Gundlach: Rising Rates And Summer Insects

June 16, 2015

by Robert Huebscher

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You should never ask summer insects about ice, according to the Chinese philosopher Chuang Zhu1, because they are bound by a single season. In the same way, many investors have never experienced a period of increasing rates. One who has, however, is Jeffrey Gundlach, who offered his forecast for rates and the one sector of the bond market that is most vulnerable.

Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke to investors via a conference call on June 9. Copies of the slides from his presentation can be found here.

The last Fed tightening cycle was more than 10 years ago, longer than the tenure of many who run hedge funds, according to Gundlach. “A great many senior people in this business have never seen anything other than secularly declining interest rates,” he said.

Gundlach said that rates will head up, although he predicted the Fed will take longer to tighten than the consensus believes.

That may be a new experience for some, but the high-yield bond market epitomizes the summer insects, he said. That sector’s existence has coincided entirely with secularly declining rates.

Gundlach had some special words of caution for those who think junk bonds will perform well when yields increase. I’ll review those, but let’s start with his forecast for Fed policy and interest rates.

How long does the Fed stay at zero?

In a conference call earlier this year, Gundlach said that the Fed would be a “blockhead” if it were to raise rates three times this year. Everyone – including Gundlach – now agrees that won’t happen.

The consensus now is that there is a 30% chance of a hike in September and a 60% chance in December, he said. Both of those probabilities are too high, according to Gundlach, who thinks the Fed will be slow to raise rates.

“The market is pricing in a virtual certainty of a rate rise by Halloween next year, which of course will come sooner than any of us can possibly imagine,” he said.

One reason for Gundlach’s thinking is economic precedent. He cited data from Bianco Research covering eight instances when the Fed raised rates at least three times. Nominal GDP growth was never lower than 4.9% when the Fed started raising rates; it is 3.9% now. The CPI was 3% or higher; now core CPI is 1.8%. The output gap (a measure of manufacturing excess capacity) is a lot larger than it has been in the past.

Hourly earnings have been highly correlated with Fed increases, Gundlach said. “The movement up in hourly earnings is what one should be looking for to signal a green light for the Fed to raise interest rates,” he said. But growth in hourly earnings has been steady at approximately 1.5% since 2012. He said the odds of a Fed increase will be “much more meaningful” if that 1.5% level is exceeded.

“The Fed wants to see more permanent traction from economic data rather than this on-again off-again type of data that we have been getting,” he said.

“I’m wondering why the Fed is so interested in talking about raising interest rates,” he said. “My conclusion is they just don’t want to be at zero. When the next economic weakness comes, it’s a real problem if the Fed is at zero.”

  1. An alternative spelling is Chuang Tzu.

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