The Big Idea

Surveying the market response to Omicron

| December 3, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The ultimate impact from Omicron on the economy and the Fed suddenly has jumped to the top of the market agenda, and the market does not have the luxury of waiting for definitive answers. It has started to reprice. Rates, volatility and spreads all have moved. And while some definitive answers about Omicron may come out in the next few weeks, the parts of the market that have moved the most so far are also the parts likely to either keep going or snap back.

To gauge market response to Omicron, it helps to put it in the context of the Delta wave. It is a noisy comparison since other important things have been in motion, too—unemployment, inflation and the Fed, just to name a few. To frame timing, awareness and interest in the Delta variant measured by Google searches surged in early June, peaked in early August and fell through the fall (Exhibit 1). Google searches for Delta have roughly paralleled case counts. Awareness of Omicron only started November 21 but has quickly surged.

Exhibit 1: Just as the Delta wave ebbed, Omicron arrived

Source: Google Trends 12/3/2021, Amherst Pierpont Securities

The yield curve has generally responded to Omicron with bullish flattening. Rates since November 21 on 2-year notes are net unchanged with 5-year rates down 19 bp and 10- and 30-year rates down 28 bp (Exhibit 2). Fed Chair Powell’s indications on November 30 that the Fed might accelerate taper and his hawkish comment that the Fed no longer considered inflation transitory has almost certainly kept 2-year rates stable. But longer rates, less under the immediate influence of Fed policy, have headed lower. Notably, 30-year rates before Omicron arrived stood slightly higher than their mark at the peak of the Delta wave but have since dropped even lower.

Exhibit 2: Shorter rates heavily weight the Fed, longer rates weight Omicron

Note: Vertical lines mark Jun 1 and Nov 22, 2021.
Source: Bloomberg, Amherst Pierpont Securities

Part of the drop in intermediate rates reflects lower inflation expectations in the near term. Breakeven inflation implied by TIPS has dropped sharply in 2-, 5- and 10-year rates with implied 5-year inflation 5-years forward basically unchanged at just above 2.20% (Exhibit 3). It is hard to attribute the drop in inflation expectations exclusively to Omicron. If Omicron in the worst case spreads easily, causes severe illness and eludes existing vaccines, then limits on economic activity while a new vaccine is being developed could be deflationary, much as Covid was in March and April 2020. But if Omicron contributes to labor shortages and supply bottlenecks, it could sharpen inflation pressures. The drop in inflation expectations suggests the market puts more weight on some disruption in the economy. However, Powell’s indication that the Fed will be aggressive against inflation also likely explains some of the drop in breakevens.

Exhibit 3: Intermediate implied inflation has dropped with 5Y5Y steady

Note: Vertical lines mark Jun 1 and Nov 22, 2021.
Source: Bloomberg, Amherst Pierpont Securities

Part of the drop in longer rates also reflects lower real rates, implying lower growth. Real 10- and 30-year rates have dropped since November 21 (Exhibit 4). Notably, real 30-year rates are now below their level at the peak of the Delta wave. On the other hand, 5-year real rates have gone up since the start of Omicron, which is hard to interpret.

Exhibit 4: Omicron has helped lift 5-year real rates, lower longer real rates

Note: Vertical lines mark Jun 1 and Nov 22, 2021.
Source: Bloomberg, Amherst Pierpont Securities

Finally, volatility in both rates and equity has jumped since the appearance of Omicron. The MOVE index on implied 1-month rate volatility moved up sharply but has given back almost all of its gain since Powell’s remarks. The market apparently has read the Fed chair to say Omicron will not affect immediate plans for taper or fed funds. But options on rates with a longer expiry are up sharply since November 21 and have continued to climb. The VIX index of implied equity volatility has jumped and remains elevated. The known unknowns around Omicron—disease spread, severity and vaccine efficacy—and their interaction with Fed policy have just widened the range of possible rate and earnings outcomes even further.

