In recent weeks, Ray Dalio – a vocal proponent of QE4 and certainly against any form of monetary tightening – has been about as doom and gloomy as we have ever heard the head of the world’s biggest hedge fund. Just last week, we reported that the founder of Birdgewater, when speaking before the New York Fed, voiced his latest warning about the potential losses that would befall asset holders if interest rates rose by just 1%. Recall from his speech that “if interest rates rise just a little bit more than is discounted in the curve it will have a big negative effect on bonds and all asset prices, as they are all very sensitive to the discount rate used to calculate the present value of their future cash flows. That is because with interest rates having declined, the effective durations of all assets have lengthened, so they are more price-sensitive.”
And the punchline:
… 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.
Using a Goldman calculation which we showed earlier in the year, we estimated that the impact of a 100bp shock to interest rates – the same one that Dalio envisions – and assuming a total US bond market size market size of $40trn, in line with estimates…
… the market value lost would be roughly $2.4 trillion.
However, it is not just rising rates that trouble Ray Dalio. Recall that in an interview Ray Dalio gave to CNBC’s Andrew Ross Sorkin and Becky Quick in late January during this year’s Davos boondoggle, the Bridgewater founder made an even more stark warning: he said that if assets remain correlated and things continue to move in the “wrong” direction, “there’ll be a depression.” (3:35 in the clip below).
So, nearly one year later, where are we now? Sadly, it appears that at least one half of Dalio’s warning is being validated and is something traders should be concerned about, because as Citi’s Matt King reveals in his latest report today Asset correlations are not only higher, but the correlations themselves are becoming more correlated.
In case someone missed the message, here it is again…
Yet while traditionally rising cross-asset volatility has been resulted in volatility spikes, that is no longer the case due to outright vol suppression by central banks.
… or maybe vol is still present: one just needs to look elsewhere…
… and at different products, like the volatility of volatility.
Where does this repressed volatility come from? By now everyone should know the answer: central bank policies, of course.
And while central banks may have given the superficial impression of stability by pressuring volatility, they have also collapsed liquidity in the process, leading to less liquid markets, a surge in “gappiness”, and “jerky moves that are typical of penny stocks.”
And as the flow chart on the right shows, the greater the cross asset correlation, the lower the vol, the greater the repression, the more trading illiquidity and wider bid ask-spreads, and ultimately increased “gap risk”, which becomes a feedback loop of its own.
* * *
All of the above means that nearly one year after Dalio’s stark warning, the cross-asset correlations have grown even greater, and continue to rise with every passing day as central banks are forced to intervene increasingly more forcefully to suppress volatility – as of this moment, global central banks inject a record $2.5 trillion in fungible liquidity every year – in the process further fragmenting and fracturing an illiquid market which, as City wrily notes, is only fit for “penny stocks.”
The good news, at least for the time being, is that Dalio have not liquidated his $150bn+ exposure; when considering that we now live in a world in which vol targeting and risk-parity funds such as Bridgewater’s All Weather fund, are some of the biggest marginal price setters, this may be the only thing preventing the market’s terminal breakdown, and the onset of the depression which Dalio himself predicted at the start of the year.