Gundlach On Why Interest Rates Are Falling

March 24, 2017

Who would have thought that after the Fed hiked rates for the second time in three months that Treasury yields would actually decline? But that's exactly what's happened.

The 10-year U.S. Treasury bond yield dropped from 2.6% on the day before the March 15 decision to 2.4% now, confounding many investors who had expected rates to continue climbing.

However, one person who’s not surprised is bond guru Jeffrey Gundlach. In a webcast that took place earlier this month, he predicted rates would go lower before they went higher, something that seems to be playing out in the markets right now.

Copper/Gold Ratio Signal

In his presentation, Gundlach forecasted that there would be a tradable rally in the 10-year bond, which would push the yield to below 2.25% (bond prices and yields move inversely). He pointed to record short positions in Treasuries as fuel for the countertrend rally.

Gundlach also said the copper/gold ratio suggested that the 10-year yield had more downside in the short term. The ratio has historically had a tight correlation with the 10-year yield, as can be seen from the chart below:

 

10-Year To Eventually Test 3%

But even as rates decline in the short term, don't expect it to last. The founder of DoubleLine Capital, with more than $100 billion in assets under management (AUM), said that once this oversold rally in bonds is over, the sell-off will resume and rates will move higher. He still expects the 10-year to jump to around 3% later this year.

Gundlach's longer-term forecast for higher rates is underpinned by the idea that growth and inflation will pick up. He noted that the consensus is calling for faster economic growth―4.7% nominal GDP growth in the U.S. this year, up from 2.9% last year―and faster inflation. He expects that, unlike in years past, the consensus may end up being right in 2017.

That stronger economic outlook means that the Fed interest rate dynamic has changed. While, as before, the Fed was following the market―raising rates only when the market allowed it to do so―now the central bank is calling the shots.

‘No More Excuses’

In Gundlach's views, "There are no more excuses of why the Fed shouldn't be raising rates." In fact, the Fed may start raising rates sequentially, as it's done in the past.

"It's almost old-school now, where, as long as the data stays where it is, you may start to see more sequential Fed rate hikes," explained Gundlach, who expects two more hikes this year. "What has happened historically is the Fed gets into a sequential hiking mode, and they keep doing it" until there's a recession. That recession is usually preceded by a flat or inverted yield curve, something that hasn't showed up yet.

Positioning For Higher Rates
When rates start to turn upward again, Gundlach believes that Treasury inflation protected securities (TIPS) are a good bet as "breakeven rates are evaluated higher." TIPS outperform when inflation expectations rise. The iShares TIPS Bond ETF (TIP) is the largest ETF in the space, with $22.9 billion in AUM.

On the other hand, the DoubleLine founder is not a fan of corporate bonds, because their valuations are too rich. He doesn't expect a big downdraft in corporate bonds anytime soon, but there's simply not much more room for credit spreads to tighten, in his view. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) is the No. 1 junk bond ETF by assets, with $17.5 billion in AUM.

Meanwhile, Gundlach continues to like emerging market bonds as a regular holding. The $9.6 billion iShares JP Morgan USD Emerging Markets Bond ETF (EMB) is a popular fund in the space.

 

TOTL vs. AGG
As for his own fund, the SPDR DoubleLine Total Return Tactical ETF (TOTL) is heavy in mortgage-backed securities, as always. Because of that, there's the risk that if prepayments spike higher, there could be losses for the fund. Still, Gundlach sees it as a defensive fund because its duration is much lower than that of the iShares Core U.S. Aggregate Bond ETF (AGG). Currently, TOTL has a duration of 4.3, compared to 5.7 for AGG.

"The duration of the AGG is at a 6, which is the highest duration ever for the Bloomberg Barclays Aggregate Index, because of all the corporate bond issuances and the broadly low yield levels," said Gundlach in the webcast. "The risk is quite high―if rates rise 100 basis points, you lose 6%. The yield on the AGG is 2.7%, so if rates go up 100 basis points in a year, your return would be -3.3%, gross of any fees."

AGG is the largest bond ETF on the market, with $42.8 billion in AUM, compared with $3.1 billion for TOTL.

Short German Bonds

Finally, Gundlach's call for higher rates isn't just limited to the United States. He expects them to rise globally, but singled out Germany, where the 10-year yield is trading at 0.4%. In the context of a German consumer price index that's growing at 2.2%, the yield is shockingly low.

"If it weren't for the European Central Bank continuing with QE, clearly German yields would be higher," said Gundlach. "There's a ton of downside on European bonds. I advocate that investors own none of them. I think a short position in the German 10-year is a hell of a lot smarter than a long position.”

The ProShares German Sovereign/Sub-Sovereign ETF (GGOV) is currently the only German-focused bond ETF listed in the U.S.

German 10-Year CPI Spread

Contact Sumit Roy at [email protected]

 

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