As the world waited for the Federal Reserve to make its third “jumbo” interest rate hike, Bridgewater Associates founder Ray Dalio issued a warning to anyone still clinging to hopes that Beaten asset prices may soon rebound.
According to Dalio’s estimate, the Fed must continue to raise interest rates substantially if it hopes to successfully control inflation. For this reason, and other factors like the ongoing war in Ukraine, Dalio expects stocks and bonds to continue to suffer as the US economy likely slips into recession 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 the election,” Dalio said in an interview with MarketWatch Editor-in-Chief Mark DeCambre at the inaugural MarketWatch “Best New Ideas in Money,” which kicked off Wednesday. morning in Manhattan.
Fed Chairman Jerome Powell has promised that the central bank will do everything in its power to rein in inflation, even if it crashes markets and the economy in the process. But to get there, Dalio believes the Fed needs to raise benchmark interest rates to between 4% and 5%. Now that the Fed has made its third interest rate hike of 75 basis points, the fed funds rate will rise above 3% for the first time since before the financial crisis.
“They need to get interest rates – short rates and long rates – up to around 4.5%, it could be even higher than that,” he said. Because the only way the Fed can successfully fight inflation is to distribute “economic pain”.
Futures traders predict the Fed could raise the benchmark rate, which underpins trillions of dollars in assets, to as much as 4.5% by July, according to the CME’s FedWatch tool. But traders only see an outside chance that the rate will hit 5% before the Fed decides to start cutting rates again.
In the United States, inflation eased slightly after hitting its highest level in more than 40 years during the summer. But a report on consumer price pressures in August sent financial markets tumbling last week as elements of “core” inflation, such as housing costs, appeared more tenacious last month than economists had predicted. But the current energy crisis in Europe has led to even greater 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 should increase the discount rate they use to determine the present value of future cash flows, or interest payments, associated with a stock or bond. given. Since higher interest rates and inflation are essentially a tax on these future income streams, investors generally compensate by assigning a lower valuation.
“When you make an investment, you put in a lump sum payment for future cash flows, and then to say what they were worth, you take the present value and use a discount rate. And that’s what makes all boats rise and fall together,” Dalio said.
“When you bring interest rates down to zero, or close to zero, what happens is that all asset prices go up,” Dalio added. “And when you go the other way, it has the opposite effect.”
While Dalio said he expects equities to take more losses, he pointed to the bond market as a particular area of concern.
The problem, according to Dalio, is that the Fed no longer monetizes the debt issued by the federal government. In September, the Fed plans to double the rate at which Treasuries and mortgage bonds leave the central bank’s balance sheet.
“Who is going to buy these bonds?” Dalio asked, before noting that China’s central bank and pension funds around the world now have less incentive to buy, in part because the real yield that bonds offer when adjusted for inflation has fallen significantly.
“We had a bond bull market for 40 years…everyone who owns bonds did the
prices have gone up, and that has gone from strength to strength for 40 years,” Dalio said. “Now you have negative real yields in bonds…and you’ve driven them down.”
When asked if ‘cash is still trash’, a quip Dalio repeatedly repeated, he said holding cash was still ‘trash investing’ because interest rates interest are not yet high enough to fully offset the impact of inflation. However, the true usefulness of money depends on “how it compares to others”.
“We’re in this ‘reduce financial assets’ mode,” Dalio added.
Asked if he was still bullish on China, Dalio said yes, but said it was a risky time to invest in the world’s second-largest economy, which could create opportunities for investors. long-term.
“Asset prices are low,” he said.
Dalio offered a humorous retort when asked to share his thoughts on where the markets might go.
“There is a saying: ‘He who lives near the crystal ball is destined to eat ground glass’.”
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