Jeffrey Gundlach and Felix Zulauf: The Second Inning of a Major Shift

Our pleasure. Thank you.

Sure. Per usual, my having discussions with Felix tends to be kind of redundant because we seem to come to the same conclusions more often than not, but I agree with the framework that Felix has presented. I'm also pointing out that what I've been focused on now for probably seven years is I've come to the belief about seven years ago that we were at the end of the secular decline in US Treasury long-term yields. At least that's over. And I started to spend a lot of time during those lockdown days thinking about what does it mean if everything that we've learned over 40 years has been largely informed by the fact of secularly declining interest rates, particularly at the long end, and how is that going to change when they start rising. And I've come to the conclusion that basically the amount of debt that the United States has makes it so that it's almost impossible in my view for long-term interest rates to decline even if Felix is right that we get into a weaker economy or a recession in 2027. And that's simply because the interest expense on the debt is so problematic. Most people are aware that we used to pay about $300 billion in the US to interest expense, say, seven years ago, and now it's rising very rapidly at close to $1.4 trillion per year. And of course that's a double-barreled interest expense problem. The deficit keeps growing by $2 trillion a year absent a recession. So obviously that's stimulative. So the deficit keeps rising and interest rates have risen. So we've gone from an average Treasury rate of under 2% across the entire maturity spectrum to now just under 4%, and rates other than T-bills are above 4% across the curve. And so on average that's going to continue to happen. And so I think that what's going to happen is that the interest expense problem during the recession is going to get obviously much worse. And that means that the deficit isn't going to be $2 trillion. It's not going to be 6% of GDP. It's going to be 10% of GDP or something like that. And that's going to cause a buyer strike as we've seen happening across the developed world. We've had long-term interest rates rising now for years. Even Japan has rising long-term interest rates, which some people thought could never happen. So I've been deemphasizing the long-term power of the US bond market. And I believe that it's fascinating that in 2025, and to a lesser extent here in 2026, but 2025 was really the big year when the tariff tantrum came out and the S&P 500 had a pretty big correction. It went down something like 18 or maybe more than 20%. I don't remember because it happened so quickly. But in the past 13, including that one in 2025, corrections and/or bear markets in the S&P 500, the dollar went up in the first 12 of them, all 12, and it went up around 8 to 10%. And I was watching to see if my thesis was right, that the next risk-off period the dollar would actually go down. And indeed, that's what happened during the tariff tantrum, about 8 to 10%. And so that is corroborating my case that I think during this cycle of rising interest rates, you're not going to get the same reaction function. And there's going to be something of a crisis in the long-term bond market just like there was in the UK when they had that one night. I think the rates went up like 150 basis points because they had a failed auction. I think something like that could come into focus in the United States. And so what are they going to do? Well, one thing could be yield curve control. So you might have a situation where long-term Treasury rates during a weak economy actually go up, which is my forecast, and they go to maybe I don't know, let's pick a number, six, six and a half percent, wherever the pain point is. And Scott Bessent decides that what he suggested early in his tenure as Secretary of Treasury might be a good idea to implement, which is yield curve control, like they did in the aftermath of World War II, where the inflation rate was going up but they just kept long-term interest rates very low and you had negative real interest rates, and that led to ultimately the 40-year bear market in long-term Treasury bonds. And so I think that might happen. That's candidate A. And then I have this candidate B which is more radical. It's more radical. I think it's less probability at least at the outset. I think they might restructure the Treasury debt if push comes to shove. And of course restructuring means extending people's maturities and dropping their coupons. And that sounds like a crazy idea except there was a white paper discussing that, talking about doing it to foreigners that hold US Treasury debt. This was back in the fourth quarter of 2024. And I don't even know if it's possible to do that because I think foreigners can hide behind other entities. I think it's hard to know exactly who's a foreign holder. But they just suggested literally that extending the maturity and dropping the coupon. And obviously that would be a disaster for the long-term Treasury bond market. But maybe that's the solution. Maybe when these bonds drop 50, 60, 70 points overnight because of the restructuring, maybe no one will lend us money anymore. At least that's what I would expect for a couple of generations. And so finally we actually are forced by circumstances to stop running these ridiculous budget deficits during times of supposed prosperity. I also wonder what the default rate and recovery rates might be in the lower parts of the corporate credit market during such a scenario, because everything that we think we know about the default cycles in lower-tier credit were all informed by secularly falling interest rates again. So if you had a junk bond, sure the spreads widened during economic weakness, but the base rate of the Treasury in some cases would fall enough so that it wasn't that painful. You could actually refinance some of the troubled company debt instead of defaulting on it. Those refinancings won't be available under a rising interest rate period. And that's one of the things we're already seeing. One of the reasons we're starting to see cracks in the lower-tier parts of the market, like triple-C bank loans and certainly parts of the private credit market, is because they are used to being able to refinance and quickly get out of deals, and that's not possible anymore. So the cycle as we move forward is going to be difficult for private companies and lower-credit companies broadly because the rates are higher now. The bonds they're rolling off will have to be re-refloated at higher interest rates, and that obviously is stressful. It doesn't relieve stress. It causes stress. So my last point, since I think the dollar is headed lower even if we go into recession, I noticed that the US outperformed foreign stocks, S&P versus the rest of the world excluding the United States, non-stop for years and years, even decades. But that has stopped. Emerging markets have been outperforming the S&P 500 in spite of the S&P 500 having a lot of momentum stocks in it. And the concentration of 10 AI stocks being 41% of the S&P 500, this is a dangerous percentage. It maps right to the tops of previous cycles. So I recommend people own nothing in the way of momentum or cap-weighted US stocks. I'm fine with equal-weighted US stocks. There is an equal-weighted index that the Fortune 500 publishes. We actually have an ETF that follows it. It just started fairly recently. It's doing terribly, of course, because it's equal-weighted and momentum is the name of the game, but it will ultimately outperform I think. But we also own emerging markets. We own emerging markets in local currencies. We have that in bonds. We also recommend that in equities because I think you have a double whammy, which certainly happened last year and it's already happening to a lesser extent this year, where as a US-based investor you had an index return that was superior last year for emerging markets and you had a positive currency translation. So it's an environment where, for the US investor, I've been pounding the table: you've got to get away from all US, you've got to get away from all dollar-based, even if you're, particularly if you're a United States person, because you're going to make money on relative performance and on currency translation. And that's been the case now for a year and a half. And I suspect that we're in the second inning of this, not the bottom of the ninth or something like that.

