Ray Dalio on QE and QT: Navigating Stimulus in a Bubble

Ray Dalio: QE and QT – What's Really Going On?

Have you noticed the Federal Reserve (Fed) announcing that it will be stopping Quantitative Tightening (QT) and perhaps starting Quantitative Easing (QE)? While it’s being described as a technical operation, it is, in any case, a monetary policy easing—which is one of the key indicators I watch closely to track the evolving dynamics of the “Big Debt Cycle” described in my previous book.

As Chairman Powell stated, “At some point, reserves will need to gradually grow to match the size of the banking system and the size of the economy. So we will be increasing reserves at a specific time.” The precise amount of the increase is worth watching closely.

Given the Fed’s role of “managing the size of the banking system” during boom times, we should also monitor the pace at which it is pumping liquidity into nascent bubbles through interest rate cuts. More specifically, if we see a significant balance sheet expansion in the face of low interest rates and high fiscal deficits, we will view it as a classic fiscal-monetary coordination between the Fed and the Treasury to monetize government debts. If this happens, with private credit and capital market credit creation remaining strong, the stock market hitting new highs, credit spreads approaching lows, unemployment being low, inflation exceeding targets, and a bubble forming in AI stocks (which I believe it is based on my bubble indicators), in my opinion the Fed will be injecting stimulants into a bubble.

Because the government and many individuals are advocating substantially easing political constraints to promote aggressive capitalistic growth-oriented fiscal and monetary policies, and with the massive outstanding deficit/debt/bond supply problem needing to be resolved, I doubt that this is just a technical issue as is being claimed—and this skepticism should be understood. I understand that the Fed is highly focused on funding market risks, which means that, in the current political environment, it is inclined to prioritize market stability over aggressively fighting inflation. But at the same time, it remains to be seen whether this will evolve into full-blown classic stimulative QE (accompanied by large-scale net bond purchases). We should not ignore currently that: when the supply of US Treasuries exceeds demand, the central bank buys bonds by “printing money,” and the Treasury shortens debt maturities to compensate for the shortfall in demand for longer-dated bonds, these are the typical characteristics of late-stage debt cycle dynamics.

Though I fully explained its mechanics in my book *Principles for Dealing with Big Debt Crises*, it is still worth pointing out that we are approaching a classic milestone in this big debt cycle and briefly reviewing its operating logic. My aim is to impart knowledge by sharing my thinking about market mechanics, just like teaching people to fish by revealing the essence of phenomena—elucidating the logic of thought and pointing out current dynamics, leaving the rest for readers to explore on their own. This approach is more valuable to you and avoids me becoming your investment advisor, which is beneficial for both of us. Here is my interpretation of operating mechanics: When the Fed and other central banks buy bonds, they create liquidity and lower real interest rates (as shown in the figure below). Subsequent development depends on the flow of liquidity:

If the liquidity stays in the realm of financial assets, it will push up financial asset prices and lower real yields, leading to expanding price-to-earnings multiples, narrowing risk premiums, and rising gold, forming “financial asset inflation.” This benefits holders of financial assets relative to non-holders, thereby increasing the wealth gap. Usually some of the liquidity will transmit to the commodity, service, and labor markets, driving up inflation. In the current trend of automation replacing labor, this transmission effect may be weaker than usual.

If inflationary stimulus is strong enough, nominal interest rates may rise enough to offset the decline in real interest rates, at which point bonds and stocks will be under dual pressure in terms of nominal and real value.

