Fixed income perspective – from the Investment Advisory Group

Fixed Income Perspectives

December 1, 2021

The omicron domino effect: Virus → supply chain → inflation → Fed

Executive Summary

The market’s current “domino effect” hypothesis—set off by the announcement of a new COVID-19 variant—makes a great deal of pessimistic assumptions about the next 6-12 months. That has pulled the yield curve to its flattest trajectory since January. While not minimizing its potential impacts, we recommend avoiding any knee-jerk reaction to the discovery of a new variant.

We remain optimistic about the economy’s resilience and adaptability galvanized over the past 21 months. Also, we expect supply pressures will continue to improve, helping producers and suppliers more readily meet strong demand. With respect to the Federal Reserve’s (Fed's) response, we believe the Fed will continue to take a slow, measured approach to tightening policy, avoiding an overly aggressive policy response. 

Therefore, we believe the recent yield move is overly pessimistic and expect the recent drop in 7-30 year yields and rise in short-dated yields to reverse course. However, the uncertainties around the new variant, the durability of inflation, and the Fed’s reaction function will preserve elevated interest rate volatility. We recommend maintaining a below benchmark duration for fixed income portfolios.

What happened

Global markets were caught off-guard by the news of the omicron variant last week, renewing fears over further disruptions to the global recovery. On Tuesday (Nov. 29), the U.S. Treasury yield curve flattened sharply, following comments by Fed Chair Jerome Powell during Congressional testimony. His statements were interpreted by markets as a hawkish pivot, adding a layer of policy uncertainty and higher rate volatility.

Accordingly, short-dated yields spiked as those between 7- and 30-year maturities declined. The bifurcated reaction is the result of a “domino effect” narrative being formed by market participants. More specifically, that:

  • The COVID-19 omicron variant injects a new threat to global growth, and...
  • May increase the risk of prolonging supply chain disruptions, which...
  • Could keep inflation higher for even longer than already anticipated, thereby...
  • Forcing a hawkish response from the Fed that hobbles the recovery.

Our take

The number of assumptions underlying the “domino effect” narrative is significant, relying upon a series of major “if-then” statements, each with their own set of potential outcomes. The fixed income market’s evaluation of the possible effect of the new variant raises the risk of more near-term curve flattening and elevated rate volatility. However, given the number of uncertainties surrounding the virus and its impact upon the economy and inflation—let alone the Fed’s response—we recommend maintaining a data-dependent and patient view.

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