Ray Dalio Warns A 1% Rise In Yields Would Lead To Trillions In Losses

Tyler Durden's picture

Last week, we shared with readers a fascinating presentation that Bridgewater's Ray Dalio made to NY Fed staffers at the 40th Annual Central Banking Seminar held on Wednesday, October 5, 2016. In it, Dalio pointed out that thoughts which dared to question the economic orthodoxy, and which were once relegated to the fringe blogs, have become the norm, pointing out that it is no longer controversial to say that:

  • …this isn’t a normal business cycle and we are likely in an environment of abnormally slow growth
  • …the current tools of monetary policy will be a lot less effective going forward
  • …the risks are asymmetric to the downside
  • …investment returns will be very low going forward, and
  • …the impatience with economic stagnation, especially among middle and lower income earners, is leading to dangerous populism and nationalism.

He further notes that the debt bubble which was not eliminated during the financial crisis of 2008, has since grown to staggering proportions, and notes that "the biggest issue is that there is only so much one can squeeze out of a debt cycle and most countries are approaching those limits."

Alas, while the underlying symptoms are clear, that does not make the solution of the problem any easier. Quite the contrary. As Dalio further adds, "when we do our projections we see an intensifying financing squeeze emerging from a combination of slow income growth, low investment returns and an acceleration in liabilities coming due both because of the relatively high levels of debt and because of large pension and health care liabilities. The pension and health care liabilities that are coming due are much larger than the debt liabilities in most countries because of demographics – i.e., due to the baby-boom generation moving from working and paying taxes to getting their retirement and health care benefits."

Here the Bridgewater head provides a simple explanation for why the system is unsustainable: debt is fundamentally a liability even though it is treated as an asset by those who "own" it. As a result, "holders of debt believe that they are holding an asset that they can sell for money to use to buy things, so they believe that they will have that spending power without having to work. Similarly, retirees expect that they will get the retirement and health care benefits that they were promised without working. So, all of these people expect to get a huge amount of spending power without producing anything. At the same time, workers expect to get spending power that is equal in value to what they are giving. They all can’t be satisfied."

How does the Fed react to this inconsistency?  By a familiar tool: financial repression.

As a result of this confluence of conditions, we are now seeing most central bankers pushing interest rates down to make them extremely unattractive for savers and we are seeing them monetizing debt and buying riskier assets to make debt and other liabilities less burdensome and to stimulate their economies. Rarely do we investors get a market that we know is over-valued and that approaches such clearly defined limits as the bond market now. That is because there is a limit as to how negative bond yields can go. Their expected returns relative to their risks are especially bad.

What does that mean in practical terms? Well, in short: lots of pain for holders of duration: "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 discoun  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.

Consider that Ray Dalio's most stark crash warning to date.

Of course, it is not new to regular readers becuase this is precisely what we warned about back in June, when we showed the massive duration exposure on the market, and explaining "Why The Fed Is Trapped: A 1% Increase In Rates Would Result In Up To $2.4 Trillion Of Losses"

As we showed using Goldman calculations, in 1994, the average yield on the bond index was 5.6%, vs. 2.2% currently. Lower bond coupons means that proportionately more of the bond cashflows now comes from principal, which tends to be distributed towards the end of the bond lifetime.

Here is the math of how much in just bond losses a 1% increase in rates would lead to:

The total face value of all US bonds, including Treasuries, Federal agency debt, mortgages, corporates, municipals and ABS, is $40 trillion (Securities Industry and Financial Markets Association). The Barclays US aggregate is a smaller number, $17 trillion, as the index excludes some categories of debt, such as money markets, with low duration. Using either measure, total debt outstanding has grown by over 60% in real Dollars since 2000.

For conservative purposes, we use the lower debt estimate, and get that when combining a duration estimate of 5.6 years with a total notional exposure of $17trn, and current Dollar price of bonds of $105.6, indicates that, to first order, a 100bp shock to interest rates - the same one that Dalio envisions - would translate into a $1trn market value loss. That is using the more conservative estimate of the bond market. Using the broader, and more accurate, bond market sizing of $40trn, the market value loss estimate would be $2.4 trillionWhile the largest number would be stunning, even the smaller $1 trillion loss estimate is massive:

it would amount to over 50% larger than the market value lost in the 1994 bond market selloff in inflation-adjusted terms, and larger than the cumulative credit losses experienced to date in the non-agency residential mortgage backed securities market. 

