Thursday, January 25, 2018

Ray Dalio on the Dollar, Stocks and Bonds?

Ray Dalio, Chairman & Chief Investment Officer at Bridgewater Associates, published a comment on LinkedIn, Mnuchin’s Comment on the Dollar:
Regarding Treasury Secretary Mnuchin’s comments about the administration’s weak dollar policy, I want to make sure that you understand what having currency weakness means—most importantly, it is a hidden tax on people who are holding dollar-denominated assets and a benefit to those who have dollar-denominated liabilities.

More precisely, a weak currency:
  1. Reduces the currency holder’s buying power in the rest of the world (e.g. dollar weakness reduces Americans’ buying power relative to foreigners’ buying power)
  2. Devalues the debt denominated in the weakening currency, which hurts the foreign holder of that debt
  3. Supports prices of assets denominated in that currency (because of the currency weakness), giving the illusion of increasing wealth
  4. Raises a country’s inflation rate
  5. Stimulates domestic activity
None of this is what the U.S. economy needs now.

While it’s described as a desirable and intended thing, it might not be a choice. The size of dollar holdings of reserves (in dollar-denominated debt) and the dollar’s role as the dominant world currency are anachronisms and large relative to what one would want to hold to be balanced, so rebalancings should be expected over time, especially when U.S. dollar bonds look unattractive and trade tensions with dollar creditors intensify.
Let me begin by showing you a weekly chart on the PowerShares DB US Dollar Bullish ETF (UUP) going back five years (click on image):


As you can see, since the beginning of 2017, the US dollar has been declining, especially relative to the euro which hit the $1.25 level against the greenback this morning, a three-year high, following comments from the ECB president Mario Draghi earlier today which left traders unconvinced on his stance on stimulus:
The euro surged Thursday afternoon to a new three-year high as doubts grew over the future of the European Central Bank's (ECB) stimulus program.

The currency hit the $1.25 level against the U.S. dollar around 2:00 p.m. London time and was on track for its biggest weekly rise since May of last year. Traders noted that, despite comments from ECB President Mario Draghi on Thursday afternoon, they remain convinced that easy monetary policy in the region is coming to an end.

"Draghi failed to surprise the market," Jane Foley, head of foreign exchange strategy at Rabobank, told CNBC over the phone. "The economic data is too strong," she said, adding that investors are therefore convinced that the central bank will have to tighten its policy, despite giving the opposite message on Thursday.

After a routine rate decision for the euro zone's central bank, Draghi spoke at a press conference Thursday, telling reporters that the recent volatility in the exchange rate is a "source of uncertainty." He added that it would therefore require monitoring.

However, he used the same wording back in September — a repetition that markets perceived as a lack of concern over the strength of the euro and thus an indication that the ECB will end up tightening its policy. Draghi nonetheless reiterated that the bank will keep its stimulus for as long as needed and stated that there are "very few chances" that it will change interest rates this year.

The euro has been on an upward trend against other currencies, including the U.S. dollar, for the past few weeks as the region's economy keeps improving and political risks dissipate. However, a stronger euro could hurt European exports and affect inflation in the euro zone — which the central bank has tried to support in the last few years — potentially prompting a change in its policy.

No change in policy

Earlier on Thursday, the ECB left its benchmark interest rate unchanged. Its interest rate on the main refinancing operations, the interest rates on the marginal lending facility and the deposit facility were kept at zero, 0.25 and -0.40 percent, respectively.

Earlier in the month, the ECB's December meeting minutes said the central bank should revisit its communication stance in "early" 2018, prompting market participants to forecast policymakers were preparing to reduce their massive monetary stimulus program. The minutes, which were published on January 11, immediately pushed the euro more than 0.7 percent higher against the dollar, extending the single currency's rally throughout the opening days of the calendar year.

Broad economic recovery

By the end of trade on Wednesday, the euro had gained more than 2 percent since the start of 2018, as a broadening recovery bolstered expectations the ECB may be forced to unwind its policy stimulus sooner than forecast. The euro zone is seeing its best economic growth in a decade, leading economists and policymakers to upwardly revise their economic forecasts for several major European countries. Late last year, the ECB increased its growth forecast for 2018 to 2.3 percent, up from 1.8 percent previously.

