How the Federal Reserve eventually sells off the hundreds of billions of dollars worth of assets it has bought in order to keep the economy afloat will be key to the future direction of the stock market, Mohamed El-Erian, Pimco CEO and co-CIO, told CNBC on Tuesday. "This exit going to be one of the most challenging issues facing any central bank," he said.
El-Erian said in a "Squawk Box" interview that he agrees with the "three hypotheses that the market is conditioned to believe." One is the Fed will not tolerate a big selloff in risk assets; two, the Fed has been forcing other central banks to be more aggressive; and third, investors can shrug off political issues.
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With blue-chip stock prices at all-time highs, investors are getting back into the market, he said, but not at the expense of bonds. El-Erian doesn't see the so-called "great rotation" — pointing out that money is flowing into stocks from cash and money markets. "Not bonds yet."
But with unconventionally, easy monetary policy, the Fed has been "artificially altering prices" and changing investor behavior, he added. "[And] this exit going to be one of the most challenging issues facing any central bank."
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El-Erian doesn't think the Fed's winding down from $85 billion a month in bond purchases, aggressive forward guidance, and near zero interest rates will "come for quite a while." But when it does happen, he said, "It's going to be incredibly complex."
"Unlike the past, we are much more structurally impaired as an economy," El-Erian explained. "We can walk, we cannot run yet. If we take away the stimulus, it's not going to be quite the same."
But he said the economy is healing. "You see it in the labor market, housing market, and most of all among companies."