Along with being expected to start a rate hike cycle in March, the U.S. Federal Reserve is expected to stop purchasing assets to add to its $9 trillion balance sheet.
And while multiple rate hikes seems to be largely factored into the stock market, winding down the balance sheet — i.e., start selling assets into the market as opposed to buying — is a less understood variable.
“When… the most reliable buyer with its own printing press and an incredible willingness to buy – when they step out of the market, that is a fundamental change to the marketplace,” Mohamed El-Erian, president of Queen’s College at Cambridge University and Chief Economic Advisor at Allianz, told Yahoo Finance Live this week (video above). “So it shouldn’t come as a surprise that [stock prices] are lower, because $120 billion a month of asset purchases are disappearing.”
El-Erian stressed that unwinding the balance sheet “need not be disorderly. If you can establish and you still have strong fundamentals, people will come in and take the leg up based on something much more lasting than a liquidity regime. The concern we have is by being late, the Fed also puts economic growth in play. And that means earnings become more uncertain. So that’s why this is a very delicate period. There is still a window to get this right. But unfortunately, that window is closing.”
‘A tightening cycle that is unlike any we have seen in the past’
The anticipation of increased Fed hawkishness is one of the reasons behind the uptick in volatility this year, with the CBOE Volatility Index averaging more than 23 thus far in 2022 after average of just under 20 in 2021. The MOVE Index, which measures Treasury market volatility, has also seen a more dramatic surge with a 19 percentage point rise so far this year.
According to Liz Ann Sonders, chief investment strategist at Charles Schwab, investors have to try to factor in the shrinking of the balance sheet – what she called “a tightening cycle that is unlike any we have seen in the past” – even if it’s uniquely challenging to do so.
“Unlike in past periods, they’re not giving us a playbook,” Sonders told Yahoo Finance Live. The Fed isn’t “telling us in advance: Here’s what we’re thinking in terms of balance-sheet shrink, the amount per month. Here’s what we’re thinking in terms of rate hikes. Data dependency is what they’re emphasizing, which means we’re all living day to day in terms of what the data looks like and ultimately how the Fed has to behave.”
In terms of relevant data, there are two more important inflation reads before the Fed’s next meeting on March 15 and 16: the Personal Consumption Expenditures Index (commonly known as the Fed’s preferred measure of inflation) on Feb. 25; and the Consumer Price Index, due on March 10.
‘If the Fed is not careful, we’ll get there’
In any case, El-Erian noted that the stakes are very high — not only in terms of market volatility and a drop in speculative asset prices (which has already been occurring), but also because of potential economic risk.
“In a perfect world, you want people to say this inflation is truly transitory,” he explained. “I don’t need to change my behavior. But because inflation has stayed high for so long, people are changing their behavior. They’re asking for compensation, higher wages, companies are raising prices.”
The danger, he stressed, is when companies expect costs to continue to rise and consequently preemptively raise prices for consumers.
“The really dangerous phase is anticipatory — when you feel that to protect your purchasing power, to protect your profit margins, you need to protect against future inflation,” El-Erian said. “And that’s what the Fed can help avoid is that inflationary expectations become a main driver of inflation.”
“We’re not there yet,” El-Erian added, “but if the Fed is not careful, we’ll get there.”
Julie Hyman is the co-anchor of Yahoo Finance Live, weekdays 9am-11am ET. Follow her on Twitter @juleshyman, and read her other stories.
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Source: https://finance.yahoo.com/news/mohamed-el-erian-fundamental-change-market-fed-142353665.html