United States

The Omicron variant is a “known unknown” we fretted about even while the economic reopening was unfolding: Being prepared for multiple viral mutations is part of learning how to live with Covid.  The market did not take the news of a new variant in a stride. At this point, little is known about the strain, its virulence, immuno-evasion, and pathogenicity.  Uncertainty begets volatility: The VIX shot up more than 50% last Friday on the back of the virus scare. Investors have swiftly rotated from the "Reopening" basket back to the “Covid winners,” i.e., Growth and Technology stocks. Treasuries spiked as investors rushed to safety. However, market turbulence per se is of little concern for long-term investors. To gain clarity on Omicron’s effect on the markets, we will be watching the rate of hospitalizations in South Africa and the median age and vaccination status of people with severe infections. On a policy front, we will watch the response of the “zero-tolerance countries,” such as China, Israel, and Australia, and how widespread border closures and lockdowns are. And then, to add insult to injury, the Fed announced its plans for an accelerated pace of tapering. This news has clashed with investors’ fears of the variant and new lockdowns, and a hope for a compassionate and patient Fed. Equities have pulled back, indicating that the aggressive Fed response to inflation is not priced-in and that investors fear that tightening will choke off economic growth. Despite recent developments, our base case is still intact – growth returning to trend, supply chains normalizing, and inflation shifting lower. Omicron and a more aggressive Fed are unlikely to derail the economic recovery for the following reasons. First, global lockdowns are no longer palatable to the general public. Second, even if vaccine effectiveness is compromised, unlike in 2020, there are several drugs available, which significantly improve outcomes of even the most severe cases, regardless of the variant. Third, if virulency and severity are inversely correlated, we are hoping for a mild variant. Last, the Fed still has the flexibility to alter its response if Omicron presents a severe public health threat. Bottom Line: Covid introduced permanent uncertainty in the markets and has become “a known unknown.” For downside protection, we recommend a barbell approach to portfolio construction outlined in the September 13 "Barbell Portfolio: Safety First" Strategy Report. 

Highlights Fed: Until more is learned about the omicron variant, our base case view remains that the Fed will lift rates later than what is currently priced in the market. We think a September or December 2022 liftoff date is reasonable. Treasuries: Our main Treasury curve investment recommendations: below-benchmark portfolio duration and 2/10 curve steepeners, are not that sensitive to the timing of Fed liftoff. Both positions should be profitable whether the first rate hike occurs in June 2022 or December 2022. Corporates: Investors should remain overweight spread product versus Treasuries in US bond portfolios, maintaining a preference for high-yield corporates over investment grade. The recent bout of spread widening caused by expectations of more restrictive monetary policy and news about the omicron variant will reverse in the coming months. MBS: Agency MBS are unattractive relative to other US spread products, and current MBS valuations may understate the future pace of mortgage refi activity. Remain underweight Agency MBS within US bond portfolios. Feature Chart 1Curve Flattening Is Overdone Up until Friday, the bear-flattening of the Treasury curve was a well-established trend, one that even accelerated early last week before revelations about the new omicron COVID variant sent yields sharply lower (Chart 1). Large swings in expectations about the timing of Fed liftoff have been responsible for the recent volatility in Treasury yields. Back in September, the market was priced for no rate hikes at all until 2023. Just two months later we find the fed fund futures market pricing Fed liftoff in July 2022 with 75% odds of three rate hikes before the end of next year (Chart 2A). At one point early last week the market was priced for Fed liftoff in June 2022, with 32% chance of liftoff in March 2022 (Chart 2B). Chart 2ALiftoff Expectations: H2 2022 Chart 2BLiftoff Expectations: H1 2022   Pre-Omicron Market Moves June and March liftoff dates came into play early last week because of mounting evidence that the Fed is considering accelerating the pace of its asset purchase tapering. As it stands now, the current pace of tapering gets net asset purchases to zero by June of next year. Given the Fed’s stated preference for lifting rates only after tapering is finished, the current pace means that Fed liftoff is only possible in H2 2022 or later. However, if the pace of tapering is increased it would make earlier liftoff dates possible. It was speculation about an announcement of accelerated tapering at the December FOMC meeting that caused the market to bring June and March 2022 liftoff