As the world waits for the Federal Reserve to deliver what is expected to be its third “jumbo” rate hike, Ray Dalio, founder of Bridgewater Associates, warned those who still cling to hope that battered asset prices may soon bounce back.
According to Dalio, the Fed must continue to raise interest rates significantly if it wants to successfully curb inflation. Due to this and other factors such as the ongoing war in Ukraine, Dalio believes stocks and bonds will continue to suffer as the US economy is likely to slide into recession in either 2023 or 2024.
“Right now we are very close to a 0% year. I think it’s going to get worse in 2023 and 2024, which has election implications,” 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 Chair Jerome Powell has promised that the central bank will do everything in its power to contain inflation, even if it crashes markets and the economy in the process. But to do that, Dalio believes the Fed needs to raise interest rates to 4% to 5%. Assuming the Fed hikes rates by at least 75 basis points on Wednesday, that would take the Fed interest rate above 3% for the first time since before the financial crisis.
“You need to get interest rates — short and long interest rates — up close to 4.5%, it could be even higher,” he said. Because the only way the Fed can successfully fight inflation is to distribute “economic pain.”
Futures traders are anticipating the Fed could hike interest rates, which underpin trillions of dollars in assets, to as much as 4.5% by July the CME’s FedWatch tool. But traders only see an outside chance that the interest rate will hit 5% before the Fed decides to cut rates again.
Inflation in the US eased slightly after hitting its highest level in more than 40 years in the summer. But a report on consumer price pressures in August sent financial markets into a tailspin last week as elements of “core” inflation, such as housing costs, appeared more stubborn last month than economists had expected. But the ongoing energy crisis in Europe has led to even greater increases in costs for everything from heat to consumer goods.
Using some of the most fundamental principles of corporate finance, Dalio explained why higher interest rates are anathema to both financial assets and real assets like the housing market.
Simply put, when interest rates rise, investors need to increase the discount rate they use to determine the present value of future cash flows or interest payments tied to a particular stock or bond. Because higher interest rates and inflation are essentially a tax on these future revenue streams, investors typically compensate by assigning a lower valuation.
“When you make an investment, you pay a lump sum for future cash flows. Then to say what they were worth, we take the present value and use a discount rate. And that’s what makes all the boats rise and fall together,” said Dalio.
“If you cut interest rates to zero or near zero, all asset prices go up,” Dalio added. “And if you go the other way, it has the opposite effect.”
While Dalio said he expects stocks to suffer 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 plans to double the pace at which Treasuries and mortgage bonds will disappear from the central bank’s balance sheet.
“Who is going to buy these bonds?” Dalio asked, before noting that the People’s Bank of China and pension funds around the world are now less motivated to buy, in part because the real yield that bonds offer, adjusted for inflation, has fallen significantly.
“We’ve had a 40-year bull market in bonds…everyone who owns bonds has done this
Prices are going up, and it’s been self-reinforcing for 40 years,” Dalio said. “Now you have negative real yields on bonds… and you’ve brought them down.”
When asked if “cash is still garbage,” a signature joke Dalio has repeated on several occasions, he said that holding cash is still “a garbage investment” because interest rates aren’t high enough yet, to fully offset the effects of inflation. However, the true usefulness of cash depends on “how it compares to others”.
“We’re in this ‘write off financial assets’ mode,” added Dalio.
When asked if he was still optimistic about China, Dalio replied that he was, but he clarified that it is a risky time to invest in the world’s second largest economy, leading to opportunities for long-term investors could lead.
“Asset prices are low,” he said.
Dalio gave a humorous response 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.'”
https://www.marketwatch.com/story/ray-dalio-says-stocks-bonds-have-further-to-fall-sees-u-s-recession-arriving-in-2023-or-2024-11663777067?rss=1&siteid=rss Ray Dalio says stocks and bonds must fall further sees US recession in 2023