Bond traders are turning into
armchair virologists again.
By just about every measure, the $22.3 trillion U.S.
Treasury market has started off 2022 with a huge sell-off. Two-
year yields reached the highest since early 2020 on Monday, and
five-year yields followed suit on Tuesday, jumping to 1.39%
from just 1.26% on Dec. 31. Even the 30-year bond yield soared,
climbing above 2% for the first time since November. In the
first trading day of the New Year, Treasuries lost almost 1% — a
big step toward the first back-to-back annual losses for U.S.
government debt in modern history.
Some of the selling pressure is likely coming from managers
who bought Treasuries in late 2021 simply to look less leveraged
at the end of the year (colloquially referred to as “window
dressing”). The decline in the Japanese yen, also considered a
haven, confirms a broader global move out of safety and into
But a deeper look at the move in Treasuries suggests the
fundamental driver is the omicron variant of Covid-19.
Specifically, it looks as if bond traders are focused on the
combination of record case numbers and studies that indicate the
new mutation is less severe. They’re then using those data
points to price in greater odds of elevated inflation in the
coming years but fewer disruptions to the U.S. labor market,
which should keep the Federal Reserve on track to raise interest
rates as projected.
Nowhere is this more evident than the five-year U.S.
breakeven rate, which lurched back above 3% on Tuesday. It’s now
higher than before Fed Chair Jerome Powell’s “pivot” in late
November, when he made clear that the central bank was prepared
to fight back against inflation that proved less transitory than
anticipated. As market-based inflation measures tumbled in the
following days, some observers speculated that simply talking
about curbing price growth was enough to make it happen.
The highly contagious omicron variant complicated that
thinking. In a potential harbinger, airlines canceled almost
18,000 flights in the U.S. from Dec. 24 through Monday,
according to FlightAware, as virus infections led to staffing
shortages. It’s not yet clear whether this latest surge in cases
will lead to the kinds of supply-chain issues that snarled the
globe a year ago, but given China’s zero-Covid policy, that risk
and the short-term inflation that comes with it can’t be counted
Meanwhile, there’s little evidence to suggest the wave of
cases will dent the U.S. labor market. For one, more than 4.5
million people quit a job in November, a record high, according
to the Labor Department’s Job Openings and Labor Turnover Survey
released on Tuesday. The so-called quits rate in the private
sector surged to an all-time high of 3.4%, implying continuing
competition among companies to raise wages. Analysts surveyed by
Bloomberg expect that employers added 422,000 workers in
December, enough to lower the unemployment rate to 4.1%, just
about the Fed’s own long-run projection.
Put it all together, and there’s little reason to expect
that the omicron variant will knock the Fed off the course for
2022 that it charted just weeks ago. Three interest-rate
increases, starting as soon as March, should remain the central
bank’s preferred path. Short-term rates markets are fully
pricing in three increases, though starting in May.
As I noted during Powell’s Dec. 15 press conference, this
was the crucial line that policy makers will most likely parrot
in the months ahead: “One of the two big threats to getting back
to maximum employment is actually high inflation.” In other
words, to achieve the central bank’s stated goal of full
employment that’s broad based and inclusive, the U.S. economy
needs to have a long sustainable recovery, which requires policy
makers to combat persistently above-target inflation by raising
interest rates. Tim Duy, chief U.S. economist at SGH Macro
Advisors, put it this way: “Hawkishness is the new dovishness.”
To be clear, the Fed’s stance will almost certainly remain
highly accommodative by historical standards. Real yields aren’t
anywhere near turning positive. In the past, the central bank
might be inclined to slam the brakes on the economy to stamp out
the sharpest price growth in four decades. The Powell Fed
absolutely won’t do that. But it does seem to have the tacit
approval of the White House to get a tad more aggressive on
Given how long the Fed has resisted adjusting its emergency
measures, even just tapping on the brakes a few times in 2022 is
enough to jolt nominal Treasury yields. A fed funds rate in the
range of 0.75% to 1% in 12 months might only have a modest
impact on the economy, but it’s a much different level than
owners of Treasuries were contemplating just a few months ago.
It’s little wonder that three-year U.S. yields have doubled in
three months to 1.02%.
No one can know what twists and turns are in store for the
U.S. economy. But in the months ahead, the one clear wild card
is the omicron variant. Bond traders are sending a clear message
that while the surge might make for a frustrating January, it
won’t harm the U.S. economic recovery through 2022. For a
typically pessimistic bunch, they’re pretty optimistic.
Bond traders are turning into