Higher, Steeper, Faster, Longer

The shift to a tighter global liquidity backdrop continues and geopolitical risks in Eastern Europe have not faded, this is a volatile backdrop for EM assets and argues for a focus on relative value and tactical opportunities

The broad theme of a high vol, tactical macro environment continued last week, with global rates continuing to have high levels of intra range volatility (with a bearish bias) and continued divergence across macro assets.

Notably, Brazilian equities had a 1.6 weekly stdev move higher while S&P fell, the USD had a 1.3 stdev move lower despite another 10bp move higher in US front end yields, and oil and the energy sector meaningfully outperformed industrial base metals. Finally, a negative outcome from the Russia - US talks resulted in a sharp move higher in Russian rates, where 1y1y rates had a 127bp rise over the week, a 4.1 weekly stdev move higher.

We have held the view for several quarters now that we are in an inflationary environment, and inflationary environments are more volatile in aggregate, as the market needs to price the risk of either policy tightening or a policy mistake.

In that vein, this week had several key macro data that supports the view that we are at an inflection point where policy support driven expansion is shifting to a policy driven normalization (or contraction). A quick snapshot of this week’s US data tells this story:

·        Headline CPI data came in at 7% on a yoy basis, despite a 0.4% mom fall in energy prices, while core CPI rose to 5.45% yoy the highest since 1991 with broad based gains for vehicles, rent, transportation, lodging, apparel, and household furnishings and operations.

·        Uni Michigan median five-year-ahead measure rose to 3.1% the highest since 2011.

·        Gov. Brainard, previously the standard bearer for the doves, said she supports rate hikes "as soon as asset purchases are terminated" and Harker among others clearly signaled to a base case of 3-4 hikes this year.

Taken together, this week's data must be concerning for the Fed. The rising and broadening inflation in core components is being reflected in both survey measures of inflation expectations and quantitative measures, such as the “sticky price" measure from the Atlanta Fed reaching the highest level since 1991. Inflation may indeed have peaked at 7% yoy, but if inflation remains high, the Fed will still be meaningfully behind the curve.

This, in our view, is why the Fed has been so quick to embrace QT as a way to tighten policy without steeper rate hikes. They have been successful so far, real yields are higher by 35bps this January, and mortgage rates reached the highest point since June 2020.

However, the most important factor does remain the Fed hiking path. Since the middle of last year, the market has been responding to the rise in inflation by bringing forward hikes (sooner), but not by pricing a faster or steeper hiking path. As a result, the Fed hiking path is extremely shallow, and the terminal rate has remained capped. However, with the market is now fully pricing a 25bp hike in March, 4 hikes to December and 6 hikes through to November 2023, something will have to give if the market (and the Fed) wishes to tighten financial conditions via the rate hiking path.

The fact is, given where inflation and inflation swaps are, the currently priced hiking path would keep rates at an extremely accommodative level. Therefore, assuming the Fed's desire to tighten policy, the risks are clearly skewed to the upside if inflation does not ease materially, and soon. The three options, steeper (greater than 25bp), faster (hikes not just on quarterly SEP meetings), longer (moving rates beyond neutral or higher terminal rate) are not mutually exclusive, but there is a path dependency in that a slower and shallower start leads to a higher probability of a longer cycle.

The key is inflation, its level and breadth. If there are no signs of easing in the key inflation data the Fed looks at, it seems reasonable that the Fed would consider the risks of waiting for each SEP meeting too high and the faster route would be taken. If inflation re-accelerates, then steeper hikes are on the table, and if inflation is persistent, we are likely to get a much longer cycle. QT buys some time by tightening financial conditions, but even if 5y inflation swaps were to normalize back to 2.60% , in order to get 5y real yields to -50bps (still very accommodative) it would require 5y nominal yields to be 50bps higher than here.

This shows the level of yield moves that may be necessary to get real yields and financial conditions back to a more normal level. Put simply, if inflation does not fall, the risks to the upside in yields are clear, and on balance they are likely to come first via a faster (hikes not just on SEP meetings) or steeper (50bp per SEP meeting) hiking cycle.

This type of risk premium is at least observable and hedgeable for market participants. The same cannot be said for the risk of war between Russia and Ukraine and there are a few observations we would share, which are informed by our long-standing focus on geopolitical risks at Calvion.

Russia and Putin have been remarkably consistent about the security demands from NATO, which would effectively end NATO as it is currently constituted and re-establish the Russian sphere of influence in ex-Soviet bloc states. Unsurprisingly, they have been rejected outright by the US and NATO. The concern is that talks in December and January have escalated the conflict, and there has been little to no sign (so far) that these demands are points of negotiation.

To be sure, the sanctions response to a Russian invasion of Ukraine would be extremely punitive, but the Russian economy is a better place than it has been to face this type of response, and furthermore the energy crisis in Europe gives Russia a key defensive lever in a sanctions response to military engagement. Put simply, if Ukraine is the prize Putin wants, the cost right now might be one he is willing to bear, and he has several strategic and tactical advantages that may not be there in the future. Our analysis therefore is that the risk of military conflict is higher than many market participants think, and we own RUB put options as a hedge against this risk.

Overall, our book remains relatively beta neutral, and we made moderate portfolio adjustments last week, adding Poland steepeners to reflect the new inflation shield 2.0 that we perceive will add to pressure on the belly of the curve. Our perception is that we are entering a new regime, but in this period of transition, a tactical orientation is prudent.

COVID Update

World COVID cases continued to rise over the last week to new record highs, with cases rising globally in every region. Despite the surge in global COVID cases, global COVID deaths remain near the lows seen in the last year. In Asia last week, Omicron waves increased to record highs in Australia and the Philippines and are rapidly approaching previous records in India. In China, where cases increased just +6.2% for the week to 1,285, COVID policymakers' zero-tolerance COVID policy approach has led to over 20 million people in multiple cities being put into lockdown. In CEEMEA, cases continued to fall in South Africa, while rising in much of CEE and rising to all-time highs in Turkey. In South America, COVID cases have rapidly increased to all-time highs - an increase that has come at a much lower cost to mobility than in prior waves, as the chart below shows.

In the US and Europe, COVID cases hit new highs last week, with hospitalizations and deaths as a share of reported cases in both regions well below the levels seen in prior waves. The last week also brought some initial signs that the Omicron waves in the US and Europe may soon peak. In the United Kingdom, one of the first countries in Europe to see a significant Omicron wave, cases are down nearly 32% from their early January peak. In the US, the leading data we track on Google searches for COVID testing and symptoms is now falling. Similarly, the charts below show that the leading wastewater data we track has peaked in Massachusetts and San Jose. In New York City, one of the first US cities to see a major Omicron wave last month, cases have begun falling sharply.

Several studies released in recent weeks have found that Omicron has a much higher rate of asymptomatic cases than prior variants. Beyond the association with lower severity, the higher share of asymptomatic cases helps explain part of Omicron’s high transmissibility levels. Omicron’s higher levels of asymptomatic carriage are another reason to believe that reported case levels are undercounting infections in this wave. An implication of these findings is that severity levels relative to confirmed cases underestimate the extent to which severity has fallen in the Omicron wave.

Potentially due to the lower severity data, there have been several signs of a shift in the policy reaction to COVID over the last week. On Thursday, UK Health Secretary Sajid Javid announced an end to COVID passes and cut in the COVID isolation period to five days. Some leading voices in global public health, such as Bill Gates, have also commented that COVID may be treated more like the seasonal flu after the current Omicron wave passes. If confidence in lower severity continues to build, it seems likely that policymakers will continue to pivot and moderate their responses to COVID risks. Markets are also starting to increasingly come around to the idea that Omicron is improving the medium-term COVID destination despite higher near-term cases which the chart below comparing Global cases with equity market lockdown outperformers/underperformers illustrates well.

Calvion's View: In the near term, we continue to see potential risks to demand and labor supply related to the elevated levels of Omicron cases. We also see policy risks associated with the rise of large Omicron waves, an economic risk that is particularly significant in China both due to the relative lack of flexibility regarding zero-tolerance and China’s importance to global supply chains. In the medium-term, we see the lower severity with the Omicron variant (along with vaccines and antiviral pills) as a key positive, which can potentially turn the COVID pandemic into a milder endemic phase, where the virus is no longer a significant macroeconomic factor.

Eastern Easing

This week will shape the macro outlook for the start of 2022, but the key themes of improving global growth and policy divergence are likely to continue

Risk assets head into a critical last trading week of the year after rising sharply over the last 5 days as markets priced lower risks relating to the Omicron variant and received incrementally positive macro news in the form of Chinese policy easing. Ahead of the Fed this week, Friday’s US CPI inflation, came out in line with expectations as the headline rose 6.8% yoy and core rose 4.9% yoy. This was another multi decade record high in inflation and showed broad price increases, however with some signs of easing supply chain pressures and falling gas prices, it may be close to the peak level of inflation in the US.

In macro markets, last week’s moves were consistent with the developments we saw in data and policy. Chinese equities, which have come under significant pressure in H2, had a 2.3 weekly stdev move higher supported by Chinese policy easing. A hawkish tone by the RBA allowed the Australian dollar to outperform in FX, rising by 2.2 weekly stdevs. In EM there was more differentiation, Brazilian 3y interest rates fell sharply and the curve inverted further following a run of weaker than expected data against a backdrop of a hawkish BCB. In contrast, Czech rates rose sharply, following higher than expected core inflation prints as well as hawkish commentary from the CNB.

