Many market strategists credit the Federal Reserve with the rally that has pushed the Dow and the S&P 500 to record highs.
The near-zero interest rate policy of the U.S. central bank coupled with millions of dollars worth of asset purchases monthly has essentially swelled liquidity in the market, and those funds have to find a home.
With the 10-year Treasury yield well under 2% and an economy in (a sluggish) recovery, investors have been pouring money into the U.S. stock market.
The Fed may have been the catalyst for the start of the stock rally but, according to Mohamed El-Erian, CEO of Pimco which runs the world’s largest mutual fund, “the latest surge is really not on the back of the Fed but the Bank of Japan.”
In early April Japan’s central bank announced a massive program of monetary easing that would double the country’s money supply and target a 2% inflation rate—all in an effort to once and for all slay the deflation dragon that has plagued Japan for at least a decade.
Fed officials are meeting today but no change is expected in Fed policy when the bank issues its latest policy statement at 2pm ET.
Related: Fed-Assisted Growth Stuck at 2% "New Normal" Rates Through 2013
At the Milken Institute Global Conference in Los Angeles this week, El-Erian explained to The Daily Ticker’s Lauren Lyster why monetary stimulus in Japan is now spilling over into the U.S. stock market. “The markets expect that the Bank of Japan action will push liquidity to markets in the U.S. because Japan can’t absorb all this liquidity," says El-Erian. “It makes sense to front-run that liquidity.“
But how long can that last?
As long as central banks maintain their easy money policies and the U.S. economy ultimately transitions “to genuine growth [that] will validate market prices," says El-Erian.
With one arm raised and the other lowered, he illustrates the current situation: a wedge between high stock prices and weak economic fundamentals, including a sluggish U.S. economy and a “horrible” European economy.
Related: Why Japan Bears Are Wrong and Retail Investors Should Stay Away
Eventually that gap has to narrow but in the meantime the continued involvement of central banks can maintain the rally, says El-Erian, they have become the markets’ best friends.
He says people often describe the current stock market as “the most unloved rally,” one that mixes excitement and anxiety. The excitement comes from the profits that investors can pocket; the anxiety from the feeling that the rally is somewhat artificial.
His advice to stock investors: recognize that you are riding this wave of central bank liquidity and “at some point that wave has to give way to something else." In the meantime, be resilient enough to be able to afford a mistake if it happens and agile enough to invest in areas where others aren’t.
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