Why the Fed will wait

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

WEISEN­THAL: It's been an ex­tra­or­di­nary week and there's a lot to talk about, so let's get right into it with a ques­tion that is sure to be on the minds of a lot of traders. Given the huge turn­around in risk as­sets in the sec­ond half of the week, is it pos­si­ble the Fed will still go in Septem­ber if the eco­nomic data hold up?

El-Erian: I don't think so. I think they will wait. Re­mem­ber, the Fed wishes to avoid ex­ces­sive fi­nan­cial volatil­ity and mar­ket in­sta­bil­ity (some­thing that I wrote about in the Bloomberg View col­umn posted ear­lier to­day). In fact, for the last few years, its ma­jor pol­icy bet has been to re­press volatil­ity in or­der to bol­ster as­set prices as a way of en­cour­ag­ing house­hold con­sump­tion and cor­po­rate in­vest­ment.

I sus­pect that the last thing that Fed of­fi­cials would wish to do is to fuel fi­nan­cial in­sta­bil­ity dur­ing a time of global eco­nomic weak­ness -- and this notwith­stand­ing data that con­firms that the U.S. con­tin­ues to heal and eco­nom­i­cally out-per­form oth­ers. So as much as risk as­sets have turned around dra­mat­i­cally dur­ing the sec­ond half of this week, this may not be enough to re­as­sure the Fed just yet to hike in­ter­est rates for the first time in over nine years.

Weisen­thal: Ob­vi­ously to­day's mar­ket ac­tion is dra­mat­i­cally less volatile than what we were see­ing in the be­gin­ning of the week. Can we say the coast is clear for now, or could the volatil­ity and the selling re­sume?

El-Erian: Yes, mar­kets have calmed down on the back of Chi­nese pol­icy ac­tions, dovish state­ments by Fed of­fi­cial Bill Dud­ley and some solid U.S. data. But the un­der­ly­ing causes of volatil­ity are still with us. They in­clude the chal­leng­ing quest for high and sus­tained eco­nomic growth, over­re­liance on cen­tral banks and fi­nan­cial as­set prices that are still de­cou­pled from fun­da­men­tals. As such, there are still many eco­nomic and pol­icy hand­offs that need to ma­te­ri­al­ize to es­tab­lish a solid fun­da­men­tal an­chor for mar­kets, and this in a po­lit­i­cal en­vi­ron­ment that is far from con­ducive. When you add to that the struc­tural change in mar­ket liq­uid­ity -- one that re­duces the size of the in­ter­me­di­a­tion func­tion rel­a­tive to end user de­mand when the mar­ket op­er­at­ing par­a­digm changes -the out­look is for more bouts of volatil­ity, some prob­a­bly quite ex­treme.

Weisen­thal: Mo­hamed, a cus­tomer is ask­ing about whether the world is at risk of a global re­ces­sion. Is that a pos­si­bil­ity, if the Fed is tight­en­ing while China is slow­ing?

El-Erian: That risk has cer­tainly grown. Europe and Ja­pan re­main mired in a vul­ner­a­ble low-level growth sit­u­a­tion. As to­day's Brazil GDP num­bers show, vir­tu­ally ev­ery sys­tem­i­cally im­por­tant emerg­ing econ­omy is slow­ing down. As such, the U.S. econ­omy finds it­self as the only mean­ing­ful en­gine of global growth.

That's the bad news. The good news is that there are pol­icy so­lu­tions -- and they in­volve a lot more than just re­liance on cen­tral banks -- and there is am­ple pri­vate-sec­tor cash on the side­line will­ing to en­gage. The key is to evolve into a more en­abling po­lit­i­cal process.

Weisen­thal: This week we saw out­flows out of emerg­ing mar­kets the likes of which we haven't seen since the week of the Lehman col­lapse. Are we near the bot­tom for EM as­sets, or do we have fur­ther to go?

El-Erian: The out­flows were caused by the volatile losses ex­pe­ri­enced by the as­set class. And, in turn, they am­plify the pres­sures on emerg­ing mar­ket as­sets, rob­bing it of in­vest­ment cap­i­tal and liq­uid­ity.

More gen­er­ally, these out­flows are a re­flec­tion of the dif­fi­cul­ties that the as­set class con­tin­ues to face in es­tab­lish­ing a large and se­cure enough base of "ded­i­cated in­vestors." Ac­cord­ingly, with "cross­over" flows of­ten be­ing an im­por­tant mar­ginal price set­ter -es­pe­cially at mar­ket ex­tremes -- this is an as­set class that can (and does) over­shoot both on the way up and on the way down (like now). So while con­sid­er­able value has al­ready been cre­ated in cer­tain names and seg­ments of the as­set class, the path for­ward will be a bumpy one.

Weisen­thal: Mo­hamed, another cus­tomer is cu­ri­ous about the idea of de­cou­pling. In 2008, peo­ple were talk­ing about the idea of China de­cou­pling and grow­ing de­spite a U.S. slow­down. Now it's the other way around, and peo­ple are say­ing the U.S. can grow even with the emerg­ing world slow­ing down. So, can the U.S. grow with all this weak­ness around the world?

El-Erian: Great ques­tion! And it speaks to the dif­fer­ence be­tween rel­a­tive and ab­so­lute de­cou­pling.

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