Omicron crushes Fed rate expectations: What is next for USD?
15:31, 30 November 2021
What a difference a week can make.
Just days ago, investors were pricing the US Federal Reserve to raise interest rates from record lows as early as May 2022 to keep a lid on inflationary pressures. But now, expectations for a rate increase that soon have collapsed as the new Omicron variant of the coronavirus renews the threat of worldwide economic disruptions.
Furthermore, money markets are currently pricing in just two US rate additions in the whole of 2022, compared with expectations as recently as Thursday for three increases, according to data from the CME FedWatch Tool.
In his first public remarks since the Omicron strain’s discovery, Fed Chair Jerome Powell this week flagged significant downside risks to both employment and economic activity, which markets have interpreted as a signal for an easy-for-longer policy stance. Meanwhile, analysts are assessing the economic risks arising from the new variant, and some of them are already expecting a slowdown in the pace of US monetary policy normalisation.
In November, the DXY Index – which measures the US dollar’s performance against a basket of six major currencies – rallied on increased expectations of Fed monetary tightening in 2022, bolstered by stronger-than-expected inflation prints. But its momentum now looks to be ebbing.
What is your sentiment on DXY?
Chart 1: May 2022’s rate hikes odds have plummeted in less than a week
Chart 2: Markets now price in only two rate hikes rather than three in 2022
Omicron impact on the dollar
According to ING, we could see USD gains capped in the near term, pending positive news on the vaccine front against the Omicron variant, as markets postponed the Fed’s first rate hike to September 2022.
ABN Amro, which earlier campaigned for three Fed rate hikes in 2022, still believes that “the Fed will be constrained by worrisome inflation trends”. The Dutch bank also stated that if the new Omicron variant causes less severe sickness, this may be a beneficial outcome for markets, as a less dangerous strain would eventually supplant the more harmful Delta variant.
According to David Woo, former BofA head of rates strategist, Omicron is not necessarily bad news for the dollar and another strong labour report in the US would help the Fed to step up the pace of tapering in December.
In an interview with Capital.com, Carraighill analyst David Higgins expressed caution about the monetary policy outlook.
“The market had begun to price in rate hikes for 2022, but the new variant has dashed these hopes. From a forward guidance perspective, the Fed does not need to change its message as it has already signalled that it will not raise interest rates until 2023. I expect the Fed to signal its readiness to act if required in light of the new variant. If more constraints on the US economy are imposed, the Fed may need to act, perhaps slowing the taper of its bond buying program”.
Citi’s expectations for the US macroeconomy and monetary policy remain unchanged following the discovery of the Omicron variant. The American bank continues to anticipate a faster rate of asset purchase tapering by the Fed as global central banks enter a new regime in which inflation risk concerns suggest that even somewhat negative economic data will not always be met with more accommodating monetary policy.
Will the Omicron variant keep the USD gain limited?
As seen by the recent sharp decline in US Treasury yields – a crucial barometer for economic growth expectations – the markets’ first appraisal of the economic risks associated with the new Omicron variant was negative.
The yield on the 10-year Treasury has fallen more than 25 basis points since last Wednesday to 1.42%, while the yield on the 2-year note has retracted to 0.46% from 0.65% last week.
The drop in US yields fuelled the dollar weakness, with the DXY Index down 1.2% from last week’s highs.
Chart 3: DXY and 10-year Treasury yields recently showed a positive correlation
In the future, the dollar performance will be closely tied to headlines about the new variant’s health implications and vaccine developments, as well as remarks from Fed members about concerns over growth and the inflation outlook.
While it is uncertain if Omicron causes more severe illness or how soon pharmaceutical firms can create new vaccines, promising news on this front might help investors to regain confidence in the economic recovery. Treasury yields could potentially bounce in this event and the US dollar may regain ground as growth fears subside.
Conversely, if the spread of the new variant poses a threat to growth and the labour market, the major central banks might use the chance to buy time and reconsider their plans for monetary policy normalisation.
This might result in lower Treasury yields for a longer period of time and a decline in the dollar’s interest rate attractiveness relative to other currencies.