Ray Dalio Says the Fed Is Almost Out of Firepower
Ray Dalio (Trades, Portfolio), the founder and long-time boss of global macro hedge fund Bridgewater, has been a student of capital markets and the debt cycle for decades. His astute observations and shrewd actions have made him a multi-billionaire and Bridgewater the largest hedge fund in the world.
Lately, Dalio has been talking a lot about the economy and his concerns that a downturn might be looming in the near-term. As we discussed in a previous research note, Dalio has been talking up the value of gold as a hedge during these times of increasing macroeconomic uncertainty, most recently in Goldman Sachs' (NYSE:GS) "Top of Mind" global macro newsletter.
Of course, gold was not the only subject on Dalio's mind during his Goldman interview. He also spent time discussing the Federal Reserve's ability to use monetary policy tools to avert a market and economic downturn:
"All told, monetary policies will be dangerously low on power in a couple of years when the next downturn is more likely to come."
According to Dalio, the Fed is depleting its ability to both prop up the current economic expansion, and soften the landing during the next contraction. If he is right, there is very good reason to feel alarmed.
Juicing up markets
Dalio began with a brief recapitulation of the impact that the Fed's easy money policies, which have been in place since the Great Recession, have had on asset prices:
"When the Fed shifted to a much easier stance, it made sense that both interest rates fell -- which was good for bonds -- and stock prices rose. But the power to do this is limited. Think of central banks cutting interest rates and purchasing financial assets (QE) as shooting doses of stimulants into their economies and markets."
This is hardly new ground, but it bears on what Dalio has to say later on. In essence, interventionist monetary tools can be very powerful, juicing up markets and causing money to sluice through the economic system at a faster pace.
However, there are fundamental limitations to these tools. Interest rates in particular are subject to the effective bottom that is 0%. True, it is possible to tip interest rates negative, as has happened in some European economies, but there is an obvious lower bound that constrains the power of monetary policy. The higher the prevailing rate, the more firepower the central bank has to deploy.
More easing on the menu
The Fed under Chairman Jay Powell took a hawkish stance in 2018, attempting to gradually bump interest rates higher and end the unprecedented era of low interest rates overseen by his two immediate predecessors. However, when markets began to panic toward the end of the year and fears of recession began to loom, Powell backed off. Now, there is even talk of cutting interest rates to stimulate the economy further.
According to Dalio, a dovish turn by the Fed may help prop up asset prices and keep the economy humming in the short-term, but it will have bearish consequences for the long-term:
"The financial world is now awash with liquidity chasing investments because of all the rate cuts and especially the QE that put $15trn into the hands of investors since the Global Financial Crisis. The Fed and other central banks easing today will push more money and credit into financial assets, which will cause prices to rise but future expected returns to decline. In other words, it's short-term bullish and long-term bearish because future expected returns will fall and central banks are running out of stimulants; interest rates are already very close to zero, and the Fed pushing more money into the system by printing it and buying financial assets will soon push the expected returns for equities and other assets as low as they can go."
Dalio's concern is understandable. The current economic expansion has been going for about a decade, while the post-recession bull market has become the longest in history. Yet, for all these apparent signs of strength, policymakers seems remarkably frightened of even moderate rate tightening.
Rates are supposed to go up during expansions to prevent overheating and to rebuild firepower. That has simply not happened during this expansion, and it appears that policymakers are too afraid to risk popping an asset bubble.
Downturn looms large
Every economic expansion eventually comes to an end, just as every bull market must eventually turn bearish. Central banks have considerable power to both prop up economic expansions when they falter, and keep the air from going out of capital markets. Yet, as we have discussed, the fuel is limited. According to Dalio, the Fed is going to be running on empty very soon:
"There is now only a limited amount of stimulant left in the bottle, and the sooner we use it, the sooner it will run out. I'd say that there is about a one-to-three year supply left...The Fed only has room to cut about 2%, which isn't much because past recessions needed about 5% of cuts. These cuts, together with QE, might be enough to prevent a recession for a few more years. But interest rates in Europe and Japan have no significant room to decline at the same time that printing money and buying financial assets will have very limited effects. So we'll see 'pushing on a string' in that part of the world."
Right now, the Fed could only practicably cut rates by about 2%, with perhaps a little wiggle-room for going negative. That is woefully inadequate compared to the financial firepower that was needed to stave off recession in the past. The Fed has never been so ill-equipped to deal with a downturn than it is now. Worse still, rather than working to conserve that precious arsenal, the Fed seems to be contemplating expending even more firepower to prop up the current, faltering expansion.
Remarkably, despite its historically weak hand, the Fed is actually better positioned than many other central banks to deal with a crisis. As Dalio observes, major European and Asian economies have even less room to cut rates. That is not good news for the global economy.
Verdict
Today, it seems that the prevailing sentiment at the Fed and on Capitol Hill is to do whatever it takes to keep this expansion going. That may help them keep their jobs for now, but it could result in dire consequences down the line.
Economies are cyclical by nature, though central banks and political leaders seem increasingly unwilling to accept that fact. No one wants to be blamed for causing a recession, nor do they want to be in the hot seat when the downturn starts. That is a recipe for short-term thinking and long-term disaster.
Investors should prepare themselves for the next downturn. Given the Fed's lack of firepower and political leaders' unwillingness to think in terms of the long-term, it could be an ugly one.
Disclosure: No positions.
This article first appeared on GuruFocus.
