Most economists, investors and traders have by now largely internalized that the global economy and financial markets are navigating three regime changes:
• Predictable injections of central bank liquidity and floored interest rates have been replaced by a generalized global tightening of monetary policy.
• Economic growth is slowing significantly as the three most systemically important regions of the global economy lose momentum at the same time.
• The nature of globalization is shifting from the presumption of ever closer economic and financial integration to greater fragmentation in part because of persistent geopolitical tensions.
Both by themselves and collectively, these three changes involve increased economic and financial volatility. In terms of the distribution of possible economic and financial outcomes, the baseline is becoming less attractive and more uncertain, and the possibility of highly negative scenarios become greater.
Last week’s market developments, including the eye-popping price moves in fixed income and foreign exchange, went beyond investors and traders having to deal with these three inconvenient paradigm shifts. Two additional factors made the week particularly unsettling.
The first was the accelerated loss of trust in policy making. Markets, which for years appreciated the US Federal Reserve and the UK government as volatility suppressors, have shifted into viewing them as significant sources of unsettling instability.
After being seduced by the notion of “transitory” inflation and falling asleep at the policy wheel, the Fed is playing massive catch-up to counter high and damaging inflation. But having fallen so far behind, it is now forced to aggressively raise rates into a slowing domestic and global economy. With that, the once wide-open window for a soft landing has been replaced by the uncomfortably high probability of the central bank tipping the US into a recession, with the resulting damage extending well beyond the domestic economy.
In the UK, the new government of Prime Minister Liz Truss has opted not just for structural reforms and energy price stabilization but also for unfunded tax cuts of a magnitude not seen for 50 years. Concerned about the implications for inflation and borrowing needs, the markets drove the value of the pound down to a level last seen in 1985. They also delivered the largest-ever surge in borrowing costs as measured by the yield on five-year government bonds.
Both these developments are inherently destabilizing, economically and financially. And both are difficult to reverse in the short term.
The second additional factor relates to the flows of funds and the implications for market liquidity.
According to data compiled by Bank of America, some $30 billion flowed out of equity and bond retail funds and into cash. This and other indicators, such as the record surge in option-related protection against equity declines, points to the possibility of large asset reallocations that have strained the orderly functioning of markets.
The greater the strains on market functioning, the more traders and investors worry about not being able to reposition their portfolios as desired. And the more they are unable to do what they wish to get done, the greater the risk of contagion. This is particularly the case in fixed income, where so many bonds now reside on the balance sheets of central banks.
As detailed in previous Bloomberg Opinion columns, I was already expecting increased volatility and price declines as markets navigated through the big three paradigm shifts. Last week’s developments point to the risk of more front-loaded instability that complicates an already bumpy journey to new economic and financial equilibria — one that makes behavioral investing mistakes more likely.
More From Bloomberg Opinion:
• Market Meltdown Sends a Warning to UK Government: Mark Gilbert
• Think of Powell as Volcker’s Wannabe Second Coming: John Authers
• Fed Must Show It’s Willing to Cause a Recession: Editorial
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of “The Only Game in Town.”
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