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Ray Dalio: The Problem With Tightening Policy Is Interest Rate Sensitivity

By Jacob Wolinsky. Originally published at ValueWalk.

Ray Dalio

Following is the unofficial transcript of a CNBC interview with Bridgewater Associates Founder Ray Dalio on CNBC’s “Closing Bell” (M-F, 3PM-5PM ET) today, Thursday, January 6th.  Following is a link to video on CNBC.com:

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The Problem With Tightening Policy Is Interest Rate Sensitivity, Says Ray Dalio

Part I

SARA EISEN: The money printing and debt binge that the world’s governments and central banks have embarked on to prop up their economies is one of the three main themes that Ray Dalio takes on in his study of the last 500 years in his new book, “Principles for Dealing with the Changing World Order.” I sat down with him earlier today to discuss it and asked how concerned investors should be today about the Fed removing all that stimulus as we’ve seen play out in the market in recent days.

RAY DALIO: Here’s how the machine works. We’ve created a lot of money and debt, a lot of buying power, everybody received all that, but you don’t create more wealth when you create more money. And we’re at the part of the cycle where all those checks went out and all that money came in and, and yet before, we’re just at the beginning of the phase, that all that money is being spent and building, increasing the inflation and with it, throughout history, it causes goods, services and financial asset prices to rise. And it’s and so we’re in the part of the cycle, we’re in the third year, this next year will be the third year in the cycle, and naturally there will be a tightening of monetary policy. And the problem with that tightening of monetary policy is that there’s a great deal of interest rate sensitivity and because it’s gotten so far and so extreme, just the pulling back of that is a very delicate thing. We’re in a situation that the raising of interest rates and the tightening of monetary policy begins the process in the third year of a cycle as we’re in that normally is not enough to send the cycle down. It can send financial asset prices lower. But I would expect that if you understand the short-term cycle, this typically seven-year type of cycle in terms of expansions and recessions, it’s the beginning of the testing of the brakes.

EISEN: So not necessarily a recession, but could see some, some increased volatility. You’ve said you don’t want to be in cash right now and you don’t want to be in bonds. But if the Fed does embark on this tightening and slows the economy and the markets that that feels like it would be a pretty turbulent time for equities.

DALIO: The important thing to realize, I think, is that the Federal Reserve and all central banks will have to keep a negative interest rate, a negative real interest rate. Right now, bond yields and have, you know, a negative real interest rate of, you know, nearly 1.5%, 2% depending on where and the cash rate is minus 4% so that all investors will be in a position where the value of their money in cash or in bonds will not keep up with inflation. I think investors need to think about, think about returns differently. I think they look at the amount of the returns in nominal dollars, how many dollars do I have. And they don’t look at the amount that they have in relation to real dollars. In other words, adjusted for inflation. And while there can be somewhat of a tightening, it can’t be enough of a tightening to raise those returns on cash and bonds to be good enough to compensate for inflation. Because if it is, if you had, that would require a very large rise in interest rates that would first set the economy down. So, when we look at the circumstances today, just imagine with the political polarity that we have as we’re coming into the 2022 elections, and then the 2024 elections, if the Federal Reserve tightened the monetary policy enough to cause a downturn. If we’re at each other’s throats when these are the, everybody’s received so much money and this is about as good as you’re going to get, just imagine the consequences that that would have. So, the Federal Reserve, I don’t believe even though they’re behind the curve by a lot, I don’t believe they’re going to be able to catch up and make cash and bonds an attractive investment.

EISEN: It sounds like you don’t see very many hikes this year. Do you think they can get three done as expected?

DALIO: I think that the, I think that the, the expected three rate hike is a reasonable thing, but they’re going to be testing and because of the duration of assets is long in other words, when interest rates come down, sensitivity to markets is greater. Even modest changes are going to have an effect and so you’re going to see a monetary tightening taking place also where the rate of fiscal spending and what will come down. Both will be very large. The fiscal deficit will be very large, and the monetary stimulation by level basis will be very large but it’ll be coming down so they’ll have to be testing those brakes and finding out, we all will find out, you know, exactly how much they can handle. It’s a risky situation.

EISEN: No doubt and you’ve said for investors to be diversified in this situation within the equity market, what do you do with tech stocks, which seem in the direct crossfire here when it comes to Fed tightening?

