Legendary hedge fund investor Ray Dalio is particularly known for his understanding of bonds, and has made billions from them. He now thinks that it is “crazy” for investors to hold them.
Ray Dalio’s story is a true rags-to-riches one, where he quit his job one day to venture off on his own with just his ideas and skills in hand. Starting from his apartment, Bridgewater Associates is now the world’s biggest hedge fund. Along the way, he managed to make many billions for his clients while at the same tucking away a little for himself, $14 billion at last count.
Ray Dalio has particular expertise with credit markets, and among his ideas, his view of the cyclicality of these markets is particularly insightful. We normally look at business cycles, but Dalio instead looks more at debt trends, and his ideas do shed a lot of light on how we normally understand economic cyclicality.
The way Dalio sees it, during the good times, borrowing keeps growing, and this is particularly the case when interest rates are as low as they have been lately. We’ve just ramped that up big time over the last couple of months, with more to come.
As we build toward a climax, this places us at greater risk of declines in the business cycle, where the cost becomes multiplied by the high amount of leverage, and this is not unlike investing on margin and losing more when your stocks go down. In this game though, there is no closing out your positions, you are stuck with the economic costs being multiplied so much.
This additional borrowing leaves us more exposed than otherwise to any negative economic influences, the ones that ultimately come around at the end of business cycles, whether natural or the man-made one we just caused. The risk that we have taken on with this additional leverage now serves to accelerate the decline that ensues.
Eventually, once this accentuated decline ends, we start to rebuild, and start another cycle. Rates go down, we put all the defaults behind us and start borrowing more, the economy gets back to health and then eventually becomes overleveraged, and we eventually hit the wall once again.
The main reason why this is so significant is that the monetary policy that we use to try to smooth out the business cycle now can be seen as planting the seeds of its own demise. This worked pretty well to get us out of the last crisis, and we did see a decade of some pretty good times, but once trouble comes, we are exposed to much bigger losses than if there wasn’t all that debt out there that we have created during our feast.
In a real sense, we prosper from borrowing against our future, and we’ve been doing a lot of that lately, where governments, businesses, and even the public have all done their part. Dalio has been warning us of the risk for quite a while now, and although things have hummed along pretty well, it’s pretty well understood that this house of cards depends on interest rates staying low to keep the party going.
Rates were actually projected to remain very stable over the next few years, at least until all the king’s horses and men were mobilized to fight the economic effects of our recent choking of our economy. This particular move has been unprecedented, and while it’s not hard to understand the effects of so many people being put out of work and companies seeing their revenue slashed, there is another side to this, a darker one that just can’t be made to go away just by opening things up again, getting up from the ground and dusting ourselves off and getting back to where we were before.
Dalio wholeheartedly agrees with the response, understanding that we really had no choice to go all in here in the way we have, because he sees the alternative to be worse. As bad as the recession from this may be, it would have been far worse had we just let the effects unfold naturally, where this could have wiped out many more jobs than it will, with the economy in true shambles, bad enough that everything we could do would not be near enough.
This is the situation we found ourselves in during the Great Depression, where we let things go too far and there was nothing to do but wait a whole decade to recover. If not for WWII, this depression may have gone on for considerably longer in fact.
To say that the economy was mismanaged in the early stages of this economic collapse would be an understatement, as this gave us a pretty good idea of what happens when we do too little, far too little in this case. We worry about widespread bank failure and do everything we can to prevent this these days, but back then, they just let them fail, with disastrous results.
On the other hand, this huge response has its price. While we were alarmed over the temporary job losses and the loss of GDP that this shutdown is producing, we spoke of a bigger demon, the repercussions of this massively expansionary reaction. We also have been bearish on bonds for quite a while, and while we may not think that bond investing isn’t particularly exposed to these new risks, this has all made bonds much less desirable right now, which Dalio is now warning about as well.
The Dollar Will Remain Strong Enough, But the Dark Side of Bonds is a Huge Worry
Just like traders can always make money from stocks as long as they are moving, bond traders can always make money trading bonds, especially with the 10:1 leverage that big institutional traders use. Dalio has made more than his share from bond investing, and this is the level of involvement he is warning about, folks that would invest in treasuries with the intent to capture the yields they offer and hold them longer-term for this purpose.
Dalio has different concerns about this than we do, but still ones that we need to at least have a look at. Much of his fear comes from what boils down to currency risk, although he doesn’t state this explicitly, but when you are worried about expansionary policy devaluing your currency, this is what you are worried about essentially.
This is certainly something to keep an eye on, and if this issue was confined to the United States, we may have a lot to worry about here, particularly with treasuries, as this would have a bearish influence on treasuries. A strong dollar makes U.S. treasuries more appealing, but if it weakened too much, this would reduce demand for them and put prices down, producing significant capital losses for bond investors, the ones that actually are looking to hold them.
As it turns out, other countries are in the same boat, so as usual, this becomes a relative thing. The U.S. dollar is and will remain king of the currencies, and even though its value is being meaningfully diluted by all this expansionism, the same thing is happening elsewhere and the level of the ocean itself is being lowered, with the U.S. ships still remaining the tallest.
