Most economists, investors and traders have now largely internalized that the global economy and financial markets are going through three regime changes:
• Predictable central bank liquidity injections and floor interest rates have been replaced by broader global monetary tightening.
• Economic growth is slowing significantly as the three systemically most important regions of the world economy lose momentum simultaneously.
• The nature of globalization is shifting from an assumption of ever-closer economic and financial integration to one of greater fragmentation, in part due to ongoing geopolitical tensions.
Both individually and collectively, these three changes are leading to 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 strongly negative scenarios increases.
Market developments over the past week, including the notable price moves in fixed income and FX, went beyond the fact that investors and traders had to grapple with these three uncomfortable paradigm shifts. Two other factors made the week particularly choppy.
The first was the accelerated loss of confidence in policy making. Markets that the US Federal Reserve and UK government valued for years as volatility suppressors have come to view them as major sources of worrying instability.
After being seduced by the notion of “temporary” inflation and falling asleep at the political wheel, the Fed is catching up massively to counter high and damaging inflation. But having fallen so far, it is now forced to raise rates aggressively amid a weakening domestic and global economy. That has replaced the once-wide window for a soft landing with the uncomfortably high probability that the central bank will plunge the US into a recession, with damage extending far beyond the domestic economy.
In the UK, Prime Minister Liz Truss’ new government has opted not only for structural reforms and stabilizing energy prices, but also for unfunded tax cuts on a scale not seen in 50 years. Markets, concerned about the impact on inflation and borrowing needs, pushed the value of the pound to levels last seen in 1985. They also delivered the largest increase in the cost of borrowing, as measured by the five-year Treasury yield.
Both developments are inherently destabilizing economically and financially. And both are difficult to reverse in the short term.
The second additional factor concerns cash flows and the impact on market liquidity.
According to Bank of America, about $30 billion flowed into cash from retail stock and bond funds. This and other indicators, such as the record surge in option protection related to stock declines, point to the possibility of large-scale asset shifts that have strained the orderly functioning of markets.
The greater the strain on the functioning of the markets, the more concerned traders and investors are about not being able to reposition their portfolios as desired. And the more they are unable to do what they want to do, the greater the risk of contagion. This is especially true for fixed income, which is where so many bonds now sit on central bank balance sheets.
As detailed in previous Bloomberg Opinion columns, I was already anticipating heightened volatility and falls as markets navigated the Big Three paradigm shifts. Developments over the past week point to the risk of even greater instability complicating an already bumpy journey to new economic and financial equilibriums – one that makes behavioral investing errors more likely.
More from the Bloomberg Opinion:
• Market meltdown sends UK government warning: Mark Gilbert
• Think of Powell as Volcker’s Second Coming wannabe: John Authers
• The Fed must show it is ready to trigger a recession: editorial
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Mohamed A. El-Erian is a columnist for the Bloomberg Opinion. A former Chief Executive Officer of Pimco, he is President of Queens’ College, Cambridge; Chief Economic Advisor of Allianz SE; and Chairman of Gramercy Fund Management. He is the author of The Only Game in Town.
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