As the world waits for the Federal Reserve to deliver what’s expected to be its third “jumbo” interest-rate hike, Bridgewater Associates founder Ray Dalio shared a warning for anybody still hanging on to the hope that beaten-down asset prices might soon bounce back .
In Dalio’s estimation, the Fed must continue to substantially raise interest rates if it hopes to succeed in taming inflation. Because of this, and other factors like the ongoing war in Ukraine, Dalio anticipates that stocks and bonds will continue to suffer as the US economy likely slides into recession either in 2023 or 2024.
“Right now, we’re very close to a 0% year. I think it’s going to get worse in 2023 and 2024, which has implications for elections, “Dalio said during an interview with MarketWatch editor-in-chief Mark DeCambre during the inaugural MarketWatch” Best New Ideas in Money “festival, which kicked off Wednesday morning in Manhattan.
Fed Chairman Jerome Powell has pledged that the central bank will do everything in its power to curb inflation, even if it crashes markets and the economy in the process. But to accomplish this, Dalio believes the Fed must raise benchmark interest rates to between 4% and 5%. Assuming the Fed does raise interest rates on Wednesday by at least 75 basis points, this would take the Fed funds rate above 3% for the first time since before the financial crisis.
“They need to get interest rates – short rates and long rates – up to the vicinity of 4.5% -ish, it could be even higher than that,” he said. Because the only way the Fed can successfully fight inflation is by doling out “economic pain.”
Futures traders are anticipating that the Fed could raise the benchmark rate, which underpins trillions of dollars in assets, as high as 4.5% by July, according to the CME’s FedWatch tool. But traders only see an outside chance that the rate will reach 5% before the Fed decides to start cutting rates again.
In the US, inflation has eased slightly after hitting its highest level in more than 40 years over the summer. But a report on consumer-price pressures in August sent financial markets into a tailspin last week as elements of “core” inflation, like housing costs, appeared more stubborn last month than economists had anticipated. But the ongoing energy crisis in Europe has led to even more severe increases in the cost of everything from heat to consumer goods.
Using some of the most basic principles of corporate finance, Dalio explained why higher interest rates are anathema to financial assets, as well as real assets like the housing market.
Simply put, when interest rates rise, investors must increase the discount rate they use to determine the present value of future cash flows, or interest payments, tied to a given stock or bond. Since higher interest rates and inflation are essentially a tax on these future revenue streams, investors typically compensate by assigning a lower valuation.
“When one makes an investment, one puts a lump-sum payment for future cash flows, then in order to say what they were worth, we take the present value and we use a discount rate. And that’s what makes all boats rise, and decline, together, ”Dalio said.
“When you bring interest rates down to zero, or about zero, what happens is it raises all asset prices,” Dalio added. “And when you go the other way, it has the opposite effect.”
While Dalio said he expects stocks will endure more losses, he pointed to the bond market as a particular area of concern.
The problem, as Dalio sees it, is that the Fed is no longer monetizing the debt issued by the federal government. In September, the Fed is planning to double the pace at which Treasury and mortgage bonds will roll off the central bank’s balance sheet.
“Who is going to buy those bonds?” Dalio asked, before noting that the Chinese central bank and pension funds around the world are now less motivated to buy, partly because the real return that bonds offer when adjusted for inflation has moved substantially lower.
“We had a 40 year bull market in bonds… everybody owning bonds made the
price go up, and that was self reinforcing for 40 years, ”Dalio said. “Now you have negative real returns in the bonds … and you got them going down.”
When asked if “cash is still trash,” a signature quip that Dalio has repeated on several occasions, he said holding cash is still “a trash investment” because interest rates aren’t yet high enough to fully offset the impact of inflation. However, the true utility of cash depends on “how it compares to others.”
“We’re in this ‘write down financial assets’ mode,” Dalio added.
Asked if he is still bullish on China, Dalio replied that he is, but he clarified that it’s a risky time to be investing in the world’s second-largest economy, which could lead to opportunities for long-term investors.
“Asset prices are low,” he said.
Dalio offered a humorous retort when asked to share his thoughts on where markets might be headed.
“There’s a saying: ‘he who lives by the crystal ball is destined to eat ground glass’.”
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