I'd like to amplify something about what I said about the bottoming in interest rates. One thing that we've been observing since really 2020, 2021, is that many indicators that worked well for decades in figuring out where, let's just say to keep it simple, a starting baseline where you might expect the 10-year Treasury to be. One of the greatest indicators was the copper-gold ratio, and it worked very well. It was probably the best single indicator in starting out where the 10-year Treasury should be, and it is completely broken since 2020. In fact, I quip at our strategy meetings, maybe we should use the gold-copper ratio, because using it that way suggests that the 10-year Treasury should be at 1% right now, which it obviously is not. This is because gold has gone up so much. It's corrected recently, but I think gold will continue to be embraced as real money increasingly as we move forward. Central banks clearly have been buyers of gold. Another thing, another indicator, we created an indicator of where we would think that consumer sentiment should be, and you use a bunch of indicators: you use the U3 unemployment rate, CPI 12-month change, personal spending 12-month change, and the S&P 500 12-month performance. And if you put these together with certain coefficients, they were the same line. From 1980 until 2020, there was almost no deviation. They were exactly the same line. Ever since 2020, it's completely broken. If you use those indicators to predict where the Michigan Consumer Sentiment Index should be, it should be at a totally normal, healthy reading. Instead, it's at the lowest of all time. So it's pretty incredible. And if you look at it by income level, not surprisingly, the top third income bracket is a little bit more optimistic, but they're way less optimistic than they've been at any time in the survey. And also the lowest third, not surprisingly, is at the all-time low, which suggests that everybody's at the all-time low or near the all-time low, which just suggests that there's a social mood of something's not going right. I think it has a lot to do obviously with the inflation rate, the energy prices, and the like, but this has been the case now for a few years before the oil price went up, before the war. Felix, I'm interested to feel your perspective. I talk about the war going to Europe. I thought the war was over yesterday.

I agree with you. I noticed that I've been talking about the entitlement programs' dire finances for a long time. And it's one of these things where it used to be our grandchildren's problem, and then it looked like it was going to be our children's problem, and suddenly it's on the doorstep. I mean, the Social Security Administration just last week acknowledged — you know, when I started this business they said they were good until '60, and then 10 years later it was good until 2050, and then a few years later it was 2040, and then it was 2038, and now they say they're out of money in 2032. Now 2032 is close enough, but since the date of running out of money keeps rolling forward because the assumptions are too optimistic, it means that it's before 2032. And I've been targeting somewhere around 2029, maybe even 2028, that this has to be really front and center. But here it is. We're getting to the second half of 2026. So we're talking a couple of years on this thing and it's going to have to be addressed one way or another. So it'll be interesting to see — what the Social Security Administration said last week was they're trying to get people's attention by saying we're going to have to cut benefits by 20 — it's a round number, they had a more specific number but it was close to 25% — and probably start cutting some people out of the program and that sort of thing. And that's another one of these systems that used to work that doesn't work anymore. All these systems that were put in place 80 years ago that aren't working anymore. And so I really agree that the repression is monotonically increasing and it's going to accelerate. In fact, this means that we have not only an economic problem and a financial problem, we will also have a social problem of major proportions.

