Bond traders are turning into armchair virologists again.

By just about every measure, the $22.3 trillion U.S. Treasury market has started off 2022 with a huge sell-off. Two-year yields reached the highest since early 2020 on Monday, and five-year yields followed suit on Tuesday,  jumping to 1.39% from just 1.26% on Dec. 31. Even the 30-year bond yield soared, climbing above 2% for the first time since November. In the first trading day of the New Year, Treasuries lost almost 1% — a big step toward the first back-to-back annual losses for U.S. government debt in modern history.

Some of the selling pressure is likely coming from managers who bought Treasuries in late 2021 simply to look less leveraged at the end of the year (colloquially referred to as “window dressing”). The decline in the Japanese yen, also considered a haven, confirms a broader global move out of safety and into riskier assets.

But a deeper look at the move in Treasuries suggests the fundamental driver is the omicron variant of Covid-19. Specifically, it looks as if bond traders are focused on the combination of record case numbers and studies that indicate the new mutation is less severe. They’re then using those data points to price in greater odds of elevated inflation in the coming years but fewer disruptions to the U.S. labor market, which should keep the Federal Reserve on track to raise interest rates as projected.

Nowhere is this more evident than the five-year U.S. breakeven rate, which lurched back above 3% on Tuesday. It’s now higher than before Fed Chair Jerome Powell’s “pivot” in late November, when he made clear that the central bank was prepared to fight back against inflation that proved less transitory than anticipated. As market-based inflation measures tumbled in the following days, some observers speculated that simply talking about curbing price growth was enough to make it happen.

The highly contagious omicron variant complicated that thinking. In a potential harbinger, airlines canceled almost 18,000 flights in the U.S. from Dec. 24 through Monday, according to FlightAware, as virus infections led to staffing shortages. It’s not yet clear whether this latest surge in cases will lead to the kinds of supply-chain issues that snarled the globe a year ago, but given China’s zero-Covid policy, that risk and the short-term inflation that comes with it can’t be counted out.

Meanwhile, there’s little evidence to suggest the wave of cases will dent the U.S. labor market. For one, more than 4.5 million people quit a job in November, a record high, according to the Labor Department’s Job Openings and Labor Turnover Survey released on Tuesday. The so-called quits rate in the private sector surged to an all-time high of 3.4%, implying continuing competition among companies to raise wages. Analysts surveyed by Bloomberg expect that employers added 422,000 workers in December, enough to lower the unemployment rate to 4.1%, just about the Fed’s own long-run projection.

Put it all together, and there’s little reason to expect that the omicron variant will knock the Fed off the course for 2022 that it charted just weeks ago. Three interest-rate increases, starting as soon as March, should remain the central bank’s preferred path. Short-term rates markets are fully pricing in three increases, though starting in May.

As I noted during Powell’s Dec. 15 press conference, this was the crucial line that policy makers will most likely parrot in the months ahead: “One of the two big threats to getting back to maximum employment is actually high inflation.” In other words, to achieve the central bank’s stated goal of full employment that’s broad based and inclusive, the U.S. economy needs to have a long sustainable recovery, which requires policy makers to combat persistently above-target inflation by raising interest rates. Tim Duy, chief U.S. economist at SGH Macro Advisors, put it this way: “Hawkishness is the new dovishness.”

To be clear, the Fed’s stance will almost certainly remain highly accommodative by historical standards. Real yields aren’t anywhere near turning positive. In the past, the central bank might be inclined to slam the brakes on the economy to stamp out the sharpest price growth in four decades. The Powell Fed absolutely won’t do that. But it does seem to have the tacit approval of the White House to get a tad more aggressive on inflation.

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