dates into play last week. Speculation about an accelerated taper really got going after an interview by San Francisco Fed President Mary Daly. Daly is widely regarded as one of the most dovish members of the FOMC, and indeed in last week’s report we highlighted her November 16th speech that called for patience in the face of high inflation.1 But last week, Daly said in an interview that “if things continue to do what they’ve been doing, then I would completely support an accelerated pace of tapering.”2 With one of the most dovish FOMC members seemingly on board, we see a good chance that the committee will announce an accelerated taper at the next meeting. As of today, we’d put the odds of an accelerated taper announcement in December at 50%, with still one more CPI report and one more employment report that will tip the scales in one direction or the other before the Fed meets. An accelerated taper doesn’t necessarily mean that the Fed will move toward earlier rate hikes, it simply gives the committee the option to hike sooner if inflation remains stubbornly high. In fact, we’ve been expecting a later liftoff date (December 2022) on the view that inflationary pressures will wane between now and the middle of next year. We continue to think that a September 2022 or December 2022 liftoff date is the most likely outcome, as we expect that falling inflation during the next six months will allow the Fed to focus more on the employment side of its mandate. However, if inflation doesn’t fall as we expect, then the Fed may move more quickly. The Impact Of The Omicron Variant Chart 3Households Have Ample Savings Friday’s revelation that a new COVID variant (the omicron variant) has been identified sent yields lower and caused the market to push out its liftoff expectations. As of today, available evidence suggests that the omicron variant will out-compete the delta variant and quickly become the world’s dominant COVID strain. There is some evidence to suggest that current vaccines will offer less protection against omicron. However, it is still unknown whether the omicron variant causes more (or less) severe illness than prior strains. Even in a severe scenario where the new strain leads to the re-imposition of lockdown measures, we are puzzled by Friday’s bond market moves. The market seems to be saying that a prolonged pandemic will be deflationary and lead to a later Fed liftoff date. We aren’t so sure that’s the case. US households continue to enjoy a large buffer of accumulated savings compared to the pre-COVID trend (Chart 3) and they have ample room to increase consumer debt (Chart 3, bottom panel). This suggests that aggregate demand will stay well supported next year, even in the face of greater pandemic concerns. The re-imposition of lockdown measures, however, will hamper the supply side of the economy and prolong the economy’s issues with supply chain bottlenecks and labor shortages. It will also prevent consumers from shifting demand away from over-heating goods sectors and towards services. All of this will only keep inflation higher for longer, a development that could actually encourage the Fed to act more quickly. Bottom Line: Until more is learned about the omicron variant, our base case view remains that the Fed will lift rates later than what is currently priced in the market. We think a September or December 2022 liftoff date is reasonable. However, if inflation refuses to fall during the next 3-6 months there is a risk that the Fed will be tempted to move earlier. The Treasury Market Implications Of Earlier Liftoff Tables 1A – 1C show expected 12-month returns for different Treasury maturities. Each table assumes that the market moves to fully price-in a specific expected path for the fed funds rate during the 12-month investment horizon. The scenario presented in Table 1A assumes that the Fed starts to lift rates in June 2022. It then proceeds with rate increases at a pace of 100 bps per year before the fed funds rate levels-off at 2.08%, 8 bps above the lower-end of a 2.0% - 2.25% target range.3 The scenarios presented in Tables 1B and 1C use the same rate hike pace and terminal rate as in Table 1A. However, we vary the expected liftoff dates. Table 1B assumes that liftoff occurs at the September 2022 FOMC meeting and Table 1C assumes that liftoff occurs at the December 2022 FOMC meeting. The first big conclusion we draw is that expected Treasury returns are negative for most maturities in all three scenarios. This justifies sticking with below-benchmark portfolio duration. Second, expected returns are better at the short-end of the curve (2yr) than at the long-end (10yr) in all three scenarios. This justifies sticking with our recommended 2/10 yield curve steepener. Specifically, we advise clients to buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Finally, the 20-year bond continues to offer greater expected returns than the 10-year and 30-year maturities. We view this as an attractive carry trade opportunity and advise clients to buy the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. Bottom