My Abyss (1979-1982)

In 1978-1980, the oil market was very volatile due to the fall of the Shah of Iran. This affected the prices of other commodities as well.

As per Ray’s understanding of the cause and effect, he figured out that the Federal Reserve (FED) would tighten the monetary policy to control inflation, leading to slower growth in the economy.

In such circumstances, precious metals (such as gold and silver) are a good hedge (against inflation).

Ray narrates a case of silver trade in this chapter. He once met Bunker Hunt, then the richest man in the world at a Thanksgiving party. Bunker had similar views on the economy, like Ray. Bunker was purchasing silver since the price was $1.29 per ounce. He had bought a huge quantity of silver, essentially cornering the silver market around $10. Here, Ray suggested Bunker to square off his long positions on silver as according to him the yield curve was going to invert. This means that the short-term interest rates (say, 1 year treasury rate) were going to rise more than long term rates (say, 10-year treasury bond rate). According to him, every time this has happened in the past, the silver prices have crashed.

However, to his surprise, the price of silver went from $10 to $40 within the next one year.

Well, why did this happen?

This was because the middle east oil producers were concerned about depreciating dollar. When the dollar depreciates, it essentially indicates a lower amount received for every barrel of oil sold.

A falling dollar also indicates lower purchasing power in the US, which in turn means higher inflation.

Hence in order to protect themselves from falling dollar (inflation), they purchased silver as a hedge.

This fact was known to Bunker, as he himself was from the oil industry.

However, in the next three months, silver did fall back to $11. Essentially, Ray was right, but missed a huge rally due to timing. The same is the lesson he wants to impart upon us by this example. Essentially, in the financial markets, timing is everything. Ray acknowledges later in this chapter, that his timing is still not good!

The story now shifts to an economic prediction of Deflation that Ray made in the year 1981. It was based on the fact that during this time due excess liquidity in the markets (FED printing money), the volatility in gold and bonds has increased to a level not seen even in 2007-08. During the 1980s, the FED was struck with dual problems.

If it keeps on printing more and more money, to save a debt crisis (default due to lack of funds), it would trigger hyperinflation in the country – Inflation was 10% in the 1980s.
If it restricts the money flow by stopping printing money and increasing interest rates, it would essentially slow an already distressed economy and move it towards depression.

In order to benefit from both these possibilities, Ray bought

Gold – Gold is a good hedge against inflation
Treasury Bills – T Bills increase in value during deflation as interest rates fall

However, similar to what happened in the silver story, here as well, Ray’s estimates were wrong. This is because the money involved was much more and his views were public.

So, how did he go wrong this time?

Well, Ray figured out that as money flew out from indebted emerging markets, the dollar kept on rising. A rise in the Dollar moderates inflation in the US economy as imports become cheaper. When inflation is moderate, the central bank (FED) could keep printing money in order to support the economy. This is called Quantitative easing and has helped the economy to run smoothly during the period.

The mistake was big enough to get Ray devastated. All his employees had to leave accompanied by his partner at Bridgewater. Here is a list of lessons he learnt from this episode:

Never be overconfident about your economic estimates. Also, do not let emotions get over you.
Read history. A similar debt restructuring instance had already taken place in 1932.
It’s difficult to time the market.

Lessons to succeed: