Omicron and US monetary policy uncertainty roil global markets

Financial markets have been whipsawed over the past week, with the Omicron coronavirus variant sweeping the globe just as the Federal Reserve signalled its willingness to accelerate US monetary policy tightening.

Dizzying swings in global stock markets have wiped trillions of dollars off valuations only to partially reverse hours later — shifts that underscore how investors must now navigate an increasingly cloudy global economic outlook.

The jolt of volatility underscores how investors are bracing themselves for the beginning of the Fed’s retreat from its massive stimulus programme, which has helped to propel stocks to records heights. A new strain of coronavirus has raised the stakes in a year when investors have pumped hundreds of billions of dollars into equities.

“Uncertainty lifts volatility, which can cause people to stay away,” said Katie Koch, co-head of fundamental equities at Goldman Sachs Asset Management. “We have markets that have very demanding valuations and they have a lot of good news priced in, so when the news flow turns marginally negative that can be disruptive.”

Traders and asset managers have been captivated by the shifts from the Fed, which in November began rolling back the policies it put in place to soothe markets at the depths of the coronavirus crisis last year.

The spread of the new Omicron coronavirus variant has threatened to complicate the Fed’s pullback, potentially undermining the economic recovery that had given the US central bank confidence to rein in its stimulus programme as it focuses on the threat of hot inflation.

Fed chair Jay Powell this week voiced his commitment to continue reducing the pace of the central bank’s $120bn a month bond-buying programme, a process that began last month. He also signalled that elevated levels of inflation may also warrant a faster tapering.

That back and forth, as well as news reports that offered contradictory views on both the strength of existing vaccines against the Omicron coronavirus variant and the severity of illness caused by the virus, provided the fuel for dramatic gains and losses in US equities markets.

Investors have been left grappling with conflicting forces, with tightening financial conditions — caused in part by market volatility — hitting up against fears that the spread of the Omicron variant could curtail economic growth, typically a cue for monetary policy easing.

Line chart of Appreciation in value of global equity markets in 2021 ($tn) showing Sliding stock prices have wiped $5.4tn off equity valuations

“What the Fed is doing, what’s happening with policy and what’s happening with the economy, all of that supports the idea that volatility will be increasing,” said Matt Freund, co-chief investment officer at Calamos Investments.

Measures of equity tumult this week jumped to the highest levels since February, with the volatility in the $22tn Treasury securities market — the backbone of the global financial system — now at the highest since the ructions in March 2020.

The benchmark S&P 500 US stock index on Wednesday recorded its biggest intraday swing in price since March, with the broad-market gauge suffering its worst two weeks of losses in more than a year. And the daily moves have been particularly powerful: for three consecutive trading sessions, the S&P 500 has moved 2 per cent or more between its highest and lowest points of the day, a streak that has not happened all year.

While the US has been at the centre of the recent market tumult, volatility has also been increasing in Europe. A measure of expected volatility in 50 eurozone blue-chip stocks on Friday last week hit its highest level in a year and has remained elevated. Similar indices for Hong Kong’s Hang Seng index and Tokyo’s Nikkei 225 have also ticked up.

Column chart of Daily intraday moves in the US benchmark (percentage points) showing The S&P 500 has whipsawed between highs and lows on volatile days

In addition to the uncertain economic landscape, investors are also wrestling with challenging trading conditions during the holiday season between the Thanksgiving break in the US and Christmas.

Typically it is a time of year characterised by lower trading volumes and a hesitancy among fund managers to place big bets, instead favouring taking risk off the table and booking profits heading into the end of the year.

“A lot of people don’t want to trade at this stage [of the year] and volumes may be lower, which may increase volatility and increase the magnitude of these moves,” said Jason Hedberg, UBS’s global head of equity derivatives sales.

Greg Boutle, a derivatives strategist at BNP Paribas, added that the surge of volatility was probably feeding on itself, as volatility-sensitive hedge funds that automatically adjust their exposure are likely to cut positions. It is selling that can exacerbate a downturn.

Money managers also said the big broker-dealers that they typically trade with had raised the cost to execute large trades, as they moved to protect themselves from any fallout if volatility remained high and markets lurched lower.

In turn, some investors are either protecting their portfolios — or making outright bets — on tail risks, or unlikely but impactful events that could send equity markets careening lower.

John Brady, managing director at RJ O’Brien, said guarding against outsized moves in equity markets had renewed significance now that the Fed’s crisis measures, which had underpinned asset prices, were beginning to be withdrawn.

That was evidenced on Friday, when derivatives markets once again lit up. Investors traded more than 26m put options — contracts that can pay off if the price of a security declines. It was the second highest level on record, trailing only a single day in February 2020 when global financial markets first began to reckon with the coronavirus pandemic.

Line chart of Number of put options traded in the US each day (m) showing Traders turn to derivatives to protect from a market sell-off

Others, such as Goldman’s Koch, say they are using dislocations to adjust portfolios, given some of the declines appear overdone.

That divergence between fund managers means that as the final few trading days of the year encroach, investors are braced for further bouts of volatility to come.

For John Leonard, the global head of equities at Macquarie Asset Management, the market swings are recalling similar events just three years ago, when a Christmas Eve sell-off bruised stocks.

“It is the natural consequence of the combined events of the emergence of the Omicron variant and the Powell pivot,” he said. “The combination of those two things has created the volatility. You’re going to have to wait for the dust to settle.”

Additional reporting by Madison Darbyshire in New York

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