Since the news of the Omicron variant broke, we have been highlighting that the Omicron variant is likely to bring heightened near-term volatility due to the wide range of potential outcomes. Part of last week's price action can be explained by the market assigning a lower probability to the negative tail outcomes, but we also got some important information about the macro outlook.

First, the Chinese policy mix is becoming incrementally easier. While the 50bp RRR cut and the additional cut of 25bp of the relending rate are not sufficient to turn the tide of weakening Chinese growth, it is a step towards policy easing. Viewed in the context of the focus on “stability” from the Politburo meeting, moderate increase in TSF in November, and steps to prevent additional RMB appreciation, it suggests the outlook for China is improving as we head into next year.

Second, we are seeing increasing divergence in the inflation outlook and policy response functions in EM. In Brazil, long end yields fell sharply following a hawkish BCB alongside lower-than-expected inflation and retail sales. While inflation in Brazil is still high, the outlook for inflation has eased, with Brazilian data clearly showing a material slowdown. The curve has inverted sharply, with the market pricing in cuts in 2022 (as are Czech and Russian curves). These are classic late cycle dynamics and is an environment that is supportive for the BRL, CZK and RUB on a relative basis.

In contrast, the National Bank of Poland placed itself behind the curve again, raising rates by 50bps vs 65bps priced, and talking again about supply side and transitory inflation pressures. Inflation pressures continue to rise in CE3, and while their regional peers in Czechia and Hungary have continued to be aggressive in tightening policy, the NBP has signaled they are reluctant hawks. Real interest rates in Poland are now among the most negative in EM, and the NBP may again need to engage in a series of corrective hikes if their bet on supply side inflation doesn’t pay off.

Holding this policy stance may be made much more difficult at the end of this week, which sees a number of key central bank meetings. Most notably, the FOMC will meet and release its updated statement of economic projections.

The Fed has clearly signaled an increase in the pace of tapering, with the market consensus for an increase in tapering from $15bn to $30bn per month. What may turn out to be more market moving is the dot plot. In September, the median expectation was zero hikes in 2022, although half the committee saw at least one hike. Consensus expectations are now that the median will shift to two hikes for 2022. This itself displays how much more hawkish the Fed has shifted in 3 months, but the range of estimates for 2022, as well as the terminal rate, will also give an updated signal as to how the Powell Fed is considering the policy outlook, given the rise in inflation dynamics and strengthening the economic outlook.

The bottom line is that inflation and the policy response function to that inflation remain the key macro theme. While inflation is broadly a global phenomenon, the heterogeneity in growth outlooks and policy responses underpins our view that we are in an environment that rewards alpha and that this environment can continue for some while longer. Our portfolio reflects this, we remain paid Poland vs received Russia and Brazil, long US homebuilders beta hedged and long Russian ruble in FX, and we have added exposure to European financials, which should benefit from a relatively easier policy stance from the ECB

COVID Pandemic

While there are still significant unknowns about the Omicron variant, the last week has provided additional clarity on several key aspects of the variant. Omicron case growth in South Africa and globally remained elevated, with this week’s data supporting the view that Omicron can likely outcompete the Delta variant in South Africa and globally. The severity trends from the Tshwane District hospital report we highlighted in last week’s note seem to have broadly held up over the last week, with several public health experts expressing cautious optimism about the potential for a lower severity of disease for the variant. While at this early stage, it is unclear how much of the difference in lower severity outcomes is due to Omicron’s intrinsic severity or the levels of immunity in South Africa’s population. Recent data appears to be consistent with either lower severity or some level of immune (natural and/or vaccine-related) protection against severe disease. Relatedly, a preprint released on Thursday found that T-Cells immunity protection from variants will likely hold up against Omicron. However, the last week also brought additional signs of significant erosion of vaccine-related antibody protection, with a recent preprint found a 41x reduction in antibody neutralization against Omicron with the Pfizer vaccine. On Wednesday, Pfizer announced a third dose of its vaccine increases neutralizing antibody titers 25 fold relative to a two-dose treatment. 

Globally, COVID cases rose, with cases rising in the United States, while falling in Asia, CEEMEA, Europe, and Latin America. In Asia, COVID cases increased markedly for the week in South Korea where cases rose to the highest levels since the beginning of the pandemic last week. In addition, Chinese cases rose for the week following last week’s notable increase in cases. In the CEEMEA region, cases rose sharply in South Africa, while falling in Russia and Turkey. In Latin America, COVID cases remained low across the region, with the recent increase in Chilean cases fading over the last week.

In Europe, cases fell slightly on the week for the first time since late September, with case declines in many Central and Eastern European countries more than offsetting continued increases in major Western European countries like France and Italy. The decline in cases is already leading to the relaxation of COVID policies in some countries, such as Austria, which is exiting its national lockdown on Sunday following a -61% decline in cases from its November 24th peak. By contrast, case growth continued to rise for the week in the US, although test positivity rates fell modestly. Leading data we track on the US COVID wave, including searches for US COVID tests and symptoms, along with leading wastewater data, points towards a further increase in US COVID cases in the coming weeks. 

Calvion’s View: While recent Omicron news has confirmed initial concerns about Omicron’s ability to erode immune protection against infection and infectiousness, recent South African hospital data suggests a worst-case scenario where Omicron is either more severe or able to evade protection against severe disease is unlikely. While we believe the Omicron variant will likely become the dominant variant globally and will drive a renewed wave in global cases, we see the reduction in tail-risks associated with either severity or immune protection against severe disease as a notable positive. With the declines in European cases and the continued rise in leading US COVID data, we see a convergence in relative COVID trends in the winter EU and US COVID waves in the coming weeks. 

In The Eye of The Hawk

Omicron uncertainty remains but Powell signaled clearly that the Fed is moving in a more hawkish direction, an important shift at a time when the US economy is strengthening.

Uncertainty remains elevated as we await more conclusive data about the Omicron variant specifically its severity. This uncertainty manifested itself as extremely volatile market conditions last week. 10 day realized volatility in the S&P has risen almost 4 fold from before the Thanksgiving holiday to this week, and 10 day annualized oil volatility has risen to 85, the highest level since May of 2020.

In terms of directional movers, idiosyncratic themes played a key role. Argentine bonds had a 1.9 weekly stdev move higher following positive developments relating to the potential for an IMF deal; in contrast, in Turkey, the lira fell by another 10% a 2 weekly stdev move despite several FX interventions by the Turkish central bank. Ukrainian bonds had a 2.7 weekly stdev move higher as risk premium fell in the region following ongoing discussions between the US and Russia (even as tensions remained high).

Aside from the heightened uncertainty and these idiosyncratic stories, there were a few important macro developments last week.

Chair Powell in the first public testimony to Congress since being renominated to Fed Chair was clearly hawkish. Among a series of comments, he stated that it may be appropriate to conclude asset purchases “a few months sooner” and that it may be time to retire the “transitory” term in discussing inflation. These were not throwaway comments, the entire tone and content of his testimony was clearly hawkish, and a shift from recent communication.

The timing and venue are commentable. Inflation is now a political issue, and it is logical that Chair Powell’s nomination over Lael Brainard comes with an implicit mandate to ensure that price stability is given appropriate weight in policymaking. These comments support this viewpoint, and certainly indicate that the Fed has shifted more hawkish in quite a short period of time.

This is in large part due to the broadening strength of the US economy. Last week’s ISM services data hit an all-time high in November, construction spending was higher than expected, and high frequency card spending data shows robust consumer demand despite low levels of consumer sentiment. The US employment data was also strong. Despite a weaker than expected headline, the household survey showed more than 1mm jobs added, bringing the unemployment rate to 4.2%. Furthermore, the participation rate, wages and hours worked all rose, pointing to an increasingly tight labor market.

The US unemployment rate is now only 0.2% above the Fed’s estimate of NAIRU, and with this week’s inflation print expected to show yoy inflation at 6.7% (with upside risks to that number), one can clearly see the rationale for the Fed accelerating their taper timeline. The fact, however, that they have shifted so soon after the taper announcement is indicative of a more responsive and hawkish Fed. This all happened against a backdrop of heightened uncertainty due to the Omicron variant and resulted in sharp bull flattening across the US curve. Curves have been flattening since the June FOMC, but we are now at levels that price a policy “error” type move.

The spread between 2y and 10y interest rates, 2 year forward is at levels that have only been seen at the end of hiking cycles.

The implications of a more hawkish and responsive Fed (with an economy that justifies this) will be a key driver of the macro environment into next year. Tightening liquidity conditions is a clear headwind to high growth tech, as evidenced by ARKK’s 12.7% fall last week, and adds to headwinds faced by EM tech. As we have previously noted, it reinforces the divergence between the Fed and ECB, which will help support the USD on a broad basis. It will require early cycle EMs to keep hiking, but for late cycle EMs (like Brazil and Russia), the global growth and inflation outlook will be priced lower, allowing deeper rate cuts to be priced.

Obviously, the Fed’s policy outlook is subject to the outcome of the Omicron variant. However, while uncertainty remains high, we remain focused on where the macro trends remain clear. We are long US homebuilders beta hedged, we are received Russian 2y rates against paid Polish 2y rates, have added a long Ruble basket against USD, EUR and NOK and remain in flatteners in Poland and South Africa. This is an alpha orientated book, reflective of both the current uncertainty, but also the environment of divergence we expect to play out next year.

