Having surprised markets with extraordinary credit easing, the Federal Reserve was hoping for a quieter period in which reduced financial volatility would allow for more of the heavy lifting to be shifted to other policy makers and markets. Instead, in a repeat of a too-familiar pattern, the markets are asking for more.
Forward-looking indicators have been flirting with the possibility of negative interest rates by the end of this year or the beginning of next year. This is happening despite repeated statements by Fed officials that negative rates are unlikely and undesirable – and for good reason. The experience of Europe with negative rates suggests that the benefits are not only small, but they may well be offset by multiple costs and risks — from damage to financial intermediation to economy-wide misallocation of resources.
Yet three distinct drivers are pushing markets to press the Fed to take rates negative: the significant deterioration in economic data, including this week’s distressing jobs indicators; a desire to validate elevated stock prices that are notably decoupled from fundamentals; and the hope that if they can’t get negative rates they will get more credit easing instead. It is also another example of markets pressing for exceptional Fed support directly after an unanticipated policy easing.
In a move that surprised many — and is still baffling to some, including me — the Fed announced last month its willingness to buy not just the bonds issued by “fallen angels” — companies whose debt was rated investment grade before the economic shutdown but was subsequently downgraded to junk — but also the high-yield index. Through such action, the central bank (with the partial support of the Treasury) is willing to underwrite credit and default risk in a way that would have been unimaginable just a few weeks ago.
The markets reacted predictably: High-yield bonds soared on the expected balance-sheet backing of the Fed, and stocks went along for the ride on the view that, having entered high yield, the probability of the central bank also buying equities was considerably higher.
Now the markets are starting to press for negative interest rates, an outcome that would make risk assets more attractive in two ways: through net-present-value effects that benefit valuations and by pushing more money out of government bonds and cash and into riskier bonds and stocks.
At play here is yet again a particularly unhealthy aspect of the co-dependency that has emerged in recent years between the markets and the Fed. It is now developing ever deeper roots.
Markets that have been conditioned to think of the Fed as their BFF, quickly incorporate a positive central bank surprise and then ask for additional easing. And the more they do so, the greater the dilemma for the Fed: Either get pushed around more by the markets and deepen the moral hazard, or resist and risk disruptive financial volatility, such as the 2013 Taper Tantrum and the dislocations at the end of 2018 that forced the Fed into a policy U-turn.
With the economy under such pressure, the continued co-option of the Fed by markets risks fueling more criticism that the central bank cares much more about Wall Street than Main Street and much more about the rich, who disproportionately own financial assets, than the less-fortunate segments of society.
The time will come when the Fed will say no to unreasonable market pressure, especially if it is interested in protecting its political autonomy and policy credibility. Most traders and investors feel that won’t be for a while.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He is president-elect of Queens' College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton. His books include 'The Only Game in Town' and 'When Markets Collide.'
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