“Wouldn’t it be a kick in the head” if the Federal Reserve Board raised interest rates and long-term 10- to 30-year Treasury bonds went up in price as their yields declined? That prospect is not as outlandish as it might sound, DoubleLine Capital CEO Jeffrey Gundlach told investors on a September 9 conference call.
After all, the consensus predictions and expectations among bond market professionals in recent years has bordered on the comical. As the rhetoric about Fed tightening and higher rates has grown louder and louder, Treasury rates at the long end of the yield curve are down or flat.
Equally comical are the predictions at the start of recent years that this will be the year in which the U.S. economy achieves escape velocity to 3.0% GDP growth. These forecasts typically are accompanied by predictions that the yield curve will climb about 100 basis points. Both predictions repeatedly fail to materialize and this year looks no different.
Gundlach, who was among the few to speculate in January that U.S. interest rates could actually fall, added that he believed 10-year Treasury rates already reached their low for the year at 2.2%, but he anticipates they will remain relatively stable for the remainder of 2014 and not rise above 2.8%. “Listen to the markets, not the talking heads, particularly if European rates remain relatively low,” he said.
More than $600 billion in foreign capital has flowed into Treasury bonds this year as U.S. bonds attract capital flows from Europe, where most nations’ government bonds sport significantly lower bond yields than in the U.S. The upshot is that the dollar is likely to remain the strongest currency among major developed nations, Gundlach said.
“Commodities have been soft,” and this is reflected in U.S. dollar strength, Canadian dollar weakness. Meanwhile, the Japanese yen is at a six-year low. It is “absolutely foolish to be long currencies besides the dollar,” he said. All of DoubleLine's positions in foreign bonds are hedged into dollars.
The key concerns of the Fed today are inflation-adjusted wages and salaries, in much the same way it zeroed in on the money supply in the 1980s. Breaking the U.S. labor market into ten separate deciles ranked by inflation-adjusted wages, Gundlach noted there is a very good reason why 60% to 70% of Americans believe the economy is still in a recession.
Why? Because when it comes to inflation-adjusted wages, the bottom 70% of the work force is making less than it was in 2007 so they are still experiencing their own personal recessions.
Inflation isn't the problem. All four key inflation indicators are "completely quiescent." What growth there is in the CPI is coming from rent.
The ongoing malaise in the Eurozone economies is yet another factor likely to make the Fed reticent to raise rates. Were the U.S. central bank to do so, the flow of European funds into Treasury bonds and other U.S. assets could turn into a flood. If the ECB was forced to raise rates to stem the exodus from the euro, more European nations could fall back into recession and deflation could spread across the continent.
In contrast, Gundlach believes the U.S. is in a much better financial position—for now. But the Goldilocks environment may have a five-year shelf life. He is willing to bet dollars to doughnuts that the Fed never sells the government bonds it purchased during QE but instead lets them roll off its balance sheet.
The day of reckoning for America is likely to arrive around 2019 or 2020. That is when the big bulge of baby boomers finally retire, placing huge stresses on the nation's entitlement programs at exactly the same time as much of the QE from 2009-2012 needs to be refinanced. One possible Fed response could be more QE.
But if the U.S. economy and demographic challenges are relatively benign, it's unpleasant to imagine what Europe and japan, with their more problematic aging demographics, will look tlike by then.