COVID Pandemic

Omicron-related risks remained a key focus this week, with new data over the last week providing some additional clarity, but still leaving some key questions about the variant unanswered. Omicron cases were identified in dozens of countries across the world last week, with many countries now seeing case levels consistent with domestic community transmission. South African cases rapidly increased with daily cases and positivity rates of 11,125 and 23.8% on Saturday, up significantly from last Saturday’s 2,858 and 9.8%, respectively. The high growth rate in South African Omicron cases is consistent with some combination of high transmissibility and immune erosion, although high confidence estimates of Omicron’s transmissibility edge are not yet known. 

Over the last week, there has been some increased insight into Omicron's immune evasion. A recent preprint shows a 3.36x greater risk of reinfection from Omicron than the reinfection risk seen with prior variants. The preprint, which looks at the level of protection against immunity provided by prior natural infection, confirms some concerns around the immune evading potential of the Omicron's mutations. While the study did not focus on vaccine recipients, the natural immunity evasion observed highlights the potential risk to vaccine-induced immunity. The chart from the preprint below shows estimates on the number of primary infections, the population at risk of reinfection, and the estimated number of reinfections in South Africa.

While severity data on Omicron remains limited, some notable trends in the preliminary data from Tshwane District hospitals show some changes relative to prior South African waves. First, as the chart below shows, the COVID admissions profile during this wave have skewed young relative to prior waves with an unusual increase in pediatric admissions (an increase that has raised new concerns about potential risks to toddlers). Second, those patients admitted in recent weeks have shown some signs of lower severity relative to prior waves. For instance, most COVID patients at the time of admission did not know they had COVID and were admitted for another condition (an unusual new development). Furthermore, the average length of stay for patients hospitalized for COVID has been notably shorter (2.8 day average for admissions in the last two weeks vs. 8.5 day average for admissions over the previous eighteen months). In-hospital death rates have also been lower at 6.6%, relative to 23% in previous waves. In summary, there are signs of potentially decreased severity, but the data remains uncertain due to still small and early sample size and an unusual age-skew that biases the data. It will be important to see how South African patients' severity and age profiles change in the coming weeks, as recent cases increasingly feed into new hospitalizations.

Globally cases rose last week, with cases rising for the week in Europe and the United States, while falling CEEMA, Latin America, and Asia. In Europe, case growth in Eastern Europe slowed, with cases falling nearly -39% from their recent highs in Austria and slowing in the Czech Republic, Hungary, Poland, and Germany. Case growth remained elevated in Western and Southern Europe, with COVID waves rising for the week in France, Italy, and Spain. In the US, cases and test positivity rates rose for the week, with last week’s Thanksgiving-related distortions falling out of the US data. As the chart below of Massachusetts COVID wastewater shows, COVID RNA concentrations suggest the US Northwest is likely to face a similar-sized outbreak to the winter wave seen last year.

Calvion’s View: We continue to see Omicron risks as uncertain and varied. While last week has confirmed initial concerns about Omicron’s natural immune evasion, the degree of Omicron’s vaccine erosion and disease severity is unknown. We continue to see two-sided risks to Omicron severity and will closely follow reports on how South African hospitalizations develop, with a focus on changes in hospitalization levels, severity, and age profile. We see winter Delta waves converging between Europe and the US, slowing European case growth and accelerating case growth in the US. In Asia, we continue to see potential tail-risks from China's zero tolerance approach to COVID risks.

Omicronyism

The Omicron variant has increased uncertainty about the short and medium term macro outlook with a wide a range of potential outcomes depending on the nature of the variant, especially its severity, and the reaction function of policy makers

It has been a volatile fall season in financial markets, and Thanksgiving week took that to extremes. The news of the Omicron variant rocked markets on Friday; front month WTI crude fell 13%, a 4 daily stdev move, airline stocks fell 10-15%, and a full hike was priced out of the front end of the US curve.

Ironically the selloff on Friday followed a run of data which had been quite positive for the macro outlook. PMI data was encouraging, showing that global manufacturing strengthened in November, and there were signs of easing supply chain pressures with delivery times and output prices easing.

In the US, data confirmed a strong rebound in the US economy from the summer Delta wave, inventories jumped 2.2%, real consumer spending rose by 0.7%, initial jobless claims fell to the lowest level since 1969, and we saw a range of upside revisions to US Q4 GDP forecasts. We also received the minutes from the Fed’s November meeting, which, viewed in the context of recent commentary and data releases, supported the view that a faster taper is on the table at the December meeting. This is a supportive picture for continued US equity and USD outperformance, and one where inflationary pressures were likely to continue over the winter.

However, this was before the news of the Omicron variant.

At this point, the way we would characterize our current research on the Omicron variant is that there is cause for concern, but most of the key facts remain unknown at this point. What we, and policy makers, do know is that nature and amount of the mutations of the virus may reduce or at worst eliminate current vaccine efficacy, while also increasing transmissibility. Importantly, we have very little data on the severity of thed Omicron variant.

Over the coming 1-2 weeks, the questions relating to vaccine efficacy will become known, and we will also begin to build a picture of transmissibility and severity. Furthermore, it is probable that as the variant is tested for, more cases will be discovered, which may give a false signal as to the ongoing spread.

As we note in our COVID update, policy responses, so far, have been swift but targeted, focused on travel restrictions and increased testing. In Europe, where lockdowns were already in place, they have been tightened. Some countries such as Israel, Switzerland and Japan have taken a more drastic approach to travel restrictions, but for now there has been little roll back of the reopening of travel on a broad basis. 

Put simply, at this moment uncertainty is elevated, and therefore the market has priced in a higher level of risk premium, particularly in assets that would be impacted by travel related lockdowns. This is appropriate, the most politically palatable policy action is international travel restrictions, while increased quarantine and testing requirements will reduce demand for travel.

What is less clear is the political will for renewed broad based lockdowns. Our sense is that it is low, especially in the US, but there is a scenario in Europe where risks associated with the Omicron variant compound the existing Delta wave and seasonal flu season to force more extended and broader based lockdowns. This can occur even without the tail risk of a vaccine resistant strain actualizing. Overall, the risks remain more skewed to the downside in Europe than in the US, and similarly, a rebound is likely to be sharper in US exposed assets. However, if news flow deteriorates and the tail risk increases, this will be a continued correlated move lower in risk assets, occurring at the worst time of the year for liquidity. The tail risk, therefore, is material, which argues for reduced risk and if the opportunity presents itself, fading this move in limited loss formats while uncertainty remains elevated.

COVID Pandemic

The key new COVID development over the last week was the rise of the Omicron variant. As the chart below shows, the Omicron variant has rapidly gained share in South Africa, where the new variant is now driving a new fourth wave. While the number of global Omicron cases still remains relatively small, the rapid spread within South Africa and the large number of mutations (including more than 30 mutations to the spike protein) have raised concerns that Omicron may be more transmissible and escape vaccine immunity. Omicron cases have been identified around the globe, with cases in South Africa, Botswana, the Netherlands, the UK, Hong Kong, Australia, Denmark, Italy, Israel, Belgium, the Czech Republic, and Germany. The global public health community has quickly reacted to this variant, with the WHO naming it a variant of concern on Saturday following an emergency meeting on Friday. National COVID policymakers are also reacting, with many countries introducing targeted travel bans on impacted countries, and Israel even going as far as to ban entry to all foreigners on Saturday night. In response to concerns about potential risks to vaccine efficacy, mRNA vaccine manufacturers Pfizer and Moderna have estimated that they believe that if necessary, they can produce a new Omicron-modified mRNA vaccine that could be available as soon as 100 days to 'early 2022'.

It is worth highlighting that there is still a lot that is unknown about the Omicron variant at this stage, given the limited amount of real-world data on the variant. While there are some initial signs (the speed with which the variant has become dominant in South Africa and mutations that have been associated with high transmissibility), that Omicron may be more transmissible, there are no high-confidence estimates of how transmissible Omicron is at this stage. It is also unclear how much Omicron’s mutations impact natural and vaccine immunity against infection and severe disease, with reliable estimates on the impact on vaccine’s efficacy against severe disease from human trials likely still at least a few weeks away. Finally, severity levels for Omicron remain unknown at this stage, with the potential for the variant to see both lower or higher severity levels (lower severity could be a meaningful positive as the variant may be able to outcompete existing strains but lower overall health risks).

Beyond the Omicron variant, the main COVID developments of the week are summarized below. On Friday, the full trial results of Merck’s Molnupiravir antiviral pill saw efficacy drop from the initially reported 50% to just 30%. COVID cases rose globally in every major region over the last week, with European cases rising to the highest levels since the beginning of the pandemic. High European cases are putting pressure on policymakers to tighten COVID policies in the most impacted countries. While reported cases fell in recent days in the US, this dip appears to be a Thanksgiving holiday-related distortion in the data. Leading data we track, including COVID testing and symptom search measures, and US wastewater data, suggest the US winter COVID wave will resume its upward trajectory in the next week. While US policymakers are less inclined to use restrictive measures than European policymakers, the underlying vulnerability of the US population is greater than in Western European countries, as the below chart from the FT shows.

