The US Federal Reserve is not paying enough attention to secular forces affecting the market, according to chairman and founder of Bridgewater, Ray Dalio, who says the “risks of the world being at or near the end of its long-term debt cycle are significant”.
In an opinion piece posted on LinkedIn, The Dangerous Long Bias and the End of the Supercycle, Dalio says “we believe that is more important than the cyclical influences that the Fed is apparently paying more attention to”.
In the article he says interest rates around the world are at or near 0 per cent, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high.
“As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant. That is what we are most focused on.”
Dalio says that since 1980 every cyclical low in interest rates and every cyclical peak was lower than the one before it until interest rates hit 0 per cent, when quantitative easing needed to be used instead.
“That is because lower interest rates were required to bring about each new re-leveraging and pick-up in growth and because secular disinflationary forces have been so strong (until printing money needed to be used instead).
“We believe those secular forces remain in place and that that pattern will persist.”
The full, unedited, article is below and can be accessed on LinkedIn
Why We Believe That the Next Big Fed Move Will Be to Ease (via QE) Rather Than to Tighten
As you know, the Fed’s template and our template for how the economic machine works are quite different so our views about what is happening and what should be done are quite different.
To us the economy works like a perpetual motion machine in which short-term interest rates are kept below the returns of other asset classes and the returns of other asset classes are more volatile (because they have longer duration) than cash.
That relationship exists because a) central banks want interest rates to be lower than the returns that those who are borrowing to invest can generate from that borrowing in order to make their activities profitable and b) longer-term assets have more duration that makes them more volatile than cash, which is perceived as risk, and investors will demand higher returns for riskier assets.
Given that, let’s now imagine how the machine works to affect debt, asset prices, and economic activity.
Because short-term interest rates are normally below the rates of return of longer-term assets, you’d expect people to borrow at the short-term interest rate and buy long-term assets to profit from the spread. That is what they do. These long-term assets might be businesses, the assets that make these businesses work well, equities, etc. People also borrow for consumption. Borrowing to buy is tempting because, over the short term, one can have more without a penalty and, because of the borrowing and buying, the assets bought tend to go up, which rewards the leveraged borrower. That fuels asset price appreciation and most economic activity. It also leads to the building of leveraged long positions.
Of course, if short-term interest rates were always lower than the returns of other asset classes (i.e., the spreads were always positive), everyone would run out and borrow cash and own higher returning assets to the maximum degree possible. So there are occasional “bad” periods when that is not the case, at which time both people with leveraged long positions and the economy do badly. Central banks typically determine when these bad periods occur, just as they determine when the good periods occur, by affecting the spreads. Typically they narrow the spreads (by raising interest rates) when the growth in demand is growing faster than the growth in capacity to satisfy it and the amount of unused capacity (e.g., the GDP gap) is tight (which they do to curtail inflation), and they widen the spreads when the opposite configuration exists, which causes cycles. That’s what the Fed is now thinking of doing—i.e., raising interest rates based on how central banks classically manage the classic cycle. In our opinion, that is because they are paying too much attention to that cycle and not enough attention to secular forces.
As a result of these short-term (typically 5 to 8 year) expansions punctuated by years of less contraction, this leveraged long bias, along with asset prices and economic activity, increases in several steps forward for each step backwards. We call each step forward the expansion phase of each short-term debt cycle (or the expansion phase of each business cycle) and we call each step back the contraction phase of each short-term debt cycle (or the recession phase of the business cycle). In other words, because there are a few steps forward for every one step back, a long-term debt cycle results. Debts rise relative to incomes until they can’t rise any more.
Interest rate declines help to extend the process because lower interest rates a) cause asset prices to rise because they lower the discount rate that future cash flows are discounted at, thus raising the present value of these assets, b) make it more affordable to borrow, and c) reduce the interest costs of servicing debt. For example, since 1981, every cyclical peak and every cyclical low in interest rates was lower than the one before it until short-term interest rates hit 0%, at which time credit growth couldn’t be increased by lowering interest rates so central banks printed money and bought bonds, leading the sellers of those bonds to use the cash they received to buy assets that had higher expected returns, which drove those asset prices up and drove their expected returns down to levels that left the spreads relatively low.
That’s where we find ourselves now—i.e., interest rates around the world are at or near 0%, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high. As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant.
That is what we are most focused on. We believe that is more important than the cyclical influences that the Fed is apparently paying more attention to.
While we don’t know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces. These long-term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars and holding a huge amount of dollar assets—at the same time as the world is holding large leveraged long positions.
While, in our opinion, the Fed has over-emphasized the importance of the “cyclical” (i.e., the short-term debt/business cycle) and underweighted the importance of the “secular” (i.e., the long-term debt/supercycle), they will react to what happens. Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required.
To be clear, we are not saying that we don’t believe that there will be a tightening before there is an easing. We are saying that we believe that there will be a big easing before a big tightening. We don’t consider a 25-50 basis point tightening to be a big tightening. Rather, it would be tied with the smallest tightening ever. As shown in the table below, the average tightening over the last century has been 4.4%, and the smallest was in 1936, 0.5%— when the US was last going through a deleveraging phase of the long term debt cycle. The smallest tightening since WWII was 2.8% (from 1954 to 1957). To be clear, while we might see a tiny tightening akin to what was experienced in 1936, we doubt that we will see anything much larger before we see a major easing via QE. By the way, note that since 1980 every cyclical low in interest rates and every cyclical peak was lower than the one before it until interest rates hit 0%, when QE needed to be used instead. That is because lower interest rates were required to bring about each new re-leveraging and pick-up in growth and because secular disinflationary forces have been so strong (until printing money needed to be used instead). We believe those secular forces remain in place and that that pattern will persist.