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There's a 'clash' coming as markets underprice how 'aggressive' the Fed will have to be - Bridgewater Associates

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(Kitco News) Markets face "significant risks" as investors are still underpricing how "aggressive" the Federal Reserve will have to be during this tightening cycle to battle rising inflation, said Ray Dalio's hedge fund Bridgewater Associates in its 2022 outlook.

"The markets are discounting a smooth reversion to the prior decades' low level of inflation, without the need for aggressive policy action -- that it will mostly just naturally happen on its own," the world's biggest hedge fund said. "We see a coming clash between what is about to transpire and what is now being discounted."

A dramatic market's selloff in January might not be the end to volatility expected for this year, with Bridgewater seeing a big difference between investors' expectations versus reality.

"Because there is such a big difference between what is discounted and what we think is likely, we see the potential for large market moves, which of course implies significant risks from holding assets, as well as significant alpha opportunity from price change," the report said.

The problem is that markets are currently pricing in the Fed to end its tightening cycle when rates are back up at 2.5%, still below their historical norms. The thinking is that it will be enough to bring inflation, which is currently at 7%, down to under 2.5%.

"Current pricing suggests that the overall stance of policy will remain extremely easy indefinitely into an already hot economy, culminating in stable nominal rates between 0% and 2% and permanently negative real rates, both in the U.S. and throughout the developed world," Bridgewater said. "And this minimal tightening is priced to be enough to curb the strength of demand and put inflation back in the bottle … U.S. short rates are discounted to plateau below 2% after one of the smallest tightening cycles on record, while inflation fully reverts to the low levels that characterized the years before the pandemic."

Market participants might be too optimistic in this belief considering that inflation is at four-decade highs and the U.S. economy is in a "self-reinforcing cycle," the report highlighted.

"Monetary Policy 3 (coordinated monetary and fiscal policy) policies have worked … now producing a self-reinforcing cycle of high nominal spending and income growth that is outpacing supply, producing inflation … Given the inertia in the system, it is unlikely that the current level of nominal spending growth and its impacts on inflation can be contained without aggressive monetary tightening in the very near term," Bridgewater explained.

This environment could prove to be a challenging one for the Fed and other central banks around the world. "Due to the strength of nominal spending outpacing the capacity to produce, central banks, and particularly the Fed, are now facing the greatest potential for a sustained rise in inflation in 40 years. That is challenging enough on its own, but the pandemic and near-zero interest rates make the choices facing policymakers especially difficult," the report said.

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Even a moderate tightening could be "painful" for U.S. stocks, which already saw significant losses since the start of the year, with the S&P 500 and the Nasdaq seeing their worst months since the beginning of the pandemic.

"In terms of assets, high valuations and long durations, driven in large part by low interest rates and plentiful liquidity, mean that a moderate tightening could be painful—especially in the bubbliest segments of the U.S. equity market," the report added.

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