Economics

Gundlach – Don’t Fear The 10-Year At 3%

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%.

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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.

Read the full article here by Robert Huebscher, Advisor Perspectives