Dalio's latest article: Behind the Fed's resumption of rate cuts

Author: Ray Dalio

Have you noticed the Federal Reserve's announcement that it will stop quantitative tightening (QT) and launch quantitative easing (QE)? Although this is described as a technical operation, it is still an easing policy in any case—and it is one of the important indicators I follow to track the evolution of the "Great Debt Cycle" dynamics described in the previous book.

As Chairman Powell said, "At some point, reserves need to grow gradually to match the size of the banking system and the size of the economy. Therefore, we will increase reserves at specific points in time." The specific increase deserves close attention. Given that the Federal Reserve has the responsibility of "controlling the size of the banking system" during bubble periods, we need to pay attention to the pace at which it injects liquidity into emerging bubbles through interest rate cuts.

More specifically, if the balance sheet expands significantly against the backdrop of lower interest rates and a high fiscal deficit, we would consider it a classic example of coordinated fiscal and monetary policy by the Federal Reserve and the Treasury to monetize government debt. If, at the same time, private lending and capital market credit creation remain strong, the stock market repeatedly hits new highs, credit spreads are nearing lows, unemployment is low, inflation is exceeding targets, and artificial intelligence stocks have formed a bubble (which, according to my bubble indicator, is indeed the case), then in my view, the Federal Reserve is injecting stimulus into the bubble. Given the government and numerous advocacy for a significant easing of policy constraints to implement aggressive capitalist growth-oriented monetary and fiscal policies, and the urgent need to address the current unresolved issues of massive deficits, debt, and bond supply and demand, I suspect this is far more than just a technical problem—a concern that should be understood. I understand the Federal Reserve's high level of concern about financing market risks, which means that in the current political environment, it tends to prioritize market stability over aggressively combating inflation. However, whether this will evolve into a full-blown, classic form of stimulus-driven quantitative easing (accompanied by large-scale net bond purchases) remains to be seen. Currently, we should not overlook the fact that when the supply of US Treasury bonds exceeds demand, the central bank purchases bonds through "money printing," and the Treasury shortens debt maturities to fill the long-term bond demand gap, these are typical dynamic characteristics of the late stages of a debt cycle. Although I have fully explained its operating mechanism in my book *Why Nations Go Bankrupt: The Great Cycle*, it is still necessary to point out that we are currently approaching a classic milestone in this great debt cycle and briefly review its operating logic. My goal is to impart knowledge by sharing my thoughts on market mechanisms, revealing the essence of phenomena like teaching someone to fish—explaining the logical thinking and pointing out current dynamics, leaving the rest for the reader to explore. This approach is more valuable to you and avoids me becoming your investment advisor, which is more beneficial for both parties. Here is my interpretation of the operating mechanism: When the Federal Reserve and other central banks purchase bonds, they create liquidity and lower real interest rates (as shown in the diagram below). Subsequent developments depend on the flow of liquidity: If it remains in the financial asset sector, it will drive up financial asset prices and lower real yields, leading to an expansion of price-to-earnings ratios, a narrowing of risk premiums, and a rise in gold prices, thus creating "financial asset inflation." This benefits holders of financial assets relative to non-holders, thereby widening the wealth gap. Typically, some liquidity will be transmitted to the goods, services, and labor markets, pushing up inflation. Under the current trend of automation replacing labor, this transmission effect may be weaker than usual. If the inflationary stimulus is strong enough, nominal interest rates may rise to a level sufficient to offset the decline in real interest rates, at which point bonds and stocks will simultaneously face pressure on both nominal and real values. Transmission Mechanism: Quantitative Easing Transmits Through Relative Prices As I explained in my book *Why Nations Go Bankrupt: The Great Cycle* (which I cannot elaborate on here), all capital flows and market fluctuations are driven by relative attractiveness, not absolute attractiveness. In short, everyone holds a certain amount of capital and credit (the size of which is influenced by central bank policy), and the flow of capital is determined by the relative attractiveness of various options. For example, borrowing or lending depends on the relative relationship between the cost of capital and expected returns; investment choices mainly depend on the relative level of expected