This means that even though the dollar may be devalued from an inflationary perspective, and a dollar will buy less than it used to, and wealth held in U.S. dollars will be subsequently depreciated, as long as this is happening elsewhere as well, people will still prefer USD the way they usually do.
The only real risk on that side of things is default risk, and while there is no doubt that our current mess has increased it, bringing the U.S. closer to the precipice of default, there’s still a lot of breathing room and enough that there really isn’t much of a worry of this happening anytime soon. Dalio shares our concerns of exploding government debt, in a way that few do, but at the same time, this risk is years away and involves the fates of future generations and not current ones so much.
Dalio famously prepared for the last crisis, which there was at least the opportunity to see coming, which he did, but this crisis arose much more out of the blue, in a way that Dalio could not react quickly enough to. Even though he runs a hedge fund, it still takes a long time to unwind positions, and he got stuck with a 20% loss from this with his flagship fund.
This does serve to demonstrate the utter lack of flexibility with funds versus investors managing their own accounts, a risk that really comes home to roost when the bear markets hit, even if your fund has all the tools at its disposal, including the ability to go short assets, as hedge funds do. When you are managing $160 billion, as Dalio’s firm does. or anything close to it, you just can’t turn these things on a dime even if you have the power to bet the other way as hedge funds do.
Moves like the one that the 2020 bear showed us cannot be managed by funds at all, and certainly can’t be by funds that are required to sit by and do nothing like regular funds are. Hedge funds can bail and reverse but this takes real time, and when you get a big drop like this over a month, you can’t even get fully out by the time things rebound, and a lot of your selling would be into the rebound, which can lead to an even bigger disaster.
In terms of investing in treasuries, Dalio compares doing this now to the period between 1930-45. What worries us isn’t that phase of the cycle, it’s the one that comes later, when it really doesn’t make sense to be in bonds, when they really start taking a hit as things come back.
You Can Just Look at Yield, But You Need to Look at Real Yields Net of Inflation
Bond investors focus a lot on yield, and tend to ignore price, but we can explain this threat merely by looking at yield, although the real one and not just the nominal one. This alone captures the risk in fact because the real losses can be measured by the difference between the nominal yield you get, about 60 basis points these days if you bought a 10-year treasury bill, and the inflation rate.
Your real yield would be the difference, where if inflation is 2% and your yield is 0.6, you experience a net yield of –1.4%. If this stays constant, after 10 years you have lost this much per year on a net basis, and since this is over 10 years, you suffer 10 years’ worth of this pain, each year, and the effect is indeed cumulative.
While this certainly should not seem all that exciting, if inflation goes up, your losses go up in turn. If inflation averages 6% over this time, for instance, which is actually a more normal number than 2% is, you’ve now lost over half your money over these 10 years. If inflation averages even higher than this, your losses will be worse, and if inflation is high enough, like 10% on average, this can almost wipe out the value of your investment.
Few bond investors realize just how much risk that there is here with inflation, as they tend to think nominally about all their investments, with bonds, stocks, gold, or whatever else they put their money in. In periods of stability such as we have seen over the last decade, the upshot of this misunderstanding of risk isn’t that bad, but the stakes can go way up when you start seeing inflation grow in the manner that we expect it to in the aftermath of our quarantining.
Dalio is right in that all this spending is going to impact the real value of treasuries, but it isn’t the spending itself that will cause this peril, it is not the recession that is of such concern to bonds, it is what happens when the recession is over and we are left with our foot fully on the accelerator when our injection system is no longer clogged up, where all this gasoline now gets to our cylinders and our vehicle races forward at a dangerous speed.
The more we exceed what is normally required to keep growth in balance, the bigger the inflation rate becomes, and the bigger the losses for bond investors will be. Bonds were already risky enough before all this, because yields have been beaten down so much over the last year and a half, artificially lowered by speculators.
When we throw in all this new inflation risk, we do get at least to the point where Dalio is right in that it would be crazy to be in these things right now.
Stocks, on the other hand, don’t really mind inflation, and over time have well outpaced it. The sad part of this story is that many investors choose treasuries over stocks because they think that they are a lot less risky, but in the face of higher inflation, they can be a lot riskier in fact.
Those who have held stocks through this big downturn at least can wait for them to come back, and they always have, but when you hold a very low yield and inflation starts to run hot, there isn’t even anything you can do to protect yourself other than just cutting your losses and dumping the bonds. A lot of these investors aren’t even clued into any of this though, not even thinking of their gains or losses in real terms, factoring in inflation at all, so they are left to suffer in ignorance.
The time to flee isn’t after this tornado hits your house, it’s when it is in the forecast with a fairly high probability. This is not about settling for less than a percentage return, as this isn’t about how little you will make, it’s instead about how much you may lose, and the losses can be pretty painful if you aren’t careful.
All things considered, crazy might not even be a strong enough word.