In his latest webcast with DoubleLine investors and the general public, Jeff Gundlach reiterated some familiar thoughts, first and foremost the recurring observation that if yields on the 10Y break above 3%, there’s a “high chance U.S. stocks will end the year down.”
“My idea that the S&P would go down on the year would become an extraordinarily strong conviction as the 10-year starts to make an accelerated move above 3 percent,” Gundlach said.
Readers will recall that this is a claim which Gundlach has repeated at most of his other recent public appearances, notably in January when he predicted a similar impact of higher yields on stocks, although he used the far lower number of 2.63% on the 10Y.
In response to Gundlach, one can ask how realistic is it that the 10Y breaks above 3% when virtually the entire market is short duration in record amounts as of this moment: who will be the marginal short?
We said that this dramatic positioning imbalance makes it far more likely that some bad economic news – such as today’s poor retail sales – would result in an aggressive short squeeze, sending yields sharply lower, and sure enough the 10Y today is back down to 2.80%, the place it was one month ago just before the February CPI spike.
In other words, between the fundamentals on one side (where the inflation impulse appears to be easing), and technicals, it is much more likely that the 10Y yield will continue testing the lows rather than spike higher, absent some major inflationary shock of course.
Besides his comments on the 10Y and stocks, Gundlach made some other notable observations during his call, such as:
- The U.S. deficit is likely to exceed $1.1 trillion in fiscal 2019 because of a combination of tax cuts and rising entitlement expenses. “It’s going to be more like $1.2 or $1.3 trillion,” he said.
- Leading economic indicators show no signs of a recession within the next 12 months.
- Core inflation is likely to increase above the Fed’s 2 percent target.
- Be prepared for further weakening of the dollar. “The odds are good that the next big move in the dollar is lower,” he said.
But what was perhaps the highlight of Gundlach’s webcast, was his remarkable indicator for the “fair value” of nominal 10Y yields, which he calculates simply as the average of Nominal US GDP and the yield on the German 10Y bund. As shown in the chart below, there is an uncanny correlation between the two series, which would suggest that all one needs to trade the 10Y is to know the latest GDP estimate and where the German Bund is trading.
Commenting on this startling relationship, Gundlach said the following last month on CNBC:
Let’s start out with something people think I know something about, which is the bond market. And it seems that bond yields, let’s just talk about the ten-year treasury, are at a level that makes a pretty good of sense right now. I mean they’ve gone up a decent amount so far this year – ended last year at about 2.41% or so, they’re up 46 basis points or so. But one thing that people talk about is nominal GDP, and I’ve been talking about this for a long time. It’s a fairly good starting place, where you think about maybe the ten-year treasury should be.
Obviously there’s a lot of noise. I mean, they don’t track each-other anywhere close to perfectly. But it’s sort of like a dog that’s tied to a stagecoach that’s going across the country. It’s on a 100 foot rope, I mean, sometimes it will be behind the stagecoach and sometimes ahead, but if the stage coach is nominal GDP, and the not ten-year yield is sort of a dog, and yeah, there will be variation, one versus another, but they’re both going to end up going across the country together. There’s no way the dog can really stay that far away from the stagecoach.
So what’s going on now, nominal GDP in the united states is at 4.4%, which sounds really high compared to the 2.87 10-year treasury yield. But to be honest, it’s also manipulated. We should talk about Germany as a good starting place. The German yield is way down at a ridiculously low level because it’s manipulated. So the economic facts of Germany and the United States are not that different. The nominal GDP is about the same, the inflation rates aren’t that different, manufacturing is good in both areas, retail sales are good in both areas, but the German yield is being manipulated.
So when you think about a 10Y treasury yield, what we’ve been doing at Doubleline for the past few years really, is noting that it tends to reside in the average of nominal GDP and the competitor yield, which is the German yield.
So let’s look at where we are today.
The German yield is roughly 70 basis point, and nominal GDP is probably going to go up a bit, because GDP now from the Atlanta fed is 3.2% at present, and we’ll tack on a little bit of inflation, so let’s call it 5%. And so if you have 5% for nominal GDP in the U.S., and you have 70 basis points on Germany, add those together, you get 5.7. You divide by two, and lo and behold, you get 2.85%, which is within two basis points, even slightly less than that, as where you are today. So as long as bond yields do not break out to the upside, which is a clear and present danger right now, then you probably can keep some stability going in risk markets
And while we leave it to readers to agree or disagree with Gundlach’s shorthand, the chart above suggests that absent a dramatic spike in US productivity, or a plunge in Bunds (and spike in yields), any move above 4% – or even 3% – on the 10y bond is unlikely to be sustainable.
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