Calvion's View: The rise of the new Omicron variant adds significant new risks to an already challenging seasonal outlook for COVID risks in Europe and the US. At this stage given the level of uncertainty around transmissibility, vaccine efficacy, and severity the path of potential outcomes from this new Omicron variant risk remains wide. While we see the statements from Pfizer and Moderna that updated mRNA vaccines may be rapidly available as encouraging and suggest a faster response time than the development of the initial vaccines, many EMs are not using the mRNA vaccines from Pfizer and Moderna which have been biased towards higher-income countries. Furthermore, antiviral pills, which are less likely to be impacted by Omicron’s mutations than vaccines (since the antivirals target the virus’s own ability to replicate rather than to attach to human cells), may not be produced in sufficient quantities to provide high levels of protection globally. Pfizer, for instance, has forecast it can produce 50 million doses of its antiviral pill globally in 2022. For context, the world has recorded 177 million reported cases of COVID in 2021 so far. In sum, if the tail-scenarios with the Omicron variant play out, the inter-country vaccine inequality seen in the first half of 2020 risks repeating in 2022 with inequality in the availability of Omicron variant updated mRNA vaccines and antiviral pill availability. In the coming weeks, it will be critical to closely monitor the incoming South African health data, the global spread of the Omicron variant, and estimates on the transmissibility, severity, and vaccine efficacy against the Omicron variant.

Lockdowner

As the US recovery from the summer Delta wave gathers steam, renewed lockdowns in Europe create downside risks to European growth while geopolitical risks on the European periphery are rising

Idiosyncratic stories drove many of the largest moves in markets last week. Beginning in Turkey where the Turkish Central Bank responded to President Erdogan's desire to “fight against interest rates” by cutting rates by 100bps despite currency weakness and rampant inflation. Unsurprisingly, the Turkish Lira fell sharply, declining by 12.6% over the week, a 5 weekly stdev move, and this sell off has acclerated falling another 14% since Mondays open.

Ukrainian assets declined further, warrants seeing a 2.5 weekly stdev move lower as the Russian troop buildup continued, and there was little sign of conciliation in comments from President Putin. 5y Hungarian interest rates had a 2.4 weekly stdev move higher following a larger than expected 70bp increase of the 1w repo rate (the effective policy rate) by the NBH. EM tech equities declined sharply following poor earnings from sectoral leaders in China and Brazil. Chilean risk premium increased ahead of the Presidential election vote, CDS moving wider by 2.5 weekly stdev.

One consistent thread across many of these moves was an increase in risk premium driven by politics and geopolitics. Politics also played an important role in the nomination process for the next Fed chair. Ultimately President Biden did not concede to the party’s progressive wing and renominated Chairman Powell for a second term. However, with Lael Brainard being nominated as Vice-Chair, this does open up 3 board seats (assuming Clarida leaves) which may be the consolation prize for those who were in Brainard’s camp and may result in a dovish shift in the committee. More broadly, this reduces the risk of a contentious nomination process which would have been a meaningful risk had Brainard been nominated.

While the re-nomination of Chair Powell will have implications over the shape of policy over the medium term, comments on Friday from Gov. Waller and Vice Chair Clarida reflect a much more immediate risk. Both comments clearly signaled that the pace of tapering is a live discussion at the next FOMC meeting. This is in response to higher inflation, with Waller specifically noting “the rapid improvement in the labor market and the deteriorating inflation data have pushed me towards favoring a faster pace of tapering and a more rapid removal of accommodation in 2022”. Eurodollar contracts moved higher in yield on Friday having previously been 10bp lower on the day.

Friday’s price action and these comments signal to a larger thematic of increased divergence across markets and regions. US rates had moved lower in yield due to the broadening Delta wave in Europe, which has led to renewed lockdowns, and with it much higher risks to European growth over the coming quarter. EU data was already tepid, dragged down by Germany, which is exposed to both supply chain friction and a slowing China. This is reflected in the solid consensus at the ECB for prolonged monetary accommodation. In contrast, in the US, there is almost no political will for new lockdowns, the economy has rebounded from the summer’s Delta wave, as evidenced by strong retail sales this week, and the Fed is shifting more hawkish. Similarly, in EM, the South African Reserve Bank kicked off their rate hiking cycle with a dovish hike, in contrast with the type of monetary policy actions we have seen in CE3 and Brazil.

We expect this theme of divergence to continue over the next year, especially as we see regional differences in inflation in the context of where central banks are in their cycle. With falling macro correlation, political risks will also play an increasingly important role in relative valuations, and this environment can result in trending moves in currency markets, as we have seen recently in EURUSD. For now, we have reduced our risk, reflecting the rise in idiosyncratic volatility and uncertainty, specifically around Russia’s intent in Ukraine and the growth outlook for Europe. However, on a medium-term horizon, we remain opportunistic as this type of alpha market with political catalysts presents a rich opportunity set for our process.

COVID Pandemic

Global COVID cases continued to advance last week by +10.5% - the fastest weekly increase since early August. Regionally, cases increased in Europe and the US, while falling in Asia, Latin America, and CEEMEA. In China, cases fell by -33.6% over the last week, suggesting recent restrictive measures are again working to keep Chinese cases at low levels. In CEEMEA, the still-elevated COVID waves in Russia and Turkey trended lower over last week. Finally, in Latin America, COVID cases generally remained low across most of the region, with mobility levels in most LatAm countries now largely recovered to pre-COVID levels.

The major COVID news of the week in Europe was the Austrian government’s Friday announcement that Austria will enter a full national lockdown on Monday - the first full lockdown announced in the EU this winter. The Austrian lockdown news comes after a significant surge in Austrian COVID cases, bringing Austrian COVID cases to the highest levels on record. While vaccinations are helping make the winter European wave less deadly than it otherwise would have been, the vaccines have not been enough to avoid sizable winter outbreaks. The below charts shows Austrian cases and deaths and deaths as a share of cases lagged by 20 days which clearly indicates that even when accounting for time lags the current wave in Austria is significantly less deadly. In Germany, where cases hit all-time highs this week, the health minister said “nothing should be ruled out” regarding a national lockdown, while the foreign minister excluded a national general lockdown. In Western Europe, cases continued to rise in Italy, Spain, Portugal, and France.

Austrian 7d Moving Avg Cases (blue) vs Deaths (orange - lagged)

US cases also increased meaningfully over the last week, with cases rising +31.2% on the week and test positivity rates also increasing to 6.1%. Leading COVID testing and symptom search data we follow points towards a continuation of the US COVID upswing. COVID wastewater data has also surged recently, as the chart below of Massachusetts COVID wastewater data shows. So far, US mobility levels and surveys on COVID concern have yet to react to the increase in cases, but the risks of a shift to US COVID sentiment and the service sector recovery are growing.

US wastewater data viral load

Calvion’s View: As we have been highlighting in recent weeks, near-term COVID risks are elevated despite an increasingly positive longer-term COVID outlook due to the combination of multiple effective vaccines and two antiviral pill treatments. We continue to see rising winter outbreaks in the US and Europe posing a renewed risk to service sector recoveries and consumer sentiment in the regions in the coming weeks. In Europe, we see the recent Austrian lockdown as a clear sign that lockdown policy risk still exists in Europe this winter and must be carefully followed in the coming weeks. In the US, it looks likely that cases will continue to move higher in the coming weeks with risks for consumer behavior and the service sector recovery. Encouragingly, in China, this week’s data suggests the most recent outbreak may be successfully contained. However, we would note that China’s zero-tolerance approach to COVID remains a significant tail risk as long as it is in place and seasonal COVID risks are currently elevated in China.

Inflation, It's Getting Political

US Inflation is rising and broadening. This is becoming a central political issue in the US. However, globally there are increasing signs of divergence in monetary policy stances, and in the pace of inflation surprises.

Inflation was again center stage in global markets last week, this time in the US, where consumer prices rose to the highest level in 30 years. Specifically, headline CPI increased 0.9% m/m while the core index rose by 0.6% bringing CPI to 6.2% on a y/y basis, the highest print since November 1990. While there was continued impact from the supply side, the October report showed broadening inflationary pressures, notably in rents where OER had the largest monthly increase since 2006. Our work on US housing over the course of this year led us to believe that the risk of a sharp rise in rents was underpriced, and this theme is now playing out.

The level and breadth of inflation caught the market by surprise and prompted a sharp move higher in front end US yields. Jun 23 Eurodollars had a 2.3x weekly stdev move higher in yield, but this actually understates the magnitude, as the move higher in yield on Wednesday post the data was in the 99th percentile of all daily moves in the last 10 years. This move in the front end and belly of the US curve precipitated further flattening in global interest rate curves, especially in developed markets and early cycle emerging markets, notably Polish 2s10s flattened by 28 bps a 2.1x weekly stdev move.

Chart: Jun 23 Eurodollar futures 1d change (lower = higher in yield). Move on 11/10 was the largest 1d increase in yield since 2016 and 3rd largest daily move observed in last 7 years

The impact of this level of inflation in the US is not to be underestimated. Politically, there is clear empirical evidence that inflation matters for voters, Joe Bidens popularity has fallen 42.7% in recent polling averages, its lowest point of the cycle and Fridays UniMich consumer sentiment data fell to its lowest level since 2011. Republicans are likely to blame this inflation on the Democrats' fiscal approach, and with Sen. Manchin’s recent comments, the political environment for passing another spending bill has cooled. It will also likely impact discussions around the next Fed Chair and would make a confirmation of Lael Brainard much more challenging.

With rising inflation being clear negative for the Democrats prospects at next year's mid-terms, there is a political imperative from the Biden administration to try to take measures to address this. Political pressure will continue to be brought to bear on OPEC, a SPR release is possible, but the fiscal policy toolkit is thin with respect to inflation outside of subsidy type payments, like we have seen already in France. We expect inflation to be a central political issue over the winter, and how the Biden administration is perceived as responding will have major implications for the shape of the next Congress.

However, even with some dominant macro trends in place right now, namely flattening and elevated inflation risk premium, there was much more divergence across markets than we have seen this year.

