Most economists, investors and traders have now largely internalized that the global economy and financial markets are experiencing three regime shifts:
• Predictable central bank liquidity injections and interest rate floors have been replaced by a generalized global tightening of monetary policy.
• Economic growth slows 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 assumption of ever-closer economic and financial integration to greater fragmentation, in part because of persistent geopolitical tensions.
In and of themselves and collectively, these three changes imply increased economic and financial volatility. In terms of the distribution of possible economic and financial outcomes, the baseline becomes less attractive and more uncertain, and the possibility of very negative scenarios becomes greater.
Market developments over the past week, including stunning price movements in fixed income and currencies, have gone beyond investors and traders having to grapple with these three troublesome paradigm shifts. Two additional factors made the week particularly troubling.
The first was the accelerated loss of trust in policy-making. Markets, which for years had valued the US Federal Reserve and the UK government as volatility suppressors, began to see them as important sources of troubling instability.
After being seduced by the notion of “transitory” inflation and having fallen asleep at the political wheel, the Fed is carrying out a massive catch-up to counter high and damaging inflation. But having fallen so far behind, it is now forced to aggressively raise rates in a slowing domestic and global economy. With that, the once wide-open window for a soft landing has been replaced by the uncomfortably high likelihood that the central bank will tip the United States into a recession, with the resulting damage extending well beyond the world. national economy.
In the UK, the new government of Prime Minister Liz Truss has opted not only for structural reforms and the stabilization of energy prices, but also for unfunded tax cuts on a scale not seen for 50 years. . Worried about the implications for inflation and borrowing needs, markets drove the value of the pound down to a level not seen in 1985. They also caused the biggest increase ever in borrowing costs, measured by the yield on five-year government bonds.
Both of these developments are inherently destabilizing, economically and financially. And both are difficult to reverse in the short term.
The second additional factor relates to fund flows and the implications for market liquidity.
According to data compiled by Bank of America, some $30 billion flowed out of retail stock and bond funds and into cash. This indicator and others, such as the record rise in options-linked protection against equity declines, point to the possibility of large asset reallocations that have strained the orderly functioning of markets.
The greater the stress on the functioning of the market, the more traders and investors worry about not being able to reposition their portfolios as they wish. And the more they are unable to do what they wish, the greater the risk of contagion. This is especially the case in fixed income, where so many bonds now reside on central bank balance sheets.
As detailed in previous Bloomberg Opinion columns, I was already expecting increased volatility and lower prices as the markets went through the three big paradigm shifts. Developments over the past week point to the risk of further instability complicating an already bumpy journey to new economic and financial balances – making behavioral investment mistakes more likely.
More from Bloomberg Opinion:
• Market crash sends warning to UK government: Mark Gilbert
• Think of Powell as Volcker’s second coming: John Authers
• The Fed must show that it is ready to cause a recession: editorial
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. Former CEO of Pimco, he is President of Queens’ College, Cambridge; Chief Economic Advisor at Allianz SE; and president of Gramercy Fund Management. He is the author of “The Only Game in Town”.
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