Omicron vs. payrolls: what will dominate sentiment?

Risk sentiment has been inconsistent in recent days as fears about Omicron have ebbed and flowed and the Fed shifted to a hawkish slant after chairman Jerome Powell’s testimony to the US Congress earlier this week. As we progress towards the end of the week, sentiment has picked up with oil and global stock indices rising, while safe havens have retraced some of their recent gains. On balance, the news-flow about Omicron has marginally improved;  the World Health Organisation said on Wednesday that most cases are mild forms of the disease, and it clarified that as yet there is no evidence to suggest that vaccines may be less effective against it. Thus, as the vacuum of information about Omicron is starting to get filled, and as the early signs do not appear to be as bad as first thought, we could see risk sentiment continue to improve as we move into the latter part of the week. 

Why risk assets should not be afraid of the Fed’s pivot, yet

The start of December tends to see risky assets perform well, as it is historically the start of the ‘Santa Rally’ for financial markets. However, this year there is an added concern to factor in: inflation and central bank tightening. 2-year Treasury yields have jumped 16 basis points since last Friday as Powell’s surprisingly hawkish comments especially around inflation and the need for the Fed to drop the word “transitory” from their communications around price pressures, have once again boosted expectations of a hawkish policy path for the FOMC. The path is being laid for rate rises next summer, after the Fed chair said that the FOMC would consider speeding up their tapering process in future meetings. Chairman Powell said that Omicron is a risk, although it is not currently baked into the Fed’s forecasts for growth, inflation and interest rate expectations. Thus, reading between the lines, the Fed chair believes that as long as the news about Omicron does not dramatically deteriorate, then it will not deter the Fed from embarking on a more hawkish policy path in the coming weeks and months. It also suggests that the FOMC is becoming more concerned about sustained inflation and the impact that this could have on the US economy and future full employment. While the initial reaction to the Fed chair’s comments was negative for risky assets, we think that his confidence in the strength of the US economy to withstand rate rises is actually positive for risk, along with his fairly sanguine view about the current threat from Omicron, and this is why risk sentiment has bounced back. 

What to expect from the November payrolls report 

Since labour market data is a lagging indicator, it could be argued that Friday’s US labour market data is irrelevant, as the impact from inflation on employment won’t be felt for some months. While we think that there is some validity to this view, we think it is worth watching Friday’s payrolls report for November, due to the variability of recent payrolls figures and the impact that this could have on future Fed policy. October’s payrolls report surprised on the upside and came in at 531k, we believe that a larger number than this, potentially one bigger than 600k would add weight to the argument that the tapering of Fed bond buying needs to speed up. Currently the Fed is reducing its $120bn per month bond-buying programme by $10bn in Treasuries and $5bn in Mortgage-Backed -Securities per month.  With the Fed’s preferred measure of inflation running at a 5% annual rate, along with a hot housing market, signs of strong employment growth could be the missing part of the puzzle to get the Fed to change gears on tapering when it meets next month. 

Wage growth and what it means for the timing of interest rate increases

The headline payrolls number is important, along with the unemployment rate, however, the data to watch for November in our view is wage growth. Anecdotally, retailers and other big US employers are reporting that they have had to increases wages to attract staff for the Christmas season. Thus, if wage growth rises above 5%, the focus could shift to when the Fed will raise interest rates and if they will bring this forward from summer 2022. Below we take a look at the potential market outcomes as we lead up to the payrolls report: 

Treasuries: These have been sold (yields higher) as the market has digested the Fed’s faster taper plans. If we get a strong payrolls report then we expect Treasury yields to move higher and for the US yield curve to flatten – i.e., shorter-dated Treasuries will rise at a faster pace than longer-dated Treasuries, as investors price in the chance of near-term interest rate increases. 

FX: The dollar steadied after a sharp rise on the back of Chairman Powell’s comments to Congress earlier this week. Sterling rose on the back of risk appetite improving in the middle of the week, and as long as stocks rise, and Omicron fears remain on the margin then we may see GBP/USD try to claw back recent losses. EUR/USD volatility remains high, as omicron fears are seen to be euro positive because it may slow the pace of Fed tightening and weigh on the dollar. EUR/USD rose from $1.1210 to $1.1380 as omicron fears gripped financial markets, however, the single currency has since fallen back to $1.1320 on Wednesday. There could be further weakness back towards the $1.1220-50 level if we see a strong US labour market report at the end of this week and no flare up of Omicron concerns. A stronger dollar is also negative for the EM FX space, with the TRY the obvious target for further declines, especially after President Erdogan once again called for lower interest rates, even though the Turkish central bank had hinted that the end of their rate-cutting cycle was in sight. 

Indices: We learned this week that when Covid fears are running high the Nasdaq tends to outperform the S&P 500 and the Dow. Essentially, growth stocks outperform value. This is something to consider in the long term, however, in an environment where the Fed is tightening policy because it thinks the US economy is strong, then we think value stocks could have a last hurrah. Due to this, we would not write off the S&P 500, the Dow Jones Industrial Index and the Russell 2000 in the coming weeks. The latter index rose more than 1% on Wednesday as smaller companies linked to the economic performance of the US recovered after recent sell offs. 

Sectors: Energy and financials were the big winners on Wednesday. Going forward, we continue to think that financials will do well in an environment where the economic data supports the hawkish tilt towards the Fed, especially in the US and the UK. Energy stocks are harder to predict in the longer term, however, if the oil price continues to rise in the aftermath of the Opec meeting then we think that the energy sector will do well. Due to the large weighting of energy and financial firms in the FTSE 100, and the prospect of a rate rise from the Bank of England next month, the UK index could be a top performer as we lead up to the end of the year.