Gundlach: Rates, Risk and the Road Ahead

I fundamentally continue to believe that given regular supply and demand pricing treasuries, the path of least resistance for long-term treasuries is up. However, as we've gone from virtually 70 basis points back six years ago to what was about five and a third or 5.35 yesterday, we're getting to the point where it's quite obvious that the government is getting uncomfortable with the level of rates. This is why you have, you know, the president wants the rate to be at zero. The secretary of the treasury has signaled Operation Twist, which is something that I have been anticipating for about three years. I just didn't know what level. I don't think it's really done it yet because, you know, he once he was about a week ago he said he had bought any bonds. I don't know if they have or not, but $6 billion, which is what they're talking about on buybacks, is utterly pointless. I just don't see how that's supposed to work. I think I'd have to go much, much higher, but at some point they might.

And I did at Jim Grant's Interest Rate Observer conference way back in 2016, I came to the conclusion that the bull market in bonds, treasuries, was coming near an end. And when I, if I have a grandchild that comes up to me and says one day, 'I hear you were this bond guy and did you... I couldn't believe it. I read there were negative interest rates. Did you own any of those?' And I said, 'I want to be able to say absolutely not. I never slipped on that banana field.' But, you know, and then we had the COVID thing. So rates went back down to those 2016 levels and for a day even lower. And then I thought for sure, for sure this is the bottom in interest rates and the only thing that's going to stop them from going up is some sort of extraordinary action by the government. And there's only two candidates for that that I can think of. One of them is Operation Twist if the Fed will go along with it. The Fed has to go along with it because if you have the Fed funds rate at 3.78 now, you know, it's not that different of a yield than on the long end. You would need them to collapse interest rates so you could borrow at negative real interest rates and then take the proceeds and stop the Treasury yields from rising on the long end. That's a radical idea. It happened from 1946 or so until the mid-1950s. Everyone knew inflation was going to go up after World War II and the economists were all right, but the government wouldn't let them go up and that led to all that inflation and that started around 1950, it started the bear market in bonds. So radical things can happen. Japan had yield curve control for a very long time. Now they're just trying to control the currency more than their yields, but they would have to do it in much bigger size. I think the six billion is a way of starting, you get the machinery in place to see if it's working and get your systems going. I would think they would do that somewhere around six and a half percent, something like that. I don't know why I feel that way. I felt like they would start getting nervous above five and that has certainly happened, but that could happen. And so as a bond manager or bond investor, you have to think about when do you have to do the pivot on those long-term rates. And it's pretty clear to me that it's not at five and a third. I think it has to... I really believe just in my gut there would have to be a six handle for them to do it. But when they do, and I remember when we had the big selloff in the gilts under Liz Truss.

Yeah. I mean, just because of an announcement, yields moved about 150 basis points in like 48 hours, but then when she reined on that policy, they like rallied right back. So you get whipsawed tremendously by tape bombs. So I'm trying to follow it very, very carefully and I kind of on a minutia sort of level to look for signals that it's happening. We have a pretty good signal with admitting it. The other thing that could happen is they could just do something totally radical and say, you know what, we can't afford this interest expense that we have to issue at based upon the market forces. What we're going to do is restructure the Treasury debt. We're going to extend the maturities. They talked about this, Scott Bessent talked about this before he was Secretary of Treasury, that maybe we should restructure the Treasury bonds that are owned by foreigners. Now that's a very difficult thing to administer because the foreigners can hide behind local entities.

Yeah, I remember the... I don't know if that was the Mar-a-Lago Accord, but I remember that phrase. There's one way that they could get it back down. You could cut it by 75%, the interest expense, just by cutting everybody's coupon. So the average Treasury debt right now is about 4% coupon. You could just say every Treasury bond that has a coupon above one, your coupon is now one. And every bond, there's not very many of them, but that have a coupon below one, you get to keep your coupon. He's not going to get a raise.

Yes.

