The Bond Market Sends a Hopeful Message About Omicron

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 riskier assets.

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 out.