Jeff Gundlach

The bonds that PIMCO’s Bill Gross sold to take a 3% short position in the Treasury market may have found a buyer in Doubleline’s Jeffrey Gundlach.  In a conference call with investors last week, Gundlach said that Treasury prices would rise in the near term, once QE2 expires on June 30.

For over a year, Gundlach has forecast a “long-term bottoming process” in government bond yields.  Last week he said he remains committed to that outlook.

If you are a buy-and-hold investor with a 10-year horizon, Gundlach said, you should position your portfolio with the expectation of inflation. But he doesn’t expect inflation to unfold any time soon.  “I am not in the camp that believes Treasury rates are about to rocket higher because of the end of QE2,” he said.  “I think just the opposite, actually.”

The $236 billion in Gross’ Total Return fund makes him the world’s largest bond investor, dwarfing the $6.1 billion in Doubleline’s Total Return fund.  But Gundlach’s performance record over the past decade, including the results at his previous employer, TCW, has surpassed Gross’.   That helps explain why Doubleline’s Total Return fund just celebrated its first anniversary by establishing a new record for assets gathered in in its first year and why Gundlach’s comments are closely followed by market observers.

I’ll look at the assessment of the economic and market conditions that underlies Gundlach’s contrarian position in the Treasury market, and I’ll also discuss why another prominent bond manager, Hoisington Investment Management, reached the same conclusion as him but for different reasons.

The elephant in the kitchen

A common theme in Gundlach’s analyses over the last several years has been increasing total credit market debt as a percentage of GDP, which peaked at 365% in 2009 and had dropped only slightly to 345% as of the end of 2010. The slight dip was caused by consumer deleveraging, but the underlying trend remains.

Gundlach called this debt the “elephant in the kitchen,” because it dominates the fundamentals underlying the investment markets.

The challenge investors face, Gundlach said, is figuring how that debt will be repaid, while at the same time funding the liabilities of federal entitlement programs, without debasing the dollar.

The present level of federal borrowing will detract from future economic growth and productive investments, Gundlach said.  “That is not a good framework, and this is why we are having so much trouble now in Washington, DC,” he said.

In the 1940s, federal receipts as a percentage of debt, as shown in the chart below, were as precarious as they are now, with debt equal to ten times receipts.  Gundlach said that imbalance was corrected with tax increases, with tax receipts rising from 5% to 20% of GDP in the 1940s. As a result, debt decreased to merely two times receipts in 1980.  But that was when consumer leveraging accelerated, putting us back where we were 70 years ago.

The problem, Gundlach said, is if interest rates go up it would cause a “really difficult fiscal situation” with interest expenses.  “We really need to get this in order if we are going to be on a sound footing,” he said.

Federal Receipts as % of Debt

Gundlach noted that the Office of Management and Budget (OMB) has estimated that the government’s fiscal position will improve slightly over the next four years, but he said he is skeptical of those forecasts.