This is what Goldman concludes in early June when delivering its own stark forecast of massive losses should rates spike:

"even if there is not a large net social loss from a rise in rates, the $1 trillion gross loss estimate suggests that some investor entities would likely experience significant distress. In the 1994 bond market decline, for example, losses on a mortgage derivative portfolio were a major factor contributing to the Orange County, California bankruptcy event. All in, the increase in total gross debt exposure, combined with lengthening bond durations and an arguably expensive bond market, suggest that rising yields should be on the short list of scenarios to be monitored by risk managers."

Now we know that it certainly is on the very short list of scenarios monitored by the world's biggest hedge fund.

So what, if any, recommendations does Dalio have now that virtually all the "smartest men in the room" admit the Fed is not only trapped, but that a spike in yields would lead to the worst crash in 35 years:

Right now, a number of the riskier assets look attractive in relationship to bonds and cash, but not cheap in relationship to their risks. If this continues, holding non-financial storeholds of wealth like gold could become more attractive than holding long duration fiat currency flows with negative yields (which is what bonds are), especially if currency volatility picks up.

Needless to say, we are eagerly waiting for precisely that inflection point.

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wisehiney's picture

Trillions in losses for the bond bears when rates collapsed back down by 1.5% the day after they spiked up 1%.

Delving Eye's picture

I gotta laugh at hedgefund guys like Dalio who made billions when they could manipulate the market. Now that his fund is tanking, he's telling the truth to us little people -- that's rich! He shows up at places like Davos, the spa-ground of the already rich and idiotic, to tell the world what's going on. Believe me, he wouldn't be so forthcoming unless it was going to help him financially.

That's the crazy thing. NO ONE knows how to play this market, not even you, Ray. But, hey, you've already made your bucks. That's why you decided to be a preacher.

Loftie's picture
Loftie (not verified) Delving Eye Oct 8, 2016 10:44 PM

It'll be TRILLIONS x (?) when the Financial CATACLYSM hits.
http://bit.ly/1KogtGi

Keyser's picture

The takeaway is, no rate hikes EVER, NIRP and more QE, along with helicopter $$$ for all the plebs that vote for a living as opposed to working for a living... Invest accordingly... 

jcaz's picture

So, "The smartest man in the room" has only been long bonds for the last 35 years, and now he's worried that he's about to give some of it back?    Cry me a river, Ray-  we're not going NIRP because you don't want your track record to flush;

I love when they're worried about the tide washing out....

Shorten your duration and wait for the tide to roll back in- it ain't rocket science.

 

Squid-puppets a-go-go's picture

Why dont we decimate the debt. Not as a figure of speech, literally. Get a global agreement to knock a zero of all ccard, mortgage, national, corporate debt.  Across the board.

Isnt that WAY more controllable than trying for inflation, missing, overshooting into hyperinflation ?

saveUSsavers's picture

It's called DEFAULT ! Biz bankruptcies are already up 38% over last yr, BRING IT ON, YOU PHUCKER-DEBTERS,

JUMP !

JRobby's picture

"rate increase" this is the thing that the nights that say ni can not hear!!!

Tarzan's picture

"I'm not going to censor myself to comfort your ignorance"

doctor10's picture

The 21st century doesn't begin until legacy 19-20th century institutions are allowed to succumb to market forces

ZH Snob's picture

can't wait to see how the SGE handles the huge drop in PM prices tomorrow.  china's markets have been closed all week, so currently the SGE has gold at the old price of $1327 and silver at $19.62.  if they choose not to follow the crooks in the west and keep those prices, maybe even raise them, the stage is set for arbitrage.

http://didthesystemcollapse.com/

 

 

 

 

 

 

 

Squid-puppets a-go-go's picture

ive made similar posts in the last few days precisely echoing your postulation

JRobby's picture

Jawboning seems to have worked so far. Nothing else works right. You can't jawbone forever .

trgfunds's picture

Rate hike = lower rates. TMF forever until heating your hands over a trash fire is considered "high tech".

Kabissa's picture

bond redeemed in "fool" nominal ends up in half real $

wisehiney's picture

These lying jackass hedgies complaining about low rates after all these years of demanding rate cuts reminds me of the dimocrats suddenly finding morality after all their years of scumdom.

