Billionaire investor Ray Dalio, founder of Bridgewater Associates, which is the largest hedge fund in the world, recently told Bloomberg Television that he believes the U.S. is on the brink of a potential late-cycle debt crisis. After passing a last-minute bill to suspend the debt ceiling until 2025 so the U.S. could continue to fund its already approved obligations, the U.S. Treasury is now gearing up to issue $1 trillion of U.S. Treasury bills, potentially threatening market stability.
Here's why Dalio is concerned.
A supply-and-demand issue
When the U.S. government hit the debt ceiling in January, the U.S. Treasury stopped issuing debt.
Image source: Getty Images.
Now, it's about to issue a whole heap of debt, and at pretty high interest rates, which could prove to be a disruption to the broader market, according to Dalio, who thinks the Treasury may have difficulty finding investors to buy all of this debt.
Said Dalio:
There are changes now in terms of the quantities [of Treasury bills] in the world that are being held by large investors around the world that have lost money in these Treasury bonds and so on. And then there are geopolitical changes, which are having an effect. In some cases, some countries are worried about sanctions.
Many U.S. Treasury bonds and mortgage-backed securities are deeply underwater because of the rapidly rising interest rate environment since March 2022. The U.S. banking system is also now effectively competing with financial instruments like U.S. Treasury bills and the Fed's reverse repo facility, which powers money market funds. When bank customers choose these higher-yielding financial instruments, banks essentially lose out on cheaper deposits.
Dalio thinks the dynamics he mentioned could lead to supply-and-demand issues, which could then lead to a crisis if the U.S. continues down this path for the next five or 10 years. The government is now on the "brink" of being able to see what this supply-and-demand path looks like going forward, he said.
One potential problem this could lead to is a surge in short-term borrowing rates, which also occurred in 2019 when overnight money market rates blasted higher and companies hoarded liquidity. Many believe a prime cause of this was related to quantitative tightening (QT), in which the Fed reduces its balance sheet and therefore pulls liquidity out of the economy. The Fed restarted QT last year.
While the Fed was able to get a handle on the situation pretty quickly and has likely learned from its mistakes, interest rates are much higher right now, which could add a different and potentially more complex dynamic. In a lot of ways, investors and the Fed are operating in the dark. In addition, Dalio doesn't see the Fed necessarily lowering interest rates anytime soon.
Getting out of this debt situation
Given the fiscal challenges the country is facing and the amount of debt piling up, Dalio believes that it will be critical for lawmakers to come together in a strong bipartisan front if they are going to manage this potential debt crisis.
Because Dalio believes interest rates will likely stay at their current level for a while, he also believes the economy is poised to slow. Combined with these debt issues, it makes for a risky situation, he said.
Dalio believes the more extreme members of both the Democrat and Republican parties and the rise of populist politicians will keep things fractured and make it difficult to get much done in Washington, although he believes the rise of populist politicians is fueled by wealth inequality. This could certainly be seen during this recent debt crisis, when lawmakers allowed the U.S. government to hit the debt ceiling, not passing a bill until the very last minute.
It's hard to imagine the government becoming bipartisan anytime soon, so investors should heed Dalio's words and be on the lookout for potential market disruptions as the Treasury begins to issue all this debt. It could very well be manageable, but preparing for a worse-than-expected scenario is never a bad idea.
