Why the Fed will wait

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BLOOMBERG View columnist Mohamed A El-Erian answered questions last Friday in a live chat for readers on the Bloomberg terminal. Here is a lightly edited transcript of the conversation, hosted by Bloomberg Markets editor Joe Weisenthal

Weisenthal: It’s been an extraordinary week and there’s a lot to talk about, so let’s get right into it with a question that is sure to be on the minds of a lot of traders. Given the huge turnaround in risk assets in the second half of the week, is it possible the Federal Reserve (Fed) will still go in September if the economic data hold up?

El-Erian: I don’t think so. I think they will wait.

Remember, the Fed wishes to avoid excessive financial volatility and market instability (something that I wrote about in the Bloomberg View column posted earlier today [Aug 28]). In fact, for the last few years, its major policy bet has been to repress volatility in order to bolster asset prices as a way of encouraging household consumption and corporate investment.

I suspect that the last thing that Fed officials would wish to do is to fuel financial instability during a time of global economic weakness — and this notwithstanding data that confirms that the United States continues to heal and economically outperform others.

So as much as risk assets have turned around dramatically during the second half of this week, this may not be enough to reassure the Fed just yet to hike interest rates for the first time in over nine years.

Obviously today’s (last Friday’s) market action is dramatically less volatile than what we were seeing in the beginning of the week. Can we say the coast is clear for now, or could the volatility and the selling resume?

Yes, markets have calmed down on the back of Chinese policy actions, dovish statements by Fed official Bill Dudley and some solid US data. But the underlying causes of volatility are still with us. They include the challenging quest for high and sustained economic growth, over-reliance on central banks and financial asset prices that are still decoupled from fundamentals.

As such, there are still many economic and policy handoffs that need to materialise to establish a solid fundamental anchor for markets, and this in a political environment that is far from conducive.

When you add to that the structural change in market liquidity — one that reduces the size of the intermediation function relative to end-user demand when the market operating paradigm changes — the outlook is for more bouts of volatility, some probably quite extreme.

Mohamed, a customer is asking about whether the world is at risk of a global recession. Is that a possibility, if the Fed is tightening while China is slowing?

That risk has certainly grown. Europe and Japan remain marred in a vulnerable low level growth situation. As today’s Brazil GDP (gross domestic product) numbers show, virtually every systemically important emerging economy is slowing down. As such, the US economy finds itself as the only meaningful engine of global growth.

That’s the bad news. The good news is that there are policy solutions — and they involve a lot more than just reliance on central banks — and there is ample private sector cash on the sideline willing to engage. The key is to evolve into a more enabling political process.

This (last) week we saw outflows out of emerging markets (EMs) the likes of which we haven’t seen since the week of the Lehman collapse. Are we near the bottom for EM assets, or do we have further to go?

The outflows were caused by the volatile losses experienced by the asset class. And, in turn, they amplify the pressures on EM assets, robbing it of investment capital and liquidity.

More generally, these outflows are a reflection of the difficulties that the asset class continues to face in establishing a large and secure enough base of “dedicated investors.”

Accordingly, with “crossover” flows often being an important marginal price setter — especially at market extremes — this is an asset class that can (and does) overshoot both on the way up and on the way down (like now). So while considerable value has already been created in certain names and segments of the asset class, the path forward will be a bumpy one.

Mohamed, another customer is curious about the idea of decoupling. In 2008, people were talking about the idea of China decoupling and growing despite a US slowdown. Now it’s the other way around, and people are saying the US can grow even with the emerging world slowing down. So, can the US grow with all this weakness around the world?

Great question! And it speaks to the difference between relative and absolute decoupling.

The US can continue to grow while the rest of the world is slowing. But it will find it very hard to achieve the “escape velocity” needed for economic lift-off. And it will continue to face downward pressure on its future growth potential.

One of the main sources of angst that you hear a lot is that policymakers around the world (especially in developed markets) lack the tools to address another crisis. Interest rates are near zero, and a strong fiscal response is seen as unlikely due to debt levels and lack of political will. A customer is asking: If we do see another downturn, what kind of techniques might the Fed have at its disposal to address the situation?