One year.

But in the United States you can see that the reaction to negative sentiment and unhappiness — the reaction has been more government programs. Look at Mamdani in New York City and those types of people are gaining momentum, not losing momentum. And so —

Right.

Well, it makes people take more imprudent risks and so forth. I mean, I thought the moment that kind of solidified all this in my mind was at the end of 2021. Every year I do a Just Markets webcast, I call it, where I just talk about people want to get your view on the upcoming year and so forth. And when I looked at the

At the end of 2021 at Just Markets, I started with bonds and I'm like, government bonds, talk about the US here just specifically, it was laughably overvalued. The 10-year, the long-term rates were at 1%, short-term rates were still at zero. And anybody who had a brain knew that the money printing, the $7 trillion of money was going to lead to an inflation spike of significance. And so you didn't want bonds. You knew you were looking at negative returns. And lo and behold, in 2022, the long bond dropped 52 points. So obviously bonds weren't any good. But of course, then if you looked at the equity market, you said, well, by all valuation, you can use like 30 different valuation measures, PE, Shiller PE, price to book, price to sales, all this stuff. And you go back decades, they were all relative to their own internal valuations for just say the S&P 500. It was in the top percentile of overvaluation on most of the indicators. I don't think there was any that weren't at least in the top decile. And so you're looking at it, you say, government bonds are terrible. Equities at their valuation look terrible. So what am I supposed to do? If I buy anything where I can map the characteristics of Treasury bonds and with a combination of equities to this other asset class, if I can map it over in any kind of significant way, I'm going to hate that other asset class, too. So what ended up happening at the end of 2021 is people said, I don't want stocks. I don't want bonds. I don't want cash because it's at zero. So what do I want? And they're sort of like, I'll tell you what. You've been coming to me, Mr. Salesperson, with this blind pool concept for a while. And you know what? I'm actually kind of listening to you now because I'll give you money for this SPA or this private thing, but under only one condition. Don't tell me what you're doing. Because if you tell me what you're doing, there's a chance I'll be going to map over and I won't like what you're doing either. So, just take my money, don't give me a statement, don't tell me what's going on, and I'm going to keep my fingers crossed that's going to be good in three to five years. And now it's three to five years later, and we're seeing a lot of the private investments that were beneficiaries of that kind of being marked only one way. They're only marked down. Well, they're marked up if the bonds pick, which is completely absurd accounting. But it's amazing that you've got a creditor that's not paying and so you say, okay, you don't have to pay me cash, put it on the back of the loan and they keep the loan marked at par. And there's one case that was actually reported last month where the private equity interest underneath the pay-in-kind bond was wiped out. It was marked down 98% from about a hundred million to $800,000 overnight. And they still marked the picking bonds at par, which I don't know where's the DOJ on this one. But that kind of stuff's going on. So it leads to what? Yes, need is the strongest. I've seen many examples of it in my career. That's what happened in the end of 2021. And it's people that haven't given up yet. They still think that they can get 10% for their return bogey on investments, you know, on a PE of 43 on the S&P 500 and on a bond portfolio that yields five. And those things just are not possible.

This concept that I said about they might restructure bonds, what I was talking about is, this idea came to me over two years ago and I actually acted on it two years ago to protect my clients and that is I said maybe they'll just say all bonds longer than five years or something like this, we're going to change the coupon to 1% or whatever the coupon is now, whichever's lower. And I kept it to myself but I actually restructured Treasury holdings in some of my funds based on this concept, moving to the lowest coupon securities possible. So I took in my largest fund the coupon on the treasuries 10 years and longer from four and three-quarters down to one and a half. So I'm completely insulated from this type of a restructuring. And I kept it under my hat for a while. But late last year I gave an interview where I actually talked about this and it ended up getting posted on Bloomberg. And so some Bloomberg person was at the Milken conference last month and they went up to Kevin Hassett who was there in the Trump administration and they asked him would you ever consider what Gundlach talked about in this interview about cutting the coupon. Hassett said it won't happen in a million years. And so I said that's an interesting answer because in the investment business the synonym for never is imminent.