Transmission Mechanism: QE Transmits via Relative Prices

As I explained in my book *Principles for Dealing with Big Debt Crises* (which I cannot elaborate on here), all money flows and market fluctuations are driven by relative attractiveness rather than absolute attractiveness. In short, everyone has a certain amount of money and credit (which the central bank influences through policies), and they decide where the money goes based on the relative attractiveness of different options. For example, borrowing or lending depends on the relative relationship between the cost of funds and the expected return; investment choice depends mainly on the relative level of expected total return on different types of assets—expected total return equals the sum of asset yield and price change. For example, the yield on gold is 0%, and the yield on 10-year US Treasury bonds is currently about 4%. If the price of gold is expected to rise annually by less than 4%, you should choose to hold Treasury bonds; if it is expected to rise by more than 4%, you should choose to hold gold. When evaluating the relative performance of gold versus the performance of bonds versus the 4% threshold, you must consider the inflation rate—these investments must provide sufficient returns to offset the inflation erosion of purchasing power. With everything else remaining the same, the higher the inflation rate, the higher the rise of gold—because inflation mainly originates from the depreciation of other currencies due to increased supply, while the supply of gold is basically fixed. That is why I monitor money and credit supply conditions, and I monitor the policy moves of central banks such as the Fed. More specifically, in the long run, the price of gold always moves in sync with the inflation rate. When the level of inflation is high, the attractiveness of a 4% bond yield is lower (for example, a 5% inflation rate will increase the attractiveness of gold to support gold prices, while simultaneously reducing the attractiveness of bonds because the real yield drops to -1%). Therefore, the more money and credit created by the central bank, the more I expect the inflation rate to rise, and the less I prefer bonds compared to gold.

With everything else remaining the same, the Fed's expansion of QE is expected to lower real interest rates by compressing risk premiums, increase liquidity, and thereby lower real yields and increase price-to-earnings multiples, especially it will raise the valuation of long-duration assets (such as technology, AI, and growing companies) and inflation hedge assets such as gold and inflation-linked bonds. When inflation risks re-emerge, companies with tangible assets such as mining, infrastructure, and physical assets are likely to outperform pure long-duration tech stocks. With a lagging effect, the level of inflation will be higher than originally expected. If QE leads to lower real yields and higher inflation expectations, the nominal price-to-earnings multiple may still expand, but real returns will be eroded.

A reasonable expectation is: similar to late 1999 or 2010-2011, there will be a strong liquidity-driven rally, which will eventually be forced to tighten due to excessive risks. The liquid euphoria stage before the bubble bursts—i.e., the eve of the inflection point where tightening policies are sufficient to curb inflation—is a classic ideal time to sell. This time is different because the Fed will create a bubble through easing policies.

While I believe the operating mechanisms will be as I have described them, the environment in which this QE is being implemented is very different than before—these easing policies are being implemented in a bubble, rather than in a slump. Specifically, when QE was implemented in the past:

• Asset valuations were in a downtrend, and prices were low or not overvalued.
• The economy was in a contraction or very weak.
• The inflation rate was low or on a downward trend.
• Debt and liquidity problems were serious, and credit spreads widened.

Therefore, QE is essentially “injecting stimulants into a slump.” The current situation is exactly the opposite:

• Asset valuations are high and continue to rise. For example, the S&P 500 index yield is 4.4%, while the nominal yield on 10-year Treasury bonds is only 4%, and the real yield is about 1.8%, so the equity risk premium is as low as about 0.3%.
• The fundamentals of the economy are relatively strong (the average real growth rate has been 2% over the past year, and the unemployment rate is only 4.3%).
• Inflation is slightly higher than the target (about 3%), but growth is relatively moderate, and the inefficient phenomena caused by the reversal of globalization and tariff costs are constantly raising prices.
• Credit and liquidity are abundant, and credit spreads are approaching historical lows.

Therefore, the current QE is actually “injecting stimulants into a bubble.”

So, this round of QE is not “injecting stimulants into a slump,” but rather “injecting stimulants into a bubble.” Let’s see how this mechanism typically affects stocks, bonds, and gold. Because the government's fiscal policy is currently very stimulative (because the massive outstanding debt and massive deficits are being offset by a large-scale issuance of Treasury bonds, especially in terms of relatively short-term Treasury bonds), the QE policy is actually monetizing government debt, rather than just allowing the private system to be re-liquified. This makes the current situation different, and makes it seem more dangerous, and more likely to trigger inflation. This looks like a bold and dangerous bet on economic growth, especially AI growth, which is being funded by extremely loose fiscal, monetary, and regulatory policies, which we need to monitor closely in order to respond appropriately.