By Mark Melin
As Ray Dalio's end of the debt super-cycle is playing itself in real time, with upside and downside volatility playing itself out as predicted, he notes the impact of quantitative easing and monetary policy in general is having less impact the further into debt cycle the economy travels. There is still currency moves to take place - and currency is perhaps the one area where stimulus will have the most significant economic impact.
If one is an investor or saver, these are difficult times as "pushing on a string" perhaps has multiple meanings - the specter of negative interest rates is on the horizon. It is through the eyes of investors/savers and borrowers/spenders that Dalio considers this rather odd moment in history. From many perspectives, success has been pulled from the future to the present. The question is: how long can this last?
The machine of how currencies, interest rates and modern economies work together can at times look like a dysfunctional family where the fight for parental attention can at times reach new and destructive lows, while at other times the kids seem like angels and the economy is on a fairytale track. It is in this sycophantic market environment that Dalio attempts to explain the economic forces that are converging to make history. ValueWalk has obtained an advance copy of a note which Ray Dalio will be releasing publicly later today. Below readers can find the entire memo (which was originally a lengthier Daily Observations note sent to clients on February 12th).
What Monetary Policy 3 Will Look Like
By Ray Dalio
Monetary Policy 1 was via interest rates. Monetary Policy 2 was via quantitative easing. It will be important for policy makers and us as investors to envision what Monetary Policy 3 (MP3) will look like.
While monetary policy in the US/dollar has not fully run its course and lowering interest rates and quantitative easing can still rally markets and boost the economy a bit, the Fed's ability to stimulate via these tools is weaker than it has ever been. The BoJ's and ECB's abilities are even weaker. As a result, central banks will increasingly be "pushing on a string." Let's take just a moment to review the mechanics of why and then go on to see what MP3 will look like.
Why "Pushing on a String"?
Lending in order to finance spending requires both investors/savers and borrowers/spenders, who have very different objectives, to each operate in both their own interests and in a symbiotic way. For example, when a debt expansion that finances spending on goods and services takes place, both a) the investors/savers increase their debt holdings because they believe that they are increasing their assets, and b) the borrowers produce those borrowings (that investors/savers call an 'asset') to increase their spending. When both are going on in a big way (i.e., when debts, financial assets, and spending are rising fast), we have a boom. However, because both savers and borrowers often don't do the calculations very well to determine whether the debt created will be used to produce more than enough income to service the debts, we also have busts. So, to understand how central banks' monetary policies work, one has to see things through the eyes of both investors/savers and borrowers/spenders.
I will look at the process from the investment side, as that is now more important because central bank policies, especially quantitative easing, have their effects more by affecting the behavior of investors/savers than by affecting the behavior of borrowers/spenders. When the central bank buys a bond, it does so from a saver/investor who takes the cash to make an alternative investment decision. What they invest/save in makes all the difference in the world. When investing/saving is in the sort of assets that finance spending, that stimulates the economy. However, when investing in that sort of asset is unattractive, which is what happens when the "risk premiums" are low and/or investors are scared, it does not. To the extent that interest rates decline, that also has a positive effect on all asset prices because all investments are exchanges of lump sum payments for a stream of future cash flows, and the interest rate (i.e., the discount rate) is the rate that is used to calculate the present value of these cash flows. All else being equal, the more interest rates are pushed down, the more asset prices will be pushed up. That is how monetary policy now works.
So, Where Do Things Now Stand?
The discount rate is just about as compressed as it can be, so the potential present value effect of lowering it is nearly at its end. That's a big thing. In terms of the risk premiums of "risky assets," they're now neither especially high nor low, so there is a bit more to be squeezed out of them, more so in the US than elsewhere. Put these two pieces together and it's clear that the future returns of assets will be low, which will be a problem given what the returns need to be to meet our future obligations. Though not pressing, that issue is something that central banks will have to deal with, which helps to inform the picture of what MP3 will probably look like - i.e., they will need more "money printing." From the perspective of an investor, if you look at the level of the returns relative to levels of volatility, the expected reward-risk could make those who are long a lot of assets view that terrible-returning asset called cash as appealing.
