FX.co ★ Ray Dalio: Fed rate hike at 4.5%, stocks to fall 20%

Billionaire Ray Dalio, founder of Bridgewater Associates, says that as the Federal Reserve continues to aggressively tighten monetary policy, interest rates will need to rise to at least 4.5%, which will send stocks down 20%.

To arrive at a 4.5% interest rate result, Dalio considered inflation and real yields. "The process starts with inflation. Then it goes to interest rates, then to other markets, and then to the economy," he explained.

His view of the US markets and economy is rather bleak. He says that, right now, markets are discounting inflation over the next ten years at 2.6%.

He estimates that in the long run it will be between 4.5% and 5%, except for force majeure, such as the escalation of economic wars in Europe and Asia, or more droughts and floods, Dalio said, describing his estimates of inflation.

Given this and real yields, Dalio sees rates between 4.5% and 6%. "The higher end of this range would be intolerably bad for debtors, markets, and the economy, I'm guesstimating that the Fed will be easier than that," he said.

The Fed funds rate is currently in the 2.25%–2.5% range. And this week, the markets are already pricing in a third consecutive 75 basis point rise, which will occur on Wednesday.

Dalio forecasts that the Fed will reach 4.5%, which will have serious consequences for the stock market and the economy. Adding that an increase in interest rates would have two types of negative effects on asset prices: 1) the present value discount rate and 2) lower asset returns due to a weaker economy.

When people lose money, they become cautious, and lenders are also more cautious in lending to them, so they spend less. A significant economic downturn is expected to be needed, but this will take some time because wealth levels are relatively high right now, so it can be used to support spending until the funds are used up.