And so that would reduce your interest expense overnight by 75%. So you go right from two trillion to half a trillion right away and you'd be right back to where you were years ago. That you buy yourself more road to kick the can down. Now, of course, every investor would erupt in anger and they would never lend to you again. You'll never be able to borrow money again, which is actually a solution to the way we're running the government. You can't borrow anymore. Somebody asked me what would I do if I were running everything? And I'd say I would tell Congress that they have to cut spending by $1 trillion in a month and find a way. You know, you just have to do it. We tried the eliminate fraud thing a couple years ago. It didn't go very far. They sent the team packing in about a month because of all the pressure and they didn't really get much savings, but you would have to get to that too. So for now, I'm a little less negative on the long end than I was say a year ago and clearly the curve has been flattening and it flattened since yesterday with the Fed raising rates 25 basis points and once again completely following the market. You try to act independent, talk independent, but the market said there says 90% plus chance, I think it was 92 actually, of a 25 basis point hike. And sure enough, it's a 25 basis point hike. As I said on CNBC, I think it should have been 50. We're starting to see weakening in credit just around the fringe edges of it where you see in the IG bond market. You're seeing the AI spreads have widened out over really the course of the past year by about 50 to 60 basis points and then you have the AI bonds in high yield. I'm saying versus the rest of the markets, the rest of the IG market. Everything but AI is contained. But AI is on a trajectory that kind of looks like it's going to be relentless on those spreads going wider. And in the low investment grade market, the junk market, of course, as you would expect, it's much more severe. And the widening really just started late the second quarter this year. And that's been about, you know, almost 150 basis points of high yield versus non-AI high yield.

Yeah. I mean, I've been around a long time and I've seen a lot of market changes and I've learned that there's a moment where you get to the peak enthusiasm and I felt that that's what it felt like to me regarding the AI stuff in June of this year that we were like at peak AI and that's really when the spread started widening and it was just that sort of euphoria. You go from a new technology, a transformational technology. It starts with this is the greatest thing of all time for humankind. You know, we can all retire and live on the beach in Tahiti with a luxury lifestyle because AI is going to take care of everything for us. And then all of a sudden, it started morphing into right around June, July, it started morphing into it's going to take your job. So suddenly it wasn't all rainbows and balloons, you know, it's now, wait a minute, I might not be able to get a job. And I think that was done to create a scare tactic to try to get some initial government involvement in oversight. And that went on steroids about a week ago where this guy nobody ever heard of who was at Anthropic and he quit there and he went over to OpenAI and he was there for some people say five months, some people say more like five weeks and he immediately says I'm resigning because I care about the world so much. I'm resigning because this is going to kill all human beings within I think he said six months potentially and certainly by the end of the decade. So all of a sudden everyone's like it's going to kill us. And so we've gone from it's going to let us live a life of luxury to it's going to kill us, you know, before Social Security runs out of money, which is 2032 per the Social Security Administration. So I find it interesting that that time frame came up like the end of the decade because it just seems like in so many ways all of these things are overlapping each other. The interest expense, the rising interest rates, conflicts among politicians, even within political parties is all happening. It looks like we're on a collision course for something. And I've been talking about this since really very early days at DoubleLine, like 2010, 2011, and I was creating this theory and I met this guy Neil Howe who came in to DoubleLine just to talk and it turns out he wrote The Fourth Turning back in 1996 or so and he uses demography to talk about the four turnings and the first turning. And he framed it in a more elegant way than, in a more detailed way than I thought about it. But we were, it was like we were completely intellectually on the same page and he was saying that there's a first turning where you dump all the old institutions. And it really, everyone has to agree that things aren't working and they change some of the rules and they rip down institutions and they put other things in place and it actually works because everybody's now in agreement with a new system and then you go along and there's a second turning and third turning and there's aspects to that but then there's the fourth turning and the fourth turning is, and Neil Howe agreed with me on this too, that's where we are and it's where everybody is disgusted with the institutions that were put in place at the first turning and they get to the point where it's sort of like in a really bad marriage, you know, till you try to keep it together for the kids or you wait for the kids to graduate or whatever, but at first you're trying to save the marriage. You can't contemplate. But you get to the point where people say anything is better than this. And we're getting very close to that point. I mean, anything is better than this. So I'll just rip the band-aid off, you know, file for divorce.