That's absolutely right. I mean, I sort of famously made a fool of myself sort of on September 30th of 1999, I turned maximum negative on the NASDAQ and it went up something like 80% in the fourth quarter. But actually, I wasn't a total idiot because 18 months later from September of 1999, you were down to about 20. So you went from 100 to 180 to something like 20 and so it ended up being good. But you know, Felix is absolutely right. It's the most dangerous part of the market is when the fundamentals are deteriorating but you still have the momentum going in the stocks and that's where we are right now.

I've been spending much more time on it more recently, meaning like the last couple of months because I'm really noticing the social aspect of it. Just recently in Lake Tahoe, which Lake Tahoe is a rich community, one side is California, the other side is Nevada, and there's a Nevada public utility that gives the electricity to Lake Tahoe, both sides of the lake. And they sent a notice to the residents on the California side that they will no longer be supplying electricity starting in the second quarter of 2027. 2027, under a year from now, we're not going to supply you with electricity because we've got these data centers that are taking up all the electricity and we don't have any for you. And so they're either going to have to somehow go to Acme company and get a build-it-your-own nuclear reactor kit for your backyard, which sounds like it could be fraught with peril. Or more likely, they're going to have the authorities going onto the wholesale market and buy electricity that will be transported through the Nevada utilities lines, but electricity will come from jurisdictions that have a surplus. Now, I have been around long enough to know that those wholesalers are going to jack the price up mightily on that electricity. So, there's already tremendous complaints about electricity prices. My electricity bills have gone very much higher in the past couple of years. There's already protests about it, not in my backyard and all this sort of thing. And I think there are projects in Louisiana that are already slated and probably already approved that would use collectively more than all of the electricity in Louisiana. So the pushback against this because the costs are enormous and it also has tremendous negative social impacts on water. You might be able to improve your technology in the data centers over time. Obviously, you can't do it today, but you can do it over time. What you can't do is create snowpack. You can't do that. And so, no amount of money is going to create more snowpack. So, the water shortage is going to be substantial. And it's also the pollution, the noise, the lights. I mean, I've seen interviews. Now, of course, you have to be careful because you can always find one or two people that have been unlucky and found themselves in the worst possible circumstance that 100 yards from their house is a monumental data center that runs 24/7/365 making huge noise, bright lights and the whole thing. But that type of thing is going on and there's tremendous pushback that is only going to increase against these projects making them more expensive, more delayed. And so we have a resource problem here. It's not just a capital problem. It's also a resource problem.

