What does the Omicron variant mean for markets? The end of the tightening threat. They get to celebrate a free extension of accomodative policies, right on time to erase inflation’s tightening talk.
The 10-month Covid rally may be about to end, and the market may be about to plunge off an abysmal cliff, some experts would have us believe. Really? The contrary is more likely to happen. Since the outbreak of this crisis, markets have had a life of their own. To be more precise, they have been as «anticyclical» as one could be. They directly benefited from bad news, and they suffered from good news. That is because bad news mean more accomodative policies ahead, and good news mean quantitative tightening and rate hikes. With this in mind, markets can hardly ever be aligned with the real economic cycle. They just have opposite interests.
Let’s look at where the US, European and Swiss stocks are heading, a week after the world learnt about the very infectious Omicron variant. After a 2,5% correction, all indices are recovering, and crawling back to new highs. The Swiss market is back from its short-lived correction. The same goes for the S&P, with an uptick since the Omicron correction. It is up 103% since its March 2020 rebound. Nasdaq is up 160%, as it is capturing all the bets on a technological, home-office future. What about bitcoin? Granted, it has overcorrected this time again, falling 10%. But will it keep sliding? Most probably not.
We just have to follow liquidity. Will it be provided? Certainly. As long as they can create it, central banks won’t fail markets. When things go wrong, that is when central banks are at their best and spoil markets. Liquidity will most probably be extended for an indefinite period of time, since we’ve entered an open-ended period of uncertainty. And we have the Omicron variant to thank for that.
In other terms, central banks have a justification to change course, and postpone any tightening they might have considered (which was already a distant prospect, let’s admit it). On November 30, Jerome Powell (Fed Chairman) and Janet Yellen (Treasury secretary) told the US Senate that the new Covid variant «poses a threat to the U.S. economy», and that inflation will move down «significantly». With this talk, one can be very confident in the continuation of the accomodative policy.
It is now clear that zero rates are here to stay until at least H1 2022 in the US and Europe. As to the asset purchase programs, no central bank will be hurried to reduce them.
Central banks know how fragile markets are. Because they created this fragility. By providing an implicit floor to any correction, for the last 12 years, major central banks have excessively lowered bond yields, encouraged risk-taking in equities, derivatives, bonds, cryptocurrencies, and in unlisted assets. That makes central banks responsible for constantly hedging the instability in markets.
Central banks are aware of how passive investing and algorithmic trading are producers of concurrent crowded sell signals.
They see how the amount of open interest in all sorts of derivatives creates uncoverable total exposure.
They observe the increasing pension fund exposure to less liquid, lower credit quality assets, such as triple B bonds, as shown in a recent ECB report. Or to unlisted private assets, the only option left to compensate for the very low bond yields.
They understand that combined bank desk positions in activities like securities lending (like total return swaps) can bear an unmonitored systemic risk, even with one single client (illustrated by the Archegos fund case, that involved several banks and cost Credit Suisse 5 bn. in losses).
They know how short-term lending on Repo markets poses the risk of cascading margin calls. In this respect, we have also seen, in September 2019, how vulnerable the Repo market was to any serious quantitative tightening, and how the Fed had to inject 412 bn. $ in the markets, even before the Covid crisis broke. Since then, we are stuck in a high liquidity regime, or in a crisis mode, that many believe markets cannot live without.
The threat, then, comes from a positive macroeconomic situation, such as growth and inflation, which would warrant a normalization and a return to tighter conditions. The opportunity, on the other hand, lies in staying in the high liquidity crisis mode that spares markets from any forseeable tightening.
But everyone agrees that this is unsustainable. What if inflation pressures remain high, calling for a monetary tightening, even while Covid variants and the economy spur pessimism and a bearish tone in the markets? Indeed, there is no guarantee that bad news on the pandemic front should come with lower inflation. High inflation and a negative growth outlook could ally against markets. The high yield market seems to know the outcome, if we listen to its forecast: yields are persistently lower than they should be, clearly below fair value. What they tell us is that no tightening will happen.