In rates markets we are beginning to see late cycle dynamics in some EM countries, which are well into their hiking cycles. Notably this week, Russian front-end yields had a significant move lower following a sequential easing in week-on-week inflation, even as DM yields were moving sharply higher. This move was unwound in part due to rising geopolitical risks in Russia, but it displays that where fiscal and monetary conditions are already very tight, the asymmetry is for lower yields once the rate of inflation eases. Similarly in Mexico, Banxico raised rates by 25bps but this was 25bps less than market pricing. Banxico are concerned about rising price pressures, but they can afford to be patient because of their tight fiscal policy stance and tepid economic recovery.

Finally, in China there was a strong rally in domestic property credits and equities, where the GS China real estate basket had a 2.8x stdev weekly move higher. This was driven by onshore and offshore media reports, which indicated authorities may ease regulatory conditions, alongside Evergrande paying two coupon payments. While these measures will not alleviate the broad macro slowdown that China is experiencing, they are positive signals and display the asymmetry in prices given the amount of negative news currently discounted.

Overall, this is a very interesting and dynamic macro environment. Our view remains in place, that inflationary pressures will keep risk premium elevated at the front-end of interest rate curves, especially in countries at the earlier stage of their rate hike cycle. We continue to be paid Polish rates and in flatteners there and in South Africa, with shorts in Eurodollars and 10y Treasuries in the US. However, there is an increasing set of alpha opportunities, especially in assets where risk premium has become acute, such as Brazilian and Chinese equities, and in interest rate markets where inflation and rate hiking cycles are peaking such as Russia and Brazil.

COVID Pandemic

World COVID cases increased again last week by +9.1% - the highest increase since the first Delta wave early August, with cases rising in Europe, CEEMEA, Latin America, and the US while falling in Asi. While cases fell for the week in China, the current outbreak is still notably elevated, widespread, and negatively impacting Chinese mobility. In CEEMEA, cases fell from their recent highs in Turkey and Russia, but case levels remain elevated in both countries. In Latin America, while cases generally remain low, some countries (particularly Chile) are showing a notable pick-up in new case growth.

Europe’s COVID wave continued to rise, with the region's cases approaching the heights seen last fall and early spring of this year. The European COVID wave continues to broaden and move from Eastern Europe to the west and south, with case growth in Germany, France, Italy, and Spain. In Germany, new cases hit the highest level of the pandemic, with 51,077 cases recorded on Wednesday. So far, the increase in cases has not translated into the levels of hospitalizations and deaths seen in prior waves due to the vaccination campaigns, as the chart on Germany shows below. While many recent restrictive policies have been largely focused on the unvaccinated, the European wave is increasingly leading to policy responses. On Friday, for instance, Netherland’s Prime Minister announced a partial three-we lockdown, while Merkel will meet next week to coordinate nationwide measures for Germany.

In the US, cases marginally increased by 0.4% for the week, with test positivity rates also rising from 5.1% to 5.3%. Given the backdrop of the rising seasonal European wave, rising positivity rates, and rising search volumes for COVID tests and symptoms, we anticipate US COVID cases will likely increase in the coming weeks. Some states, such as Colorado, are already struggling with rising cases, with reports of some areas in rural Colorado struggling with rising COVID hospitalizations.

Calvion’s View: Medium-term, we are constructive on the continued recovery from the pandemic, with the recent news on two successful antiviral pills representing a major breakthrough that will significantly reduce COVID related tail-risks for individuals and healthcare systems in the coming years. In the near-term, however, increasing European and US cases this winter represents a developing risk to the service sector recovery. While the recent decline in cases is encouraging in China, we still view risks as elevated due to how widespread the current outbreak is, and China’s continued adherence to strict zero tolerance measures.

When Doves Cry

Goldilocks NFP and no major hawkish surprises from DM central banks is a good outcome for risk assets, however EM policy makers remain on a hawkish path and this policy divergence is likely to continue

Last week was significant for global asset markets. Against a backdrop of historical interest rate volatility, we had several key central bank meetings in both developed and emerging markets, and the first US employment report without meaningful unemployment benefit and Delta related distortions.

Beginning in developed markets, the FOMC announced it would begin tapering the pace of its asset purchases this month at a pace of $15bn per month, which was in line with expectations. In his press conference, Chair Powell successfully walked the fine line of acknowledging the greater uncertainty with respect to the inflation outlook and did not explicitly push back on market pricing, however did emphasize the FOMC commitment to both the inflation and employment part of their mandate. His communication was both credible and dovish, which led to the market reducing risk premium moderately at the very front end; the forward curve steepened, and real yields moved further into negative territory.

However, the following day the BoE and Gov. Bailey surprised the market by keeping rates on hold. A full hike had been priced following increasingly hawkish public communication from Gov. Bailey among other BoE officials through the fall. Indeed, this hawkish “pivot” in rhetoric from the BoE (further amplified by the RBA, which were also more dovish than expected last week) was a major catalyst for the thematic increase in developed market front end interest rates in October. The subsequent failure to deliver on their signaling, combined with a dovish press conference, led to a sharp retracement lower of UK and global front end yields. Notably, the move lower UK 5y gilt yields on Thursday was a 3.6 daily standard deviation move and the largest since Brexit.

In emerging markets, central bank MPCs also delivered surprises, however in contrast to DM central banks these were more hawkish than expected. The National Bank of Poland followed their surprise 40bps hike in October with a 75bps hike at the November meeting vs market pricing of 50bps. While its communication remains opaque, in terms of delivery, the Polish central bank is now moving aggressively, having fallen far behind the curve. In Czechia, the CNB raised rates by 125bps vs market pricing of 100bps and has now tightened rates by 200bps total in 5 weeks. Curves flattened aggressively in CEE, with Polish 1s5s having a 3stdev weekly move lower and Polish 2s10s ending the week 33bps flatter a 2.8 stdev weekly move lower.

The key takeaway is DM central bankers displayed that, when it comes to rate hiking paths, they still see elements of transitory inflation and a willingness to balance inflation and growth factors. Chair Powell executed this communication challenge effectively, Gov. Bailey significantly less so, and the BoE will likely pay a serious credibility price moving ahead. In EM, however, the dynamic is different. Central banks consider inflation to be a material risk. They are, in fact, tightening policy and are attempting to do so aggressively (with respect to market expectations).

This means that for EM, as long as inflation remains high with increasing momentum (note Russia's higher than expected CPI print last week), risk premium will continue to be built at the front end of EM rates curves, and yield curves will likely flatten further. Indeed, we are past the COVID normalization phase in CEE, both Czech and Polish 1y1y rates are well above pre-COVID levels, but this can continue, especially in Poland where real yields are still deeply negative.

In DM the picture is different. As we highlighted last week, “what the market is pricing is an increased risk premium for sharper and steeper hiking cycles driven by rising inflation…. this is not the same as a delivered counter-cyclical hiking cycle”. Last week's DM policy actions reduce this near term risk premium and increase the modal length of accommodative policy. In line with this, real yields moved further negative, curves bull steepened, and financial conditions eased. This positive backdrop for risk assets was enhanced by Friday’s US payroll report, which showed a strong labor market, no acute wage pressures, and a strong recovery out of a Delta affected summer.

Therefore, the near-term outlook for risk assets has improved, and for now, the peak of the rate selloff in the front end of DM curves looks to have passed. The broad market outlook continues to argue for a balanced book, but with a greater tilt towards directional beta exposure given last week's developments. We continue to be positioned for flatter curves in EM and we have added to equity risk exposure in both DM and EM, and continue to hold frontier carry positions. On a medium-term horizon, the rally in longer end yields in the US is an opportunity to re-enter shorts, given our positive outlook for US growth into Q1 next year.

COVID Pandemic

World COVID cases increased last week for the third week in a row, with cases rising in CEEMA, Europe, and the United States while falling in Asia and Latin America. While cases in Asia continued to fall across much of Southeast Asia, cases continued to increase in China. In China, the current Delta outbreak is the most widespread since the initial Wuhan outbreak in early 2020. The Chinese government has responded to the wave by implementing lockdowns in multiple cities across the country and telling residents to stock up on food and other essentials in case of emergencies. In CEEMEA, cases continued to advance in Russia, with cases hitting new all-time highs despite recent restrictive COVID measures.

In Europe, COVID case growth continued to advance over the last week, with cases remaining highest in Central and Eastern Europe. Case growth has also been broadening across Western Europe, with cases rising in France, Italy, and Germany over the last week. In Germany, COVID cases rose to the second-highest daily level since the beginning of the pandemic on Thursday, with 37,640 cases. While most European policymakers have primarily focused new restrictions specifically on unvaccinated individuals, in Belgium, the Health Minister has responded to the rise in infections and hospitalizations by urging people to work from home. As the chart from FT illustrates, the recent increase in European cases (in a change from the summer wave) is increasingly spreading among the elderly, as immunity levels from initial vaccination wane.

In the US, COVID cases were flat last, with an increase of less than 1% week on week. Positivity rates, however, increased to 5.4% from 5.0% the week before - an increase that implies US infections are rising faster than indicated by the headline case numbers. In addition, our COVID Trends Index measure, which tracks US search volumes for COVID tests and symptoms, has started increasing in recent days. The combination of slightly rising US cases, rising test positivity rates, and rising search volumes for COVID tests and symptoms suggests the US will likely have rising cases in the coming weeks. So far, US COVID concern levels remain relatively low, but the experience of the summer Delta wave illustrates that higher case levels can impact COVID concern levels even in the context of high vaccination rates.

