Grants 40th Anniversary: "Rates Can Never Rise" (Redux) 10-3-23

DoubleLine CEO Jeffrey Gundlach, speaking Oct. 3, 2024, at Grant’s Interest Rate Observer fall investment conference, shares (1:31) his views on why fixed income yields are headed much higher and the implications of the end of a 40-year decline in interest rates. The title of his presentation reprises the “Rates Can Never Rise” title of his Grant’s fall conference presentation on Oct. 4, 2016. With that title, Mr. Gundlach took issue with erroneous predictions at the time of frozen lows in U.S. Treasury yields and called for a rise in rates.

Mr. Gundlach foresees an explosion in the cost of servicing the national debt due to the confluence of surging interest rates, including “by far the steepest” Fed hiking campaign going back to 1987 (3:02), and the size of the federal deficit as a percentage of GDP, which will swell as GDP contracts in the next recession. “When you have this massive budget deficit and you increase interest rates by 500 basis points, up from zero to around 5½% at the top of the Fed’s range, it’s almost like you have a death wish, right?” he says. “You have all this debt, and you’re voluntarily raising interest rates.” The interest burden of the national debt, he notes, has already exceeded U.S. defense spending.

Fed Chairman Jerome H. Powell, Mr. Gundlach tells the audience, has locked the Fed into raising rates by targeting so-called super core inflation, which has continued to run high since the Fed started its tightening campaign (5:00). Noting that this inflation metric is “PCE core less shelter,” Mr. Gundlach asks, “You’re down to what? Boxes of pencils? What are we measuring here? There’s no food. There’s no energy. There’s no shelter. I mean, what is it? FanDuel spending?”

Under the pressure of rising rates, borrowing costs for small businesses have climbed from 4% a little over 18 months ago to 9%. What the Fed is “trying to do is to destroy these borrowers through raising interest rates and eventually, of course, they’re going to get there.”

Mr. Gundlach surveys three indicators of the 50 recessionary gauges he follows. The Treasury yield curve (6:27) historically has delivered the earliest recession warning when it inverts and stays inverted. A de-inverting curve “puts you on basement mode.” That appears to be underway. More of a coincident or real-time recession gauge, rising negative consumer sentiment about the current context (7:55) has been catching up with negative sentiment about the future. The unemployment rate (8:50) is the most lagging of the recessionary indicators. Mr. Gundlach expects heavy layoffs of middle management at the end of this year. “They’re going to come, and they’re going to be heavy.” [chart “U.S. Unemployment Rate vs. 12 Month Moving Average and Recession] When the unemployment rate crosses over its 36-month moving average (10:57), “you’re cooked. And that’s going to happen, I think with high probability, in the first quarter of 2024.”

Mr. Gundlach considers various outcomes on the future of the U.S. government interest expense in the event recession comes (14:32). These include average interest rates on the national debt of 3%, 6% and 9% and the size of the federal deficit, today running at 8% of GDP, a fact that flies in the face of Congressional Budget Office estimates projecting a deficit of 4% GDP and no recession. Varying the size of the deficit and the level of interest rates, Mr. Gundlach shows scenarios where interest expense could equal 40% to 140% of federal tax revenue. Such outcomes would mean massive money printing and much higher interest rates.

Turning to secular trends (19:57), Mr. Gundlach notes the 30-year Treasury yield “did nothing but fall since the 1990s, early ’90s, in a fairly controlled pattern. You’ll notice it was pretty well contained inside of these (standard-deviation) bands, but it’s pretty clear that something changed, and now we’re completely out of the context of the past.” He continues: “When you’ve been around for 40 years, you think you’ve learned stuff, right? You think that you understand relationships. You can tap into your experience and how things interrelate and act. But what if your experience is all informed by a secular trend that isn’t in place anymore? What happens if falling interest rates were significant in creating those relationships? And if they’re not falling anymore, maybe those relationships are irrelevant. Maybe they’re even misleading.” Among the consequences for an end to the era of falling interest rates, Mr. Gundlach foresees higher default rates and lower recovery rates on high yield bonds than were experienced over the prior history of that sector of the bond market.

Rising interest rates (23:09) also mean more competition for stocks from the fixed income universe. “Now bond yields are up at 5%, 5½% on Fed funds, and you can buy BB bank loans, which at some point you’re going to want to sell them because their high yield is kind of a blessing and a curse. It’s a blessing because you get the income. It’s a curse because the company has to pay it. So you’ve got to watch out for that. But stocks were twice as cheap as bonds 18 months ago, and now they’re twice as rich. There’s been a 4x reevaluation of stocks versus bonds on a valuation basis.”

In the context of the end of the secular decline in interest rates, Mr. Gundlach notes a number of knock-on effects (24:27). For example, for every year until 2021, the 10-year Treasury yield undershot the rate forecasts. Since then, the forecasts have been underestimating actual future levels on the 10-year yield. In further support of the case for higher interest rates (26:15), he observes that the seven-year moving averages of the year-over-year change in nominal GDP and core PCE led the 10-year yield higher into the early 1980s and then lower until recent years. Now those variables are heading up, dragging the 10-year higher with them.