Gundlach – Don’t Fear the 3% Yield on the 10-Year
Fear that the multi-decade bull market in bonds will end has centered on the benchmark 10-year Treasury yield breaching 3%. But Jeffrey Gundlach said that is the wrong focus. Instead, investors should worry if the 30-year “long bond” goes above 3.22%.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke to investors via a conference call yesterday. Slides from that presentation are available here. The focus of his talk was DoubleLine’s asset-allocation mutual funds, DBLFX and DFLEX.
“I am not that concerned about the 3% yield on the 10-year Treasury,” Gundlach said. “The 3.22% yield on the long bond is a bigger deal.”
“If the 30-year takes out that yield,” Gundlach said, “then the 10-year yield will break out upwards.” He said that the 10-year yield could then break 4% relatively quickly, which would be “problematic” for competing assets – specifically equities.
The 10-year yield last closed above 3% on April 24 and remained above that level for three days. It closed at 2.97% yesterday.
The 3.22% yield on the 30-year is significant, Gundlach said, because it is a “resistance” level that was last reached on February 21, 2018. It closed at 3.13% yesterday.
Rates will break to the upside, Gundlach said, but he qualified that comment as “not a high conviction forecast.” He said that investors should be reactive and “let the market play things out.”
“This is not a bad place to own bonds,” Gundlach said.
I will discuss Gundlach’s assessment of valuations in various sectors of the bond market. But, first, let’s look at what he said about the odds of a recession and the economic forces driving the bond market.
What is the chance of a recession in the next year?
Since 2010, real GDP growth has been extremely stable, according to Gundlach – between 1.25% and 2.25% without much variation. “We are now at the higher end of the range,” he said. The current expansion, at 36 quarters, is surpassed only by the 2001 expansion in terms of its length. He said there were at least three others with as much cumulative growth.
Gundlach said this expansion has been “aided and abetted” by monetary policy, “but now we are going to see the opposite.”
Monetary policy has already tightened in the U.S. and Gundlach said he expects quantitative easing (QE) to end in Europe this year.
Unless the leading economic indicator (LEI) goes negative, he said, there is no chance of a recession. It has been rising for about a year, he said, and is above 5%, but it showed a downtick recently. It would need to weaken further to show a possibility of a recession in 2019, according to Gundlach.
The ISM purchasing manager index (PMI) needs to go below 50 to signal a recession, according to Gundlach. It has fallen off sharply in the last couple of months, he said, but that would need to continue for a few months to signal an oncoming recession. There has been a slowdown in growth in Europe, he said, that might signal the peak of the business cycle.
Gundlach said that high-yield spreads typically expand starting a year before a recession by as much as 400 basis points, based on the last two recessions. High-yield bond investors “seem to know more than Treasury investors,” Gundlach said, because government yields have not risen in anticipation of recessions as noticeably as have junk bonds. High-yield spreads have widened by a “very small amount” and “bear watching,” he said, but they are not giving a recessionary signal.
The economic surprise indices, which measure actual data versus expectations, are a “little bit disconcerting,” Gundlach said. They include both hard and soft data, and the latter was very strong just after the election, but has weakened since.
According to Gundlach, recessions happen when the two-year to 10-year spread goes negative. The spread is now 47 basis points. The yield curve has flattened, but Gundlach refuted claims that the yield curve has been “flattening like a banshee” this year. Indeed, he said, the slope has not changed much year-to-date – only a seven basis point flattening. The flattening happened in 2017, he said; this year has seen mostly a parallel shift up in yield.
“I would not get concerned about the yield curve unless we reestablished that flattening trend,” he said.
Inflation and commodities
Turning to inflation, Gundlach said the CPI has been remarkably stable since World War II, aside from recessions. The CPI has gone up, he said, as is typical in the late stages of the business cycle when the Fed tightens – but it is not signaling a recession. Gundlach said that core CPI is now 2.1% year-over-year, which is above the Fed’s 2% target, and it is getting quite close to 2.25%
“Market psychology depends on whether the core CPI goes above 2.25%,” Gundlach said. It hasn’t been there since 2007 or 2008 and that level will trigger a “real change in attitude.”
Inflation in core services has been rising since 2011, while core goods had mostly been declining over that period, he said. Both are increasing now. As an aside, Gundlach said that core CPI has never been above 3% in the last 30 years.
Wage growth has been 4% in the second quarter, although Gundlach said it has typically been downgraded after strong reports at the beginning of a quarter.
The dollar should move higher, he said, to as much as 94-95 based on the DXY index. It has moved up about 4% to 5% this year, which Gundlach said explains the drop in the price of gold over that period.
Oil has risen to approximately $70/barrel, which is amplified in non-U.S. markets whose currencies have weakened against the dollar, according to Gundlach. He said it is surprising that emerging equity and bond markets have not done worse than they have this year, given the strength of the dollar. Emerging-market performance has been historically strongly correlated to the strength of the dollar against emerging-market currencies.
Gundlach did not speak as extensively about the federal deficit as he has in prior webcasts. But he warned that the combination of growing deficits and future Fed rate hikes would be a “dangerous cocktail.” Deficits and interest rates have consequences for long-term investors, he said, but they are not something that gives an investable signal in the short term.
Fed chairpersons typically hike rates at the end of their tenure, according to Gundlach. They leave at prosperous times, he said, as did Yellen at the precise peak in the equity market.
According to the Taylor rule, the Fed funds rate should be at 4.75%, Gundlach said. “That gives the Fed cover to continue to raise rates.”
The bond and equity market outlooks
In 2018, success in the bond market has been tied to keeping duration short, Gundlach said, as rates have been rising. He said the best performing sector has been bank loans, represented by the ETF BKLN. He said it has the best “Sherman ratio,” a metric popularized by Gundlach’s colleague, Jeffrey Sherman, which is calculated by dividing the yield by the duration. “Nothing is close” to the Sherman yield of bank loans, Gundlach said.
He went through various sectors of the bond market, commenting on their valuations relative to Treasury bond:
- Investment grade was the most overvalued sector at the start of the year and it is a still “bad time” to be long. There is a lot of leverage in the corporate sector, Gundlach said.
- Mortgage-backed securities (MBS) are “a little rich” versus Treasury bonds.
- Emerging-market bonds similarly overvalued as are MBS.
- High-yield bonds are absurdly overvalued versus 10-year Treasury bonds, but he said that they should be matched to the long bond. On that basis, high yield is still highly valued, but not as badly.
Gundlach reiterated his prior prediction that the S&P 500 would register negative returns for 2018. But he said that the Shiller cyclically adjusted price-earning (CAPE) ratio was 30% higher in 2000 than it is now. However, on a forward-earnings or price-to-sales basis, valuations are “off the charts,” he said.
One of the great arguments for owning equities – the fact that dividends yields were greater than bond market yields – is no longer true. Gundlach said the dividend yield on the S&P 500 is 1.97%, which is not only lower than the 10-year yield but it is lower than the one-year Treasury bill rate.
“The value argument for the S&P versus bonds is pretty bad,” Gundlach said.