DALIO: Well, again, tech stocks have a very long duration meaning they’re sensitive to interest rate changes because the earnings and the payoff of tech stocks is very much in the future. So, they’re particularly sensitive to interest rate changes and also, they’ve experienced in many cases a bubble type of behavior. And so, they’re more sensitive than, you know, the meat and potato guy of basic company type stock. So that type of behavior, this is not an environment that’s particularly conducive to those types of investments.

EISEN: As we’ve seen. So, you just put out a warning, just moving on to your second big theme around the wealth gap and the political gap about some key elections coming up including in this country 2024 where you say it’s plausible that we might not have a clear result or disputed result. How would that manifest do you think in the markets? What should investors be doing with that type of situation?

DALIO: Well, I think that investors look at their whole position, you know, they’re, they’re people, they think about many things, you know, where they live and so on. So, let me just describe that environment. I think we’re coming into an environment, we are in an environment in which there might be irreconcilable differences and that people are just adjusting, people are moving, not just for taxes, but they’re moving to places that they feel might be more hospitable. That causes a dynamic sometimes it causes a hollowing out as people take, richer people leave to go to places that they feel more comfortable in causing them loss of a tax base and more, more conflict and so also this dynamic in which there’s maybe a question of rule of law or the Constitution resolving these types of things, has implications in terms of the locations or the ways that people diversify. So, I think that investors and in the broader sense, people’s, you know, seeking their wellbeing, have to be aware of those things. It could, to some extent, it could be state taxes, the financial conditions of the places that they’re in. I think they have to be aware of those. And I think they have to be aware of that in the broader sense. So, it also moves in a direction that is very questionable. You know, what opens the Pandora’s box to what it means when we don’t have the same rule of law working in the same way, you know, that opens a lot of questions. We’ll have to see how that transpires. But there’s that issue that that wealth gap will be between, you know, increasingly more and more extreme left and right and more and more and that’ll have implications for taxes locally and federal taxes and the like.

Part II

EISEN: Conflict between the world’s two biggest economies is only heating up and the tension over Taiwan certainly a risk factor for investors this year. It’s one of the other big issues Ray Dalio takes on in his new book, “Principles for Dealing with the Changing World Order,” which is a study of the last 500 years, including the ascendancy of China as a global superpower. As far as US China tensions go I did ask Dalio when I spoke to him earlier, whether he thinks investors are understanding the risks and ramifications of this brewing battle.

DALIO: There are five types of wars basically. There’s a trade war, a technology war, a geopolitical influence war, a capital war and could be a military war. All of those five have implications. We’re seeing all of those intensified. They have investment implications, they have geopolitical implications, and I don’t think that they’re well understood. So, I think they need to be better understood and that’s why I wrote the book.

EISEN: What do you think investors should do about that? For instance, there are a lot of US multinational companies that do a lot of business in China. Are they at risk or, or are you talking about something bigger and broader around the markets?

DALIO: Right now, our economies are so interlinked. Everybody is involved right? Every time you buy Nike sneakers, or you buy a, you know, an Apple product, buy so much more than a fifth of our imports of manufactured goods come from China. All of that, General Motors sells more cars in China than they sell in the United States. There’s an inter connectedness there that, you know, on, I think unavoidable, and the separation of those things would be catastrophic. So, I don’t believe that either side wants to produce that kind of separation. I think that would just be terrible for everybody. So, I don’t think that that’s going to be as much of an issue. There are geopolitical issues such as the Taiwan issue and so on. So, but I don’t think that these will be allowed to get out of control because the consequences would be so bad so I think it’ll be more like a competition. And the most important thing is where will there be strengths and capabilities? In other words, on each side and in this competition, the main thing is be strong, be capable, and you want to invest and in the places that are strong and capable and I think you want to be diversified to some extent, of course, in the United States to some extent elsewhere, perhaps some in China, but some places around the world. I think from an investor perspective, the important thing, the most important things are to longer term, not be very much in cash or bonds as we have this tightening there’ll be of course some corrections, but we’re in a new paradigm in which those will be bad assets. And that too, it’s important to have a well-diversified portfolio and that diversification includes not just sectors or an asset classes but countries.

EISEN: The other factor of competition here between the US and China which, which really spoke to me in your book and you look at the world a lot through this lens is the, the competition for reserve currency status and the rise and fall of reserve currencies, which you’ve looked at the Dutch, the British, and now America and how we go into this new world order. Do you see ultimately the competition between the US dollar and the Chinese renminbi and do you see China taking over that reserve currency status at some point?

