Author: Shenchao TechFlow

This article refers to Dalio's new book "How to go bankrupt", and at the end, it combines my personal views to sort out the opportunities and risks of the US large debt cycle, which is only used as an auxiliary to investment decisions.

I will first introduce the founder of Dalio-Bridgewater Fund. He has successfully predicted major economic events such as the 2008 financial crisis, the European debt crisis, and Brexit. Steve Jobs, known as the investment industry, enters the main text below.

In the past, when studying debt, it usually refers to a credit cycle (about 6 years ± 3 years) that is synchronized with the business cycle, while large debt cycles are more important and lower-level. This is because there have been about 750 currencies or debt markets around the world since 1700, but only about 20% of them are still alive. Even the surviving currencies have experienced serious depreciation, which is closely related to the "big debt cycle" in the book.

The core difference between a small debt cycle and a large debt cycle is whether the central bank has the ability to reverse the debt cycle. In the traditional deleveraging process of small debt cycles, the central bank will lower interest rates and increase credit supply. But for large debt cycles, the situation can be very tricky because debt growth is no longer sustainable. A typical path to dealing with a large debt cycle is: private sector health -> private sector over-borrowing and difficult to repay -> departments to provide help, excessive borrowing -> central bank prints money and purchases debt to provide help (central bank is the last borrower).

The large debt cycle usually lasts about 80 years and is divided into five stages:

1) Sound Money Stage: The interest rate is very low at the beginning, and the returns generated by borrowing debt are higher than the cost of capital, and debt is expanding at this time.

2) Debt Bubble Stage: As debt expands and the economy begins to prosper, the prices of certain assets (stock markets, real estate, etc.) begin to rise. As asset prices rise and the economy continues to prosper, the private sector is more confident in its own ability to repay debts and return on assets, and therefore continues to expand debt.

3) Top Stage of bubble bursting: Asset prices have reached the bubble stage, debt expansion has not stopped.

4) Deleveraging Stage: Debt default wave burst, asset prices plummeted, total demand shrinks, and fell into a debt-deflation cycle (Fisher effect), nominal interest rates dropped to zero lower limit, real interest rates increased due to deflation, and debt repayment pressure intensified.

5) Debt Crisis Stage: As the asset bubble bursts, the debt bubble bursts at the same time. In this case, the person who borrows debt to buy assets may not be able to repay the debt. At this time, the entire economy is facing bankruptcy and debt restructuring. This stage also marks the subsidence of the major debt crisis, reaching a new balance, and the beginning of a new cycle.

In each of these five stages, the central bank must adopt different currencies to ensure the stability of debt and economy, so we can also observe the current large debt cycle stage through currency.

At present, the United States has experienced 12.5 short-term debt cycles since 1945. The U.S. debt interest expenditure this year is expected to exceed $1 trillion, while its total revenue is only $5 trillion. In other words, for every $4 charged in the United States, it will take out $1 to pay interest on the debt!

If this trend continues, the United States will become increasingly difficult to repay its debts and will eventually be forced to monetize debts (print money to pay off debts), which will further push up inflation and cause serious currency depreciation. Therefore, the United States is currently on the verge of the second half of the big debt cycle, namely the "bubble burst stage" of Stage 3, which means that the debt crisis may be coming soon.

Below we review the first long debt cycle experienced by the United States from 1981 to 2000, which is divided into several short cycles.

The first short cycle (1981-1989): The second oil crisis that broke out in 1979 caused the United States to enter the era of "stagflation 2.0". From February to April 1980, the most preferential loan interest rate of Bank of America rose nine consecutive times from 15.25% to 20.0%. Inflation is at an all-time high, and interest rates are also at an all-time high. In order to avoid systemic risks, the currency turned from tight to loose. From May to July 1980, the Federal Reserve cut interest rates three times, each time of 100 BP, and the interest rate was lowered from 13.0% to 10.0%, with a total interest rate of 300 BP. After Reagan took office in 1981, he significantly increased defense spending. During this period, the leverage ratio surged, and the existing debt expanded rapidly during this period, and reached the highest point of the long-term debt cycle in 1984, with a deficit accounting for as much as 5.7%. In May, the top ten U.S. banks in Mainland China Bank of Illinois experienced a "bank run". On the 17th of the same month, the bank accepted temporary financial aid from FDIC, which was the most important bank bankruptcy resolution in FDIC's history. In June, the bank's most preferential loan interest rate continued to rise until the Plaza Accord in 1985, forcing the US dollar to depreciate. After the signing of the Plaza Accord, the Gram Ludman-Hollings Act of 1985 required that the federal budget balance be basically achieved by 1991. On October 28, 1985, Federal Reserve Chairman Volker delivered a speech, believing that the economy needs help from lower interest rates. In this stage, the Federal Reserve gradually lowered interest rates from 11.64% to 5.85% in order to restimulate the economy.

