Monday, July 16, 2018

Dancing on the Edge of a Volcano: "The yield curve needs to be respected"—Jeffrey Gundlach

Hah! I scoff at the yield curve.

That was intended as joke.
The current situation actually got me thinking of Weimar's Foreign Minister, Gustav Stresemann who had the original volcano line back in 1928:
"The economic position is only flourishing on the surface. Germany is in fact dancing on a volcano. 
If the short-term credits are called in, a large section of our economy would collapse"
Stresemann was a pretty sharp guy* and might have been able to stave off Hitler and the Nazis but he died in 1929.

Here's Barron's Roundtable:

Jeffrey Gundlach Says We’re Getting Closer to a Recession
July 13, 2018 8:03 p.m. ET
Barron’s: What’s the good word, if any, on the economy and the markets?
Jeffrey Gundlach: We are more cautious about 2019 than about this year. We always start by asking whether a recession is coming. We have found about a dozen indicators to be helpful on a forward-looking basis. At the beginning of this year, not a single one was negative. We look at the leading economic indicators, consumer and small-business sentiment surveys, GDPNow from the Federal Reserve Bank of Atlanta, and other things. The one indicator that is somewhat negative is the yield curve, which has flattened pretty relentlessly for the past year or two as the Fed has been tightening. There’s a narrative out there that says the flattening yield curve isn’t sending any message about a recession, and that couldn’t be more wrong. In fact, with rates so low, the yield curve signal is even stronger than usual.

What exactly is it signaling?

We are getting closer to a recession. When the curve goes flat from the two-year Treasury to the 10-year [meaning that the yields are identical], the recession risk is at least a year away. Recently, that spread was 28 basis points [hundredths of a percentage point], which is pretty close to being flat. It is flashing yellow. It needs to be respected. The other reason to think 2019 might be more problematic is that quantitative tightening has just started. The Fed has started to let bonds roll off its balance sheet [the central bank isn’t buying new bonds when many current holdings mature]. Several billion dollars of bonds per month are coming due, but by October the amount will be up to $50 billion per month.

At the same time, the Fed has said it intends to keep raising interest rates, probably twice more this year. That, together with the signal from the yield curve and perhaps $600 billion of quantitative tightening, and a budget deficit that is growing, is an issue. The strangest thing is that Congress passed a $280 billion tax cut and spending increases so late in the cycle, and with interest rates rising. It’s like a death wish. The U.S. is taking on hundreds of billions of dollars of debt while raising rates, which means our debt-service payments are going to be under serious pressure to the upside.

Where do you expect the 10-year bond yield to end the year?

I thought the 10-year would get above 3% this year. It did so, briefly. More important, the long bond [the 30-year Treasury] closed above 3.22% for one session. You’d need more than one close like that to send a signal. It turned out to be a buying opportunity. I expect the 10-year yield to be range-bound for the rest of the year. Rates should be much higher, based on nominal gross domestic product, which probably ran around 5% in the second quarter. But weirdly, again, in this era of quantitative easing, if you average nominal U.S. GDP and the German Bund’s 10-year yield, that’s where the 10-year Treasury yield is. The German 10-year yields 30 basis points. Average that with nominal GDP of 5% and you get about 2.65%. So, 2.65% is my year-end number.

What is the best way to invest in this sort of environment?

Be conservative. I still recommend low-risk, relatively low-duration bonds. I recommended PowerShares Senior Loan Portfolio at the January Roundtable [now Invesco Senior Loan (ticker: BKLN)]. It has been a good performer, up almost 2% year to date, whereas most bond strategies are negative.

I still favor commodities. They are weirdly strong, given how powerful the dollar has been. Commodities prices have been spooked recently by the tariff situation, but that is a buying opportunity. I recommended the XLE [the Energy Select Sector SPDR exchange-traded fund] at the beginning of the year. Now I prefer the XOP [ SPDR S&P Oil & Gas Exploration & Production]. It just hit a high for the year, but we are looking for further gains in the commodities complex....MUCH MORE
One word of warning, Gundlach was either early or wrong at the last Barron's Roundtable: 

Jeffrey Gundlach’s Report Card
Jeffrey Gundlach Says We’re Getting Closer to a Recession

*Back to Stresemann, he saw what was coming. After doing his damnedest to play the extraordinarily weak hand the Kaiser and the generals had left Germany after 1918, he was made Chancellor for 100 days in 1923 and got in front of the Weimar hyperinflation.
Following that stint he was Foreign Minister for six years cutting deals with France and Britain and picking up a Nobel Peace Prize along the way (with France's Aristide Briand).

In 1928 he wrote to British diplomat Sir Albert Bruce Lockhart:
If the allies had obliged me just one single time, I would have brought the German people behind me, yes; even today, I could still get them to support me. However, they (the allies) gave me nothing and the minor concessions they made, always came too late. Thus, nothing else remains for us but brutal force. The future lies in the hands of the new generation. Moreover, they, the German youth, who we could have won for peace and reconstruction, we have lost. Herein lies my tragedy and there, the allies' crime. 
Related: yesterday's ICYMI: "U.S. Yield Curve to Invert in Mid-2019, Morgan Stanley Says" for more on the curve.
No history rambles, I promise.

See also Keynes' Economic Consequences of the Peace