Markets expectations of a Fed pivot have led to the largest loosening of financial conditions, Mohamed El-Erian said.
He told CNBC that a slowdown will happen, but markets are pricing in recession-level cuts.
El-Erian expects the Fed to remain careful, warning that current inflation trends might not hold.
Growing consensus that the economy will slow down enough to allow interest cuts next year has led to a substantial market turnabout, economist Mohamed El-Erian told CNBC.
But it appears to have gone too far.
"There is a market romance right now with the soft-ish of soft landings," he said. "I think that's probably too much of a romance, but it is one that led to the biggest monthly loosening of financial conditions on record."
While the Federal Reserve hasn't lowered benchmark rates yet, other indicators of borrowing costs have plunged recently on hopes that monetary policy easing is coming next year.
For example, the 10-year Treasury yield hit 5% in late October, but plunged below 4.3% a month later.
In fact, the decline has been so sharp that S&P Global Ratings noted that week it amounts to significant easing in financial conditions — enough that it may even require the Fed to raise rates one more time.
Meanwhile, the rate-cut optimism fueled stocks, with all three indices rallying heavily through November. The S&P 500 jumped around 9%.
But the loosening has come at a time when the Fed is still warning investors that a pivot to rate cuts would be premature, El-Erian warned. And while investors are right to expect a 2024 slowdown, they're pricing in cuts that indicate something is about to break.
"I wouldn't go as far as the market to price in a 50% probability of a March cut and five cuts next year, unless you believe we're going into recession," he said. "If you believe we're going into recession, then equities shouldn't be where they are."
Instead, he thinks the Fed will remain careful in its approach, and reminded investors that forthcoming inflation data may not be as encouraging as it recently has been.
Barclays also projected a cautious Fed, saying the central bank is expected to limit interest rate cuts to around 100 basis points next year due to continued economic strength.
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