Last Wednesday’s Federal Open Market Committee (FOMC) meeting and its aftermath highlighted the growing contradiction between the US Fed’s policy stance and evolving economic realities. Central bankers see no need to alter their ultra-stimulative monetary measures even though they substantially revised up both their growth and inflation projections. Market inflationary expectations are at multi-year highs, bond yields have risen and the yield curve has steepened significantly. Hoping to counter the upward pressure on yields, Fed Chair Jerome Powell on Friday doubled down on the FOMC’s message, writing in The Wall Street Journal that “the recovery is far from complete, so at the Fed we will continue to provide the economy the support that it needs for as long as it takes." This messaging puts investors in a bit of a bind. On the one hand, it sounds reassuring because it suggests the Fed is willing to be even more stimulative, a stance consistent with last Thursday’s disappointing jobless claims. On the other hand, it amplifies concerns about financial and economic overheating, an issue that was highlighted during the weekend by Larry Summers’ warning about “the least responsible" macroeconomic policy for the last 40 years.
Two, how vulnerable is the liquidity paradigm to bond market volatility?
The first question confronts investors with a choice: Should they position for more effective Fed market intervention, be it additional large-scale purchases or outright yield-curve control, or should they worry about the Fed being less able, as opposed to willing, to repress bond yields? The answer has drastically different implications for how much risk investors should take and how, from investing in passive indexes to picking individual stocks to structuring. If the Fed is able to generate yet another round of effective bond-yield repression, the advice for investors would be to continue to ride the liquidity wave, setting aside for now the stunning inconsistency between Fed policy and economic development. But an erosion in the power of the Fed to keep yields low and well behaved has the clear potential of disrupting the liquidity paradigm that has been so profitable for investors in stocks and a wide range of other assets regardless of their underlying fundamentals. It would risk pulling the rug out from under the TINA narrative (there is no alternative to stocks) while muting the ‘buy’ incentives from model-driven flows influenced by discounted cash flows. This would weaken the BTD (buy the dip) and FOMO (fear of missing out) conditioning that has ensured that market pullbacks are reversed quickly and decisively.
Three, how vulnerable is the American economy to potential adverse spillovers from volatile markets?
This question speaks directly to the Fed policy response—assuming, that is, the world’s most powerful central bank is not co-opted by financial markets. Based on current indicators, risks from volatile markets are likely to run a distant third to those that come from covid and the design of macroeconomic policies. Specifically, if the US economy were to fail to achieve growth expectations, increasingly in the 6% to 7% range for 2021, that would more likely be the result of a hit from a third wave of covid infections (as is happening in parts of Europe) or because of a policy accident.
As much as I have thought about these three questions, I have failed to come up with a deterministic answer—and, I think, for good reason: It involves the twin challenges of predicting the Fed’s mindset (currently stuck in active inertia mode) and market psychology (still deeply conditioned by the experience of the last few liquidity-dominated years).
Having said this, my inclination is: The risk is significant and rising that the Fed will be less able to tame the bond market anytime soon because the high-probability means to do so—active yield-curve control—comes with its own set of significant risks to market functioning, efficient price signalling and pro-productivity/growth allocation of resources throughout the economy. With this, the paradigm of ample and predictable liquidity could also be at risk, potentially undermining the remunerative wave that so many investors have surfed so successfully.
Finally, the threat of adverse spillover effects for the US economy seems limited even though the Main Street-Wall Street disconnect has grown materially in recent years.
Mohamed A. El-Erian is a Bloomberg Opinion columnist, president of Queens’ College, Cambridge; and chief economic adviser at Allianz SE
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