King Tut's picture
King Tut (not verified) wisehiney Oct 8, 2016 11:12 PM

It's a shame about Ray

BennyBoy's picture

 

Ray knew this would happen as interest rates kept going down to zero. He can do math.

On the other side, insurers and pension funds need rates to go up.

WHo could have seen this mess coming? Not the FED.

NoWayJose's picture

Trillions in losses to speculators but trillions in interest paid to savers!

DutchZeroPrinter's picture

Only problem is that rising rates will also trigger the defaults on company bonds. Holders of these loans will get pennies on the dollar. And then they lose their loan and future interest.

Singelguy's picture

Not only that, but the increased debt service cost reduces net profit per share and will cause stock prices to drop. In some cases, like IBM that has borrowed $35 billion to buy back their stock, the increased debt service cost could bankrupt the company.

saveUSsavers's picture

Cry me a fking river ! You don't buy CCC- JUNK from ZOMBIE COMPANIES that wouldn't exist without ZIRP !

galant's picture

So what, Mr Dalio?

Isn't there universal agreement the market is grossly over-valued?

1980XLS's picture

Why would he even care how much the sheeple will lose?

Urban Redneck's picture

Nominal or Relative interest rate changes...
Notional or Net derivatives exposure...
At this point, what difference does it make?
They didn't listen in 2007-08, they're not going to start now.

Lost in translation's picture

Can someone please explain to me the relationship between bond prices and yields?

My (previous) understanding was/is that yields price in risk: the higher the interest paid to the bondholder, the riskier the bet is in buying it.

If that is correct then it's the only thing I know; if it's incorrect, then I don't know anything.

fellatio is not fattening's picture

When bonds are issued with a specific interest rate, say 4% they trade at "par" or $1000, as rates rise and new bonds are issued the existing bonds must adjust their prices to be comensurate with the new, thus a new bond issued at 8% and $1000 your older bond with the 4% coupon now must drop in price til it also pays 8% which means the price will be down 50% or $500.  You can calculate rates and prices in increments to see just how badly old bonds drop in price as rates rise (opposite is the same when rated drop, then an 8% bond issued at par, $1000 will go to $2000 if rates drop to 4% or $1500 if they went to 6%

K_BX's picture

the yield is the return you get from buying the bond at the current price, holding it to maturity and hopefully getting your money back. yields price in risk thats correct: The more risk the more yield you can earn, the cheaper the bond. If risks increase, bond prices fall. At the moment bonds do not price risks correctly with yields near 0 the bond is already trading at maximum price -> there is only losses ahead if risks start to rise. The best case at the moment?: you get your money back.

Kone Wone's picture

Suppose you have a bond that pays $100 each year; assume you paid $2000 for it, and that was its par issue value; therefore the yield at purchase date was 5% ( $100/$2000). Equivalently $100/.05 = $2000.

Now let's assume that interest rates go down so that an equivalent bond of $2000 with the same expiry would pay $75 per year; yield is 3.75% ($75/$2000)

But your bond still pays you $100 per annum so that it is now worth $2667  ($100/.0375) meaning that you have a capital profit unrealized of $667 (current value $2667 less original purchase price $2000).

And yes, generally the higher the yield on an investment, the higher the risk. But the real risk now is from a potential increase in interest rates: do the arithmentic above in reverse and you will get the picture. It's not a pretty one. For example if the rates went up to say 6% then your $100 pa bond interest is now worth  $1667  ( $100/.06). You have an unrealized loss of $333.

In short, the relationship between bond prices and yields is an inverse one: yields go up, bond prices (values) go down, yields go down, bond prices (values) go up.

PirateOfBaltimore's picture

Another metric for interest rate sensitivity would be modified duration - what amounts to a measure of the size of a given debt instruments sensitivity to interest rate changes.

https://en.m.wikipedia.org/wiki/Bond_duration

 

What's interesting today wrt duration is the impact of ultra-long time to maturities (thinking 50 and 100 yr bonds being issued at historically low rates). Those bonds are extremely sensitive to interest rate risk relative to short term bonds, because in effect, you're stuck with proportionally lower coupons for a longer period of time.

