Why Is Ray Dalio Worried?

Katherine Burton of Bloomberg reports, Ray Dalio Is Worried About Next Downturn as Fed Prepares Move:

Ray Dalio, founder of $154 billion Bridgewater Associates, said he’s worried about the next economic slowdown because monetary policy will be less effective than in the past.

“I don’t care whether they raise 25 basis points,” Dalio said Wednesday in an interview with Tom Keene and Michael McKee that was broadcast on Bloomberg radio and television. “What scares me, or what worries me, is what the next downturn in the economy looks like, with asset prices where they are and a lesser ability of central banks to ease monetary policy.”

He predicted that returns across asset classes over the next decade will only average 3 percent or 4 percent. Narrower spreads will make it much harder for asset purchases to have a big effect on the market, he said.

As the U.S. Federal Reserve meets Thursday to decide whether to raise interest rates, Dalio said a big increase in the near future is impossible because the global environment requires lower borrowing costs. He reiterated that the central bank will eventually return to quantitative easing.

Dalio, who manages the world’s biggest hedge fund, is among a small number of prominent money managers who have urged the Fed not to raise interest rates. Jeffrey Gundlach, co-founder of DoubleLine Capital, has said the Fed would have to reverse course if it raises rates prematurely.

‘Downturn’ Coming

“We will have a downturn,” Dalio said in the interview.

Futures contracts show a 28 percent probability that the Fed will boost rates when it meets this week, according to data compiled by Bloomberg. That was down from 48 percent on July 30. The calculation is based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase, versus the current target of zero to 0.25 percent.

Economists are split on what action Fed policy makers will take on Thursday. More than half of 111 analysts in a Bloomberg survey predict no change, while 50 say the rate will be increased by 0.25 percentage point and four see a 0.125 percentage-point increase.

Dalio’s Pure Alpha hedge fund strategy, which accounts for roughly half his assets, has gained 6 percent this year, he said. His passive, long-only strategy, known as All Weather, is down about 6 percent, he said.

Dalio said August was a “lousy” month for his firm, as concern about slowing growth in China sent global markets tumbling, erasing more than $5 trillion from stocks around the world. He said that in the longer run, China will manage its challenges, even if it won’t return to growth rates of the past.

“I think China is going to be just fine,” Dalio said. “But its going to be weaker.”

Dalio is setting the record straight on China after earlier reports in late July said his fund was bearish on the country. That would have been the correct investment move, especially after China's bubble burst unleashing a 'Big Bang' response, but it's not exactly good PR for Bridgewater which is looking to garner ever more assets from China's big pensions and its huge sovereign wealth fund.

When it comes to China, even Ray Dalio has to walk a fine diplomatic line. Unlike the noted short-seller Jim Chanos, he can't come out publicly to criticize Chinese leaders because it will have serious ramifications on his fund's ability to conduct business there. Interestingly, after a three year losing streak, Chanos's fund Kynikos Associates is racking up gains this year amid China's slowdown, betting big against energy companies like Consol Energy (CNX) and Cheniere Energy (LNG).

Dalio joins a chorus of big investors, including the bond king, who are openly worried the Fed will be making a monumental mistake if it starts raising rates too early. Even David Rubenstein, co-founder of the Carlyle Group (CG), came out stating he doesn't think the Fed will raise rates:

"The Fed is really the central bank of the world. If the Fed raise rates a little bit, it will have an impact all over the world, particularly in emerging markets," Rubenstein told CNBC's "Squawk Box."

"I think the Fed is sensitive to that, and I think therefore the Fed is likely to wait for another month or two to get additional data and probably telegraph a little bit better than it has now that it's about ready to do it at a particular time."

I agree with Ray Dalio, Jeff Gundlach and David Rubenstein and went over my thoughts on why I don't think the Fed should raise rates in my last comment. As I stated: "in a world where deflation fears reign, the Fed would be nuts to raise rates at this time and is better off erring on the side of inflation."

But there is one thing that concerns me and also concerns the Fed. Cheap money is stoking huge speculative activity in the bond and stock market. All these large hedge funds taking on huge leverage to buy U.S. bonds or engage in risk-parity strategies which are suffering a cruel summer are making Fed officials very nervous (although Ray Dalio isn't concerned and is still defending this strategy). The same goes for the stock market where some see a biotech and buyback bubble ready to pop if rates start rising.

I'm obviously not as concerned about the so-called biotech bubble as the Fed and have publicly stated the latest selloff was another big buying opportunity. I track over 200 biotech stocks every day and some of them have made huge moves in the last couple of weeks. Experienced biotech traders are making a killing trading these stocks and this could very well be the next big bubble but in my humble opinion, we're nowhere near bubble territory in the sector (but some biotech stocks are very bubbly and will crash back down to earth!).

As far as the bond market, I can't say I'm too concerned of systemic risk right now because I'm firmly in the deflation camp and think Dalio is right, eventually the Fed will have to reengage in quantitative easing, especially if it ignores its deflation problem and sparks another global financial crisis.

That's all from me. You can watch Ray Dalio's latest on Bloomberg here. Below, David Rubenstein, The Carlyle Group co-CEO, discusses the likelihood of the Fed raising rates.

Also, the bond king, Jeffery Gundlach, appeared on CNBC explaining why he thinks the Fed should not raise rates. "The Fed would surprise the market in a way it hasn't in a very long time. I think the Fed is not going to raise interest rates today" he told CNBC's "Fast Money: Halftime Report." Listen to his comments as you wait for the Fed's big decision. I think he's absolutely right.

Lastly, for a different take, David Stockman, author of “The Great Deformation: The Corruption of Capitalism in America” and publisher of the Contra Corner blog, visited Yahoo Finance ahead of the Fed announcement to discuss his predictions and the potential impact of today’s interest rate decision. Stockman is not a fan of the Fed and claims it's on a “jihad” against retirees and savers.

Update: As I anticipated, the Fed left interest rates unchanged. You can read the official FOMC press release here and Wall Street's reaction to the decision here.