El-Erian: Historic Fed Announcement Yet Unchanged Markets?

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Analysts will be hard pressed to explain how equity markets ended unchanged on the day of an unprecedented policy announcement from the Fed. Rather than resort to cliches, they could consider the competing emotions felt by a patient taking an experimental drug that has not been through clinical tests. Let me explain.

The "expected and therefore fully priced in" excuse for an unchanged market does not work. A notable component of today's Fed announcement - the shift to quantitative (employment and inflation) thresholds - was a surprise. Most had expected this would not occur until March 2013 at the earliest; and the few outliers had mostly opted for January.

The second traditional explanation - compensating news - also does not work. Away from the Fed, it was a relatively quiet day.

A better answer can be found by considering the competing emotions a patient feels when confronted with news of a new drug that is yet to go through clinical testing.

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Professional investors welcomed the news that the Fed is "all in" when it comes to trying new drugs to stimulate the economy. And they fully understand that the transmission mechanism runs right through the equity markets. As Bernanke has stated, the Fed is looking to "push investors to take more risks." Hence the initial positive reaction to the announcement.

Later in the day, however, and especially when Fed Chairman Ben Bernanke answered questions, the enthusiasm dissipated. There are reasons for this too.

As the day proceeded, investors realized that, like any experimental drug, there is a material risk of complications. After all, the Fed's operational modalities are not straightforward; the analytical underpinnings are far from robust; and the Fed's prior experimental measures have not succeeded in generating sustainable growth.

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All this speaks to the competing factors that were in play today. Analysts will have to wait for more definitive evidence on the extent to which investors are willing to romance yet again another experimental and untested measure out of the Fed. In the meantime, expect the shift to quantitative thresholds to lead to greater daily volatility, especially around data releases (and most pronounced when the monthly employment reports are released).

Now, back to the fiscal cliff.

Mohamed El-Erian is the CEO and Co-CIO of PIMCO, which oversees nearly $1.8 trillion in assets and runs the Pimco Total Return Fund, the largest bond fund in the world. His book, "When Markets Collide, " was a New York Times and Wall Street Journal bestseller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year and was named a book of the year by The Economist and one of the best business books of all time by the Independent (UK).