November 14, 2017 / 4:23 PM / a year ago

Pimco's Fels sees U.S. stuck in 'new neutral' of low rates as fear vanishes

NEW YORK (Reuters) - A top economist at Pacific Investment Management Co on Tuesday said global markets are stuck in a low interest rate environment that has siphoned fear from investors who may be ill-prepared for when the market environment next heads south.

Speaking at the Reuters Global Investment 2018 Outlook Summit, Joachim Fels, Pimco’s global economic advisor and a managing director, said the “neutral” level for interest rates has fallen as people live longer and the world becomes more globalized and technology savvy.

Fels, whose employer has about $1.69 trillion of assets under management, said that leaves central banks with less leeway to boost interest rates without triggering unwanted inflation.

“Markets are stuck in the new neutral, we will continue to live in a low interest rate environment for the foreseeable future,” said Fels, a former global chief economist at Morgan Stanley. “The drawback is that if we were to see a correction ... central banks have very little room to react.”

Investors have reacted in part by plowing money into riskier assets such as stocks and higher-yield bonds, while maintaining exposure to safer fixed-income securities as a diversifier.

That appetite for risk could backfire.

“While we think the risk of a recession over the next year is very low,” Fels said, “what we worry about most is that the fear is gone, that the fear among investors is gone for the first time in this expansion.”

Fels said investors have since the 2008 global financial crisis been “climbing this wall of worry” over such factors as the stability of U.S. banks and the euro, only to see their risk-taking rewarded in 2017 when “nothing went wrong.”

“The bigger worry is that once the correction happens, financial market participants start to realize that central banks don’t have enough bullets to fight this,” he said. “That may be the ‘Oh my God, the emperor has no clothes’ moment.”

Indeed, he said last week’s weakness in U.S. junk bonds could be a “taste of things to come.”

Fels worries that such a recession, whenever it occurs, could be “long and shallow” because central banks won’t have the tools to fight it.

He said a recession could be hastened in the United States if Congress implemented tax cuts, as opposed to more general “tax reform,” that overstimulate the economy, and used up bullets that lawmakers could use to fight the next downturn.

“For a tax cut to stimulate demand, this is probably the worst time to do it, he said.

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“It’s not a bad idea to cut taxes, don’t get me wrong,” he said. “But in terms of cutting taxes now, at a time when the labor market is almost at full employment, that raises the risk of a pickup of inflation ... It could well pave the way for a short boom now ... but possibly a recession in 2019 or 2020.”

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Editing by Jennifer Ablan and Susan Thomas

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