Dalio warns Fed of 1937-style rate risk

Bridgewater founder say policy shift could have unintended consequences

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The US Federal Reserve risks causing a 1937-style stock market slump when it finally moves to raise interest rates, one of the world’s most powerful hedge fund managers has warned.

Ray Dalio, founder of the $165bn hedge fund group Bridgewater Associates, said in a note to clients and followers that he was avoiding large bets on the financial markets for fear that the Fed’s expected change of policy could have unintended consequences.

The note emerged as Christine Lagarde, head of the International Monetary Fund, warned on Tuesday that US rate increases could trigger instability in emerging markets, leading to a re-run of the Fed-induced “taper tantrum” of 2013.

The comments frame a high-stakes Fed meeting at which the central bank’s policy makers are expected to open the door to the first US rate rises in nearly a decade.

The Fed is on Wednesday expected to remove pledges to be “patient” before lifting rates when it concludes two days of deliberations. Market expectations are for it to raise rates either in June or September, but the soaring value of the dollar and several soft economic indicators have muddied the waters going into the meeting.

In Mr Dalio’s note, the stark tone of which has led it to be widely circulated around the industry, he and his co-author urge the Fed to proceed with caution and to set out a public plan B, in case monetary tightening goes wrong.

“We don’t know — nor does the Fed know — exactly how much tightening will knock over the apple cart,” Mr Dalio and Mark Dinner, his colleague, wrote. “What we do hope the Fed knows, which we don’t know, is how exactly it will fix things if it knocks it over. We hope that they know that before they make a move that could knock over the apple cart.”

“We are cautious about our exposures,” they added: “For the reasons explained, we do not want to have any concentrated bets, especially at this time.”

The note likens financial conditions today to those in 1937, eight years after the 1929 stock market crisis and at the end of four years of money printing that had led to surge in equity valuations. Premature tightening by the Fed led to a one-third slump in the Dow Jones Industrial Average in 1937 and the sell-off continued into the following year.

Today, many analysts fear the knock-on effect any Fed tightening will have, particularly on emerging markets, especially when combined with a strong dollar.

Messrs Dalio and Dinner wrote: “If one agrees that either a) we are near the end of the developed country central bankers’ ability to be effective in stimulating money and credit growth or b) the dollar is the world’s reserve currency and that the world needs easier rather than tighter money policies, then one would hope that the Fed will be very cautious about tightening.”

Although Bridgewater’s investment style is computer-driven, Mr Dalio’s investment commentary has long been valued by investors. His Pure Alpha fund, with $80bn in assets, is among the top performing funds on record, according to a 2014 survey from LCH Investments.

Many emerging market corporations, such as Chinese property companies, have borrowed dollars, despite their lack of dollar revenues, with few anticipating how strong the US currency would become.

Ms Lagarde said in Mumbai that she feared “spillover” effects from rate rises could lead to a re-run of the crisis that engulfed developing economies nearly two years ago, after then-Fed chairman Ben Bernanke hinted at an early end to its “quantitative easing” bond purchasing programme.

“I am afraid this may not be a one-off episode,” Ms Lagarde said.

Officials from Asia and South America have repeatedly urged the Fed to take international conditions into account when they formulate monetary policies. Fed officials stress that they watch global developments closely when reaching policy decisions on US rates — even if their formal mandate focuses on US employment and inflation.

That message was underscored in January when the Fed included wording to emphasise it was watching “international developments” when deciding monetary policy.

Stanley Fischer, vice-chairman of the Fed, said in October he recognised that it was “not just any central bank” and that it took account of feedback effects between the US and the rest of the world. He added, however, that the most important contribution it could make to the health of the global economy was to “keep our own house in order”.

Mr Fischer also said that a gradual exit by the Fed from ultra-easy monetary policy should prove “manageable” for emerging markets, and that the Fed was doing all it could to avoid upsetting markets with policy surprises.

Additional reporting by James Crabtree in Mumbai


Letters in response to this report:

Fiscal tightening dealt the hammer blow in 1937 / From Andres Drobny

Calm down — the parallels with 1937 are not as close as has been suggested / From George Magnus

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