Ray Dalio says capital markets are no longer “free”.
This, apparently, is news to some folks, but certainly not to the perpetually irritable crowd who spends an inordinate amount of time every week waxing hysterical about moral hazard (as opposed to just riding the wave in, for example, high yield, which would have delivered you a record return in the second quarter).
Dalio spoke to Bloomberg’s Erik Schatzker on Thursday via teleconference. “I’ve heard you say, Ray, that central banks control the capital markets”, Schatzker began, speaking deliberately, as you would to your grandfather. “What does that mean?”
Ray was happy to regale Erik.
“In the normal world, central banks put money on deposit and banks come along and borrow that money and lend it to those who they expect will pay it back”, Ray said. “That then passes through the credit system and then all financial assets compete with each other — credit gets expanded, and there’s the issue of payback and then we have these cycles”.
If that’s too vague for you, trust me when I say that Ray will be happy to explain it in painstaking detail via 10,000-word installments (see the archive here).
Dalio then moved to describe the system as it exists currently. Here is the key excerpt:
Today, the economy and the markets are driven by the central banks and the coordination with the central government. The purchases of financial assets by the Fed are the drivers of that market. The Fed will set an interest rate for different types of creditors based on its economic objective. After [the financial crisis] we needed to protect banks, and money market funds, and commercial paper and the like. Now it’s much broader than that. The whole economy is systemically important. If they didn’t go out and make loans to companies including fallen angels, we would lose large parts of our economy. We’re in a situation now where they’re the market makers.
There are a lot of notables in there, all of which have been discussed in these pages at length.
Note that Dalio is describing what analysts have taken to calling “administered markets”.
“At the extreme, central banks could become permanent command economy agents administering equity and credit prices, aggressively subduing financial shocks”, Deutsche Bank’s George Saravelos wrote, in a short critique called “the end of the free market” published in early April.
“With unlimited capacity to print money, central banks have unlimited capacity to intervene in asset markets too”, Saravelos said, adding that “a central bank that pegs bond, credit and equity markets is highly likely to stabilize portfolio flows as well”.
Dalio also makes it clear that central banks are administering these prices based on a desire to engineer economic outcomes and, if you listen to the short clip, he mentions political outcomes as well, especially in the European context, although it’s not clear that Ray meant to imply anything nefarious.
He also touched on the absolute necessity of ensuring that funding markets (i.e., the “plumbing”, as it were) function properly. I’ve gone to great lengths to differentiate for readers between the Fed’s facilities aimed at ensuring funding markets don’t freeze (a non-starter) and the facilities that are more controversial (e.g., the corporate credit program).
Perhaps most importantly, Dalio characterizes “the whole economy” as being systemically important”. Although it’s not entirely clear what he means by that (it’s tautological if taken literally), there are two points I would make.
- Central banks’ response to the last crisis had the effect of encouraging corporate borrowers to take on ever more leverage. That effectively meant that when the cycle finally turned, any potential de-leveraging had the potential to be catastrophic.
- Second, Dalio’s remarks recall the following classic passage from Deutsche Bank’s Aleksandar Kocic : “In the absence of a major disruption, the system is capable of moving along by collecting small installments of rent (‘clipping the coupons’) from a large segment of the population. However, if an exogenous shock disrupts the fragile order of these cashflows, there is a chain reaction of collective insolvency ready to sink the entire system. As precarity becomes everyone’s prospect, the consumers from a wider sector of the population withdraw and the rest of the economy gradually has to contract or shut down” (Much more here)
That latter bit ties into the broader discussion of late-stage capitalism, something Dalio has critiqued relentlessly.
In any event, the overarching message from Dalio is straightforward.
“These are markets which are driven by central banks. Not only their actions but their desire to be an owner of assets”, he said Thursday. “Their priorities about that ownership — when they buy and when they sell — are not the same as the classic free market allocations”.
More from the interview