Due to the highly stimulative fiscal side of government policy, quantitative easing will effectively monetize government debt rather than simply reinject liquidity into the private system.

Author: Ray Dalio

Translation: Jin Shi Data

On November 5 local time, Ray Dalio, founder of Bridgewater Associates, posted on social media, sharing his views:

Have you noticed that the Federal Reserve announced it will stop quantitative tightening (QT) and begin quantitative easing (QE)?

Although this has been described as a "technical operation," it is nonetheless a loosening measure. This is one of the indicators I (Dalio) use to track the dynamic progress of the "big debt cycle" described in my last book, and it requires close attention. As Chairman Powell said: "… at some point, you will want reserves to start to grow gradually to keep up with the size of the banking system and the economy. So, at some point, we will increase reserves…" How much they will increase is the key point to watch.

Given that one of the Fed's jobs is to control the "size of the banking system" during bubbles, we will need to closely monitor this while observing the speed at which it implements easing through interest rate cuts in emerging bubbles. More specifically, if the balance sheet starts to expand significantly while interest rates are being lowered and the fiscal deficit is large, then in our view, this is the classic monetary and fiscal interaction between the Fed and the Treasury, monetizing government debt.

If this occurs while private credit and capital market credit creation remain strong, stocks are reaching new highs, credit spreads are near lows, unemployment is near lows, inflation is above target, and AI stocks are in a bubble (according to my bubble indicators, they indeed are), then in my view, it looks like the Fed is stimulating a bubble.

Given that this administration and many others believe that significant reductions in restrictions should be made so that monetary and fiscal policy can be formulated through a "full-speed pursuit of growth" approach, and considering the upcoming massive deficit/debt/bond supply-demand issues, it should be understandable if I suspect this is not just the technical issue it claims to be.

While I understand that the Fed will be highly focused on the risks in the funding markets, which means it tends to prioritize market stability over actively fighting inflation, especially in the current political environment, it remains to be seen whether this will become a complete and classic stimulative quantitative easing (accompanied by large-scale net purchases).

At this point, we should not overlook the fact that when the supply of U.S. Treasuries exceeds demand, and the Fed is "printing money" and buying bonds, while the Treasury is shortening the maturities of the debt it sells to compensate for the lack of demand for long-term bonds, these are all dynamics typical of the late stages of the classic "big debt cycle." While I have comprehensively explained how all of this works in my book "How Countries Succeed or Fail: The Big Cycle," I want to point out the proximity of this classic milestone in the current big debt cycle and briefly review its mechanisms.

I am eager to teach by sharing my thoughts on market mechanisms and demonstrating what is happening, just as one teaches fishing by sharing thoughts and pointing out what is happening, leaving the rest to you, as that is more valuable to you and avoids me becoming your investment advisor, which is better for me. Here are the mechanisms I see at work:

When the Fed and/or other central banks buy bonds, it creates liquidity and pushes down real interest rates, as shown in the chart below. What happens next depends on where the liquidity goes.

Changes in money supply compared to short-term real interest rates

If liquidity stays in financial assets, it will push up financial asset prices and lower real yields, leading to an expansion of price-to-earnings ratios, narrowing risk spreads, rising gold prices, and creating "financial asset inflation." This benefits holders of financial assets relative to non-holders, thereby exacerbating wealth inequality.

It typically permeates to some extent into the markets for goods, services, and labor, pushing up inflation. In this case, the extent to which this occurs seems to be lower than usual due to automation replacing labor. If the inflation it stimulates is high enough, it could lead to nominal interest rates rising to offset the decline in real rates, which would harm bonds and stocks on both nominal and real levels.

Mechanism of Operation: Quantitative Easing Through Relative Price Transmission

As I explained in my book "How Countries Succeed or Fail: The Big Cycle," all financial flows and market movements are driven by relative attractiveness rather than absolute attractiveness, and this explanation is more comprehensive than I can provide here.

In short, everyone has a certain amount of funds and credit, and central banks influence these funds and credit through their actions, with everyone deciding how to use them based on the relative attractiveness they choose. For example, they can borrow or lend, depending on the relationship between the cost of funds and the return they can obtain; where they put their funds primarily depends on the relative expected total returns of various alternatives, with expected total returns equaling the yield of the asset plus its price change.