In one sense, the world has used quite a bit of its crisis management ammo. Interest rates are already very low and, concurrently, central banks’ balance sheets have grown significantly — both adding to questions in some people’s mind as to the future effectiveness of unconventional policies.

Add to that the possibility of growing private sector risk aversion — one that could fuel another round of deleveraging — and there is cause to worry.

But, importantly, there are also positive elements. If you look beyond central banks, there are still quite a few underutilised policy tools. The most important ones have to do with unleashing existing growth capabilities and better matching the will and wallet to spend. Their effectiveness would be turbocharged by the engagement of the significant amount of cash now sitting on the sidelines (or being deployed in a non-economically productive fashion), as well as transformational innovations.

In an ideal world, this more comprehensive set of policies would be deployed now in order to reduce the risks of a crisis down the road. Again, it’s a question of political will rather than economic/financial design.

According to JPMorgan, much of this (last) week’s volatility is attributed to programmatic selling, into investors piling into CTA funds (a CTA [commodities trading adviser] fund is a hedge fund that uses futures contracts to achieve its investment objective) and risk-parity funds. Are you worried about strategy overcrowding and algorithmic selling?

I am not as much worried as I am conscious that this has become an important factor in assessing market technicals. Specifically, one should not be surprised at a broader range of markets overshoots — that is prices that end up at levels well beyond what would be warranted by fundamentals, whether it’s upward or downward.

One of the discussion points that arose this (last) week, amid the volatility, had to do with China selling some of its Treasury holdings in order to support the yuan. A Bloomberg terminal user is wondering what happens to the US yield curve down the road, when China doesn’t have the need to buy Treasuries to support its currency.

This is a very complex issue as it speaks not only to China’s behaviour, but also to what then happens to the cash that the country raises by selling part of its holdings of US Treasuries (USTs) and how others react.

So — with apologies — my answer will be wishy-washy and non-deterministic. Sorry!

The key issues to watch include: the maturities that China decides to sell, how the cash is then deployed (particularly, whether it ends up with another central bank elsewhere or within the private sector), who decides to “front run” the Chinese sales, and how other large holders of Treasuries react.

If I may, let me end this reply by a political observation. Absent a significant deterioration in the China-US relationship, it is hard to imagine that the Chinese authorities would embark on a huge disposal of USTs without consulting with their US counterparts. There is simply too much economic and financial codependency between the two. As such, America will have the opportunity to minimise the disruptive effects should these be deemed large.

Mohamed, this question from a terminal user gets back to the Fed. Do you think there’s still too much obsession with when the first rate hike will begin, as opposed to the ultimate pace of hikes once tightening does begin? Furthermore, do you think the yield curve adequately reflects what the Fed has been communicating?

Yes. And we should expect Fed officials to deploy a lot of effort in the weeks to come to decisively shift market attention from the timing of the first rate hike to the subsequent path and terminal point.

We are looking at the prospect of what I have labelled as the “loosest tightening” in the modern history of the Fed. It is one that will involve a very shallow path. Its destination will be a policy rate below historical averages. And, rather than consisting of quasi-automatic hikes at each meeting, the process will be much more data dependent and likely to involve stop-go characteristics.

So while the obsession with the timing is not surprising — after all, it would constitute the first hike in over nine years — it is a small part of the policy equation.

All right, the most important question of the day, and it’s something multiple customers want to know about: What’s your forecast for the [New York] Jets this season?

Oh man! You are killing me with this question.

Having supported the Jets for so many years, I cannot but hope for the best — maybe a 9-7 season that allows us to sneak into the play-offs. But it’s a big hope — a virtually eternal one I suppose.

More realistically, we may well be looking at something closer to a 6-10 season. And, you know what, I would be happy with that, especially if the wins include two against the New England Patriots! (Sorry Pats fans!) – Bloomberg View

Any opinions El-Erian expressed are his own. Bloomberg makes no recommendations about particular securities or investment strategies.


This article first appeared in digitaledge Daily, on September 2, 2015.