Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

The Federal Reserve is in a bad position right now.

It must decide whether to raise interest rates this month despite economic data that paint an unimpressive picture of U.S. growth. Bond traders are betting the Fed won't pull the trigger. But there's one big reason to think they may be in for a surprise.

Not-So-Great Expectations
Futures traders have ratcheted back their expectations for a September Fed interest-rate hike
Source: Bloomberg

Mohamed El-Erian, Allianz’s chief economic adviser, put it well when he said,"This is going to ultimately come down to one fundamental issue: How worried are Fed officials about the collateral damage and the unintended consequences of a protracted period of low interest rates?" 

If they're as worried as El-Erian is, they'll raise rates, he said in a Bloomberg Television interview last week. If not, they'll wait.

El-Erian brings up an important point. The Fed has come to a crossroads after suppressing volatility for years. Investors from retirees to insurers are still piling into risky assets such as junk bonds, equities and emerging-markets debt even though corporate profits are declining and leverage is rising.

Big Winners
Risky assets have soared this year against a backdrop of low volatility and central bank stimulus
Source: Bank of America Merrill Lynch index data

It's hard to blame them. Investors have been penalized with below-average returns for their caution and rewarded for taking risks that may turn out to be irresponsible in the long run. Meanwhile, risk-adjusted returns look great for these assets because the Fed is dampening all types of risk.

This raises two questions: First, can the U.S. economy withstand a rate hike, given the tepid growth even after years of unconventional policies? The answer is most likely yes, and if it can't, holding rates low forever won't necessarily save it. It'll just create a bigger financial problem that needs to be dealt with eventually.

And second, can a single rate increase significantly dampen this zest for yield?

I argued a few weeks ago that it's hard to see how a quarter of a percentage point would make much of a difference. European and Japanese central bankers are still plumbing the depths with their novel stimulus efforts. Last year’s rate hike did little to nothing to diminish investors’ risk-taking appetite.

But I overlooked a critical element -- the element of surprise, which could induce some price swings into markets that are eerily calm. A dose of volatility would be healthy right now. It would remind investors of potential hazards. And more important, perhaps it would even goad politicians into enacting fiscal solutions that the Fed has indicated would help improve the U.S. economic outlook.

Eerie Calm
A measure of expected volatility across markets has shrunk to relatively low levels
Source: BofA Merrill Lynch GFSI Market Risk index
Levels greater/less than 0 indicate more/less stress than is normal.

Such a surprise would also be a positive development for other central bankers overseas as they grapple with oversized asset purchases programs that are rapidly losing their punch. While the Fed doesn't control global monetary policy, it can set an important tone.

This month the Fed could finally send a message that it's willing to potentially sacrifice short-term stability for a better chance at longer-term financial balance. The central bank has steered a cautious and deliberate course. Now may be the time to shake things up a little.

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

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net