Last Tuesday, the U.S. Department of Labor released the latest inflation data. Inflation in August was still soaring, with the Consumer Price Index (CPI) rising 8.3% year-on-year that month, higher than market expectations of 8.1%.
This CPI data immediately caused waves in the financial market. After experiencing "Black Tuesday", the U.S. stock market continued to fall again on Thursday, while investors were selling out large numbers of U.S. Treasury bonds, causing the policy-sensitive two-year Treasury bond yield to a new high since 2007.
This undoubtedly further aggravates the expectation of Fed's aggressive rate hike in September (this week, the Federal Open Market Committee's monetary policy meeting in September will determine the extent of interest rate hike).
At present, CME (Chicago Commodity Exchange) "Federal Watch" tool data shows that the probability of raising interest rates by 75 basis points in September is close to 80%, and the probability of raising interest rates by 100 basis points is 20%.
htmlOn September 13, Ri Dalio, founder of Bridgewater Fund , shared an article titled "It starts with inflation" on his LinkedIn platform.
Dalio believes that if the interest rate of rises to 4.5%, the stock price will fall by 20%.
interest rates may rise to the high end of the 4.5%-6% range, which will lead to a slowdown in private sector credit growth, which will affect private sector spending and the overall economy.
So in Dalio's view, the U.S. economy is unavoidable.
Dalio starts from inflation and focuses on explaining how inflation, interest rates, markets and economic growth are related to each other and what this means for the future.
is the content of the article published by Dalio on LinkedIn . Smart investors translated this short article and shared it with everyone.
In this post, a) I will explain very briefly how what I think is the "economic machine" that determines inflation, interest rates, market prices and economic growth rates work, b) work with you to apply the current situation to that "machine" to predict the future.
working principle
In the long run, the improvement of living standards is because people have come up with ways to make the daily work more valuable. We call it productivity.
The reason why there are ups and downs around this development trend is because of the existence of monetary and credit cycles that drive interest rates, other markets, economic growth and inflation.
When all conditions are the same, demand and economic growth will also become strong when currency and credit growth is strong, while unemployment will drop, all of which will lead to higher inflation.
When the opposite situation is true, then the opposite situation will happen.
Most people agree - most importantly, the central bank , which determines the amount of currency and credit available in countries with reserve currency, believes that as long as there is no bad inflation, the countries with the highest economic growth rate and the lowest unemployment rate are good.
What kind of inflation rate does not want to appear?
answer is that it will have a negative impact on productivity; most people and the central bank believe that this level is about 2%.
Therefore, most people and most central banks hope to maintain strong growth and low unemployment on the one hand, while keeping inflation at an ideal level on the other hand.
Because strong growth and low unemployment rate will accelerate inflation, central banks tend to solve the problem with greater impact when weighing inflation and growth, while changing monetary policy will minimize the cost of another problem.
In other words, when inflation is high (more than 2%), they will tighten monetary policy and make it fall by weakening the economy. The higher the interest rate, the tighter they tighten.
Inflation is much higher than the expectations of the people and the central bank (for example, today's CPI report shows that the core CPI changes by 0.6% per month, equivalent to an annualized rate of 7.4%) and low unemployment (3.7%). Obviously inflation is the primary issue, so the central bank should tighten monetary policy.
This is the starting point for all changes in the future.
tells me what the future inflation rate would be without the central bank pushing interest rates, currency and credit growth rates, and I can almost tell you the answer.
The whole process starts with inflation, then interest rates, then other markets, then the economy.
First of all, inflation.
Since the price of anything is equal to the amount of money and credit spent divided by the quantity sold, the change in price, i.e. inflation equals the change in the amount of money and credit spent on goods and services, divided by the change in the number of goods and services sold.
This depends mainly on the amount of money and credit and the level of interest rates provided by the central bank, but it will also be affected by the supply of available goods and services, such as supply disruptions.
and then the interest rate.
Central Bank determines the amount of money and credit available for consumption. They buy and sell debt assets by setting interest rates and printing currencies, such as quantitative easing and quantitative tightening. Compared with inflation rate, real interest rates have a great impact.
and then other markets.
Interest rate compared to rising inflation will lead to lower prices in stocks, stock markets and most interest-bearing assets, because
a) its negative impact on income, b) asset prices need to fall to provide competitive returns, i.e. "present value effect", and c) less currency and credit available to purchase these investment assets.
In addition, because investors know that these things happen to slow the growth of returns, which will also be reflected in the price of investment assets, thereby affecting the economy.
then economy.