Exhibit 5: Omicron has increased uncertainty about rates and equities

Note: Vertical lines mark Jun 1 and Nov 22, 2021.
Source: Bloomberg, Amherst Pierpont Securities

The flatter yield curve and higher volatility have both helped push credit and MBS spreads wider. Both investment grade cash spreads and par 30-year MBS spreads have widened sharply since Omicron showed up (Exhibit 6). The flatter curve implies a higher probability of weaker future economic conditions and lower long rates, the former cause for wider credit spreads and the later cause for more prepayment risk and wider MBS spreads. Higher equity and rate volatility add to these tails of credit and prepayment risk.

Exhibit 6: Omicron has coincided with wider spreads, too

Note: Vertical lines mark Jun 1 and Nov 22, 2021.
Source: Bloomberg, Amherst Pierpont Securities

At one extreme, Omicron could turn out to show significant spread and severity and elude current vaccines. At the other, it lacks spread, severity or both, or it is handled well by current vaccines. The market is pricing somewhere in between right now. The options markets are right to anticipate volatility. The market is unlikely to stay at current levels as more information about the new variant comes out.

The other lesson from Omicron is that this may be just the first in a series of variants that continue to emerge from the pandemic. The virus continues to evolve. The frequency of new variants and the challenges posed by each one will depend on vaccination rates and other factors that epidemiologists regularly cite. The market is likely to get very good at pricing a long tail of risk from the pandemic. We are likely early in the process.

* * *

The view in rates

The Fed’s RRP facility is closing Friday with balances at $1.475 trillion. The facility posted its high mark on September 30 at $1.6 trillion, and with taper starting, the facility has likely seen its peak.

Settings on 3-month LIBOR have closed Friday at 18.013 bp, its highest level since late April. With a more aggressive taper, deceleration of liquidity and anticipated Fed hikes, yields even at the shortest end of the curve should start to rise.

The 10-year note has finished the most recent session at 1.34%, sharply lower since before Thanksgiving. The 10-year real rate finished the week at negative 111 bp, down from before Thanksgiving. The market continues to price for significant excess liquidity in the future and an economy too slow to generate the borrowing needed to fully absorb it all.

The Treasury yield curve has finished its most recent session with 2s10s at 75 bp and 5s30s at 54 bp, both sharply flatter since before Thanksgiving

The view in spreads

All spreads are likely to suffer in the volatility around Omicron and remain soft as volatility likely stays elevated or rises next year. The strands of pandemic, inflation, growth, labor and Fed policy create an unusually wide range of possible outcomes next year and beyond.

Of the major spread markets, corporate and structured credit is likely to outperform. Corporates benefit from strong corporate fundamentals and buyers not tied to Fed policy. The biggest buyers of credit include money managers, international investors and insurers while the only net buyers of MBS during pandemic have been the Fed and banks. Credit buyers continue to have investment demand. Demand from Fed and banks should soften as taper begins, Once the Fed shows it hand on the timing and pace of taper, the market should be able to fully price the softening in Fed and bank demand and spreads should stabilize. But something else is on the horizon.

MBS stands to face a fundamental challenge in the next few months as the market starts to price the impact of higher Fannie Mae and Freddie Mac loan limits. Home prices are tracking toward a nearly 20% year-over-year gain, which should get reflected in new agency loan limits traditionally announced in late November for loan delivered starting January 1. The jump in loans balances should add significant negative convexity to the TBA market and increase net supply. And this will come just as the Fed leans into tapering, which will take out a buyer that often absorbed the most negatively convex pools from TBA and a large share of net supply. The quality of TBA should deteriorate and the supply swell.

The view in credit

Credit fundamentals continue to look strong. Initial earnings reports from the third quarter are still strong. Corporations have record earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. The consumer balance sheet now shows some of the lowest debt service on record as a percentage of disposal income. That reflects both low rates and government support during pandemic. Rising home prices and rising stock prices have both added to consumer net worth, also now at a record although not equally distributed across households. Consumers are also liquid, with near record amounts of cash in the bank. Strong credit fundamentals may explain some of the relatively stable spreads.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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