Markets will ignore the headlines out of Washington, D.C., as long as the Federal Reserve continues to provide liquidity and keep interest rates near historically low levels, said Allianz Chief Economic Adviser Mohamed El-Erian.
"‘We are gonna stay low for long.’ That's the message the Fed wants markets to hear," El-Erian told Yahoo Finance’s On The Move on Thursday.
But in the longer-term, he says markets could be setting themselves up for disappointment if it takes central bank-provided liquidity for granted.
“If you are a tactical investor, life is relatively easy. If you are a longer-term, secular, and structural investor life is getting much more difficult,” El-Erian said.
He added that the Fed’s “dramatic 180” on policy over the last year gave markets an accommodative environment to work through political headlines like the impeachment process.
During the last year, the Fed cut interest rates by a cumulative 75 basis points and re-expanded its balance sheet to the tune of about $400 billion by buying Treasury bills. In addition, the New York Fed has provided over $200 billion in liquidity through repo market operations to ease pressures on overnight lending rates.
“The market is basically saying, ‘as long as central banks are supportive that’s what matters,’” El-Erian said.
El-Erian added that markets would be wrong to assume that the Fed could repeat these efforts “over and over again” in the face of increasing uncertainties. With geopolitical concerns brewing in Iran and ongoing negotiations in the U.S.-China trade war, the Fed has interest rates in a range of between 1.5% to 1.75%.
In previous downturns, the Fed has had to lean on at about 500 basis points of easing, well above the policy space the Fed has now.
He said the U.S. economy faces downside risks from three possible sources: geopolitical tensions (such as an escalation with Iran), a liquidity shock to the financial system, or a “major” policy mistake from the Fed.
On the U.S.-China trade negotiations, El-Erian described the phase one trade deal as a “ceasefire” and said next steps are unclear.
“I think phase two is going to be really hard to achieve,” he said.
Chinese Vice Premier Liu He will reportedly travel to Washington next week to sign the phase one trade deal, which will suspend new tariffs on Chinese imports but maintain the first round of tariffs.
Brian Cheung is a reporter covering the banking industry and the intersection of finance and policy for Yahoo Finance. You can follow him on Twitter @bcheungz.