To clarify, take current bond yields (less than 2%) and cash (0%) and compare that to something like a 4% expected return on equities. Because of volatility, the 4% expected annual return pick up of equities over cash, or 2% over bonds, can be lost in a day or two. (For example, stocks fell by nearly 5% in a week earlier this month.) And then there is the feedback loop where a sell-off in the stock market in turn has a negative pass-through effect on the rate of economic activity. All that makes for asymmetric risks on the downside in the US - and the pictures in other countries are even more asymmetrical on the downside, as their interest rates are even lower and their risk premiums are nearly gone.
The mechanics of how currencies, interest rates, and economies work together is also important to understand at this time as they will have a big effect. Remember that all debt is a promise to deliver a specific currency, so when the currency gets more or less valuable, it affects people's behaviors. That is true now more than ever because those who have money are exposed to alternative currencies to keep their wealth in (or to borrow in) and because the major currency systems are all in fiat currency. So more money than ever will move from one currency to another, or from currencies to other assets (e.g. gold), based on what people are thinking about how the values of currencies will change. Also we should expect currency volatility to be greater than normal because 1) when interest rates can't be lowered and relative interest rates can't be changed, currency movements must be larger, and 2) when both relative interest rates and relative currency movements are locked together (e.g., in European countries and wherever there are pegged exchange rates), relative economic movements must be larger. Said differently, to avoid economic volatility, currency movements must be larger. That reality creates "currency wars," pegged exchange rate break-ups, and increased currency risk for investors. Because currency movements benefit one country at the expense of another (e.g., they're beggar-thy-neighbor), if the world's largest economies all face the difficulty of pushing on a string, exchange rate shifts won't create a needed global easing. Nobody intends these wars to happen. That's just how the economic machine works.
For these reasons investors should expect to experience lower than normal returns with greater than normal risk.
Asset prices have fallen largely as a result of this, together with the deflationary pressures brought about by most economies being in the later stages of their long term debt cycles.
So, how might the current decline in risky assets transpire? That depends on what levels risky assets need to decline to in order to raise their risk premiums enough to cause investors who have a long bias (which most all have) to take their cash holdings (or to borrow cash) to add to those assets. With the central banks' abilities to be effective in easing to reverse a downturn weaker than before, the past may not be a good guide because the self-reinforcing cycle of falling asset prices having negative economic effects may not be as easily reversed as in more normal times. In other words, the downside risks are greater. That doesn't mean that a downturn is likely - it's just that the risks are asymmetrical if one does.
Most likely, as risk premiums increase, central banks will increasingly ease via more negative interest rates and more QE, and these moves will have a beneficial effect. However, I also believe that QE will be less and less effective because there is less "gas in the tank." To convey how much gas they have left in the tank, we created an index based on the previously described drivers. It is shown below for the US since 1920 and for Euroland and Japan since 1975. As shown, for the US it is as low as ever and approximately the same as in 1937. Because of this, we think that the 1937-38 period, though not identical, is the most analogous period to look at when thinking about interest rates, currency rates, monetary policies, and global economic activity. It, and the mechanics behind it, are worth understanding.
The next two charts show the same measure going back to 1975 in Euroland and Japan.
Ray Dalio: What Will Monetary Policy 3 Look Like?
While negative interest rates will make cash a bit less attractive (but not much), it won't drive investors/savers to buy the sort of assets that will finance spending. And while QE will push asset prices somewhat higher, investors/savers will still want to save, lenders will still be cautious lenders, and cautious borrowers will remain cautious, so we will still have "pushing on a string." As a result, Monetary Policy 3 will have to be directed at spenders more than at investors/savers. In other words, it will provide money to spenders and incentives for them to spend it. How exactly that will work has to be determined. However, we can say that the range will extend from classic fiscal/monetary policy coordination (in which debt to finance government spending will be monetized) to sending people cash directly (i.e., helicopter money), and will likely fall somewhere between these two (i.e., sending people money tied to spending incentives).
To be clear, we are not describing what will happen tomorrow or what we are recommending, and we aren't sure about what will happen over the near term. We are just describing a) how we believe the economic machine works, b) roughly where we believe that leaves us, and c) what these circumstances will probably drive policy makers to do - most importantly that central bankers need to put their thinking caps on.