Line: Our main Treasury curve investment recommendations: below-benchmark portfolio duration and 2/10 curve steepeners, are not that sensitive to the timing of Fed liftoff. Both positions should be profitable whether the first rate hike occurs in June 2022 or December 2022. Corporate Spreads: Just A Tremor, Not The Big One Chart 4IG Spreads Troughed In September Corporate bond spreads had already been widening before Friday’s news sent them even higher (Chart 4). Prior to Friday, the most likely reason for spread widening was a concern about a quicker pace of Fed tightening. As we highlighted in last week’s report, corporate balance sheet health is sublime and all signs point to default risk remaining low for some time.4 In fact, up until Friday, investment grade corporates were performing worse than high-yield as spreads widened. This suggests that the widening had more to do with perceptions of monetary accommodation than with perceptions of default risk. Then, on Friday, spreads widened sharply and high-yield underperformed investment grade. This is consistent with the market pricing-in an increase in expected default risk due to the emergence of the omicron variant. Our view is that the recent bout of spread widening will reverse in the near-term. Spreads will tighten back down to their recent lows giving investors an opportunity to reduce exposure sometime next year. We posit three possible scenarios: In the first scenario, the omicron COVID variant turns out to be less economically impactful than the recent delta strain. In this case, the recent spike in default expectations will reverse and inflation will moderate during the next six months as pandemic fears recede. In this scenario, the Fed will be able to wait until September or December 2022 – when its “maximum employment” target will be met – before lifting rates. Spreads will tighten on expectations of more accommodative monetary policy. Chart 5Pace Of Curve Flattening Will Moderate In the second scenario, the omicron COVID variant turns out to be inflationary. US consumer demand is not curbed significantly, but supply chains remain under pressure and labor shortages persist. This will encourage the Fed to move more quickly, possibly lifting rates as early as June. However, even this scenario would only see the 3-year/10-year Treasury slope dip below 50 bps in March of next year (Chart 5). Our prior research has shown that excess corporate bond returns tend to be strong when the 3-year/10-year Treasury slope is above 50 bps, as this suggests a highly accommodative monetary environment.5 We would likely see another period of spread tightening between now and March, even in this worst-case scenario for corporate spreads. The final possible scenario is one where the omicron COVID variant turns out to be deflationary. Growth and inflation both slow and the Fed significantly delays tightening, possibly into 2023. Given the robust health of corporate balance sheets, this scenario would be excellent for corporate bond returns. The deflationary shock would have to be very severe, much worse than the delta wave, to push the default rate meaningfully higher. Further, a shift toward more accommodative Fed policy would lengthen the runway for strong corporate bond returns. That is, it would be some time before the 3-year/10-year slope dips below 50 bps. Bottom Line: Investors should remain overweight spread product versus Treasuries in US bond portfolios, maintaining a preference for high-yield corporates over investment grade. The recent bout of spread widening caused by expectations of more restrictive monetary policy and news about the omicron variant will reverse in the coming months. Investors will be able to reduce cyclical corporate bond exposure at more attractive levels sometime next year. Stay Negative On Agency MBS We have been recommending an underweight allocation to Agency MBS in US bond portfolios for quite some time, and that is not likely to change anytime soon. Since the March 23rd 2020 peak in credit spreads, conventional 30-year Agency MBS have outperformed a duration-matched position in Treasuries by 0.59% while Aaa and Aa-rated corporate bonds have outperformed by 16% and 15%, respectively (Chart 6). MBS performance has been particularly poor since the spring. A big reason why is that MBS spreads did not adequately compensate investors for the magnitude of mortgage refinancings. Chart 7 shows that the compensation for prepayment risk embedded in MBS spreads (the option cost) plunged in mid-2020 as interest rates were cut to zero and mortgage refis spiked. In fact, the option cost embedded in MBS spreads was the lowest it had been in several years (Chart 7, panel 2), signaling that the market was priced for a big drop in refi activity. However, that big drop in refi activity never materialized. The MBA Refinance Index has remained elevated in 2021 (Chart 7, bottom panel), despite the back-up in bond yields. Chart 6MBS Returns Have Lagged Corporates Chart 7Option Cost Must Rise An increase in cash-out refinancings is a big reason for the stickiness in refi