Yoruk Bahceli and Dhara Ranasinghe

LONDON (Reuters – The risks of a new COVID hitting economic activity are clobbering the expectations for rate increases next year by the major world central banks. This could be a setback for dollars and other currencies that have been the most aggressively bet.

As they were just days ago, the money markets do not fully price an increase of 25 basis points in the Federal Reserve’s interest rate by June 2022.

From 75% on Thursday, 53% of Bank of England’s chances of raising interest rates next month can be seen.

This shift comes after scientists discovered a new variant of coronavirus in South Africa.

Chris Scicluna of Daiwa economic research, stated that while central bank commentary has focused on the upside risks of inflation, the new COVID version highlights that there is significant downside risk and we are entering a phase of uncertainty.

Rate hike bets slip as new COVID variant rattles markets: https://graphics.reuters.com/MARKETS-RATES/mopanleydva/chart.png

Oil prices fell more than 6% Friday in a resounding echo of panic when COVID began spreading earlier last year. Travel industry shares also suffered a drop of at least 6%, while two-year Treasury yields dropped 12 bps to their lowest daily level since March 2020.

The U.S. dollar was favoured by currency traders, who were attracted to higher inflation and more powerful economies.

It appears that a shake-out may be in order.

After President Joe Biden’s Monday announcement that he would nominate Fed Chairman Jerome Powell for a second term, the stock market had reached 17-month highs. Minutes of the Fed’s November 2-3 meeting revealed that more Fed policymakers were open to lifting rates and tapering asset purchases.

Speculators had a $20 billion position “long” in the dollar after three Fed increases of 25 basis points for 2022. Data from the U.S. CFTC revealed this.

The euro, Swiss Franc, and yen have been trading bearish in recent weeks, reflecting the belief that those countries are unlikely to see any policy tightening.

Francesco Pesole (FX strategist at ING Bank) stated that if the Fed has changed its COVID variant, the dollar could be more vulnerable than the Euro because there are two to three rate increases next year.

Yen positions: https://fingfx.thomsonreuters.com/gfx/mkt/lgvdwndokpo/Pasted%20image%201637919367896.png

German yield premium was 10 bps lower due to the sharp yield fall on Treasury 2-year notes. This is a bond segment that is especially sensitive to change in interest rates.

It is not surprising that the yen, Swiss Franc and dollar gained more than 1% against the dollar. However, the euro jumped 0.75% during one of the largest daily jumps this year.

Many saw it as a reality-check.

Arend Kapteyn of UBS Investment Bank said that although there is a possibility for a decline in confidence regarding the U.S.’s labour market, it wasn’t impossible to assess its effect.

However, he said that the “market had become too ahead of itself in pricing a shorter taper window as well as multiple hikes next Year”.

US rate hikes: https://fingfx.thomsonreuters.com/gfx/mkt/movanlewdpa/USRP1.JPG

COVID AT A TIME OF INCLATION

If the new version causes delays in the supply chain that is partly responsible for inflating inflation, it could also make the job more difficult for central banks.

In Britain, which has seen inflation rise to 10-year highs in the past decade, there were 70bps of tightening policies by 2022, despite an economic slowdown.

However, sterling dropped 0.6% to the euro on Friday. The MUFG analysts predicted that the pound would be most susceptible to easing rates expectations.

The new European strain may strengthen the position of the doves in the ECB’s Governing Board.

Peter McCallum from Mizuho sees a higher chance of the programme being extended than the March deadline, despite the fact that the ECB expects to end its 1.85 Trillion euro ($2.08 Trillion) pandemic emergency stimulation scheme.

The program’s largest beneficiaries, southern European bond markets were influenced by this view. Italy’s 10-year borrowing expenses fell to below 1% in the last three weeks, with the greatest daily decline in 3 weeks.

McCallum explained that while the European position doesn’t affect the PEPP outcome, McCallum claimed that if there was a new version that requires new vaccines, it would change the picture.