DALIO: Changes in reserve currency status are evolutionary. It’s almost like speaking a language. You know, if everybody if the world language is English, most everyone will learn English and then it evolves over a period of time, but it also has supply demand issues. I think it’s an evolutionary type of change. I think the United States is testing the limits because when there’s a production of a lot of debt that is money, it’s promised to receive money that is then has to be sold and the world right now is overweighted, has a lot of US dollar denominated debt, therefore promises to receive dollars. And as and it’s going to receive a lot more because there’ll be large deficits, lots of bonds that have to be sold. And as a result of that, the world is also underweighted in China and assets. It’s diversifying more, not China today is the largest trading country in the world, and also large, larger than the United States in terms of the important capital flows for lending and, and such. And so, there is an evolution in favor of China having a larger share of the reserve currency status. I think that is our greatest strength right now, the reserve currency status, because it’s that which allows us to print money and print the world’s currency. Wow, that’s a great power and, and to have it accepted. It is being taken for granted and it’s being challenged. Should the United States lose that because of the supply demand issue that I’m referring to. That would be very bad. I think what you’re seeing right now, is that all currencies are going down in value relative to goods and services because I think we’re in a situation where all countries are producing more debt and money and not so much relative to each other and that’s having the effects on the markets and the economies that we’re seeing.

EISEN: So how do you diversify away if all the major currencies are devaluing themselves, even if we get little blips like a 6% rise in the dollar last year? How ultimately do you see it playing out?

DALIO: I think currency is a medium of exchange and a store hold of wealth. I think one has to realize that it’s an ineffective store hold of wealth. In other words, when you hold a, an interest rate, an asset, that depreciates in relationship to the purchasing power and so what that means is that the most monies, it’s not going to be an effective store hold of wealth, and that’s why one should look at other store holds as well. That means a well-diversified portfolio of assets that don’t depreciate, depreciate in the kind of paradigm that we’re now in. This is a paradigm in which there will be more depreciation of the value of money. Not, not every day, not every month, not every six months, but over the period that over an extended period of time. So, we should look at other sources of store hold of wealth.

EISEN: Like what? Is Bitcoin in that category because it seems to me that regulators can just regulate it out of existence?

DALIO: I think we’re entering an era where the question will be, what are the monies, what are the store holds of wealth? What are those items that you can globally take from, move from one country to another to buy things? Some that the governments will not be able to influence, such as gold and Bitcoin and so on, but there’ll be other currencies. I think that you’ll start to see the renminbi China’s currency become more internationalized and the range of choices will be increasing, you know, and we’re entering a new era of what is the money that is the store hold of wealth. So that kind of competition, I think we’ll have to see. Bitcoin has accomplished a lot over the last 11 years. It’s shown that it’s not been hacked and it’s still operative, but there’s constant evolution. There’s things like NFTs and so many different things that are new. I don’t think that they’re nearly as likely to be supported as other investments and those other investments to some extent, might be gold, they can be inflation index bonds, which haven’t been given nearly enough attention by investors. So, I would expect, you know, there will be an interesting redefinition of what the popular monies are and you’re correct, no country wants to have an alternative currency because controlling the currency is one of the most valuable important powers for a government to have and certainly history has shown that there’s the risk of outlawing those that compete with the regular currency. So, I think it’ll be interesting times in the years ahead particularly as we get into, you know, 2023 and 2024 with the political situations and all that’s going on, even globally with the competition from China and other places. It’s going to be interesting.

EISEN: No question. So just to wrap it all up, I mean, the main theme from you and your studies and this and these takeaways are investors should be diversified, but not in bonds and not in cash. So, so it sounds like gold is definitely on your list. Stocks, but not necessarily tech stocks, just, just give us a sense of what you do think is safe in this increasingly scary environment.

DALIO: Well to think about, for example, also including inflation index bonds as a possibility in the portfolio to be thinking about other countries, and when thinking about other countries to think about them differently, like I have just a few basic criteria and looking at almost every country as well as companies, are they earning more than they’re spending? So, do they have good finances, good income statement and balance sheet? Do they have internal order? Do they have civility? So, do their populations behave well with each other so they have internal order? And do they have a risk or not of external order? And so when I look at different places, that’s kind of a checklist that I keep in mind in terms of finding out in this kind of an environment, what will be the safer assets.

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