However, Greenspan, who took office as Federal Reserve chairman in 1987, tightened the currency again. The rising financing costs led to a decrease in the willingness of enterprises and residents to raise funds. Rate hikes have also become an important reason for triggering the "Black Monday" stock market crash, and economic growth has further declined. In 1987, Reagan signed the bill to reduce fiscal deficits, and the increase in leverage also began to decline. The increase in leverage ratios of various departments continued to slow down by the end of 1989, and the scale of social leverage entered a sideways stage..

The second short cycle (1989-1992): In August 1990, the Gulf War broke out, international oil prices rose sharply, CPI rose to its high since 1983, GDP growth reached a negative growth rate in 1991, and in March 1991, the unemployment rate continued to rise sharply. In order to reverse the dilemma of economic stagflation, the Federal Reserve adopted a loose currency during this period, lowering the target interest rate of the federal funds from the high of 9.8125% in the cycle to 3%. The large amount of fiscal expenditure caused by the war also caused a surge in sector leverage, which triggered an increase in social leverage in 1991. On April 1, 1992, a stock market crash occurred in Japan, and the Nikkei index fell below 17,000 points. At this time, it had fallen by 56% from the historical high of 38,957 points in early 1990; the stock markets of Japan, the United Kingdom, France, Germany and Mexico all experienced chain declines due to economic deterioration. In order to cope with the global economic recession, on July 2, the Federal Reserve cut interest rates by 50BP again.

The third short cycle (1992-2000): Clinton, who came to power in 1992, balanced fiscal deficits by raising taxes and reducing expenditures, but the friendly economic development environment and good economic development expectations enhanced the financing intention of residents and enterprises, and promoted the increase in social leverage ratio. Since then, the economy has expanded and inflation has risen again. The Federal Reserve began to raise interest rates six times in February 1994, a total of 3 percentage points to 6%. In December 1994, due to the Fed's continuous interest rate hikes of six times this year, the short-term interest rate increase significantly exceeded the long-term interest rate increase, and the bond yield curve has inverted. From early 1994 to mid-September, the US bond market lost $600 billion in value, and the global bond market lost $1.5 trillion in the whole year. This is the famous bond collapse event in 1994.

There was then an Asian financial crisis in 1997 and a Russian debt crisis in 1998, which directly led to a collapse of Long-Term Capital Management (LTCM), one of the four major hedge funds in the United States. On September 23, Merrill Lynch and Morgan invested to take over LTCM. In order to prevent financial market fluctuations from hindering US economic growth, the Federal Reserve cut interest rates by 50bps in the third quarter of 1998, and the enthusiasm for Internet companies to develop continued to rise, and the increase in non-sector leverage ratio continued to increase. Among them, the increase in corporate leverage reached the highest since 1986, driving the increase in social leverage ratio to rise.

In 2000, the Internet bubble burst and the Nasdaq fell 80%. After punctured the Internet bubble, the increase in non-sector leverage and GDP growth rate both fell significantly, the increase in social leverage ratio turned negative, the scale of leverage ratio declined, the economic recession and inflation decreased, triggering the next round of credit easing and economic recovery. Since then, this debt cycle has come to an end.

After the financial crisis in 2008, the unemployment rate in the United States reached 10%, and global interest rates dropped to 0%. It was no longer possible to stimulate the economy by cutting interest rates. The Federal Reserve launched the biggestSub-debt monetization, buying debts by printing money. During the 12 years from 2008 to 2020, the United States launched the central bank's balance sheet expansion to purchase bonds, which was essentially banknote printing, debt monetization and quantitative easing. Then, it began to tighten at the end of 21 to fight inflation. U.S. bond interest rates rose and the US dollar strengthened. In 2021, the Nasdaq index fell 33% from its highs respectively. At the same time, high interest rates also led to losses of the Federal Reserve.

After briefly reviewing a debt cycle, it was mentioned that the United States is about to enter the brink of the bubble bursting stage. The transmission path of the large debt cycle is the private sector - the Federal Reserve. So what happens when the large debt cycle reaches the central bank.

Step 1: The Federal Reserve expands its balance sheet to monetize its debt

When there is a debt crisis and the interest rate cannot be lowered (for example, to 0%), it will print money and buy bonds. This process has started in 2008, which is quantitative easing (QE). Currently, the United States has conducted a total of 4 rounds of QE, buying a large amount of US Treasury bonds and MBS. The characteristic of QE is that the assets purchased last a long time, which will forcefully lower the yield on treasury bonds, prompting money to flow to risky assets, and pushing up the price of risky assets.

The money for QE here is achieved through reserves (the money that commercial banks have in the Federal Reserve). When the Federal Reserve goes to buy bonds from banks, it does not need to spend money, but tells the bank that the Federal Reserve has increased.

Second step: When interest rates rise, the central bank will suffer losses

The Federal Reserve mainly involves interest income and interest expenses. The structure of the balance sheet is to buy long by borrowing short-term assets such as RRP and Reserve, and interest will be paid by relatively long-term assets such as U.S. Treasury and MBS. However, since the interest rate hike in 22 years, the long-term and short-term interest rates have been inverted, so the Fed is losing money. In 23 years, the Fed has lost 114bn US dollars and 82bn US dollars in 24 years.