On Friday, Pfizer announced its antiviral pill Paxlovid reduced the risk of hospitalization and death by 89% among high-risk individuals who begin taking the drug within three days after the onset of symptoms. The Pfizer’s Paxlovid trial results announcement comes one day after Merck’s 50% effective antiviral pill was approved for use in the UK. An antiviral pill that can eliminate 9/10 hospitalizations is a major advance for the world that, when scaled into full-scale production, can materially reduce the risks of overloaded hospital systems. Pfizer expects to produce over 180,000 packs of Paxlovid by the end of the year and over 50 million in 2022.

Calvion’s View: We see the Pfizer antiviral results (along with the Merck antiviral results) as a very important medium-to-long term positive that will help allow - especially when paired with vaccines - countries around the world to more fully reopen and return to normal against a likely ongoing endemic reality, given that COVID-19 is now one of the common human coronaviruses. More tactically, we see the COVID risks as increasingly elevated in Europe, China, and increasingly the US as the winter. We see risks as particularly elevated in China as a result of their zero-tolerance policy approach, which has the potential to create sizable economic costs if the country is faced with a large-scale winter outbreak.

Testing Credibility

Higher volatility and risk premium at the front end of developed market interest rate curves constitute a regime shift, but are not an impediment for the growth outlook.

The market has priced a regime shift from a world where inflation risks were one-sided and central banks could control both the front end and long end of curves, to one where inflation risks are to the upside, and risk premium must be built for sharper hiking cycles.

This regime shift has been playing out over the month, but last week's moves were acute even in the context of recent volatility.

The largest moves were in front end interest rates, with multi-standard deviation selloffs in Canadian front-end rates, following a hawkish Bank of Canada, and Australian 2y bond yields, which had two consecutive 5+ standard deviation daily moves higher after a higher than expected CPI print was followed by the RBA failing to defend its yield curve control target in the bond market. European 1y1y interest rates rose by 17bps (2.8 weekly stdev move), and the 10s-30s curve flattened following a tepid defense of forward guidance by President Lagarde during the ECB press conference. In the US, the market brought forward rate hikes, resulting in a significant flattening of the curve for shorter dates, most notably Dec 22 vs Dec 26 eurodollars flattened by 29 bps.

In emerging markets, 2y vs 10y curves flattened by ~25 bps in Poland and South Africa driven by higher CPI prints in Poland and the broad flattening of global yield curves. In Brazil Jan 23 DI yields rose by 115bps on the week (2 weekly stdev), due to heightened fiscal risks at a time when global liquidity conditions are worsening. The 150bp rate hike on Wednesday from the BCB was below market pricing of a 175 bp hike and was not sufficient to prevent additional selloffs in Brazilian fixed income assets.  

The velocity of the moves higher in interest rates constituted a VAR shock for short term interest rate markets. Liquidity was impaired, and market price action suggests large, forced position stop outs. Noise in the market is high, and at times like this, it is important to focus on what happened, the meaningful changes to the macro outlook, and resulting structural changes to our view.

What happened and what’s changed?

At its essence, what has happened in higher beta developed market rates markets (NZD, GBP, AUD, CAD) over the last 6 weeks is what has already happened in emerging markets this year. Central Banks have delayed tightening due to a belief in the transitory nature of inflation, falling behind the curve, and then subsequently capitulating. Risk premium increases, both as a function of rising inflation and as a function of the central bank being behind the curve and having to subsequently change course.

This capitulation in the face of rising inflation has significantly damaged the efficacy of forward guidance as a policy tool, both in fact and in the minds of market participants. It takes a long time to build trust, but an instant to destroy it. Like the Fed’s wavering on FAIT in June, portfolio positioning that reflected the forward guidance of the RBA would have resulted in severe losses this week.

Australian 2y govt bond yields

Forward guidance was the tool used to control the front end of yield curves. If its efficacy has fallen and inflation remains elevated, then risk premium and volatility should move higher structurally until central banks anchor the front end with credible hiking cycles. This is a significant change.

Where to from here?

October played out largely as we have been highlighting throughout this year. Inflation is rising, inflationary environments are more volatile in aggregate, and the market may need to price DM central banks being behind the curve.

However, it is important to recognize that the market is pricing an appropriate increase in risk premium for sharper and steeper hiking cycles driven by rising inflation. This is not the same as a delivered counter-cyclical hiking cycle, where real yields are tightening sharply as central banks move ahead of inflation. In fact, real yields remain deeply negative and moved more negative this month and financial conditions remain easy. While there are clear risks to growth, there are also signs of strength, especially in the US. Corporate earnings were at record highs and household balance sheets are exceptionally strong.

Therefore, our view remains that despite the moves we have seen in the front end, the outlook for growth is still reasonably positive and cyclical assets can perform. We continue to be short US front end rates, paid Poland rates and in flatteners in EM to reflect our view on global interest rate risk premium but we also continue to like holding equity exposure and longs in the front end of high carry frontier countries. Finally, the volatility of recent weeks does open up idiosyncratic opportunities and we will be looking to add to those exposures as volatility falls.

COVID Pandemic

Globally, COVID cases increased last week for the second week in a row, with cases rising in Europe and CEEMEA while falling in Asia, Latin America, and the US. While cases continued to fall in most countries in Asia, Chinese cases increased over the last week, with multiple cities in China’s Inner Mongolia region facing travel lockdowns. In the CEEMA region, cases in Russia continued to rise over the last week to the highest levels since the beginning of the pandemic in Russia -- an increase that has led to an eleven-day shutdown of non-essential services in Moscow. Finally, in Latin America, COVID cases continued to fall across much of the region, although cases continued to move higher in Chile over the last week.

In Europe, COVID cases increased at an elevated pace of +25% for the week, with case growth remaining elevated in Central and Eastern Europe and broadening across Western Europe. Weekly case growth in countries such as Poland, Hungary, and the Czech Republic ranged from +70% to +101% for the week, while Germany, France, Italy, and Spain saw cases rise between +5% and +38% for the week. Increasingly, the elevated COVID waves are challenging policymakers in the most impacted CEE countries. For instance, in Poland on Monday, Health Minister Adam Niedzielski was quoted saying the government would need to consider tighter COVID measures if cases averaged over 7,000 cases per day -- on Saturday, Poland recorded 9,806 cases.

While COVID cases fell slightly last week in the US, test positivity rates increased slightly to 5.0% from 4.8%. Furthermore, in contrast with the benign outlook over the two months, some leading US data we track has begun to show more mixed signs, with wastewater positivity data in Colorado, Connecticut, and Massachusetts moving higher over the last week. While the near-term services recovery appears supported in the US due to still falling levels of US COVID concern, elevated vaccination rates, and US policymakers who are reluctant to reinstate COVID measures, the risks are rising around a renewed national or regional US COVID wave.

Calvion’s View: The key COVID theme for the last week was the continued rise in cases in Europe, with a focus on the significant and increasingly disruptive COVID outbreaks in poorly vaccinated parts of Central and Eastern Europe. While we generally remain constructive the economic impacts from the COVID outlook on the back of higher vaccination levels and changed policymaker incentives, we are closely monitoring the rising European COVID wave and the potential risks it poses as the colder winter season approaches. In Asia, we remain positive on the continued recovery from Delta waves in Southeast Asia, although we continue to see tail-risks from China’s strict zero-tolerance COVID approach.

Calvion Capital awarded Best Macro Fund - Americas

We are proud to announce that Calvion Capital was awarded best Macro Hedge Fund at the 2021 Hedgeweek Americas awards.

This award is a testament to our team's dedication and performance over the last number of years. Central to this award was how we navigated the volatility of 2020, especially in emerging markets

Calvion was founded on the premise that investing at a time of rapid macro and political change requires new tools and investment approaches. 

The integration of Computer Assisted Learning methods (the CAL in Calvion) from information and data science with a traditional discretionary macro investment management is at the core of Calvion’s process. 

We believed that by harnessing the power of technology, a lean and efficient team could achieve a breadth of opportunity assessment and depth of analysis previously attainable only by large institutions.

The COVID pandemic presented us with an extreme use case for our distinct process, and it was validated through the returns we delivered for our investors. Our Natural Language Processing (NLP) systems enabled us to get further ahead on the learning curve and successfully navigate macro markets throughout this unprecedented period. These alternative data-driven insights, which we proactively shared, gained the attention, trust and capital of some of the world's highest caliber institutional investors. 

Looking ahead, we are building on this success through the recent launch of Calvion Co-Investments. This is a natural extension of our differentiated investment process and Knowledge Partnership with our investors. It allows institutional investors to participate in the asymmetric upside associated with political catalysts and regime shifts, and after this year's volatility in emerging markets, there is a rich opportunity set.

In addition, Calvion plans to grow in the next 12-18 months via specific carve out fund launches and geographical expansion. The central thesis of the fund is that geopolitical and political catalysts are rising in importance for macro investing. This thesis is playing out, and we intend to be in position to offer investors as many ways as possible to benefit from this regime.

Crossing The Rio-bicon

Inflation forces policy makers to make tradeoffs; markets are punishing a lack of policy credibility with sharp increases in risk premia in rates.

Our central case is that we are in an inflationary environment, and inflationary environments are more volatile in aggregate.

This viewpoint continues to play out, especially in interest rate markets, where the market continues to increase risk premium in the front end of curves. In the US June 23 Eurodollar contract increased by 13bps in yield and Mexican 2y yields rose by 27bps following higher than expected inflation reading. Inflation proxies rose, 5y US inflation swaps reached the highest level since 2008, and US equities rallied, led by strength in financials.

