Ray Dalio, the founder of the world's largest hedge fund Bridgewater Associates, said the firm believes the next big move by the Federal Reserve will be to loosen U.S. monetary policy, not tighten it.
In a client note sent out on Monday, Dalio said the Fed is paying too much attention to the short-term ups and downs of the business cycle rather than the longer-term ramifications of central banks driving interest rates to zero, which now leaves them no room to act if worldwide deflation takes hold.
"The ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias," said Dalio, who helps manage $162 billion at Bridgewater. "Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant."
Dalio said Bridgewater thinks it should now be apparent that the risks of deflationary contractions are increasing, relative to the risks of inflationary expansion. He noted that since the early 1980s, each subsequent decline in interest rates was lower than the previous, encouraging more borrowing and more leverage.
"These long-term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars and holding a huge amount of dollar assets - at the same time as the world is holding large leveraged long positions," Dalio said.
Dalio said the Fed has overemphasized the importance of the cyclical short-term business cycle in its desire to raise rates, but has been less attentive to the longer-term trend toward deflation.
He said the Fed will react "to what happens," suggesting it should undertake more quantitative easing, or QE, but he isn't positive of that, given Fed officials' desire to raise rates.
Dalio warns of global disinflation, slow global economic growth, and the lingering risk aversion that is behind the proclivity to hold cash despite its significant negative real returns.
"Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required," Dalio said.
Bridgewater's Pure Alpha fund has returned 13.2% net of fees for the past 5 years as of July 31 and 13.4% annualized since inception in 1991 as of July 31.