Asset Allocation Weekly – The Omicron Problem

Over the Thanksgiving holiday, news broke that a new variant of COVID-19 had been isolated in South Africa. This new variant has a generally high number of mutations, which increases the likelihood that current immunity will be compromised. In other words, a previous infection or inoculation is likely to be less effective in preventing infections. Financial and commodity markets did not take the news well. The main stock market indices gave way. Crude oil fell more than 12% the day after Thanksgiving. It is still too early to know the impact of this new variant. Early reviews suggest it may be less deadly than previous variants. This would be a pattern often seen with infectious diseases. But there are reasonable fears that the new variant will have a disruptive effect on the global economy. However, an additional complication is the reaction of policy makers. Last week, President Powell took a hawkish stance during testimony to Congress, suggesting that the Fed may reduce its balance sheet purchases more quickly and may tighten policy before labor markets fully normalize. He also abandoned the “transitory” description of inflation.

His statements led to a shift in market expectations on the way to monetary policy. What has changed for the chair to move towards a stricter policy? As we discussed a few weeks ago, the composition of the FOMC next year will be much more hawkish unless the president moves quickly to fill the three remaining FOMC positions. Without those vacancies being filled, Powell could face close votes to keep politics stable. His position may reflect the fact that the composition of the committee is changing.

Another factor affecting Powell’s stance is that cyclical inflation has jumped recently. The San Francisco FRB has a measure that separates the cyclical and acyclical components of the personal consumption staples deflator, the FOMC’s most favored measure of inflation. In general, there is little point in the Fed changing its policy if acyclical inflation rises because such inflation is unlikely to be sensitive to monetary policy. In contrast, cyclical inflation should be sensitive to monetary policy. Cyclical inflation has surged over the past three months, which has likely caught the attention of policymakers.

Until September, this index was still within historical norms, but the rise since then suggests that (a) cyclical prices are rising and (b) monetary policy should have some effect on reducing this inflation.

At the same time, the recent surge in financial volatility will likely affect the decision to raise rates.

This chart shows the target policy rate as well as the 12-week average of the VIX. We have placed a line at 20 for the VIX. Over the past two decades, the Fed has tended to avoid raising rates when this VIX measure exceeds 20. Although the current reading is below 20, it is near that level, so recent volatility The market could easily push the VIX above 20 in the coming weeks.

The unknown key is the trajectory of inflation. Due to the disruption caused by the pandemic, forecasting inflation is currently particularly difficult. Yet the same base effects that pushed inflation up this year will likely have the opposite effect in 2022. Overall, we expect the Fed to end its balance sheet expansion in the year. next, but the first rate hike will likely be at the end of 2022 at the earliest and more likely in the first quarter of 2023.

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