FORTUNE — Those trading in many market segments would have noticed a subtle change last week: Volatility is on the rise, liquidity is getting tougher in certain places, correlations are morphing, and anxiety has increased. Moreover, rather than impact all market segments simultaneously, such dislocations seem to be cascading gradually from the least liquid to the more liquid ones.
This could well be just a blip. After all, we have had similar episodes in the last two years. Alternatively, it could be indicative of a deeper change; and, if it is (as I suspect), the related underlying shifts could be secularly beneficial or could well signal more volatile times ahead.
The answers to these questions are consequential. They speak to whether investors should expect the strong rally in risk assets to resume or whether markets face the possibility of a correction; and they have an important influence on the prospects for growth and jobs.
So let us take a look at some of the key issues, starting with Japan:
Investor reaction to Japan’s boldest post-war policy experiment has been an important contributor to the rally in risk assets over the last few months. The combination of large purchases of securities by the Bank of Japan and more expansionary fiscal policy, along with the possibility of meaningful structural reforms, has pushed investors around the world to augment their holdings of equities and risky corporate bonds at increasingly elevated prices.
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In the last few days, however, Japan is no longer emitting a consistently constructive signal. The Nikkei has fallen 12% since May 22, with some notable daily drops of 7%, 5% and 3%. The behavior of Japanese government bonds has been quite volatile and increasingly inconsistent. And the Yen is now less unidirectional.
Japan’s government seems worried about this, and it should be.
The policy experiment is a huge one. If it fails to dislodge the country out of its 25-year growth malaise, the risk of subsequent financial disruptions would rise significantly.
Having taken its initial policy measures, the Japanese government is now essentially “all in.” It has no choice but to venture even deeper into experimental territory as it attempts to influence market pricing and investor behavior. Already there is an unconfirmed news report stating that “the nation’s $1 trillion public pension fund is considering increasing its holdings in equities.” For its part, the Bank of Japan is under pressure to be even more explicit and forceful.
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The disruptive market impact of uncertainties in Japan has been accompanied by concerns about another important policy prop for markets — the large security purchases by America’s Federal Reserve Bank.
Recent signals out of Washington have led many market participants to believe that the Fed will be “tapering” its buying program, and thus reduce the enormous support it provides to financial markets. The result has been a sharp move upward in yields on U.S. government debt, the impact of which is visible in other government bond markets in both advanced and emerging countries.
Together, these two factors have contributed to higher market volatility and more patchy liquidity in certain market segments. We are also seeing a reduction in risk tolerance among intermediaries and some large investors.
All this may be nothing more than a market blip. After all, what is particularly special after the recent drops in the Nikkei given that this index has returned 57% in the last seven months? And what is so peculiar about the current level of the 10-year Treasury given that it is still broadly consistent with the range of the last year?
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A blip is certainly a possibility, but I doubt it is the most probable interpretation. Rather, markets may be signaling a deeper shift.
The hope is that recent market behavior is indicative of two eagerly-anticipated handoffs: from assisted-growth to genuine private-sector led growth; and from purchased financial stability to structurally-sound stability.
These two shifts, if and when they materialize, would mean that risk markets no longer depend on the highly experimental policies of central banks. Instead, they would be solidly anchored by improving economic and financial fundamentals – which would validate currently-artificial prices and allow them to go higher.
The problem is that recent data do not sufficiently support this hypothesis as yet.
The U.S. economy continues to heal, but economic escape velocity remains elusive. Europe is in recession and shows few signs of revamping its growth engines. Japan is still to announce growth-enhancing structural reforms. China has slowed. Some other large emerging countries (e.g., Brazil) are struggling to manage well their economies in the context of such a fluid global environment.
I worry that, rather than signal positive handoffs, recent changes are indicative of a gradual erosion in the trust that investors have placed in the power and effectiveness of central banks. It would be natural for this phenomenon to start in Japan as the country faces a difficult set of initial conditions and the lowest historical level of policy credibility.
Should this indeed be the case, look for central banks to be even more aggressive in the next few months as they try to regain control of the narrative. The Bank of Japan and the European Central bank would go further down the road of unconventional policies, and the Fed would not taper QE3 in its upcoming policy meeting as some expect.
It remains to be seen whether these additional steps would be sufficient to launch yet another robust rally in risk assets. But what is clear is that, absent a solid pickup in growth, they will fuel greater market volatility and threaten even more the longer-term credibility of central banks.
Mohamed A. El-Erian is the CEO and co-chief investment officer of PIMCO.
