Gundlach – The Psychology Of A Rate Hike
November 17, 2015
by Robert Huebscher
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The consensus is building for a Fed rate hike in December. But how the market will react is far less certain. According to Jeffrey Gundlach, that will depend on the context in which the Fed takes action.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke to investors via a conference call on November 9. Slides from that presentation are available here. The focus of his talk was DoubleLine’s closed-end funds, DBL and DSL.
Sentiment in favor of a rate hike increased following the release on November 6 of the employment report, which was generally viewed as indicative of accelerating economic growth.
Gundlach, however, cautioned against assuming that a rate increase is certain. If the Fed raises, he said its impact on the markets is even less certain.
“If the Fed raises the Fed funds rate against a backdrop where people come to believe that inflation pressures are growing, then they [the Fed] are behind the curve,” he said, and “the yield curve will steepen. The long bond under that scenario would not be happy.”
Prior to the November 6 jobs report, the likelihood of a rate increase was approximately 50%. Now, the market puts the odds at 70%. If the economic data between now and when the Fed meets in December does not show continued growth, then Gundlach said the long bond would rally.
“If the Fed raises interest rates, the shape of the curve will have everything to do with the economic context in which they raise interest rates,” he said.
I’ll look at Gundlach’s take on the jobs report and the factors at play in the bond market. I will also review his comments on a few sectors of the bond market.
Jobs, the economy and interest rates
Gundlach said the jobs report was not entirely positive despite the 271,000 increase in payrolls and the 2.5% growth in hourly earnings. The “asterisk” in the data was that most of the job growth came from those 55 and older; there were job losses for younger cohorts. He said the growth in 55-and-older employment was a consequence of zero-interest rate policy, which forced many to delay retirement.
The economic data released over the next month will dictate how the market will react to a Fed rate hike, Gundlach said.
If the Fed raises rates against a backdrop of largely unchanged data, which Gundlach said had been the speculation for the last 18 months, then he predicted that the long bond (30-year maturity) would rally. But if the data continues to support economic growth, then speculation will increase that the Fed is acting “behind the curve” and, according to Gundlach, volatility and yields will increase.
Gundlach said it was unlikely the Fed would engage in another round of quantitative easing if the economy were to weaken. If that happened, he said, it would first reverse any interest-rate increases it had undertaken and then go to negative yields, as has happened in Europe.
Since October 14, the five-year yield has increased by 50 basis points and the long-bond yield by 30 basis points. Gundlach ascribed some of the weakness in the stock market to fears of a rate increase, and he said that “we are starting to see big negative correlation starting to maybe develop between stocks and bonds where interest rates going higher might cripple the stock market, and the stock market rallying might cripple the bond market.”
Indeed, other economic indicators are signaling weakness. Gundlach said there is “something like a manufacturing recession” going on in the U.S. Industrial production year-over-year might go negative, he said. Durable goods are similarly weak. He said that a strong dollar is causing some of this weakness.
“The dollar may end up ruining the Fed’s rate hike party that they have scheduled for December,” he said, “because over the next month if the dollar gets stronger, we may see further volatility to make the Fed nervous.”
Across the bond market
Gundlach warned about the high-yield market. He said the “clock is running out” for energy companies due to low oil prices. Those companies that hedged their exposure for a two-year horizon will see those hedges expire in the next nine months, he said. If oil remains where it is today – approximately $50/barrel – then he said that defaults are “almost certain.”
High-yield downgrades are already accelerating, he said.
“With the Fed raising interest rates in the context of flat corporate earnings and declining corporate profit margins,” he said, “it is not exactly the reason to buy high-yield bonds.”
Emerging-market debt is at risk, according to Gundlach, due to the strength of the dollar. But he said it is cheaper than high-yield debt for equivalent credit risk.
Closed-end funds (like the ones DoubleLine offers) and REITs are trading a steep discounts, Gundlach said, because of fear of a Fed rate. Such a move would increase the cost of leverage for those funds and depress their underlying value. He said that many funds have moved from a premium to a discount recently, and that has “stopped people from having the courage or the fortitude to buy closed-end funds.”
Gold being suddenly back down to $1,100 or a little lower is a bad sign for commodities, according to Gundlach. That is consistent with a strong dollar. He said that if the DXY breaks 100 and stays above that level for a couple of days, a “race for the dollar” would begin.
Finally, Gundlach responded to the many who claim that the Fed has left rates at zero for too long, or that zero is the wrong rate to maintain.
“If that were true,” he said, “then why is the economy booming? If zero interest rate policy is so inappropriate, then why do we have 2.9% year-over-year nominal GDP.”
“I think raising interest rates at 2.9% nominal GDP is not a great idea,” he said.
Gundlach is not in favor of zero-interest rates. But he doesn’t support a rate hike unless the economic data clearly argue for one.
“I’m against the Fed raising rates on a coin flip,” he said. “It should be something that is analyzable and defensible. One economic report is a bad reason against the context of a new low in junk bonds and nearly new lows in banks loans, plus weakness in emerging markets, the fact that the global Dow chart is very weak and commodity prices are on their lows.”
He reminded the audience that the Fed engaged in quantitative easing in September 2012, when zero-interest rates were deemed insufficient and global GDP growth, like many other economic indicators, was higher than it is now.