It was also an important week in data. On the positive side, flash October PMI services data beat expectations in the US, UK, and France, driven by a fading Delta effect on services activity. However, manufacturing, and industrial production data showed that supply chain issues are getting worse. EU manufacturing PMI fell to the lowest level since July 2020; in the US September Industrial production fell by 1.3% and flash PMI revealed that supplier delivery times made another record. The bottom line is that supply side inflationary pressures are not showing signs of easing yet.

Overall, the view that the inflation pressures in the global economy were transitory has resulted in central banks being behind the curve. The distribution of risks for inflation and the policy pathway is now skewed higher. Furthermore, rising inflation narrows the options for central banks, as seen in Russia last week where the central bank increased rates by 75bps while Moscow re-enters lockdown.

Indeed, it is not just monetary policy makers who face difficult trade-offs in a rising inflation environment. Inflation is now a major political and fiscal issue.

In response to rising inflation and falling popularity, President Bolsonaro decided to change the spending cap rules to accommodate ~BRL40bn/$7.25bn in transfer payments. This decision resulted in front end Brazilian interest rates rising by 150bps last week. Substantively, the additional spending will have limited impact on fiscal sustainability but breaching the spending cap displays that fiscal prudence is now secondary to political expediency.

This puts all the pressure on the central bank to anchor policy credibility. They will now likely raise rates even more sharply than before, further tightening financial conditions, and with it, making the political prospects of President Bolsonaro even dimmer. The only potential silver lining to the scenario is that it raises the possibility of a centrist candidate gaining ground, but the likelihood of a centrist winning the election is low at this point, given the polarized voting blocs in Brazil and Lula’s strong support base. Lula may moderate in response to this threat, but his spending priorities are less likely to change.

The one positive that Brazil has is a solid institutional foundation with a credible central bank. In contrast, Turkey is far beyond that point. Like President Bolsonaro, President Erdogan popularity has fallen, and his political future is uncertain. Unlike his Brazilian counterpart, he has control of the central bank which, to foster growth, breaking with policy orthodoxy once again, cut rates by 200bps last week despite inflation remaining well above target. This was followed by the expulsion of 10 ambassadors, including from the U.S., France, and Germany following a statement from the ambassadors calling for the urgent release of activist Osman Kavala. This rise in geopolitical risk comes a time when energy costs have risen, and global liquidity conditions are tightening. The prospects for the Turkish Lira are bleak.

The events of the week support our thesis that we remain in a murky market environment where inflation risk premium will remain high to reflect the risk of policy errors and continued oscillation between perceived stagflation and reflationary regimes. We are paid US inflation swaps, front end US and Polish rates, and have exposure to energy equities and energy exporting frontier currencies with sufficient real rate buffers. However, the volatility of this environment also creates dislocations and opportunities. While the outlook in Brazil is not positive, the market has priced a significant amount of risk premium in Brazilian assets. Brazil is not Turkey, the strength of institutions does constrain President Bolsonaro, and given this, we see opportunities to fade some of the more extreme moves in Brazilian equities, in particular in the financial sector.

May You Live In Interesting Times

Rising inflation, an uncertain growth picture and falling tail risks means this is an environment that rewards alpha over beta

We are living in interesting times, especially in markets. After years of falling macro volatility and benign inflation conditions, the market is now pricing the risk of a regime shift in inflation. This comes at the same time as China is undergoing its own regime shift to Xi-ism. Higher volatility should be expected, and it is being delivered

Front end yields and inflation swaps rose again last week; 2y UK inflation swaps rose by 27bps, CZK 2y swaps by 25bps and in Chile, where the central bank hiked rates by 125bps, 2y swaps rose by another 45bps. Developed market curves twist flattened; Dec 22 vs Dec 26 Eurodollar futures flattened by 28bps (2.6 weekly stdev), a similar magnitude of the move post the June Fed meeting, and US 5s/30s flattened by 20bps. The rally in commodities broadened, copper rose by 9.8% (1.7 weekly stdev) and in currencies the JPY significantly underperformed, due to the dual headwinds of higher energy costs and higher DM yields. Finally, equities rallied on a broad basis due in part to falling tail risks from Chinese property and a lower terminal rate providing a tailwind to technical breaks to the upside.

In aggregate, the market continues to price higher inflation risk premium in the front end of curves. This inflation risk premium drives demand for inflation hedges, especially in commodities and inflation swaps, and the risk of sooner, steeper hiking cycles results in flattening.

Growth, however, remains highly uncertain which is why the market continues to oscillate between stagflationary or reflationary price action. Last week, rates markets priced down the terminal rate, while real yields moved more negative. This is stagflation-lite price action, which is supportive for long-duration assets and equities, more specifically tech equities rallied.

So how much of this price action is justified, and does it change our view?

1. Inflation: Our core view is that we are in a higher inflation environment with a meaningful risk of a regime shift in long term inflation expectations. Central to this thesis in the US is the effect of the twin drivers of higher wages and higher rents on long term inflation expectations. Last week’s US CPI data has added confidence to our view. The details showed tenants rent jumping 0.45% and owners’ equivalent rent (OER) increasing 0.43%, the highest levels since 2006. Alongside rising wage inflation, the drivers of inflation are broadening beyond goods inflation, which characterized 1Q. On a global basis, add rising energy prices, food inflation, continuing supply chain bottlenecks, and you have a potent inflationary mix.

2. Growth: The data picture last week was mixed. US retail sales on Friday significantly exceeded expectations, rising by 0.7% vs a decline of 0.2 expected. Curves re-steepend following the data print as a strong US consumer is a necessary condition for a bullish inflation / reflation environment to actualize. In contrast, the University of Michigan consumer sentiment fell while year ahead inflation expectations rose to a new high of 4.8%.

In China, the PBOC struck a confident tone, stating that “we can contain the Evergrande risk” and it was reported that policy makers have loosened restrictions on home loans. This resulted in a strong rally in China property bonds on Friday.

However, headline macro developments were hawkish / credit contractionary. Credit data showed TSF and bank loan growth both fell in August; the PBOC did not cut the RRR as some had expected and signaled, they will use targeted liquidity tools to address credit tightening. Over the weekend, the Communist Party’s top theoretical journal issued an excerpt of Chinese President Xi Jinping’s 17 August “common prosperity” agenda, in which he clearly confirmed a shift to a tax and transfer environment in China, and that the era of laissez-faire wealth creation is finished. On Sunday night, China GDP data confirmed the sharp slowdown in Q3, showing real GDP grew 4.9%oya, following growth of 7.9%oya in 2Q.

Taken together, we observe the following dynamics at play.
First, inflation continues to firm and there are asymmetric upside risks to spot inflation over the winter due to energy costs. Second, central banks are responding to inflation as are market participants. The transitory thesis has weakened significantly, both in the mind of the market and central bankers. Third, the growth outlook is very uncertain over the medium term, but in the near term there are upside risks due to fading Delta effect, notably from NE Asia and the US. Finally, tail risks have eased, China credit is contracting, but the risks of a China property blowup have fallen.

We find this to be an environment that rewards alpha over beta. From a portfolio perspective it argues for a balanced portfolio, positively exposed to higher inflation, with a flattening bias in rates. From a trading perspective it argues for fading when the market prices extremes in the stagflation - reflation distribution, given the underlying macro uncertainty.

We have positioned our portfolio to reflect this view. We remain paid US inflation swaps, with flatteners in early cycle EM, and are exposed to energy moves via KZT, Russian, Saudi equities and Oil sector equity call options, and have long USD hedges. This is balanced with EM equity and credit exposure, which had underperformed significantly in the stagflation selloff late Sept and early Oct. Tactically, we have also added short-term call options on global equities. There is strong near-term technical support for equities and clear asymmetry, especially if rate volatility falls.

Why Flip Burgers When You Can Flip NFT's

Structural inflationary forces are rising but stagflationary risks have eased.

There were two dominant and related themes in macro markets this week.

First, a significant repricing of front-end rate expectations across high beta developed markets and emerging market countries. There was a surprise rate hike in Poland, and Polish 1y yields had a 4.8 weekly stdev move higher. However, even where there was no central bank action, yields repriced sharply higher in anticipation of more hawkish central bank actions. This was the case in South Africa, Australia and Chile, all experiencing multi standard deviation moves higher in the 1-3y part of their interest rate curves.

Second, unprecedented volatility in energy markets. European 1mth natural gas forwards rose by 70% in two days at the start of the week, following an 110% rise in September, before comments by Russian President Putin resulted in gas fully retracing the spike to end the week lower by 28%. In oil, the WTI front month contract rose by another 6% to reach the highest level since 2014.

These moves happened in a week full of macro data, most notably Friday's US employment report.

We have held a core viewpoint over the course of the year that we are in a structural inflationary cycle and, as we have been writing, “inflationary environments are more volatile in aggregate, as the market has to price policy reaction or policy mistake”. This risk is exactly what actualized in Poland this week, where the central bank, in the face of consistently rising inflation, capitulated on its view that they could maintain an accommodative stance justified by their heavily challenged belief in the transitory nature of inflation.

This is not a new theme. We have witnessed monetary policy pivots this year in Brazil, Chile, Mexico and Czechia. The bottom line is that when inflation is rising, an additional risk premium needs to be built into the front end of curves to reflect that central bank may have to hike sooner and more sharply. The greater the velocity of inflation, the more risk premium needs to be built in, and with that interest rate volatility moves higher. This risk premium ultimately pushes curves well beyond what is eventually delivered in terms of hiking cycles, but in the early stages of a cycle, while inflation is rising, this risk premium tends to be maintained and should not be faded - even if central banks maintain dovish policy stances.