Nonetheless, the ECB has long-struggled to bring up core inflation to its aim of about 2 percent and the central bank is not projected to meet its target level until 2020 at the earliest.

Late last year, the bank said headline inflation would be at 1.5 percent in 2017 and 1.2 percent in 2018.

In October, the ECB announced a reduction in the level of its monthly purchases from 60 billion euros ($71 billion) to 30 billion euros. At that time, the bank also said that its quantitative easing program would stay in place until September 2018. It kept the door open to further extensions in the program, depending on the economic conditions of the euro area.
The key thing to remember is currency swings matter and let me explain why:
  • When a currency appreciates, it decreases import prices and suppresses inflation expectations. When Draghi said  the recent volatility in the exchange rate is a "source of uncertainty" and would require monitoring, he meant it because if the euro keeps rising, hitting inflation expectations and exports, it could cause major problems down the road because the spectre of deflation still looms large in Europe (never mind the recent headlines, I'm talking structural deflation here). 
  • The eurozone is growing but the appreciation of the euro will pose problems for exports, stocks and is acting to tighten financial conditions there. Some may argue as long as the euro appreciates, it allows the ECB to hold off on raising rates/ cutting its stimulus, for now. Once the ECB moves, traders will take profits and start shorting the euro.
  • Conversely, in the US, the decline in the US dollar is a boon for exports, raises inflation expectations by raising import prices, and loosens financial conditions, putting pressure on the Fed to keep raising rates or risk being behind the inflation curve (even if it's temporary inflation due to a weaker dollar). 
All this to say, Ray Dalio is right, Mnuchin's comments defending a weaker dollar sent the greenback lower and will, in the short run, lift inflation expectations.

[Note: President Trump is already talking back Mnuchin's comments on the dollar. On Friday, Treasury Secretary Mnuchin clarified his statements on CNBC, stating a stronger dollar is in the best interest of the country.]

The conspiracy theorist in me says the US Treasury Secretary is doing his part in talking down the US dollar to raise inflation expectations and prevent global deflation from reaching the US.

Will it work? In the short run, yes, but longer term it might create an even bigger problem. Why? Quite simply, the depreciation in the US dollar means the appreciation of the euro and yen, and exacerbates deflationary pressures in these regions. If deflation rears its ugly head back in Europe, Japan and elsewhere, it then heightens the risks that deflation will be exported to the US.

Right now, nobody sees this. "Global synchronized growth" rules the day, everyone is excited about the great market melt-up of 2008, and companies like Caterpillar (CAT) and Boeing (BA) leveraged to global growth are seeing their shares rise to record levels, lifting the Dow to record levels.

Good times!! Just buy more stocks! Nothing can stop this bull market! Even Ray Dalio says there's a market surge ahead and "if you're holding cash, you're going to feel pretty stupid.”

He might be right on stocks, after all, just look at this 5-year weekly chart below of the S&P 500 (SPY) and tell me who in their right mind wouldn’t want to buy more stocks (click on image):


As you can see, the S&P 500 broke out in the fall of 2017 on the weekly chart and hasn't fallen below its 10-week moving average. If this isn't momentum trading at its finest, I don't know what is.

And here we are talking about an index of 500 large companies, not a high-flier stock like Intuitive Surgical (ISRG) which keeps making new highs (click on image):


I'm astounded at people who come on television and keep repeating the mantra, buy stocks, sell bonds, stocks are overbought but they will melt up to the moon!!

I'm not saying this melt-up can't continue, it most certainly can, but as stocks keep making record highs, downside risks are rising even faster.

Earlier this week, Yves Martin, a former colleague of mine from the Caisse who ran his own commodity fund, gave me this update on the market melt-up (he was quoting someone):
"The largest melt-up occurred in 1929 when the Dow rallied 29.9% in 94 days. The current rally - which I believe is in a melt-up - has lasted 95 days and is up 21%."
Of course, history doesn't repeat itself, it's possible that this QE/ central bank engineered melt-up lasts longer, but people tend to get way ahead of themselves when they see stocks making record highs and many extrapolate recent good performance well into the future.

