Just as the outlook was starting to improve and everyone was looking forward to the festive season, news of a new COVID variant sent risk assets tumbling last week. European indices closed Friday’s session down ~3.5%, front month Brent plunged almost 11% (see chart below) and the yield on 10-year treasuries fell 12bps. FX markets weren’t immune to the news with commodity linked currencies feeling the most pain but while sterling was a touch softer, generally speaking, the major pairs remained relatively sedate.
Chart 1 – Front month Brent
At this stage, the biggest problem with the new variant is uncertainty. What we do know, is Omicron has a much higher number of mutations than previous variants which increases the prospect of it being more transmissible than other variations of the virus. It has become the dominant strain in South Africa and is responsible for more than 75% of new cases. A growing number of cases have been identified in the UK and across Europe, as well as in Canada, Australia and Hong Kong. Unsurprisingly, many countries are reintroducing travel restrictions.
On a positive note, this new strain appears to be far less deadly than previous variations. Many patients in South Africa have reportedly recovered quickly from relatively mild symptoms. Professor Karl Lauterbach, who is running to become Germany’s next health minister has even said that a mild strain could be an early Christmas present (implying that it will help build heard immunity). Critics argue that the average age of the South African population (27) is much younger than the UK (40) and Europe (42) and therefore, the risks are higher and the impact potentially greater for us. Either way, the one point the scientists seem to agree on is that more data is needed and we’ll only be able to gauge the impact of Omicron in two weeks’ time. The problem for the markets though is
this creates uncertainty. Already today, we’ve seen risk assets come under heavy pressure following the publication of an interview with the Moderna CEO in the FT stating “There is no world, I think, where [the effectiveness] is the same level… we had with Delta…… I think it’s going to be a material drop (efficacy). I just don’t know how much because we need to wait for the data. But all the scientists I’ve talked to . . . are like ‘this is not going to be good’.”
The chart below of the VIX Index (a.k.a. the Fear Index) shows two notable spikes in option volatility, one on Friday and a second this morning.
Chart 2 – VIX Index
5 take aways from the Omicron news:
- Interest rate hikes are unlikely in the short term – this time last week, the market was pricing a 90% chance of an interest rate hike from the BoE when they meet on 16th December. This probability has since fallen to 52%. Likewise, the market was expecting the first Fed hike in by July 2022, but this has since been pushed back until September.
- As interest rate differentials narrow, the cost of hedging for euro funds hedging sterling and dollar assets has fallen. A 1 year forward selling GBP, buying EUR is currently 8 basis points cheaper than it was a week ago, while a USD hedge for a EUR fund is 6 bps lower.
- Despite extreme volatility in both rates and commodities, FX volatility remains surprisingly subdued. This is a point we’ve made previously, but once again, we see a significant risk of increased FX volatility in the months ahead (FX playing catch up with rates as opposed to rates vol falling back lower in line with the FX markets).
- The dollar continues to perform well in a low yield environment – Despite expectations of a rate hike from the Fed being pushed back, the dollar has continued to stand its ground. This is in contrast to sterling which has come under pressure as yields have fallen. However, the standout performer in the FX markets in recent sessions has been the euro where rates were always expected to remain low for an extended period. With expectations of rate hikes elsewhere diminishing, the euro is back closer to a level playing field.
- The events of last week offer a stark reminder that there are still many unknown unknowns – Just when it felt markets were becoming slightly more predictable (good data = increased probability of a rate hike = stronger currency) markets get turned upside down again. The black swan events seem to be becoming increasingly frequent.