When the Federal Reserve made a profit, it handed over the profits to the Treasury Department. When the loss is made, this part becomes deferred assets (Earnings remittances due to the U.S. Treasury). This part has accumulated to more than US$220 billion.

Step 3: When the central bank's net assets are significantly negative, it enters the death spiral.

If the Federal Reserve keeps losing money, one day it will lead to a sharp negative net assets, which is a real red flag. This marks a death spiral, that is, rising interest rates cause creditors to see problems and sell off their debts, which leads to further rising interest rates, which further leads to debt and currency selling, with the final result being currency depreciation, triggering stagflation or depression.

In this step, the Federal Reserve faces the need to maintain easing to support weak economic and fiscal weakness on the one hand, and tighten (high interest rates) to prevent the market from selling currency.

Step 4: Deleveraged debt restructuring and devaluation

When the debt burden is too heavy, large-scale restructuring will occur and/or depreciate, thereby significantly reducing the size and value of the debt. At the same time, the currency depreciates, and the actual purchasing power of currency and debt holders is greatly lost until a new monetary system with sufficient credibility can attract investors and savers to hold the currency again. At this stage, very taxes and capital controls are usually implemented.

Step 5: Return to the establishment of a new cycle

When debt is depreciated and the cycle is at its end, the Federal Reserve may strictly implement the transition from a rapidly depreciating currency to a relatively stable currency by pegging the currency to a hard currency (such as gold) in the case of very tight currencies and very high real interest rates, that is, the establishment of a new cycle system.

Through the above steps, we can basically judge that the United States is now in the middle of the second step (the central bank's loss) to the third step (the central bank's net assets are significantly negative, entering the death spiral). So what is the next step for the Fed to respond?

There are usually two paths to control debt. One is financial repression, which is essentially to lower interest costs, and the other option is to control the fiscal policy, that is, to reduce the non-interest deficit. To lower interest costs is to reduce interest expenses, alleviate the pressure of interest expenses, and there are only two ways to reduce non-interest deficits. One is to reduce spending and the other is to increase taxes. Trump is already actively promoting these two. DOGE's Ministry of Efficiency reduces fiscal spending and tariffs increase revenue.

Although Trump has already started, the global financial market is not so recognizable. Major central banks around the world have long begun to continue buying gold. Now gold has surpassed the Japanese yen after the US dollar and the euro, becoming the world's third largest reserve currency.

The current fiscal situation in the United States has a serious problem - borrowing new debts to repay old debts, but issuing bonds to fill the fiscal gap, and these new debts bring higher interest expenses, thus causing the United States to fall into a "vicious cycle of debt" and may eventually fall into the dilemma of "never repayment".

In this case, the dilemma of US Treasury will not be solved for a while, and in the end, it will still be handled according to the above two paths of the debt crisis. Therefore, the Federal Reserve will choose to lower interest costs and alleviate the pressure on interest expenditure. Although interest rate cuts cannot fundamentally solve the debt problem, it can indeed temporarily alleviate the pressure on part of the interest payment and give more time to deal with the huge debt burden.

The interest rate cut is actually highly consistent with Trump's "America First". The current market is unanimously convinced that the tariffs and fiscal policy after Trump took office will make the US deficit out of control like a "broken wild horse", and lead to a decline in credit, inflation and interest rates in the United States. In fact, the rise of the US dollar is caused by the decline in other market interest rates relative to the US market interest rates (relatively high interest rates, currency appreciation). The decline in US bond prices (i.e., the rise in yields) is also a normal phenomenon of a short-term rebound in the interest rate downward cycle.

As for market expectations of reinflation, unless Trump breaks out on the fourth oil crisis, it will be from anyA logical step cannot explain his hope to push up the inflation level that Americans hate the most.

As for why the rate cut is always difficult to produce? Since the beginning of this year, expectations of interest rate cuts have been swaying continuously and repeatedly. I think I don’t want to overdraft the expectation of interest rate cuts. Now the “eagle” can provide space for subsequent “downloads”.

Recalling the historical experience since 1990, the Federal Reserve suspended interest rate cuts in August 1989 and August 1995 respectively to assess subsequent growth to determine the speed and intensity of interest rate cuts. For example, after the "preventive" interest rate cut in July 1995, the Federal Reserve held its last three consecutive meetings until the United States closed twice due to the failure to reach an agreement on the new fiscal year budget, and decided to cut interest rates by 25bp again in December 1995.

Therefore, you cannot reason according to market ideas. There are often problems and you should "think about it and do it oppositely." So what are the subsequent opportunities?

1. From the perspective of US dollar assets, gold is still a relatively good asset; US bonds, especially long-term bonds, are very poor assets. 2. At a certain point in time, the United States will actively or passively start to cut interest rates. We should make deductions and prepare and keep a close eye on the yield on ten-year US bonds.

3. Bitcoin is still a high-quality investment target among risky assets, and the value of Bitcoin is still tenacious.

4. Once the US stock market sees a large-scale pullback and buys in batches at low prices, technology stocks will still have a high return ratio.