Why equities sold off despite a dovish Fed

On the surface, you would have thought that the stock market would have liked the outcome of the Federal Reserve meeting; and you would have expected that front-end interest rates would have been relatively well anchored. Instead, equities sold off while the yield curve flattened as a result of a selloff in shorter maturities.


Mohamed El-Erian
Joshua Roberts | Bloomberg | Getty Images
Mohamed El-Erian

In attempting to answer this question, let us start with a quick summary of what the Federal Open Market Committee decided at the end of its two-day meeting:

* As expected, our central bankers continued to taper their experimental purchases of securities, reducing the pace of monthly purchases by another $10 billion. They remain on track to exit quantitative easing fully by the end of the year.

(Read more: Fed tapers, backs away from unemployment target)

* To compensate, they strengthened their forward policy guidance in two ways: by replacing the increasingly outmoded and partial 6.5-percent unemployment threshold with a more holistic approach to the labor market; and by making explicit an inflation indicator that is above the current rate.

* They reiterated their intention to keep policy rates floored for quite a while, even after inflation and unemployment are near their "mandated levels." During her press conference, Janet Yellen stated that the FOMC could keep interest rates lower than "normal values" and that the glide path would be shallower.

(Read more: What's new in the latest Fed statement)

By any measure, this is quite a dovish outcome — overall and relative to expectations. Unambiguously it signals a Fed that remains dedicated to support the economy, and to do so by continuing to use the asset market channel.

So why didn't markets like it? I would suggest three inter-related possibilities:

Higher uncertainty premiums: The Fed is in the midst of not one but two policy transitions. It is pivoting from reliance on a direct instrument (QE purchases of securities in the marketplace) to an indirect one (forward policy guidance to convince others to devote their balance sheets) — thereby raising effectiveness questions. It is also moving from a readily-observable unemployment threshold to a set of indicators that include qualitative judgments — thereby raising less predictable interpretation questions.

(Read more: How did the market react? Click here)

Technical market conditions: Given the impressive multi-year rally, it doesn't take much these days to convince equity traders to book profits (and it hasn't taken long for buyers to buy on the dip). Similarly, over-extended front end rates positions can be destabilized in the immediate term even if the Fed is committed to maintaining low rates for long.

Reaction to the interest-rate selloff: With a significant part of the economy sensitive to short and intermediate interest rates, including housing, and with the economic recovery yet to broaden sufficiently, it is not surprising that the stock market would be concerned with a sharp selloff in the shorter-dated rates.

What about the longer-term?

(Read more: Fed is now doing 'qualitative easing': Insana)

Here, much depends on your assessment of the first factor — namely, Fed policy effectiveness during its policy transition. Unfortunately, there are no tested models, policy playbooks or historical data to confidently guide investors. What is clear, however, is that they will require quite a bit of evidence of ineffectiveness before abandoning their faith in an institution that has significantly supported markets in recent years.

Finally, it is refreshing to see the extent to which the new FOMC chair is willing to provide information, explanations and clarifications — thereby taking the world's most powerful central bank further down the road of greater transparency. It will not take long for the markets to get used to this, and appreciate it.

Mohamed A. El-Erian, former CEO and co-CIO of PIMCO, is a member of the International Executive Committee at Allianz and chief economic advisor to its management board, chair of the President's Global Development Council, and author of the NYT/WSJ bestseller "When Markets Collide." Follow him on Twitter @elerianm.