So far, most of the other subasset classes in the fixed-income complex have handled higher and more volatile government yields relatively well. What remains unclear is whether such continued yield volatility will destabilize other risk factors such as credit, liquidity and market functioning.
Should that happen, stocks could also be impacted after having benefited significantly from Fed-induced conditioning that made valuations a function of TINA (there is no alternative to stocks), FOMO (the fear of missing out on yet another move higher for stocks) and, therefore, BND (buy the dip, regardless of its cause).
The Impact On The Economy
Traditionally, higher yields have influenced the real economy through three channels: affordability, wealth and risk sentiment.
The effects of the affordability channel, which are traditionally transmitted first and foremost through housing and cars, will be moderated this time by supply disruptions in the auto industry. Similarly, they will be tempered for companies given the extent to which many of them took advantage of ultra-loose financial conditions to extend their low-cost debt and reduce their carrying costs.
The indirect effects for both, however, will be strong given the increasing number of households and companies that are facing rising costs, particularly from high food and energy prices.
The wealth effect is something that is more uncertain. Undoubtedly, years of highly accommodative monetary policy pushed asset prices ever higher. The immediate reversal, however, is a function also of the extent to which investors are willing to think about absolute risks and not just relative ones.
This is related to general risk sentiment. There is likely to be an erosion, but the pace and extent will depend in large part on what happens in the country’s strong labor market.
Bottom Line
Even this narrow analysis of the effects of quantitative tightening highlights the multifaceted and fluid nature of the shift in the Fed’s liquidity paradigm. While significant uncertainties remain, there are also clear takeaways at this initial stage: The reduction in the Fed’s balance sheet is likely to be consequential, the broad contours of where the effects will be felt are clear, but the specific magnitude and timing are impossible to pin down now with a high degree of certainty.
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.