total returns for various assets—expected total returns equal to the sum of asset yields and price changes. For example, gold yields 0%, while the 10-year US Treasury yield is currently around 4%. If the expected annual price increase of gold is less than 4%, then holding Treasury bonds is the better choice; if the expected increase is more than 4%, then holding gold is the better choice. When assessing the relative performance of gold and bonds relative to the 4% threshold, the inflation rate must be considered—these investments must provide sufficient returns to offset the erosion of purchasing power by inflation. All else being equal, the higher the inflation rate, the greater the increase in gold prices—because inflation primarily stems from the depreciation of other currencies due to increased supply, while the supply of gold is relatively fixed. For this reason, I pay attention to the money and credit supply situation and the policy moves of central banks such as the Federal Reserve. More specifically, in the long run, the value of gold always moves in tandem with the inflation rate. The higher the inflation rate, the less attractive a 4% bond yield becomes (for example, a 5% inflation rate would increase the attractiveness of gold and support its price, while weakening the attractiveness of bonds as real yields fall to -1%). Therefore, the more money and credit central banks create, the higher I expect inflation, and the lower my preference for bonds compared to gold. All else being equal, the Fed's expansion of quantitative easing is expected to lower real interest rates and increase liquidity by compressing risk premiums, thereby lowering real yields and pushing up price-to-earnings ratios, especially boosting the valuations of long-term assets (such as technology, artificial intelligence, and growth companies) and inflation-hedging assets like gold and inflation-linked bonds. When inflation risks reappear, companies with tangible assets such as mining, infrastructure, and physical assets are likely to outperform pure long-term technology stocks. Due to the lagged effect, inflation will be higher than originally expected. If quantitative easing leads to a decline in real yields while inflation expectations rise, nominal price-to-earnings ratios may still expand, but real returns will be eroded. A reasonable expectation is that, similar to late 1999 or 2010-2011, there will be a strong liquidity-driven rally, eventually forced to tighten due to excessive risk. The liquidity frenzy before the bubble bursts—that is, just before the critical point when tightening policies are sufficient to curb inflation—is the classic ideal time to sell. This time is different because the Federal Reserve will create a bubble through easing policies. While I believe the operational mechanism will be as I described, the implementation environment for this round of quantitative easing is drastically different from the past—this easing policy is being implemented amidst a bubble, not a recession. Specifically, in the past, when quantitative easing was implemented: Asset valuations were declining, and prices were low or not overvalued. The economy was contracting or extremely weak. Inflation was low or trending downward. The debt and liquidity problems are severe, and credit spreads are widening. Therefore, quantitative easing is essentially "injecting stimulus into the recession." However, the current situation is quite the opposite: asset valuations are high and continue to rise. For example, the S&P 500 index yield has reached 4.4%, while the nominal yield on 10-year Treasury bonds is only 4%, and the real yield is about 1.8%, so the equity risk premium is as low as about 0.3%. The economic fundamentals are relatively strong (the average real growth rate over the past year reached 2%, and the unemployment rate was only 4.3%). Inflation, while slightly above the target (approximately 3%), is growing at a relatively moderate pace, while inefficiencies caused by the reversal of globalization and tariff costs are continuing to push up prices. Credit and liquidity are ample, and credit spreads are approaching historical lows. Therefore, the current quantitative easing is actually "injecting stimulus into a bubble." So, this round of quantitative easing is not "injecting stimulus into a recession," but rather "injecting stimulus into a bubble." Let's see how this mechanism typically affects stocks, bonds, and gold. Because government fiscal policy is currently highly stimulative (as massive outstanding debt and huge deficits are being covered by massive issuance of government bonds, especially in the relatively short-term tranches), quantitative easing is effectively monetizing government debt rather than simply getting the private system flowing again. This makes the current situation different and also makes it look more dangerous and more likely to trigger inflation. It looks like a bold and dangerous gamble on economic growth, especially on artificial intelligence growth, funded by extremely loose fiscal, monetary, and regulatory policies, which we need to watch closely to handle properly.