Treasury Traders Are Betting Omicron Will Add to Inflation Spike

(Bloomberg) -- Treasury traders are betting the rapid spread of the omicron variant will increase inflationary pressures in the U.S. economy, rather than weaken them.

U.S. 10-year break-even rates -- which are market estimates for the average rate of inflation over the next decade -- climbed to as high as 2.66% on Tuesday, the most since November, and up from as low as 2.36% on Dec. 14. The extra yield on Treasury 10-year notes over two-year securities has also jumped this week, indicating the bias may be switching back to a steeper yield curve.

The move came after Treasuries posted their worst start to the year since 2009 -- sending ripples through markets from Australia to the U.K. -- amid growing expectations that the Federal Reserve will start to raise its policy rate as soon as May, earlier than the July liftoff projected a month ago. In the U.K., the Bank of England's move to kick off a hiking cycle last month has already damped break-even rates.

The U.S. announced a new daily record of more than 1 million virus cases on Monday, hurting optimism that supply chains will return to normalcy in the near future. The annual U.S. inflation rate has climbed for three straight months to reach a four-decade high of 6.8% in November.

“Inflation continues to be the major theme of the market given life with the coronavirus,” said Makoto Noji, chief currency and foreign bond strategist at SMBC Nikko Securities Inc. in Tokyo. There is speculation that “the widening spread of the virus will lead to a decline in labor participation and supply constraints,” he wrote in a research note.

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Monday's sharp Treasury declines were followed by U.K. bonds in a catch-up move Tuesday, sending the 10-year yield surging as much as 10 basis points to 1.07%, the highest since Nov. 3. The country's benchmark breakeven rate was four basis points higher at 3.98%, having fallen last month by the most in more than two years from a 25-year high.

Money markets are now betting the BOE will hike interest rates again in March before climbing to 1.25% by February next year.

Still, inflation expectations in both the U.S. and U.K. may be headed higher, according to Michael Bell, global market strategist at JPMorgan Asset Management.

“If Omicron turns out not to be as big a problem, then the labor markets look very tight, particularly here in the U.K., but also in the U.S.,” he said. “And that could lead to some more sustained wage pressures than I think some people are expecting.”