Gundlach – Rates Will Remain Low in 2014


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By Robert Huebscher,

Slowing economic growth, low inflation and a lack of motivated sellers will keep interest rates depressed, at least for the rest of this year, according to Jeffrey Gundlach. But investors should prepare for an eventual rise in rates, he said, because he is skeptical of the Federal Reserve’s ability to successfully exit from quantitative easing (QE).

Gundlach, the founder and chief investment officer of Los Angeles-based Doubleline Capital, spoke with investors in a conference call March 11.

His talk was titled “What Hath QE Wrought?” and the slides from his presentation are available here.

His title was taken from the first words transmitted via the telegraph by its inventor, Samuel Morse, in 1844, “What hath God wrought?” Those words, Gundlach said, foretold the electronic and telecommunications revolution that transformed society over the next 170 years.

QE might not leave as many positive benefits as did the invention of the telegraph, Gundlach fears.

If the Fed is able to “just exit from the bond-buying exercise, exit from stimulus, without any economic volatility, then we have an invention that’s as good as the telegraph,” he said.

“It would be a perfect way of countering deflationary forces and deleveraging during economic crises,” Gundlach said. However, “I really am skeptical,“ he said.

Let’s look at Gundlach’s assessment of the economy and fixed-income markets and his outlook for several key asset classes.

The message from copper and China

Gundlach often takes a contrarian position with respect to market sentiment. But he isn’t with regard to the outlook for China.

China will suffer slower-than-historical growth, he said, and signs of that are already showing up in the price of copper, a key industrial commodity. Copper prices have fallen 10% in the last week, to levels not seen since 2010.

“A lot of people point to China as something to worry about in 2014,” he said. “A lot of people cried wolf on that for the last few years. But it seems like it might be shaking up here. I agree with the consensus that China is a variable that has to be watched.”

He doubts that China will achieve the consensus forecast of 7.5% growth this year. Even if it did, Gundlach said that would be its slowest growth in the last 24 years. “China really seems overdue for something of a significant setback economically,” he said.

Gundlach said recent declines in the Shanghai index reinforce his view of unfavorable growth in China’s economy.

China’s currency has also weakened since the middle of February. The danger for the U.S. is that other countries – particularly the Asian emerging markets – could respond to Renminbi devaluation by allowing their currencies to weaken. This would lower the cost of goods imported into the U.S., as Asian countries essentially export deflation to the U.S. Gundlach did not reference this scenario in his talk, but it is consistent with his outlook for low inflation in the U.S.

Albert Edwards, a London-based global strategist for Societe Generale, elaborated on this scenario in a research note he published March 13. Edwards warned of the potential for a “rout” in emerging markets and advised U.S. investors against assuming that our economy is decoupled from those forces. “China has an awful lot to give the world and economically one of the main things it has to give is the fruits of years of overinvestment, i.e., deflation,” he wrote.

Gundlach noted that, throughout 2013, movements in emerging-market currencies correlated closely to the 10-year Treasury yield. Signs of tapering signaled higher U.S. yields, he said, and emerging markets reacted by devaluing their currencies. But that relationship broke down in 2014, he said, as U.S. yields and emerging market currencies moved in the same direction.


“The only interpretation is this change is for a weaker global economy, because falling bond yields and weaker emerging market FX are consistent with a weaker economy,” he said. “It’s now the economy which is trumping the movement of tapering. This is something to pay attention to.”

Other forces acting on the bond market

Low inflation and slow economic growth were just two of the factors Gundlach said would restrain interest rates.

The Fed’s QE policies have resulted in it becoming the largest owner of government debt (it now buys 70% of new issuance), with other foreign governments – notably China and Japan – not far behind. He doesn’t expect any of those entities to sell their bonds, particularly if rates rise and they are underwater.

Nor does he expect selling by mutual funds, if that were to occur, to exert pressure on yields. Mutual funds own a “small slice” of the overall bond market, according to Gundlach.

