“Anything that has happened economically, has happened over and over again.”
– Ray Dalio
Founder, Bridgewater Associates, in Bloomberg Interview
My thinking is impatient and mostly critical as I sift through research each week. I’m sure my “get to the point” personality frustrates my co-workers and I’m sure at times my beautiful wife. It’s a personality flaw, I know; but hey, I’m just not sure any amount of therapy can help.
As I sift through research, my head clicks doesn’t matter, doesn’t matter… matters! Last week I wrote about Camp Kotok. There were some important “matters” moments. For example, there was an interesting moment when Bloomberg’s Mike McKee fired hard questions at the panel of economists and former Fed insiders.
Stress test very bright thinkers on stage with their peers and you get to watch their body language as you listen to their answers. Further, you get to watch the movements and facial expressions of others in the room. The panelists debated what the Fed will do next.
The most important takeaway from camp was confirmation of my view that the Fed, at the highest level, is heavily reliant on, if not married to, a limited equation called the Phillips Curve. The Fed’s goals are to keep employment strong and inflation in check.
The Phillips Curve is a single-equation empirical model, named after William Phillips, describing a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result within an economy.
The Phillips Curve assumes that high levels of employment will pressure wages, increase incomes, increase spending and drive inflation higher. And that is true in the short-term debt (or business cycles) we move through over time, but is it always true? In my view, the answer is no.
I argued they need to consider where we are in terms of both the short-term and the long-term debt cycle. A retired senior Fed economist said to me, “Until someone comes up with a better model, it’s the best we’ve got.” At this moment in time, they are looking at the wrong thing. “Matters!”
Put “how the Fed will likely react” in the matters category. Put the Phillips Curve in the matters category simply because it is what the Fed is focused on and not because it is the right metric and put, as I mentioned last week, the understanding of short-term and long-term debt cycles and where we are within those cycles in the matters most category.
Bottom line: We sit at the end of a long-term debt cycle. One very few of us have ever seen before yet one that has happened many times over hundreds of years. The data exists. The Phillips Curve doesn’t see it.
I wrote last week, “… the Fed is Focused on the Obvious and the Unimportant.” That is important for us to know. But then, what should the central bankers and you and I be focused on? Let’s take a look at that today and see if we can gain a better understanding.
Meeting Bloomberg’s chief global economist Mike McKee at Camp Kotok was a real treat for me. If you have listened to Bloomberg radio over the years, you’ll know him as Tom Keene’s co-host. So how will the next few years play out? What does it mean in terms of the returns you are likely to receive? In the matters category, I believe this is what you and I need to know most.
Following are my abbreviated notes from a recent Keene-McKee-Ray Dalio video interview to better understand how the economic machine works and how Bridgewater uses this understanding to invest their clients’ money.
There are three main factors. There is productivity which produces income. You can spend at the end of the day what you earn. And what you earn is a function of your productivity. For a country it is the same as for individuals. You can be more productive if you work harder and you can be more productive if you are creative.
Over a short period of time you can spend more money than what you earn. That’s because we have debt. So we have debt cycles. There are two major debt cycles. There is a short-term debt cycle which we are used to (it’s called the business cycle). We have recession and the Fed eases. What they do is reduce interest rates and as a result, money and credit goes out into the system.
It first bids up asset prices and then the lower borrowing costs enable business to make items that are cheaper because interest rates go down… so we have that business cycle. When that cycle gets past a certain mid-point in the cycle, there is a tightening of monetary policy as you get to the later part of the cycle (Fed raises interest rates) as you start to have inflation. It then gets too tight and the economy starts to go down. And that’s the business cycle. We are all used to this cycle.
So when we look at every country, we can see where we are in that cycle. We are in the mid-part of that cycle and hence we are having the conversation we are having about the Federal Reserve.
And then there is a long-term debt cycle because these cycles add up. In a long-term debt cycle, imagine you start off with no debt. Think of low debt-GDP ratios. Say you’re earning $100,000 a year and you have no debt. You borrow $10,000 so you can spend $110,000. Your spending is somebody else’s income. They are earning more so they can spend more. And it becomes self-reinforcing until you get to the point where debts rise too high relative to the income (like a balance sheet, at some point you can’t borrow anymore because you owe too much relative to what you can make, your income).
Central banks, all central banks, are in the business of helping this process go along. They lower interest rates, and lower again until rates hit 0% and we then come to a dilemma. We reach an end of monetary policy as we traditionally have it and as a result, you can’t keep that cycle going.
At this point the Fed puts money into the system. There is a difference between debt and money. With debt, for example, you go into a store and buy a suit, you put down your credit card and you later have to pay back money to settle the transaction. So the central banks can’t create credit because we’ve reached a point of too much debt so they put money in the system. They do this by buying financial assets.
When they buy bonds, the seller of those bonds takes the cash and he does something else with that cash. As a result of this, it causes longer-term yields to fall as the buying drives asset prices to rise.
So there are three equilibriums we have longer term:
- The first equilibrium is debt can’t rise faster than your income for long.
- The second equilibrium is that the operating rate in the economy can’t be too loose or too tight.
- The third equilibrium is that in the capital markets structure. In other words, cash is going to have a lower yield than bonds which is going to have a lower return