activity this year. Home prices have been on a tear and households have an increasing incentive to tap the equity in their homes (Chart 8). Freddie Mac recently noted an increase in both the share of refinancings that are for “cash-out” and the aggregate dollars of equity that borrowers are extracting from their homes.6 They also noted, however, that the amount of equity extraction as a percent of property values has trended down. This suggests that this trend toward cash-out refinancings is not yet exhausted. In fact, we expect refi activity will remain elevated during the next 6-12 months, even as bond yields move modestly higher. Chart 8Households Can Tap Their Home Equity Against this back-drop, our sense is that the compensation for prepayment risk embedded in MBS spreads remains too low. But, even if we assume that the MBS option cost is exactly right, it still wouldn’t make Agency MBS look attractive compared to alternative investments. The option-adjusted spread (OAS) offered by conventional 30-year Agency MBS is below the OAS offered by Aaa and Aa-rated corporate bonds (Chart 9). It is only slightly above the OAS offered by Agency CMBS and Aaa-rated consumer ABS. Chart 9OAS Differentials Bottom Line: Agency MBS are unattractive relative to other US spread products, and current MBS valuations may understate the future pace of mortgage refi activity. Remain underweight Agency MBS within US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 2 https://news.yahoo.com/san-francisco-fed-mary-daly-certainly-see-a-case-for-speeding-up-taper-142328227.html 3 The effective fed funds rate currently trades 8 bps above the lower-end of its target range, and we assume that this will continue to be the case. 4 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 5 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 6 http://www.freddiemac.com/research/insight/20211029_refinance_trends.page Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Investors and consumers expect that inflation will remain quite high over the next year, but they are unconcerned that upward price pressures will last: According to surveys and market prices, inflation will exceed 4% next year before subsiding over the longer term to the comfortable levels of the last two decades. The Fed also views elevated inflation as a near-term phenomenon and accordingly expects to hike the fed funds rate at a deliberate pace: The Fed is on the same page as the hoi polloi, and is not gearing up to remove accommodation with any particular haste. While the decade following the financial crisis demonstrated that extremely easy monetary policy does not by itself promote high inflation, the landscape has changed: A decade of ZIRP and QE failed to produce any dire effects, but it remains to be seen how extreme monetary and fiscal accommodation will interact. We expect the bull market will end once the Fed falls behind the curve on inflation and is forced to tighten monetary policy aggressively to catch up: We think the bull has another year to run, but excessive stimulation will eventually bring about its demise. Feature For most of the year, every discussion with our investor-clients has eventually worked its way around to inflation. How high is it going to go? How long will it last? What will it mean for the economy? What will it mean for stocks? How will the Fed react? As the year-over-year change in the Consumer Price Index has climbed steadily higher, breaking above 6% last month for the first time in 31 years (Chart 1), the tenor of the conversations has shifted. Investors have come to recognize that the economy is subject to upward price pressures that are more than the temporary by-product of pandemic base effects. Inflation is nonetheless still largely viewed as a temporary phenomenon that will fade once reopening supply bottlenecks can be resolved. While markets are resigned to another year of high inflation, they are secure in the notion that the disinflationary currents of the last several decades will squelch them over the longer term. Chart 1Long Time, No See The tension between the competing ideas that both inflationary and disinflationary currents are real sets up a potential market showdown. If it is only a matter of time before disinflationary forces return to smother today’s post-COVID disruptions, the widely shared consensus view that the fed funds rate will meander its way to a peak of 2% will be validated. The equity bull market will continue, albeit at a slower pace, until it dies of natural causes. Markets could be in for a rude awakening, however, if the forces supporting higher prices outlast the pandemic and overcome the long-running disinflationary trend. This report considers how inflation could ruin the party. Our base-case view is that the Fed will find itself behind the curve. When it does, it will be forced to tighten monetary policy fast and furious, moving more swiftly to a higher terminal fed funds rate than markets currently expect. That will bring down the curtain on the bull market in risk assets and it may also spark the next recession, but