When last we checked in on bond king for the post-Gross world, exposer of WSJ conspiracies, and man who showed up at Sohn dressed in a Jack Nicholson Joker costume, Jeff Gundlach, the DoubleLine boss was busy “doubling” down on his “line” (get it?) about how rising deficits and Fed rate hikes are a toxic combination.
Earlier this year, in one of his webcasts, Gundlach suggested the U.S. is on a “suicide mission” and he expanded a bit on that during an interview with Barron’s last month:
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.
No arguments there, Jeff. In the same interview, Gundlach suggested (actually he demanded) that markets “respect” the signaling power of a flattening yield curve.
“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”, Jeff told Barron’s.
Goldman doesn’t necessarily agree with that. In a note dated August 16 called “Yield curve inversion: a sheep in wolf’s clothing”, the bank argues that investors need not necessarily panic about inversion. It’s a lengthy piece, but here’s the most poignant excerpt:
On the question of the yield curve being a signal, it’s worth asking which yield curve? Is it 2s10s, fed funds/10s, some short term forward curve that serves as the best signal? A historical analysis from the 1960s onwards shows that each of those curves identify every recession, but curve inversion isn’t a sufficient condition for a recession—in three of the last ten instances when these yield curves inverted, there was no recession over a subsequent two year window.
Goldman goes on to note that during periods of high inflation, an inverted curve is a more “immediate signal”. That makes intuitive sense – if inflation is overshooting, you get a more aggressive policy response. Here’s a visual that shows you how many months from a flat or inverted 2s10s it took for the economy to fall into recession (dashed lines are periods where a flattening wasn’t followed by a recession within two years):
“The bottom line is we don’t believe that investors ought to overly fear a flat yield curve, either as a signal or a cause of a recession”, Goldman concludes. Again, there’s a ton more in the full note, but in the interest of brevity, we’ll leave it at that for the purposes of this post.
Whatever the flattening curve presages for the U.S. economy, it certainly seems to suggest that market participants believe the bar is high when it comes to international (read: emerging market) turmoil compelling the Powell Fed to take a pause. We talked a good bit about this on Sunday in “This Is Not A Drill: Jerome Powell Needs To Be Careful In Jackson Hole“.
Powell has been steadfast in his upbeat assessment of the U.S. economy and the data generally supports his assessment. The effects of late-cycle fiscal stimulus and tariffs threaten to push up inflation, which only add to the case for a hawkish bias. At an IMF/SNB event in early May, Powell explicitly said he did not believe developed market monetary accommodation played a particularly large role “in the surge of capital flows to emerging market economies in recent years.” If you take him at his word on that, it means he’s not going to be predisposed to pausing on rate hikes just because emerging markets are crumbling.
Some emerging market central bankers have implored Powell to at least consider calibrating balance sheet rundown to take account of the deluge of Treasury supply necessitated by the tax cuts and the spending bill. That raises questions about how the Fed will approach balance sheet rundown going forward and that’s a discussion you’re going to hear more and more about in relatively short order. For those interested in a longer take on this and what it means for the curve, see “Why The Fed Will Be Forced To Halt QT Early And Expand The Balance Sheet In 2020, According To Morgan Stanley“.
In any event, another sign the market believes Powell will stick to his guns despite adverse international developments is the massive short in 10Y Treasury futures. The net non- commercial short in the 10Y increased to a record 698,194 contracts in the week through last Tuesday, jumping 111,895 from the previous week, the largest increase since the week of July 3.
Guess who thinks that makes markets ripe for a short squeeze? Why, Jeff Gundlach, of course. Here’s “the truth” from the place where all truths emanate, @TruthGundlach:
Massive increase this week in short positions against 10 &30 yr UST mkts. Highest for both in history, by far. Could cause quite a squeeze.
— Jeffrey Gundlach (@TruthGundlach) August 17, 2018
Jeff might be onto something there. After all, markets are staring down a veritable laundry list of risk factors any one of which has the potential to spark a flight to safety, presumably to the benefit of the U.S. long end.
Of course if that overcrowded trade does get squeezed but expectations for the Fed don’t budge, well then that’s just more flattening pressure. Additionally, it’s worth asking whether today’s flights to safety will necessarily entail the same kind of appetite for the long end as they would have previously. After all, why not just rotate to cash and cash equivalents with short-end rates now the most attractive in a decade?