasts into what is a behemoth when it comes to event risk. Liquidity is certainly becoming more of an issue across asset class and that will certainly drop away next week, as the big hitters are still at the desks and won’t want to miss this week.
We’ve seen measures of implied volatility in bonds, equities, and FX, move lower after the US CPI print failed to get above 7% and while the inflation numbers were inline, the market was positioned for more. Relief from a 6.8% YoY headline inflation print almost seems ironic, but risk assets soldier on despite the evolving narrative on Omicron and that the Fed is going to have to slam the breaks on in 2022.
It feels like everyone wants to turn bearish but are just not prepared to put money into that position, with perhaps the exception of shorting the liquidity beneficiaries such as ARKK Innovation, GameStop, or AMC.
Omicron and the FOMC to dictate flow
Omicron (or Covid more broadly) and the Fed should dictate sentiment this week, and while the FOMC meeting won’t come until later this week, many are looking at the scenarios and drawing up distributions of probability and what the likely market reaction will be. My own view is the Fed increase the pace of tapering to $30b (from $15b), lift the median projection (of fed funds) for 2022 by 50bp to 0.63% and raise the 2024 dot to 2.37% (from 1.75%). This is more or less in-line with consensus expectations, and perhaps a higher pace of hikes in 2024 than some expect.
We could get a reaction in the USD if the median estimate for the fed funds rate is lifted to three hikes for 2022 – a situation where we could easily see the USD stage a solid rally, with US 2yr Treasuries pushing back above 70bp. Given the market is pricing a 73% chance of a hike (from the Fed) in the May 2022 meeting, and three hikes by Feb 2023 the hurdle to shock the market seems high, but the market may well take direction from the level of concern the Fed have for inflation.
Remember the overwhelming consensus trade for 2022 remains to play policy divergence and that means holding a bullish USD view.
The ECB meeting is a hard one to gauge and price risk around. The best reaction for EUR traders comes from the bond market again, and the difference between US and German 2- or 5-year bonds yields. The market is keen to learn about the future of the ECB’s asset purchase program – the PEPP – with high expectations this ends in March, with the APP program then expected to do the heavy lifting in keeping EU bond yields low.
The market is clearly short EURs and rate hike expectations are relatively sanguine (11bp of hikes priced), so one questions if this tilts the balance of risk to be long EUR? Theoretically, we could see a reasonable rally in the EUR if the markets feel the ECB are committed to a hard finish for APP by end-2022, subsequently seeing the possibility of the ECB hiking in early 2023, potentially late 2022.
The BoE expected to stay on hold
GBPUSD and the GBP crosses get good attention this week – on one hand, we’re seeing the UK as a model for restrictions, with PM Johnson launching a program to accelerate boosters against Omicron, saying the efficacy is “substantially reduced”. We’re not seeing much reaction in the GBP, and I’d say we’ll need far more restrictive measures to push cable towards 1.3000, but the UK has become somewhat of a case study on how others may react to the rising Covid threats, with a clear push for a third jab.
By way of the BoE meeting, the news on Omicron has seen the consensus firmly move to no hike this week, with the markets pricing a token 5bp, with 21bp of hikes priced for the February meeting. Obviously if the BoE hike by 15bp then we could see a sharp 50-75pip rally in GBP, but it seems unlikely given the circumstances. Counter to that, any narrative that suggests a February hike is up for debate, even if there is some time to pass, and we may see an element of hikes priced out of the market – let’s see the CPI print first, with core expected to rise to 3.7% and headline at 4.8% YoY.
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