‘This is the end….my only friend, the end.’
So went The Doors’ classic song.
What does it have to do with the world of finance?
Well, nothing, of course. It just came to mind when I read a Bloomberg article over the weekend about Bridgewater Associates boss, Ray Dalio. Here’s how it started:
‘Famed hedge-fund investor Ray Dalio called time on the era of central bank stimulus, saying the global economy is heading toward a new stage where markets won’t get the same level of support from monetary policy makers.
‘“The directions of policy are reversing,” with central banks slowing the flow from their proverbial punch-bowls of stimulus, Dalio, chairman of Bridgewater Associates, the world’s largest hedge fund, wrote in a July 6 note. “Our responsibility now is to keep dancing, but closer to the exit and with a sharp eye on the tea leaves.”’
Dalio is an investment legend. He handles huge sums of money. He is always worth listening to.
That last quote bears thinking about:
‘“Our responsibility now is to keep dancing, but closer to the exit and with a sharp eye on the tea leaves.”’
It’s hardly news that the mindset of central banks is in the process of changing. The Federal Reserve has been on a tightening path — albeit a very gradual one — since December 2015, when it raised nominal interest rates for the first time in the cycle.
Before that it spent a long time preparing the market, first for the end of quantitative easing and then for the actual rate rise.
The next phase for finance
Now we’re entering the next phase. This is when the Fed continues to tighten at the same time that Europe and Japan also wind back on their longstanding monetary stimulus.
Dailo no doubt knows that monetary tightening precedes all economic slowdowns. The question is at what point does the tightening start to impact the economy and stock prices.
The answer to that question depends on what the ‘natural rate of interest’ in the economy is. Unfortunately, no one knows what it is. In 1898, the Swedish economist Knut Wicksell (what a name) defined it as the rate of return on newly invested capital in the economy.
This rate wasn’t a fixed one. As Wicksell defined it, the natural rate is:
‘…never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.’
To avoid booms and busts then, you want to see the financial rate of interest (the one controlled by central banks) as close as possible to the natural rate.
But this is impossible. In our ‘US dollar as international reserve’, credit based financial system, the bias is always to set the financial rate below the natural rate.
In such an environment, there is a boom as capitalists rush to borrow to take advantage of low financial rates.
Not that those individual borrowers knew what the natural rate was. They just used their judgement. This speculation had the effect of pushing asset prices up. And as asset prices rose, the future returns available from them declined. In other words, the natural rate of interest declined.
Meanwhile, authorities saw the increase in borrowing and asset prices, and raised financial interest rates to slow things down. At some point, the financial rate would rise above the natural rate and cause a slowdown, with the severity of it depending on the size of the preceding boom.
The main point to note here is that as soon as the financial rate of interest moves above the natural rate, it represents monetary tightening. Stock prices start to slide, and the economy slows.
Getting back to Ray Dailo and his comments, he knows that the financial rate of interest is rising. He also knows that the natural rate of interest is very low by historical standards. That’s because we’ve been through massive asset booms in recent years (low financial rates have led to record highs in US stocks).
He doesn’t want to panic. He wants to ‘keep dancing’. But he also knows that he’s one step closer to the exits, and will have a sharp eye on the tea leaves to get a sense of where the natural rate of interest might be.
My rough guess is that the US economy can handle a few more interest rate rises yet before genuine tightening kicks in. As I’ve mentioned before, Alan Greenspan increased rates 17 times from 2003 to 2006, before the tightening wreaked havoc with the economy.
The Fed won’t raise rates anywhere near as much in this cycle. The natural rate of interest is much lower. Therefore, there is less room for error.
There is also the complication of the Fed wanting to wind down its balance sheet as a part of the tightening process. It expanded due to the Fed’s quantitative easing program, which was in place from 2009 to 2013.
I’ll get into that tomorrow, as well as look at Australia’s position in the cycle. As you’re probably aware, Australia is now one of the few developed nations not looking to raise rates anytime soon.
That should be good for the stock market.
For now though, take the advice of one of the greatest money managers of his generation. That is, keep dancing, but suss out the exit points and maybe move a step or two closer.