Volatile week for prices. The next one could be worse
The volatility of financial markets increased significantly after the emergence of the omicron variant. Last week it turned out to be good for rates and bad for equities. This week was a different story.
While omicron’s collective opinion remains cautious, several high-level comments rebuffed the defensive backlash seen the week before. Stocks eagerly rebounded to pre-omicron levels and bonds reluctantly followed.
On the contrary, the timid movement of the bond market is encouraging for rates. This speaks to a certain level of demand in the market in light of other headwinds.
Several of these headwinds have already been resolved this week. They included things like the expected treasury auction cycle, high corporate bond issuance, and the release of CPI (Consumer Price Index) inflation data for November.
While the CPI hit the highest levels in more than 30 years, the number was very much in line with economists’ forecasts. Traders expected it to be a bit higher than expected based on the bond market rally that followed. Bonds don’t like inflation, so if yields fall after an inflation report, bond traders were prepared for the news to be worse.
If traders are nervous, it has a lot to do with the Federal Reserve’s expected policy announcement next week. Fed speakers have expressed the likelihood that tapering will need to accelerate.
Tapering refers to the gradual decrease in the amount of bonds the Fed purchases each month. This bond purchase is seen as an important ingredient in the low interest rate equation. In the past, rates rose rapidly upward when the tapering was announced.
This time around, we already knew about tapering. In fact, the process has already started. But the Fed is increasingly concerned about inflation – concerned enough to slow to a faster pace in order to remove the accommodation from the economy. The Fed has also generally made it known that it would like to complete the cut before raising the fed funds rate – a policy change meant to combat inflationary pressures.
Coming “as expected”, this week’s inflation data only adds to the potential volatility next week. Had inflation been much higher than expected, we would have seen rates rebound on Friday in order to prepare for the likelihood of harsher talk from the Fed.
If inflation had been lower than expected, we would have seen the opposite trend.
As it stands, the market is quite divided as to what the Fed will say. They have several options ranging from “doing nothing” to doubling the current rate of reduction. If they choose either of these extremes, the ensuing volatility would also be extreme, at least in the context of recent trading ranges.
In addition to the Fed’s decision on tapering, this will also be one of 4 meetings per year that includes updated economic projections. The most important part of these projections is the prediction of future rate hikes, affectionately known as “the dots” due to its presentation in the dot plot format.
A lot has happened between now and the previous version of the points in September. This means that the market consensus could be further away from the Fed consensus than normal. The larger this spread, the greater the potential volatility. The Fed’s announcement and dot plot will be released Wednesday afternoon at 2 p.m. ET.