On the flip side, bonds are bad! Who in their right mind would want to buy US long bonds (TLT) when the Dow (DIA), S&P 500 (SPY) and Nasdaq (QQQ) keep making record highs?

Even Ray Dalio appeared on Bloomberg yesterday stating bonds face their biggest bear market in 40 years, echoing what Jeffrey Gundlach and Bill Gross have been warning of.

As you are well aware by reading my comments, I don't buy this nonsense on the 2018 Treasury bond bear market and neither should you.

I've had market disagreements with Ray Dalio privately when we met back in 2004. I don't care if he manages the world's largest, most successful hedge fund, I'm firmly in the camp that believes there is no bond bear market, only a temporary backup in yields due to a temporary rise in US inflation.

Importantly, I can't tell you whether the yield on the 10-year Treasury note will hit 3% in the next three months but if my Outlook 2018 is right, the yield will be below 2% by yearend, which is why I've been telling investors to buy US long bonds (TLT) as yields back up and prices fall (click on image):


Remember, bonds aren't going to make you rich but they're going to save your portfolio from a serious drawdown when risk assets get clobbered.

There is something else that irked me which Ray Dalio said on bonds which Zero Hedge repeated yesterday in its comment:
Joining the likes of Bill Gross and Jeffrey Gundlach, and echoing his ominous DV01-crash warning to the NY Fed from October 2016, Bridgewater's billionaire founder and CEO Ray Dalio told Bloomberg TV that the bond market has "slipped into a bear phase" and warned that a rise in yields could spark the biggest crisis for fixed-income investors in almost 40 years.
“A 1 percent rise in bond yields will produce the largest bear market in bonds that we have seen since 1980 to 1981," Bridgewater Associates founder Dalio said in a Bloomberg TV interview in Davos on Wednesday. We’re in a bear market, he said.
Readers may recall that when addressing the NY Fed in October 2016, Dalio made virtually the same prediction when he commented on the bond market's DV01:
... it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets, that would send them all much lower.
Dalio is referring to the record DV01 in the bond market, which according to the latest OFR report released in December, has risen to $1.2 trillion: that's the P&L loss from a 100bps rise in rates.
The watchdog found that "valuations are also elevated" in bond markets. Of particular interest is the OFR's discussion on duration. Picking up where we left off in June 2016, and calculates that "at current duration levels, a 1 percentage point increase in interest rates would lead to a decline of almost $1.2 trillion in the securities underlying the index."

I asked Brian Romanchuk, publisher of the Bond Economics blog, his thoughts and he shared this with me:
"That just tells us that the nominal size of the bonds outstanding has been growing faster than inflation. Well duh, nominal GDP grows faster than inflation, and the debt/GDP ratio went up as inflation fell.

You could just as easily plot the dollar losses for a 1% move in the S&P 500, and “adjust for inflation”. It would be even worse!"
Bottom line: Stop listening to scaremongerers warning you of a big, bad bear market in bonds!!

Hope you enjoyed reading this comment. As always, please remember to support this blog via a donation on PayPal on the right-hand side, under my picture. I thank all of you who support my efforts and value the work that goes into these comments.

Below, Ray Dalio discusses why he thinks holding cash is a bad idea, why the markets may be in late cycle behavior and how a change in interest rates may result in a bear market. Dalio had a more extensive interview on Bloomberg which you can watch here. I also embedded it below.

Where I agree with Ray is the potential for the Fed to bungle things up by raising rates too fast. If that happens, it will only reinforce deflationary pressures down the road (that's great for bonds, bad for stocks and other risk assets!).

If you watch the Bloomberg interview below, toward the end he discusses the dangerous divide which I've already discussed on my blog. He's right that the bottom 60% (I'd say 90%) is in terrible shape and that's something which should worry us when the economy goes down.

By the way, rising inequality won't just stoke populism, it will exacerbate deflation all over the world, which is why I consider it a deflationary structural headwind that needs to be addressed.

Update: Treasury Secretary Steven Mnuchin, under fire for comments he made earlier this week seemingly advocating a weak dollar, told CNBC on Friday the US has a long-term interest in a strong greenback. Maybe he had a chat with Ray Dalio in Davos. -:)



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