we think the good times will last for at least one more year. What Markets Expect: Inflation Despite all the attention higher prices have drawn, investors haven’t gotten too worked up over them. Although they’ve made considerable revisions to their near-term expectations, their expectations for inflation ten years from now haven’t budged since the start of the year. As the Treasury1 (Chart 2) and CPI swaps (Chart 3) markets show, big consumer price increases are expected to be concentrated in the next year, come off the boil in year two and then slowly cool over the next few years. At the back half of the 10-year curve, year-over-year CPI increases are expected to settle into the range that prevailed during the nineties’ and early 2000s’ inflation moderation. Financial markets do not exist in a vacuum, of course, and the expectations of participants in the real economy matter as well. The University of Michigan’s consumer survey indicates that households’ expectations accord with financial markets’ (Chart 4): inflation will be uncomfortably high over the next year but an afterthought five years from now. Whether the phenomenon is called adaptive expectations or recency bias, everyone’s – investors’, consumers’, businesses’, and economists’ (Chart 5) – expectations of the future are colored by the recent past. It is not a stretch to envision consumer prices rising by more than 4% in 2022 after having watched them surge since March, but apparently economic participants will need to see them remain elevated for a longer stretch before they can picture inflation enduring for two or three years, much less five to ten years. Chart 45% Now, But Only 3% Later Chart 5Reliably Anchoring To The Recent Past What Markets Expect: Fed Policy Chart 6Faster, Yes; Farther, No If inflation isn’t expected to persist at an elevated rate for an extended period, there’s no reason to expect that the Fed will aggressively tighten monetary policy. Higher-than-expected inflation readings have led money markets to bring their first rate hike ETA (the liftoff date) forward to next July, and to price in two rate hikes in the second half of next year (Chart 6, top panel). They continue to expect that the Fed will conclude its tightening cycle once the fed funds rate is around 2% (the terminal rate). They also expect that the Fed will take its time getting to that terminal rate, hiking by no more than 75 basis points (“bps”) in a single year (Chart 6, bottom two panels), roughly in line with the 100-bps annual pace of 2017 and 2018. The Fed concurs. As per the latest Summary of Economic Projections (SEP), released after the September FOMC meeting, the 18 board members and regional presidents casting votes expect the FOMC to take its time hiking rates. With exactly half of the voters calling for no rate hikes next year, the median and mean expectations were for one-half and two-thirds of a 25-bps rate hike in 2022, respectively (Chart 7A). By the end of 2023, the median and mean SEP voter expects a cumulative 3.5 and 3.1 25-bps rate hikes, respectively (Chart 7B). By the end of 2024, median and mean expectations are for a cumulative 6.5 and 6.1 25-bps rate hikes, respectively (Chart 7C). ​​​​​​ ​​​​​​​​​​​ Table 1Same Terminal Rate, Different Liftoff Date Conditions have changed since late-September upon the release of September and October inflation data, though Chair Powell didn’t give any ground in his press conference following the November 3rd meeting. Rounding the expectations at each year-end period as of the September 22nd meeting, the median SEP voter expected zero or one rate hike in 2022, three in 2023 and three in 2024, pushing the top end of the fed funds rate range to 2% as of the end of 2024. Market expectations have moved since the last SEP, with the overnight index swap curve going from zero rate hikes in the next twelve months to two, and from two rate hikes in the next 24 months to five, but financial markets and the Fed remain on the same page (Table 1). A Kinder, Gentler Fed Emboldened by the experience of the last expansion, in which worrisome inflation did not materialize despite a zero fed funds rate and 50-year lows in unemployment, the Fed has embarked on a course quite different from the one the late Paul Volcker might have charted. Nagged by persistently low post-crisis inflation, the FOMC has decided that pursuing an average inflation target that makes up for previous shortfalls will best allow it to meet its price stability mandate. Letting undershoot bygones be bygones paved the way for inflation expectations to slide, constraining its ability to stimulate the economy at the zero bound. To re-anchor expectations in its preferred 2.3-2.5% range, and give a zero fed funds rate more zip, the FOMC must convince markets that it will occasionally let inflation run hot. A more aggressive pursuit of its full employment mandate, as outlined in the August 2020 revisions to the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy, should also help nudge expectations upward. Per the revisions commentary on the Fed’s website, “The