El-Erian On The Fed, Advisors & Bitcoin

December 22, 2017

Mohamed El-ErianMohamed El-Erian, chief economic adviser at Allianz, parent company of PIMCO, is one of the most well-known economists today. He’ll be sharing some of his keen insights into the markets at InsideETFs next month in Florida, and here, offers some of his thoughts on the economy and on the biggest challenge facing financial advisors. (But don’t hold your breath for a major scoop: He’s still not talking about whether he’s interested in the role of Federal Reserve vice chairman—a position he’s said to be in the running for. We’ll just have to wait and see.)

ETF.com: Most economic outlooks seem to suggest more earnings growth, more global expansion in 2018. But what does the relatively flat yield curve say about the macroeconomic environment?

Mohamed El-Erian: It says less about the macroeconomic environment than it did in the past. I'm not with those who are worried the curve has flattened so much this year, because technical influences are playing a very large role—and two in particular are dominating.

One is a spillover effect of continued large purchases of securities by the Bank of Japan and the European Central Bank. And two is a pickup in liability-driven investing, in which investors who’ve done very well on their stock holdings are de-risking their portfolios. They’re selling their stocks at record levels and covering or immunizing their liabilities by buying bonds. This isn’t about maximizing return; it’s about prudently covering your liabilities.

These two technical influences are really important, and they explain why the curve has flattened even though the economy and its prospects have improved.

ETF.com: Why is this happening? Is it unusual to see a focus away from maximizing returns?

El-Erian: No. Different investors have different risk preferences and risk appetites. And for those who have long-dated liabilities, if they don't fund it well enough, doing an LDI [liability-driven investing]-type approach is the right thing to do. And one thing the stock market has done is improved the funding levels of several institutional investors.

ETF.com: Do you expect this to continue in 2018 to the point where we should fear an inverted curve next year?

El-Erian: I don’t, because I think a few things are going to happen in 2018. First, the pace of securities purchases is coming down. We know the ECB is going to start halving its monthly purchases of securities from 60 million to 30 million euros a month. I suspect it will also signal a further reduction will happen later in the year. So, the first thing that's going to happen is less buying.

The second thing that's going to happen is I expect a pickup in the issuance of government bonds. So, technicals will slowly evolve. You're going to have a change in the balance. And the price is going to have to adjust accordingly.

ETF.com: In the U.S., will the automatic roll-off of bond positions and the shrinking balance sheet actually happen? Do you think the market can absorb the implied extra $50 billion a month of Treasuries if the Fed isn't going to be an indiscriminate buyer anymore?

El-Erian: Yes; I call this a beautiful normalization. And I'm adapting here a phrase that Ray Dalio, founder of Bridgewater, used in a different context. A few years ago, he talked about beautiful deleveraging. I think the Fed is well-embarked on a beautiful normalization.

By that, I mean it's slowly raising interest rates. It will very slowly reduce its balance sheet. And importantly, it will do so without disrupting markets or derailing the economy.

I expect that to continue in 2018. And what will it look like? I suspect it would look like two to three more interest rate hikes. And they will stick to the timetable that they have set out for reducing their balance sheet.

The biggest risk from a central bank perspective is that we don't know what happens when four systemically important central banks start taking their foot off the accelerator. We know that the Fed can do it, and that the Fed has been doing it well. What we don't know is what happens if the Fed, the ECB, the Bank of Japan and the People's Bank of China all try to do it.

If you're looking for risk factors, it's less to do with the Fed and more to do with simultaneously having more than the Fed normalize at the same time. Now, that is a risk factor, not the baseline.

The other thing that's happening that very few people are talking about is that the tax bill allows for a handoff or for a rebalancing between fiscal and monetary policy. And that is a window of opportunity for the Fed to continue normalizing without disrupting markets and without derailing economic growth.

ETF.com: On the tax bill, we hear it's good for companies, but wouldn’t the extra deficits—and Treasury sales—imply that such a supply glut would significantly impact yields?

El-Erian: There are three ways yields can be impacted. One is the noncommercial buyers, the nonprofit-maximizing buyers, do less of their buying. The second way is if growth picks up in a big way and the market prices that. The third way is if we have massive deficits, and then it's a supply issue.

In terms of direction, all three factors are going to be in play. But in terms of magnitude, they're not going to be very disruptive. I want to stress that you can always have the direction, but they're not going to be massively disruptive to the fixed-income market.

ETF.com: What are some of the signals or metrics fixed-income investors should look for?

El-Erian: First, I would focus on the strength of what is a synchronized pickup in global growth. Two, I would focus on the next steps in policy implementation in the U.S. and Europe, in particular. Three, I would focus on what the ECB and the Bank of Japan are doing. Those are the things that I think are going to play a very important role.

ETF.com: I’ve seen you characterized before as “slightly hawkish” on monetary policy. Do you find that a fair characterization?

El-Erian: I saw that, too, and I was a little bit puzzled.

ETF.com: But it sounds like you think the Fed can deliver the so-called beautiful normalization well. It's doing a good job.

El-Erian: I've been saying that for about six or seven months now. They’ve been able to very skillfully deal with it. I think the most impressive move came in March.

In March, two weeks before the FOMC meeting, the market probability of a rate hike was less than 40%. In the next week, through very skillful guidance, the Fed managed to change that probability from under 40% to over 90%. And it did so without disrupting the markets. That made me realize the Fed is really able to progress on its beautiful normalization.

Now, it did it again in October, November when market expectations of a December hike were very low. And again, the Fed guided these expectations higher. We got the March rate hike without disrupting markets. We got the December rate hikes without disrupting markets.

ETF.com: As you think about speaking at InsideETFs in January, what message do you want to get across to a group of financial advisors?

El-Erian: The biggest issue for financial advisors today is what I call the "yes, but." Yes, things are looking great. Yes, we have proliferation products, including in the ETF space, that allow us to do things in a much more sophisticated manner.

Yet in the back of their minds, there's a big "but." This "yes, but" is very challenging to investing. I hope to talk a little bit about the "yes, but," and how they can think and help their clients think about navigating the "yes, but" world.

What most advisors are going to have to distinguish is between the journey and the destination. The journey is the tug of war between the "yes" and the "but." The destination is either "yes" or "but"; it can't be both. How to think about that distinction between a journey and a destination is something a lot of the advisors' clients are going to want to talk about.

ETF.com: Is an example here something like, “Yes, equities keep breaking new records, but valuations are high”?

El-Erian: Correct. Or, “Yes, we've had great support from central banks, but central banks are looking to normalize.” If you want to get everybody's attention in the room, the "yes, but" is in bitcoins.

ETF.com: What do you think of bitcoins?

El-Erian: I always make the distinction between the underlying technology and bitcoins themselves. The underlying technology is real; it is a notable disruptive technology—the blockchain. We will see more and more public and private uses of blockchain technology. That's for real, that's important and it has to be taken seriously.

I'm more cautious about bitcoins. Valuations assume a much faster rate of adoption than what’s likely to happen, particularly for those who believe that this is a new currency. It takes time to establish a currency. I worry that valuations may have gotten way ahead of what’s likely to materialize.

Having said that, I would’ve told you the same thing when bitcoins were half the price. So, I'm also humbled by the extent to which the price has moved.

Contact Cinthia Murphy at [email protected]

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