However, the larger question for the direction of risk assets is whether we are in an inflationary or stagflationary regime.

Data especially in the US has shown clear signs of stabilization, especially in services data. Last week, the ISM services PMI unexpectedly increased from an already high level, and the US economic surprise indices have begun to move higher after several months of decline. In Europe, the data picture is mixed. Supply chain issues and slowing demand from China are a significant drag on the auto sector, which saw German industrial production last week fall sharply by 4% m/m. We will have more information about the Chinese data picture this week, following golden week. However, what is clear is that the Delta variant’s effect on global data is fading, but supply chain issues remain a drag especially on manufacturing activity.

The important point is that these supply chain issues reflect demand, and to date, the inflationary forces in the market have not yet led to significant demand destruction. The employment report this week gives us a clue why.

Wages are rising in the US and globally. Rising wages help offset the real income losses due to inflation. The US employment report this week showed that wages are rising, the labor force participation rate has fallen, and unemployment is dropping. All at a time when job openings are at an all-time high. This is rare but it is consistent with a thesis we have held that the unique combination of post-pandemic fiscal and monetary policy combined with broader societal factors has structurally altered parts of the labor market. The bargaining power of labor has increased, wages are rising, but not enough to bring some people who have amassed savings or found different means of income (hence our tongue in cheek title this week: Why Flip Burgers When You Can Flip NFTs (Non Fungible Tokens))  during the pandemic back into the workforce. This is inflationary and the type of dynamic that can precipitate a structural shift in inflation.

Viewed together, we may be on the cusp of a regime shift in inflation, out of the 2015-2020 secular stagnation era. Market pricing reflects this, 5y5y inflation swaps are at 5y highs, but well below 2010-2014 levels. We have held this view since Q2, especially around wage inflation, but it took many months for the market to come to this view. This is reflected in our positioning. We remain paid rates in Poland and have added to flatteners. We have positioned for higher inflation via inflation swaps in the US, and have added upside structures on energy sector, Saudi and Russian equities, as well as long positions in European financials. We have also used the September stagflation sell off to add to positions in commodity exposed EM credits. A regime shift in inflation will open up many more opportunities, and if this theme plays out, these are just the early innings.

The Antiviral to End the Pandemic?

Inflation pressures continue to rise but risks of a stagflation growth shock are mitigated by stability in data and positive developments relating to COVID treatments

Global risk sentiment deteriorated last week as the market priced increased risks of a stagflationary environment. Markets were volatile, with moves exacerbated by month and quarter end flows.

Global equity markets fell; MSCI world had a 1.8 weekly stdev move lower and S&P500, European equities and the Nikkei all fell by more than 1 weekly stdev. In currencies, the US Dollar made yearly highs. The Euro fell by 1.8 weekly stdev reaching the lowest level since the US presidential election night in 2020 and the Mexican Peso underperformed in emerging markets. Emerging market interest rates continued to rise, led by sharp moves higher in Czech and Polish rates. European energy prices continued their parabolic rise, with 1mth LNG prices rising by 29% over the course of the week, 88% on the month.

September was a challenging month for risk assets. Indeed, on a volatility adjusted basis, it was the worst month for emerging market currency and fixed income assets since March 2020. Volatility rose this month from a low base driven by interest rate volatility and idiosyncratic stories such as Evergrande. The sharp move higher in US interest rates and the USD, pressured the EM credit complex which saw large selling on the back of ETF outflows.

While there were technical and idiosyncratic factors that worked in September to exacerbate price action, the market is pricing a growing risk of a slowing growth, high inflation environment into 4Q. The question is, is this warranted? There are two areas where there is little uncertainty.

1/ Inflation: Inflation, especially in emerging markets does continue to rise and is broadening.

In Latam rising energy and food prices, (exacerbated by Brazil experiencing a historic drought) continues to push headline inflation higher. In EMEA, German and Polish inflation rose again last week as rising energy prices add to existing inflationary pressures. Global input prices and supply chain friction remain high, and wages are going up in many developed economies. There is an energy “crisis” in Europe driven by extreme lows in natural gas inventories.

2/ Policy: Global liquidity conditions are tightening.

Emerging market central bankers are tightening policy in response to inflation, even as domestic demand has not fully recovered from COVID levels. Last week, the Czech central bank increased rates by 75bps, the largest rise in 20 years, and we saw rate hikes from Colombia and Mexico. The Federal Reserve is very likely to taper in Q4 and complete the process by mid-2022. The Bank of England may raise rates as early as December in response to rising wage inflation.

However, when it comes to the growth outlook, the picture is less certain.

Growth deteriorated over the summer driven by the Delta variant, ongoing supply chain friction and Chinese policy measures. September data does not show a sharp rebound in activity on a broad basis; PMI momentum has slowed in the Euro area and US real consumption has also slowed. There has been no policy response from China yet to any of the myriad challenges facing their economy.

However, manufacturing PMI data did stabilize, showing a modest improvement for the first time in 4 months and the US economic surprise index had the largest rise since June. Delta affected sectors in Asia are showing signs of recovery. Most importantly for the medium-term outlook for emerging market growth, 19 of the top 25 fastest vaccinating economies are now in emerging markets, and the Merck antiviral may reduce the need to take economically damaging measures to protect healthcare systems in the future.

Taken together this is an inflationary environment, and one where policy is being tightened. As we have highlighted previously, inflationary environments are more volatile in aggregate, as the market has to price policy reaction or policy mistake. Therefore, we are comfortable that as long as inflation continues to rise in EMEA, the market will continue to price higher risk premium in interest rate curves; which is why we remain paid Polish rates and have been short German bunds. Given the Federal Reserve are likely to tighten policy, we have run USD hedges and have had shorts in Treasuries, which we reduced this week following a large move higher in US interest rates.

However, the growth outlook remains uncertain. Indeed, from where the market narrative is currently and where some assets are priced, the asymmetry is to the upside with respect to global growth. This creates opportunities, especially where prices have been brought to levels close to valuation floors. In particular, we don’t think that September data justifies the deep sell off in emerging market credit. We have taken advantage of the selloff in September to buy Argentinian and Zambian USD bonds. These bonds should benefit from an easing in the global risk environment, while at current prices they have a very asymmetric return profile given expected recovery values.

Past Peak Uncertainty

Uncertainty has fallen: central banks are heading towards removing accommodation and the asymmetry is for earlier starts; the Delta outbreak is easing and Evergrande is unlikely to have significant financial contagion.

It was an extremely busy week in global markets. Volatility was elevated due to key central bank meetings, concerns about negative global growth affects from the Chinese property slowdown, and spillovers from the Evergrande situation. Risk assets were whipsawed, with sharp falls in global equities and interest rates in the earlier part of the week before a strong recovery due to falling risks relating to Evergrande and the passage of key risk events. 

The key central bank meeting was the FOMC, which resulted in a moderately hawkish outcome relative to expectations. In sum, the FOMC and Chair Powell believe the conditions for tapering have been met, that tapering is to commence this year and that they want to follow “a gradual tapering process that concludes around the middle of next year”. This is a more rapid taper than what had been expected, and is a significant change from the dependency associated with tapering in the period 2013-14. Alongside this, the median “dot” is now evenly split for the first hike coming in 2022. 

This monetary policy stance is internally consistent. The Fed wants to complete tapering as soon as it is practicable to open the possibility of a hike next year. In addition to this hawkish development were upward revisions to where the FOMC anticipates the policy rate to be in 2023 and the first data relating to 2024 where the median expectation was for the policy rate to be at 1.625%, above market pricing. 

Regarding other policy decisions, the Bank of England meeting was also hawkish, signaling the committee is losing some confidence in the idea that the inflation pressures experienced in the economy are transitory, especially with respect to the labor market. The minutes suggested that there is even a possibility of a 2021 rate hike. In contrast, the South African central bank held rates unchanged in a unanimous decision. While their forward inflation and rate path projections were revised higher, this decision raised the bar for rate hikes this year and contributed to the South African Rand falling by 2.5 weekly stdevs vs the USD in the last two days of the week. 

Overall, the Fed and BoE clearly stated that key central banks are on a pathway towards tighter policy stances. Furthermore, the Fed’s relative lack of equivocation with respect to the start of tapering and the speed of the presumptive timeline reduces uncertainty about the Fed’s policy stance. The takeaway being that due to inflationary pressures, as long as growth data remains relatively supported, the asymmetry is towards incrementally tighter policy. 

Therefore, even though PMI data disappointed this week, the steady fall of Delta variant related risk premium combined with falling Evergrande contagion risk premium allowed interest rates to move higher following this week's central bank meetings. Indeed, after a long period of consolidation over the summer it was this week that saw a sustained break higher in developed market interest rates. A market backdrop of rising rates and higher rate volatility is not a positive environment for credit and indeed, the high yield credit complex came under substantial pressure this week. 

However, what does perform in a high inflation, rising rate environment are shorts in fixed income and ultimately, longs in cyclical assets. We continue to have shorts in Bunds and US Treasuries as well as payers in Polish rates which performed this week. We are also looking at adding to longs in European and emerging market financials, where higher long end rates can be a cyclical tailwind. More broadly, a reduction in uncertainty with the Fed risk event now behind us is a good thing for markets, and we now have answers to some key questions. The path is now clearer heading into the 4Q.