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Inflationary pressures could ultimately trigger an uncontrollable spike in interest rates, according to Jeffrey Gundlach, but such predictions are likely at least five years too early. In the short run, he identified the key driver that will keep rates low – the strong performance of European bond markets.
Gundlach said it is “overwhelmingly tempting” for European and Japanese investors to buy U.S. Treasury bonds, which yield considerably more than their non-U.S. counterparts. The U.S. 10-year bond, for example, yields 150 basis points more than German bonds with similar maturities.
Deflation and recession in major economies in Europe is driving European bond rates lower, Gundlach said.
“Buying from foreign buyers has been more than sufficient to offset any amount of so-called tapering that has happened from the Federal Reserve,” Gundlach said.
International buying of Treasury bonds, he said, is up by $600 billion year-to-date versus last year.
Fed policy will keep rates low, he said. “I’m virtually certain that Janet Yellen does not want to raise interest rates,” Gundlach said. Recent easing by the European Central Bank (ECB) will add further support European bond prices.
Gundlach spoke Sept. 9 on a conference call with investors. He is the founder and chief investment officer of Los Angeles-based DoubleLine Capital.
A copy of Gundlach’s presentation is available here.
Let’s look at Gundlach’s assessment of the global bond market.
The driver of the U.S. bond market
U.S. bond-market investors have benefited from remarkably strong performance and low volatility this year. The yield on the 30-year bond, for example, has fallen 73 basis points. Gundlach said that bonds have delivered the third-best year-to-date performance in the last 40 years and that downside volatility – spikes in interest rates – has been exceptionally rare.
That performance is remarkable, he said, given the high level of bearish sentiment at the beginning of the year.
He expects low yields to persist, despite the fact that rates are already low.
U.S. rates are being “dragged down” by European bond yields, he said. “Who would want to sell U.S. bonds and buy European bonds when you’re giving up so much yield?” Gundlach asked. A strong dollar makes U.S. bonds even more attractive, he added.
In his previous webcast, Gundlach predicted that the budget deficit would decrease, limiting the supply of bonds, and that pension plans would step in to buy bonds in order to lock in gains and secure their funding. Those factors have played out, he said, and will remain in place – although he noted that short interest in bond positions among pension funds is at a high level.
Danger ahead?
Gundlach identified the signs investors should monitor as warnings of an impending rise in rates.
Yields in Europe have increased in the last week as a result of Scottish secession fears, he said. But the French 10-year bond would have to increase to 1.75% from its current level of 1.30% before it could threaten the U.S. 10-year, according to Gundlach.
Peripheral yield spreads – in Italy, Spain, Ireland and Portugal – have reverted to their pre-crisis levels. Gundlach said there is no sign of those reversing.
“If Spanish and Italian bond yields start to rise on the upside, that would be bad news,” he said. “If French bond yields rise, that would be another really definitive sign that something funny is happening in terms of not having the same drag lower on U.S. yields.”
He expects yields on the U.S. 10-year to remain in the range of 2.2-2.8%, as he stated in his previous webcast.
A factor that could push U.S. rates to the upper end of that range is the large number of pending corporate-bond issuances. But don’t worry about excessive leverage from corporations taking on too much debt, Gundlach said. Those fears are symptomatic of “fighting the last war.” He said that corporate debt in relation to overall market capitalization is not excessive by historical standards.
The possibility of mutual funds selling bonds and pushing rates up is remote, according to Gundlach, because ownership among those funds is very small percentage of the overall market.
Could the Fed inflict a rate increase by selling a portion of its $4 trillion bond portfolio? Gundlach is confident that won’t happen. He said, “The Fed knows precisely the market disruption that would cause. I’m absolutely convinced the Fed will never sell a Treasury bond in their portfolio.”
Gundlach remarked that it is ironic that, in 2012, the Fed started its third round of quantitative easing (QE3) with monthly bond purchases of $85 billion at least partly in reaction to Congressional pressure to spur economic growth, yet GDP growth was higher at that time than it is now.
That is partly why Gundlach doesn’t expect a Fed-induced rate increase. He said the Fed will want to keep its policy options available, in the event of slower-than-expected growth in Europe or China.
Inflation is unlikely to pressure rates upward, and those who worry about inflation are also fighting the last war, Gundlach said. The PCE deflator – the Fed’s preferred measure of inflation – has not risen significantly since the crisis and, in particular, since QE3 began in 2012.
Employment weighs more heavily on Fed policy decisions than does inflation, according to Gundlach. He said the Fed is most concerned about the “hollowing out of middle-class salaries.” Wages as a percentage of GDP has yet to bottom out, he said. “The Fed would really need to see this move up to start talking seriously about raising short rates any substantial amount.”
“With so many people losing purchasing power on their average hourly earnings, you wouldn’t raise interest rates. It could potentially tip things over into a recessionary period sooner than many people think,” Gundlach said.
Whatever inflation there is, Gundlach said, is showing up in the price of necessary good and services, like rent and medical care. “No wonder Janet Yellen is scared of raising short-term interest rates,” he said. “If she does, that means it becomes that much more difficult to make the ends meet between this modest but necessity-based inflation and a stagnant hourly earnings picture.”
An uptick in average hourly earnings could signal a rate increase, he said.
Even if the Fed tightens, historical data suggest that 10-year rates could remain low, according to Gundlach. The last tightening cycle began in mid-2004, when the Fed raised short-term rates to 5.25% in 2006. Over that period, the 10-year was range bound, he said, and the yield curve flattened. Gundlach added that recent market movements – when rates rose in response to strong economic data – support his belief that the yield curve would flatten if the Fed tightened.
Investment recommendations and longer-term outlook
Gundlach identified some bond categories that are attractively valued – and a few that are not.
Investment-grade bonds are more overvalued than they have been in 30 years, he said. High-yield bonds were similarly overvalued a few months ago. Their valuations have improved and he said it’s no longer appropriate to minimize one’s investment in them.
Mortgage-backed bonds have “cheapened a little bit” since the end of July, he said, and are reasonably valued.
Emerging-market debt is one standard deviation rich, Gundlach said. He cautioned that only investment-grade dollar-denominated bonds should be owned.
“I think that it is absolutely foolish to own currencies other than the U.S. dollar right now,” he said.
For those seeking a short-term bet, Gundlach suggested Chinese equities. For the long term, though, his favorite market is Indian equities, despite the fact that they have been up significantly this year. Over the next 10 to 20 years, he predicted that India’s performance would match that of China’s over its “long super cycle.”
In the U.S., Gundlach’s longer-term worries are centered on the budget deficit and entitlement programs. Over the next several years, he expects low inflation or even deflation – especially if the Fed raises rates, the yield curve flattens and a recession results.
By the end of this decade, Gundlach said the government could face budget problems caused by underfunded entitlement programs. If that happens, he said the Fed would likely reinitiate a QE program.
The principal danger for U.S. policymakers, according to Gundlach, is that a premature increase in rates could trigger a recession. “That could lead to a deflation scare that would usher in the potential for a truly inflationary policy,” he said.
Read more articles by Robert Huebscher
