Likening bullishness on Treasury bonds to a “mass psychosis,” Jeffrey Gundlach made his strongest statement yet that interest rates are about to rise. In a conference call with investors last Tuesday, he said that the rate on the benchmark 10-year Treasury bond could increase by 100 basis points by the end of the year.
Gundlach told his audience that bond-market conditions today reflect the mirror image of those nearly three decades ago, when long-term interest rates peaked. He said that July of 2012 marked “an important bottom” for interest rates.
Gundlach is the founder and chief investment officer of Los Angeles-based Doubleline Capital. The slides from his presentation are available here.
“I do not want a high degree of interest-rate risk,” he said, “not if we can generate the types of returns we have been in our portfolio.”
Gundlach said that he has decreased the duration on Doubleline’s flagship Total Return Fund (DBLTX) to a little over a year, the lowest value in the history of the fund. The fund has returned approximately 7.25% this year, outperforming US government bonds and GNMAs by over 500 basis points.
Let’s look at Gundlach’s view of the economy and the market and why he now fears that interest rates – and possibly inflation – may rise.
Deficits and interest rates
Since 1982, the dominant market conditions have been benign inflation – and occasional deflation – with falling – and occasionally stable – interest rates, Gundlach said.
In part, Gundlach’s fears are rooted in what he called the “fragility” of the financial system, which threaten that stability. Investors should not rely on attempts by the Fed and the ECB to bolster markets through quantitative easing. He agreed with Jim Grant, editor of Grant’s Interest Rate Observer, that capital markets now resemble a house of mirrors.
“You don’t know if the prices you are looking at are real or if they are distorted or manipulated,” he said.
Gundlach’s deepest concerns are related to the inability of the federal government to cope with the growing federal deficit. As in past presentations, he reviewed data showing the acceleration of those deficit problems in the 1980s, creating what he called a “monumentally large” deficit today by historical standards.
“It is quite clear that we can't keep forward in this way,” he said.
Gundlach noted that federal spending as a percentage of GDP was relatively constant at 22% until the Clinton years, when it fell because of the bull market in stocks and favorable economic conditions. But it rose to 25% under George W. Bush and has remained at that level under Obama.
Very little federal spending has gone toward research and development or infrastructure, Gundlach said, so much of the debt the government has incurred has come “without any real investment in the economy.”
Obama will be reelected, Gundlach predicted, and taxes will go up in 2013. Spending cuts will be passed, but their implementation will be pushed back a number of years.
Meanwhile, uncertainty about fiscal policy will deter corporations from expanding, he said, which means the economy will remain weak and unemployment will remain high.
