Interest rates: could Jerome Powell remove the markets’ “punch bowl”?

Have markets learnt to stop worrying and love Omicron? After a nervy fortnight, traders regained confidence early this week. On Tuesday, the FTSE 100 returned to the levels it had reached before news of the variant triggered a mini-meltdown at the end of November. Other world markets have also rallied. Brent crude oil hit $76 a barrel, although it remains short of its pre-Omicron level.

Much remains unknown about the new variant, but investors have been reassured by early reports from South Africa suggesting that while Omicron is highly transmissible, it may cause less severe illness than previous variants of Covid-19.

The Fed turns hawkish

Yet below the surface all is not well. As John Authers notes on Bloomberg, the CBOE VIX Volatility index, the US stockmarket’s “fear gauge”, spiked above 30 last week before falling back. From the global financial crisis to the advent of Covid-19, VIX spikes have almost always coincided with “a significant financial event”.

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The cause this time may be as much Jerome Powell as Omicron. The boss of the US Federal Reserve said last week that he would “retire” the use of the word “transitory” to describe inflation.

The Fed’s insistence that inflation is “transitory” has been “much-maligned” as successive monthly figures show price rises sticking around, says Randall Forsyth in Barron’s. Powell has also suggested that the Fed may reduce – or “taper” – its $105bn in monthly bond purchases more quickly than planned. The Fed has bought $3trn in government bonds with printed money since March 2020, which has financed “about half” of the US government’s pandemic stimulus deficits. It is sometimes said that a central bank’s job is to remove the punch bowl from the party; in this case, the Fed “would be slowing its pour only gradually”. Faster tapering would see policy go from being “super-crazy easy to merely highly accommodative”.

In the past Powell has backed down if his hawkish comments upset markets, Matt Maley of Miller Tabak + Co. tells Bloomberg. Yet this time he has “doubled down… they’re hitting the brakes much harder”. High inflation is becoming a political issue in the US, while Powell needs a Senate confirmation vote before he can begin a second term as Fed chair next year.

No more market bailouts

Bond markets have taken Powell’s comments to heart. Yields on long-dated bonds have fallen, while those on short-term ones have risen, a sign that markets expect higher interest rates and slower growth ahead.

Traders are used to relying on the “Fed put”: when bad news comes around the Fed reliably rescues markets with easy money. The result has been that stocks sometimes rise following bad economic data (a pattern known as “bad news is good news”). The fact that Powell struck a hawkish tone even as Omicron uncertainty gripped markets has taken away that comfort blanket. For the first time in years, traders are having to get used to the idea that bad news might just be ba