I've always been suspicious of private things because they're laundering their volatility. They're not really reporting the volatility. So you get Sharpe ratio arguments, you get drawdown arguments that aren't really valid. But I've been thinking about that for a long time, but I really first started thinking that something was changing one year ago, just about exactly one year ago when I was speaking at a conference here in Los Angeles. And before my fireside chat, the group before me was a bunch of private credit people and they were senior people from the big firms. And I was listening to them and I got this eerie feeling that I had heard the tone change sounded a lot like where we were going pre-global financial crisis where suddenly everything looked absolutely fantastic. Then all of a sudden you started to hear different language being used on the panels. And in this panel they started talking about tension between different private credit firms. They started talking about the need to increase their runway. They were basically admitting that they couldn't liquidate any of their investments. And I sort of thought, wow, this is starting to sound like they're not as confident as they used to be. And then early last year in the first quarter, I had a big insurance company client come to me. We managed money for them, but they've, like most insurance companies, they're drowning in private credit and private equity. They've got tons of it. And this firm has had a lot of managers. And he told me, he just shared with me unsolicited that he had gotten a valuation report for I think year end 2024. And that eight of the managers owned exactly the same position, exact, you know, if it was a public thing, it would have been the same CUSIP, literally. So it was exactly the same loan. And he said, I was really sort of surprised and getting concerned because one firm had it marked at 95 and one of the firms at the other end of the spectrum had it marked at eight. And so I started saying, uh-oh, this is starting to sound like what I expected. And then I started reading about the ratings, you know, that you have ratings on these private deals and they're being purchased. They're not coming from S&P or Moody's. Not that they were perfect 20 years ago, far from it. But they're coming from sort of private, small, relatively unknown rating agencies. And we all know what that means. We know that you're not really getting a deep dive from an analyst. A lot of these firms have 30 employees, including the receptionist, and yet they're rating hundreds and hundreds of loans, each one with a 200 or 250 page document. So, I don't think they're really rating them. I think what they're doing is giving them a price list. If you want a triple-C rating, it costs you a dollar. If you want a single-B rating, it's going to cost you $10, etc. And they somehow find their way to getting a triple-B-minus rating on it. And then I got a pitch book. One of my best analysts was looking at pitch books from some of the biggest private credit funds. And this one that has trillions and trillions of dollars right across all private spectrum, they said one of the pillars of their private credit portfolio is investment-grade corporate bonds. And we looked into it and it turns out that bonds that are rated in the private world that have a rating that is B-plus or higher represent only 2% of all securities. That's single B-plus or higher. I'm going to go out on a limb and say the single-B-plus ones are more than half of that 2%. So how many of them are triple-B-minus? Very few. And I'm sure they don't really deserve that rating in many cases. How can something that is under 1% of a market be a pillar of your portfolio? So I started to say, I'm getting that feeling that I had in 2005-2006 where I feel like everybody's lying about everything. They're lying about the credit quality. They're lying about their software exposure. They say it's 15% when it's 28%. They've created an illusion of liquidity on these interval funds that has completely fallen apart. As of December 31st, I think a lot of people that bought these products through financial intermediaries were led to believe they get all their money out every quarter. They didn't focus on the fact that at the fund level, not at the investor level, it's only 5%. And so, suddenly people say, wait a minute. I thought I could get out and I can't get out. I'm seeing the marks being written down sequentially. One of the biggest private credit funds at year end was marked at 100. Today it's marked at 77. And I was giving a talk and I said, and this was right after the markdown to 77, who in this room, and a lot of sophisticated people, a lot of people, who in this room, show of hands, thinks the next adjustment to the NAV is going to be up? Of course, not a single hand went up. Because everybody knows. So there's this awareness that something's not right. And the defaults are starting to come. The bonds are picking yet they're not being marked down. This is checking just about every box. But unlike 2007 where we had data points every minute of every day because we had the ABX triple-B index that started to fall like a brick, here we only get when they feel like reporting and there's no requirement that they actually do it. And there's also, I don't want to go on too much further, but there's also this very incestuous link between private equity, private credit, insurance companies that are captive, they're owned by the private credit, that then are moving risk supposedly to offshore insurance companies which have no regulation, no reporting, no visibility. So since there's been shady disclosures or shady communications on almost every level, I'm not sure I believe that this risk is really offset out there in Barbados and the Caymans and Bermuda. So what's going to happen when the actual reality comes that life insurance has to be paid, fixed annuities have to be paid, and suddenly we're in a recession and those assets actually aren't really properly reserved for? And there's significant intelligence by very experienced United States insurance regulators, now retired, that are opining on what the state of this offshore reinsurance is. And I'll just put it in a nutshell. It's not good. And so this is all wrapped up. This is a problem wrapped up in an enigma with no solution. And it will all come to the surface when the tide goes out and the market goes down all together.

So I keep hearing that there's no problems. But why then are you marking your portfolio down? That's early summer of 2007. Yeah. A year ago, I told my staff, I said, this feels a lot to me like 2005. Well, now it's a year later, so now it feels like 2006.

It's funny that a year ago what was being touted as like an anchor to the credit market was software. Software was perceived to be the safest thing. And then all of a sudden in the fall, people woke up and said, wait a minute. This is being disrupted potentially by AI. It reminded me of 2007 when everyone thought that Fannie Mae was going to come in and rescue the problems of defaults and mortgages. And one weekend, it was on a Sunday, I was thinking about it and I got this crack of doom feeling that all of a sudden I said, wait a minute, Fannie Mae is bankrupt. When I actually thought about it I said they're drowning in these problems. Their stock is worth nothing. They can't bail out anybody. And so the market went in a very short time in 2007 from Fannie Mae can fix this to uh-oh, Fannie Mae is one big barrel of gasoline that's being poured on this fire. And that happened to private credit in the software consideration. And I suspect there's going to be other pivots to what we thought was pretty good actually has some hidden features in it or hidden macroeconomic events happening that will make it not seem as safe as maybe you thought it was. Like the SpaceX thing came out last week and people talk about how SpaceX was a good company. They were not very capital intensive. Well, not anymore. They're suddenly massively capital intensive because they're now going full on into AI with all of its spending requirements. So, we'll see what happens to that one.

I just think it's a problem and it's been lurking for a long time that the yields are too low, but now they seem to be having a problem with their currency particularly versus the dollar where they intervene but they just keep defending that 160 level but it just doesn't hold. So there seems to be pressure there that will certainly not be a positive for the global economy. I think you probably know better than I do.

I believe so. Yeah, it's been there for nine years now. I've got about 500,000 followers.

Thank you. Enjoyed it, Grant. Thank you.