When central banks create lower interest rates compared to inflation, and when they can provide a lot of credit, they encourage
a) borrowing and spending, and b) investors to sell debt assets (such as bonds) and buy hedge inflation, which accelerates economic growth and raises inflation (especially when the number of goods and services is almost incapable of increasing).
and vice versa, that is, they have the opposite effect when their interest rates are higher than inflation and when the supply of money and credit is tight.
The solution to these problems will be near the most tolerant level, and all factors are taken into account, that is, if there is one thing that is intolerable, such as excessive inflation rate and weak economic growth, central bank experts will change this, policies will change, and other aspects will change to achieve this.
so, figuring out what will happen in the future, the whole process is an iterative process, just like solving systems of equations, so that the most important things can be optimized.
Substitute the current situation and see
Now, let’s take a look at what it means for inflation, interest rates, markets and economy as mentioned above.
By correcting our estimate of determinants, we can obtain the final estimate result.
As mentioned above, starting with the inflation rate, your estimate represents your expectations for the future.
Currently, the market predicts that the U.S. inflation rate will be 2.6% in the next 10 years. I predict that the long-term level of inflation will remain between 4.5%-5%, unless there is a shock (e.g., the worsening of the economic war in Europe and Asia, or more droughts and floods), and this number will rise significantly if subject to economic shocks.
In the short term, I expect inflation will drop slightly as the negative impacts of some past events (such as energy) fade, and then rebound to 4.5% to 5% in the medium term.
I won't expand on how I made this estimate (I'm very unsure about it), because that would take too long.
What is your guess?
Next, what we need to estimate is to what extent interest rates are related to inflation.
At present, the market expects the discount rate to be 1% in the next 10 years. Compared with the long-term real rate of return, this is a fairly low real rate of return, considering the moderately high rate of return in the near future.
What is your guess?
Based on the number of outstanding debt assets and liabilities, the debtor's debt repayment cost, and the meaning of the creditor's actual return, my guess is that the actual interest rate will be between 0% and 1%.
Because this level is a tolerable high for debtors; it is also a tolerable low for creditors.
Put the inflation estimate and the real interest rate estimate together and you will get the expected yield on the bond. If you want to estimate short-term interest rates, then first determine what the yield curve looks like.
What is your guess?
My point is that will have a relatively flat yield curve unless the economy suffers from unacceptable negative impacts.
Based on my guesses about inflation and real yields, I think both long-term and short-term interest rates are between 4.5% and 6%. However, I guess the Fed won't easily cross this range (although 4.5% may be too easy) because I think 6% is unacceptable for debtors, the market and the economy.
Although interest rates and credit availability will be affected by the above factors, there will also be supply and demand effects of interest rates caused by borrowing.
For example, the U.S. government will have to sell a large amount of debt to cover the deficit (4-5% of GDP this year), and the Federal Reserve will also sell (and liberalize) in large amounts (about 4% of GDP).
So the question is, where will the demand matching such a large supply (8-9% of GDP) come from, or how much interest rates have to be raised to reduce the credit demand in the private sector to balance supply and demand.
What do you think?
I think it seems that interest rates will have to rise sharply (near the high end of the 4.5% to 6% range), and a sharp drop in private credit will cut spending. This will slow down private sector credit growth, resulting in a decline in private sector spending, which in turn leads to an economic downturn.
Now we can estimate what rising interest rates mean for market prices and economic growth.
interest rate rise will have two negative effects on asset prices:
1) cash flow discount value; and 2) a decline in asset income due to economic weakness. Both must be considered.
What is your estimate of these?
According to the present value discount effect, I estimate that if the interest rate rises from the current level to around 4.5%, it will have a negative impact on the stock price by about 20% (on average, because the longer the duration of the asset, the greater the impact, the smaller the duration, the smaller the impact), and a decline in income will have a negative impact on the stock price by about 10%.
Now, we can estimate what the market decline means to the economy, i.e. the "wealth effect".
When you lose money, people will become cautious, and lenders will be more cautious when giving them loans, so their spending will be reduced.
My guess is that there will be a significant economic contraction, but it will take some time to happen, as cash and wealth levels are relatively high now and they can be used to support expenditure until the ammunition is out of food.
now we see this happening. For example, although we see a significant decline in interest rates and debt-dependent sectors (such as housing), we can still see a relatively strong consumption spending and employment situation.
The result is that, in my opinion, inflation will be much higher than what people and the Fed expect (while year-on-year inflation will fall), interest rates will rise, other sectors of the market will weaken, and the economy will be weaker than expected, which has not taken into account the deterioration trend of internal and external conflicts and its impact.
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