previous expansion demonstrated that a strong labor market can be sustained without inducing an unwanted increase in inflation. To the contrary, when unemployment fell to levels that were previously thought to be unsustainable, the labor market proved remarkably adaptable, bringing many benefits to families and communities that all too often had been left behind. Accordingly, the new Statement … only … [pledges to address] ‘shortfalls of employment from its maximum level’ rather than the [previous] ‘deviations from its maximum level’[.] This change signals that high employment, in the absence of unwanted increases in inflation or the emergence of other risks that could impede the attainment of the Committee’s goals, will not by itself be a cause for policy concern.”2 The Fly In The Ointment Chart 8Wall Street And Main Street While we acknowledge that the September 22nd SEP may be somewhat out of date as a guide to the board members’ and regional presidents’ fed funds rate expectations, the easier stance outlined in the revised monetary policy strategy statement remains very much in effect. The upshot, from our perspective, is that the FOMC intends to be behind the inflation curve in the coming rate-hiking cycle. If inflation remains contained after lingering pandemic dislocations are resolved, the behind-the-curve takeaway will not be all that impactful for investors. After all, those who positioned for dollar debasement and runaway inflation when the Bernanke Fed introduced QE and ZIRP were clobbered by investors who loaded up on risk assets and blithely rode easy money tailwinds higher. There is a critical difference this time, however, beyond the increasing magnitude of the Fed’s accumulated asset purchases. Pandemic fiscal stimulus has dwarfed the comparatively meager fiscal response to the global financial crisis. And going forward, the Biden administration’s spate of ambitious spending proposals contrasts sharply with the Obama administration’s deficit reduction focus. The post-crisis era has served as a natural experiment on the effects of unprecedented monetary accommodation on economic activity and consumer price inflation. Asset prices surged, buoyed by a negative real fed funds rate and a ballooning Fed balance sheet (Chart 8, top panel), but the rate of growth in consumption (Chart 8, bottom panel) was unchanged. Although household net worth gains lead consumption growth, the vast majority of financial assets are held by households with a low marginal propensity to consume. Asset price inflation doesn’t necessarily lead to consumer price inflation because it doesn’t necessarily have an observable impact on aggregate demand. Fiscal stimulus is different, however. The stimulus packages created to counter the economic effects of COVID-19 put money directly in the hands of households with high marginal propensities to consume. They have been consuming avidly since emerging from their spring 2020 lockdowns (Chart 9) and we expect that they will continue to do so until they’ve run down at least one half of their $2.3 trillion of excess pandemic savings. Rising wages may additionally promote demand, as will the baby boomers’ shift into their peak consumption years, along with the massive investment required to meet green energy goals. Chart 9Consumers Have Momentum (And The Savings And Borrowing Capacity To Sustain It) Demand was sluggish for an entire decade following the GFC, but it appears as if it will be quite robust for a while after the pandemic. We believe that aggregate demand is on a course to exceed aggregate supply after reopening supply chain issues are resolved. At that point, the transitory inflation view will no longer be credible, and the Fed may find itself having to play catch up. When it does, it will have to hike rates more and faster than financial markets expect. Once the Fed has shifted into fast and furious mode, or markets develop a widespread conviction that it will, the bull markets in risk assets will end and the expansion might, too. In the meantime, setting investment strategy will depend on how long it takes for the inflation inflection point to arrive. We do not yet think the inflection point is in sight and therefore continue to recommend that investors with a twelve-month timeframe overweight equities and credit in multi-asset portfolios. We remain on the alert, however, and will shift our view if events move faster than we currently expect. We would rather leave some upside on the table than stay at the party too long.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Off-the-run Treasury maturities do not trade all that well, and TIPS other than 1-, 2-, 5- and 10-year maturities are even less liquid. The TIPS inflation expectations curve (Chart 2) is therefore less reliable than the CPI swaps curve (Chart 3) at individual points, but it confirms the broad direction of investors’ inflation expectations. 2     Question 6, How has the review altered how the Federal Reserve will pursue its maximum employment objective? Accessed November 22, 2021. Emphasis added. Federal Reserve Board - Q&As.