Bond Tumult Complicates Life for the Fed

(Bloomberg Opinion) -- The volatility in government bond yields last week compelled several market participants to call on the Federal Reserve to say, or better, do something about it, though such calls have lacked specifics. At the same time, a handful of foreign central bank officials expressed concern that the financial conditions in their own countries are experiencing, to use the words of a European Central Bank official, “undue tightening.” The tumultuousness risks complicating a long overdue evolution in the macroeconomic policy mix pursued by the U.S., including a reduction in what has been excessive reliance on unconventional monetary measures.

The root cause of these developments is, in my opinion and for the reasons foretold in my 2016 book, “The Only Game in Town,” too many years of central banks, particularly the Fed and the ECB, being pushed to compensate for the lack of responsiveness on the part of other policy makers. The use of such measures went into overdrive last March because of the pandemic-induced sudden stop of the economy. The result has been a previously unthinkable doubling of the central bank's balance sheet to more than $7 trillion, the expansion of its asset purchase program to high-yield bonds, extended guidance for ultra-low interest rates going out at least to 2023 and an often-repeated willingness to do even more.

It is more than appropriate for the Fed to do all it can to support jobs and the economy. In doing so, however, it must continuously balance the benefits of ever more intrusive intervention in the functioning of markets with the costs and risks of doing so, especially in light of the strong conditioning influence that the Fed has on a wide range of private sector market participants.

In dealing with this inherently complex and fluid benefit-cost-risk equation, the Fed has inadvertently provided the foundation for a sharp rise in risk-taking in the nonbank segment of the financial markets based more on liquidity than fundamentals. Think of it as a high-rise building. The more the Fed has stressed the reliability and strength of this foundation, the more eager the private sector has been not just to add floors on it but also shoot for the grandiose penthouse. This has played out in one asset class after another, including, most recently, the proliferation of special purpose acquisition companies (including celebrity SPACs), the explosion of debt issuance amid rock-bottom risk spreads (including for CCC rated bonds that are highly vulnerable to default), and the surge in volatile stocks (such as Telsa).

The integrity of this liquidity-based building is being challenged by both the notable steepening of the yield curve and two market near-accidents in the past few weeks that, fortunately, were avoided because of timely self-corrective flows. It's no wonder the building's residents are asking the Fed — whom they perceive to be the chief architect and superintendent — to do something to restore its stability and attractiveness. Yet, when judged in terms of what is both desirable and feasible, it is far from clear what the Fed should say and do.

By repeating the reassuring policy guidance that it used at the beginning of January following what was then a smaller 20 basis point steepening in yield curves, the central bank risks encouraging yet more floors to be built when many, including a growing number in the official sector, worry about not just the size of the building but also its implications for the neighborhood (the economy) should parts fall off. In the process, it would also open itself wider to complaints that it is fostering a worsening of inequality. These risks are even greater if the Fed were to do any or all of these: follow the Reserve Bank of Australia's example last week of an ad hoc purchase of debt; increase its program of monthly $120 billion bond purchases; or opt for more direct yield-curve control.

Given where we are, and for the reasons detailed here, the best option is for the Fed to prepare to start signaling a gradual reduction of such heavy reliance on unconventional central bank measures. This would need to be done in the context of a well-targeted fiscal relief effort, progress in supporting the war against Covid-19 (through steps to keep infections falling, accelerate vaccination and guard against new strains of the virus), congressional approvals of longer-term measures to promote productivity and inclusive growth (such as infrastructure), and better efforts to mitigate excessive risk-taking in the nonbank sector (including “sand in the wheels” measures to limit margin borrowing). Pending progress on this, the Fed should refrain from saying much, if anything. As illustrated last week by the market's reaction to remarks by both Chair Jerome Powell and Vice Chair Richard Clarida, the risk of triggering more volatility, rather than squashing it, is far from immaterial.

But what I think should happen is unlikely to be what will happen. A series of Fed officials will speak this week, culminating with Powell on Thursday as part of the Wall Street Journal's Jobs Summit. Their understandable objective will be to try to regain the narrative quickly. This requires striking a rather tricky balance between, on the one hand, reassuring markets that the Fed is not just willing but also able to promptly counter volatility and, on the other, avoiding a sharper rise in inflation expectations after the move in real yields.

In the meantime, market participants should internalize the likelihood that the main threats facing their investment portfolios do not come, in risk factor language, just from credit or interest rate components or both. A significantly bigger risk comes from the liquidity risk factor — a reality that was vividly demonstrated last Thursday in the U.S. Treasury market, the most liquid of all, when the 10-year yield suddenly exploded in a few minutes to more than 1.6% from less than 1.5% after a rather dismal auction of 7-year government bonds.

The Fed has its work cut out for it. It starts this week with the tricky need for a common set of finely crafted speaking points for central bank officials to regain control of the message. In the meantime, investors would be well advised to test the robustness of the liquidity risks they have taken in what has been a historic rise in leverage, debt and risk-taking.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens' College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."

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