Markets spooked by Powell pivot on inflation and Omicron
VIX above 30 normally signals trouble
Risk-off sentiment dominated markets in November as concerns over the Omicron variant and a pivot towards tighter monetary policy from the US Federal Reserve shook markets. The equity market’s VIX “fear index” rose from 16.4 to above 30 in a matter of days to set at its highest level since January, and in the FX markets funds flowed into the safe haven currencies of JPY and CHF. The JPY finished the month trading at its strongest level since February against both the euro and pound while the EURCHF is back trading at levels last seen in early 2015 after the Swiss central bank stopped maintaining its formal peg of 1.20 against the euro.
Powell no longer sees inflation as transitory
Powell, fresh from being reappointed for another term as Fed Chair, unsettled markets by warning that price pressures that were previously concentrated in a few corners of the economy had broadened out. Noticeably, he also told congress that it was a good time to retire the term “transitory” in relation to inflation, which in October printed at a 30-year high of 6.2%. November’s numbers are released on Friday. The last time inflation was at this level, the Fed Funds rate was at 7.75% (currently 0.10%). The market is preparing for a more aggressive taper to the Fed’s $120b a month bond purchase programme but still has only 2 rate hikes priced in for 2022 so there is plenty of room for rate expectations to increase. Diverging rate expectations can be a key driver for currencies and have allowed the dollar to trade to 2021 highs against both the pound and euro.
Low volatility in FX over 2021 but 2022 could be very different
A feature of FX trading over 2021 has been extremely tight trading ranges. Strong equity and bond markets as well as historically low real interest rates have facilitated these unusually stable FX markets. Over the calendar year, GBPUSD is on track to have its least volatile trading range in 50 years and similarly, the volatility in EURUSD has seldom been lower since the euro’s inception just over 20 years ago. For businesses trading internationally, this is a welcome development but is unlikely to be repeated in 2022. With inflation still escalating, it is increasingly likely that 2022 will herald the onset of tightening cycles which may trigger a sharp increase in volatility in both capital and financial markets. Risk- asset markets like US equities are trading close to all-time highs and their rich valuations are predicated on deeply negative real interest rates, which are not sustainable. Corporates should not be lulled into a false sense of security by the benign conditions experienced in recent years. Tukey’s travails in November where the lira fell 40% over the month alone is a useful reminder that market adjustments can be punishing when the narrative changes.