Ray Dalio on the next downturn
“The next downturn may be a difficult one for central banks to reverse,” warned Ray Dalio, CEO of Bridgewater Associates, the world’s largest hedge fund, in a September 15 strategy note.
Ray Dalio sees an economic downturn coming. At the recent Delivering Alpha conference, Dalio shared his thoughts about the world economy reaching the end of the long-term debt cycle. “There’s only so much you can squeeze out of the debt cycle, and we’re there globally,” he said.
He also talked about the Fed’s inability to lower rates further, and the chances of interest rates going the other way (that is, up). According to Ray Dalio, if the Fed isn’t gentle in raising rates, the Fed could disrupt “price sensitivities” in the bond market (TLT) (AGG). So, Dalio’s advice to Janet Yellen and the US Federal Reserve is to “Be very cautious about tightening, and avoid tightening much faster than what Markets are pricing in.”
What are the markets pricing in?
So, what are the markets pricing in? The movement of the Federal funds futures is a good indicator of how the market (SPY) (IWM) predicts that the Fed will act. Investors tend to sell these futures if they think the Fed will hike rates. They tend to buy them if they believe the Fed will lower rates. Simply put, these are contracts that are settled at a price determined by where the Fed’s interest rate is in the month of expiration, or 100 minus the effective Fed funds rate at the time.
For example, currently the 30-day Federal funds futures with a maturity of October 2016 trades at 99.57. That implies that investors predict an interest rate of 0.43% in October 2016. The target range for the Fed funds rate is 0.25%–0.50%. With the 30-day Fed funds future for December 2016 trading at 99.5, implying a 0.51% interest rate, and the May 2017 futures trading at 99.4, implying a 0.63% interest rate, the markets do seem to be pricing in a slow and steady rise in rates beginning in December 2017.
How bad could it get?
Moreover, bond price sensitivities have been rising, so much so that the developed markets (EFA) could see a 9% loss in bonds for every 1% increase in interest rates, according to Dalio. This bond price sensitivity to interest rates hasn’t been seen in recent decades. We will discuss this more in the rest of the series.
Let’s first look at what Ray Dalio believes could have led to the increased price sensitivity of bonds in the current market environment.