For instance, gold has a yield of 0%, while the nominal yield on a 10-year Treasury bond is currently about 4%. Therefore, if you expect the price of gold to rise less than 4% per year, you would be more inclined to hold bonds; if you expect it to rise more than 4%, you would be more inclined to hold gold. When considering the performance of gold and bonds relative to this 4% threshold, one should naturally consider what the inflation rate will be, as these investments need to provide sufficient returns to compensate for inflation that will reduce our purchasing power.

All else being equal, the higher the inflation rate, the more gold will rise, as most inflation is due to the value and purchasing power of other currencies declining due to increased supply, while the supply of gold does not increase much. This is why I pay attention to the supply of money and credit, and why I focus on what the Fed and other central banks are doing.

More specifically, for a long time, the value of gold has been linked to inflation. As inflation levels rise, the 4% bond yield becomes increasingly unattractive (for example, a 5% inflation rate would make gold more attractive, supporting its price and making bonds unattractive, as it would lead to a real return of -1%), so the more money and credit the central bank creates, the higher I expect inflation to be, and the less I like bonds relative to gold.

All else being equal, an increase in quantitative easing by the Fed should lower real interest rates and increase liquidity, specifically manifested as a compression of risk premiums, a lowering of real yields, and an increase in price-to-earnings multiples, especially boosting the valuations of long-term assets (such as technology, AI, and growth stocks) and inflation-hedging assets (such as gold and inflation-protected bonds). Once inflation risks re-emerge, tangible asset companies (such as mining, infrastructure, and physical assets) may outperform pure long-term tech stocks.

The lagging effect is that quantitative easing should push inflation higher than it otherwise would be. If quantitative easing leads to a decline in real yields but an increase in inflation expectations, nominal price-to-earnings ratios can still expand, but real returns will be eroded.

It is reasonable to expect that, similar to the end of 1999 or 2010-2011, there will be a wave of strong liquidity inflow that will ultimately become too risky and must be curtailed. During this inflow period, and before tightening actions sufficient to curb inflation and burst the bubble, is the classic ideal selling opportunity.

This time is different: The Fed is easing into a bubble

While I expect the mechanisms to operate as I have described, the conditions under which this quantitative easing is occurring are very different from those that existed before, as this time the easing will be a response to a bubble rather than a stimulus to a recession. More specifically, in the past when quantitative easing was deployed, the situation was:

1. Asset valuations were declining, and prices were cheap or not overvalued.

2. The economy was contracting or very weak.

3. Inflation was low or declining.

4. Debt and liquidity issues were severe, with wide credit spreads.

Thus, past quantitative easing was "stimulus to a recession."

Now, the situation is exactly the opposite:

1. Asset valuations are high and rising. For example, the earnings yield of the S&P 500 is 4.4%, while the nominal yield on a 10-year Treasury bond is 4%, with a real yield of about 1.8%, so the equity risk premium is low, around 0.3%.

2. The economy is relatively strong (with an average real growth of 2% over the past year and an unemployment rate of only 4.3%).

3. Inflation is above target, at a relatively moderate level (slightly above 3%), while "de-globalization" and tariff costs are putting upward pressure on prices.

4. Credit and liquidity are abundant, with credit spreads near historical lows.

Thus, the current quantitative easing is "stimulus to a bubble."

Economic data at different stages in the U.S.

So, the current quantitative easing is no longer "stimulus to a recession," but rather "stimulus to a bubble."

Let’s look at how these mechanisms typically affect stocks, bonds, and gold.

Due to the highly stimulative fiscal side of government policy (attributed to massive existing debt and huge deficits, financed through large-scale Treasury issuance, especially over relatively short maturities), quantitative easing will effectively monetize government debt rather than simply reinject liquidity into the private system.

This is where the current situation differs, making it seem more dangerous and inflationary. It looks like a bold and risky "bet" on growth, especially the growth brought by artificial intelligence, which is financed through very loose fiscal, monetary, and regulatory policies. We will have to monitor closely to respond appropriately.

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