Yen Cross's picture

 Take your 2/20 and shove it up your ass Dalio.

big-data's picture

But the big story here is the interconnection of bonds with currencies and derivatives and the consequences of what happens when there finally is a global bond selloff. In the background, silently?, for the last 30 years a dangerous bond bubble has been inflating that is on a vastly greater scale than the 2000 dot com bubble and the 2008 housing bubble combined. The Achilles heel of the global financial system is a sustained, high-volume, sovereign bond selloff because that is what blows up the interest rate derivatives. That is trillions on the table more than the bond losses.


https://medium.com/deepconnections/prevailing-gray-swans-7-september-30-2016-8c1df681fd52#.r3bw5x8sf
lester1's picture

PPT/Central banks with unlimited money buying stocks and bonds have been kicking everyones butt. Dalio and his fund don't stand a chance vs PPT.

Muad'Grumps's picture

And this is why Greenspan always warned against leaving rates too low for too long, never more than 6 months. If too much of the stock of debt rolls over at such low rates then...

 

And we've been at zero for 8 years. Practically everything has rolled over at these bond prices. 

 

fellatio is not fattening's picture

This FED controlled by the White House (where the true ignorance lies) has stopped the normal and healthy cycles of our economy, they decided a recession wasn't a good idea after so many years of growth so they prevented it by lowering rates as they've done, now when allowed to cycle again the recession and subsequent inflation will be Carteresque, I do remember 30 yr Gov't. debt at 18%, picture what that'll do to your 3%-4% coupon bonds, can you say $150-$180 down from par $1000

331Warren 4's picture

Sooner or later all this cash injection is gonna cause inflation and they are going to have to raise rates talk about a crash ha 

King Tut's picture
King Tut (not verified) 331Warren 4 Oct 9, 2016 12:11 AM

Try as they might they cannot increase the velocity of $- the more they keep rates at near 0 the more the serfs will hoard cash

sessinpo's picture

My understanding is that the serfs aren't even getting much of that cash to hoard. A good bit of the population is pay check to pay check and so are those on whatever entitlement program. Think of all the trillions created, it isn't in the pockets of the serfs.

The real flood is when us dollars return from overseas because no one wants them.

Blopper's picture

Only IF there is going to be a rise of 1% in yields.

Or else..... everything stays the SAME.

DrZipp's picture

Trillions of losses on paper profits is really of no concern to me.

dunce's picture

Debt is currently controlled by political machinations rather than whether the money borrowed can be invested to produce a profit. The heavy, ignorant, and clumsy hand of government can not choose which enterprise should be funded, only people in the private sector have that limited ability. Even then they are sometimes wrong but the financial damage is limited to the private sector unless the govdernment blunders in and bails them out with tax money. Interest rates are a reflection of the risk involved in normal markets.

Richard Head's picture

Dalio obviously has massive bond positions that he can't get out of. He's just begging Uncle Janet not to hike.

fellatio is not fattening's picture

So many people especially older folks have NO CLUE that if a 3% coupon bond trading at par has rates rise to 4% the value of their bond drops to ~$750 thus a loss of principle of ~25%

trgfunds's picture

Which is why they can never raise. And why, if they do, they'll crash the equity markets and get everyone to sell, and once they sell, they gotta buy something. And what do they buy? They buy treasuries. And what does this do? It lowers rates. We'll have negative rates on every single developed market long before we ever see 100 basis points higher. Unless some wacko new invention happens like carbon nano tube free energy time travel. Then we might get 100 basis points. Maybe. 

kenny500c's picture

Bonds trade on inflation, the current increase in yields is the result of higher oil prices.

But with oil still in surplus and at the top of its range, look for bond yields to head back down.

8th Estate's picture

When gold goes to the moon, conditions on Earth will be so bad you'll want to join it.

In any case, the globalists have a plan for gold.

Once it becomes obvious that gold is about to blow, they will blame it for all the problems.

"Hoarders"

Cue massive capital gains taxes on metals sales, and IRS audits for all bullion dealers.

If you're holding physical metal for when we get Thunderdome, fine.

But if you're hoping to pay off your mortgage with a few ounces of gold..........forget it.

After all, better to owe a bank $200,000 and pay a small amount each month than have a $180,000 CGT bill from the IRS which they want TODAY, right?