Gundlach predicted that the Fed’s QE will not end in 2014. At some point, he said, the Fed will not be able to maintain its pace of $10 billion of tapering at each of its meetings. “Economic volatility” will prevent that, he said, and QE will continue in 2015.

As a result of QE, the Fed now owns longer-maturity bonds than it did a decade ago. Three-quarters of the bonds owned by the Fed have maturities of five or more years, according to Gundlach, and the Fed has said repeatedly that it will allow them to mature, rather than sell them.

Gundlach acknowledged that U.S. consumers have de-levered since the financial crisis, but he is skeptical that will result in economic growth. He doesn’t believe consumers can take more debt that would lead to increased spending without causing adverse consequences in the economy. “That’s another reason why I just don’t think interest rates can rise quickly any time soon,” he said.

In the past, he said, Treasury yields have fallen when the Fed has withdrawn its stimulus, because that weakens the economy. He noted that rates are down 20-25 basis points since tapering started.

The Fed won’t increase short-term rates until its QE program is over, Gundlach said.

Gundlach predicted that the 10-year Treasury yield would approach 2.5%, although he did not attach a timeframe to this forecast. For yields to drop below that level, he said, there would need to be “serious deterioration in the economy or an increase in the deflation risk.” In July of 2012, when he called the bottom in the bond market, he said he was 90% confident in that declaration. Now, he said, he is only 70% confident in that call.

If yields were to drop below 2.5%, he said to expect an “incredibly painful short-covering scramble.” A popular strategy among many long-only bond managers and leveraged exchange-traded funds over the last year has been shorting Treasury bonds as a source of cheap financing, he said.

Pension funds may provide a ceiling on interest rates, should they rise, Gundlach said. Those funds would shift allocations from stocks to bonds in order to lock in their funding status.

Other asset classes

Gundlach said the high level of corporate profitability reduces default risk for corporate bonds, making them more attractive. But he said profits are overdue for a mean reversion, and he thinks junk bonds are overvalued at their current yields.

Double-B bonds now yield 4.2% assuming no defaults. Gundlach said that yield is very low on a historical basis, particularly when compared to 30-year Treasury bonds. He also said that investors would be wrong to value those bonds as short maturities, assuming they will be called. If rates rise, Gundlach said the probability of those bonds being called is reduced. Their volatility will increase as they trade more like long-term bonds. “This could really be a debacle should that happen,” he said, “given all the inflows that have gone to junk bonds.”

Indeed, Gundlach said, for the first time since such data have been compiled, junk bonds have lower yields than emerging-market bonds.

Gundlach offered a couple of comments on the stock market. He said that historically, when stimulus was withdrawn, equity markets weakened. Margin debt, he said, is in a “scary zone” that “characterized previous market tops.” If margin debt were to decline from its current level, he said a “double-digit decline” could result.

The longer-term outlook

Gundlach’s longer-term outlook centered on entitlement-driven deficit growth, which he said could create problems in a few years. He showed projections that Social Security would go “massively into deficit” starting in about three years, although its conditions now are “copacetic,” he said. Medicare is likely to follow a similar path, he said.

That timeframe roughly coincides with when the Fed’s portfolio of Treasury bonds will start maturing, according to Gundlach.

“Some of the big blob [of the Fed’s Treasury holdings] will start maturing each and every year, and that will occur simultaneously with the deficit re-exploding to the high side, all things being equal, with Social Security, Medicare, Medicaid and Obamacare expenditures really accelerating into a deficit mode,” he said.

“Something’s got to give here,” Gundlach said.

“It will be very difficult to … borrow the money that needs to be borrowed and then finance the rollover of these government bonds, should the Fed not continue to buy them,” he said. “This is something we’re going to be following very closely in future webcasts in the years ahead.”

Before we get to that point, however, we’ll get to see whether Gundlach’s skepticism over the Fed’s ability to gracefully exit from QE is justified.

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