Get ready for greater instability as monetary policy in the U.S. and Europe moves away from the business of suppressing volatility.
The increase in market instability should come as no surprise. It was clear from early in this (now-ending gradually) exceptional monetary-policy phase that central banks’ “unconventional policies” were aimed at repressing volatility as a means of promoting economic activity. Also, central banks have been consistent and clear about their intentions to exit this phase as economic conditions allow.
The resulting journey away from the prolonged implementation of unconventional policies inherently involves more financial and economic volatility. This is especially true given how much market participants have downplayed liquidity risk in certain segments and how many governments have been slow in implementing pro-growth structural reforms. What the destination will look like remains an open question, however. The outcome essentially depends on the orderliness and comprehensiveness of the handoff to better economic and corporate fundamentals, as well as the reset of market technicals.
As I have argued, this transition is made more uncertain by the divergent economic performances within the advanced world, as well uncertainty about trade policy. It will also be tested by two elements:
- Pockets of excessive risk-taking that emerged during the prior period of ample liquidity (from the excessive reach for yields, including through off-benchmark investor exposures, to the spread of products that implicitly promise immediate liquidity at reasonable bid-off spreads notwithstanding the inherently structural illiquid nature of the underlying assets).
- The extent to which certain governments and corporates used the period of unusually low interest rates to pile on too much debt and allow excessive currency mismatches to emerge.
The message to governments, corporates and market participants is clear: Central banks are dead serious about getting out of the business of suppressing volatility, and the process could be approaching critical mass. Much like what happens to you when you take off those fancy noise cancellation headphones in midflight on a plane and notice all sorts of noises around the cabin, markets and economies are becoming more sensitive as QE and guidance on low rates decay.
Economic actors and market participants need to get ready for greater environmental instability as monetary policy transitions away from unusual and experimental measures to historically more recognizable ones. This change has the potential to place both the global economy and markets on a more solid fundamentally based foundation over the longer-term. But it also requires timely adaptations in both or the possibility of the better could give way to the agony of the worse.
by Mohamed A. El-Erian