New Bond King: Expectations for the Federal Reserve have never been so turbulent! U.S. economic data is being "manipulated," firmly believing that interest rates are secretly bottoming out

On the 22nd, DoubleLine CEO and "new bond king" Jeffrey Gundlach emphasized in an interview with Drew Watson, an expert in art services at Bank of America, that the era of low interest rates lasting for forty years has ended, which will fundamentally change investors' past investment decisions.

He predicts that the Federal Reserve will cut interest rates once in the remaining time of this year and holds an optimistic view on next year's inflation rate, expecting it to be below 3%, believing that the market's concerns about inflation are excessive.

Gundlach expressed concerns about the U.S. government's debt issues, suggesting that once the debt scale becomes too large, the government may take extreme measures, leading to significant fluctuations in long-term Treasury prices. He worries that the U.S. could experience an extreme situation similar to the sharp rise in UK government bond yields three years ago, firmly believing that interest rates have bottomed out.

Notably, Gundlach believes that market expectations for the Federal Reserve have never been so turbulent. At the beginning of the year, the market widely expected the Federal Reserve to cut rates significantly, but as economic data fluctuated, rate cut expectations were also adjusted dramatically. Additionally, changes in inflation and employment data have had a significant impact on rate cut expectations.

Here are the key points from the interview:

• Over the past few decades, interest rates have been on a downward trend. However, in the past two years, interest rates have risen sharply. Due to the fundamental shift in the interest rate environment, past experiences may no longer apply.

• Three years ago, the UK had to sell some bonds. Overnight, the yield on long-term UK government bonds rose by 150 basis points, which was a huge loss. But what would happen if this occurred in the U.S.?

• I firmly believe that interest rates have secretly bottomed out. Interest rates will rise again, and some past relationships will completely reverse. People often say that the dollar rises during a recession; I believe everything will fall in the next economic recession.

• I expect the Federal Reserve to cut rates once this year, and by mid-next year, the CPI will remain below 3%.

• I think a lot of data seems to be manipulated. There are two different employment reports: one is the establishment survey, and the other is the household survey. I am curious why there is such a large discrepancy between these two survey results.

• The federal government's interest expenditure is $300 billion per year. Today, it has reached $1.3 trillion and is still rising. The reason is that there are $17 trillion in bonds maturing between this year, next year, and 2026. Many of these bonds have an average interest rate of 0.2%. So what we will see is $17 trillion.

• Due to the issuance of a large number of low-quality bonds and the lowering of interest rates, the default rate on corporate bonds may be higher than ever.

• I have worked in this industry for over 40 years, and I am wrong 30% of the time; I often make mistakes. But I am right 70% of the time. If you can maintain that, then you have a money-making machine.

Here is the original text of the interview:

The current low interest rates and quantitative easing policies will accumulate a huge debt burden in the long run

Jeffrey Gundlach:

Most people don't know that the economic crisis of 1921 was a huge problem. That year, GDP fell by one-third. They forced the liquidation of all bad debts and poor investments, raised interest rates, and cut government spending, leading to an economic collapse. In fact, the reason for the 1921 depression was that such measures were correct. After enduring the pain, everything returned to normal by 1923. However, when the Great Depression hit in the early 1930s, they took the opposite measures, and the Great Depression continued as a result.

This reflects the state of our era. In my over 40 years of career, whenever faced with economic difficulties, the situation seems to get worse. This is not a coincidence; it is because they strive to prevent economic difficulties, pushing the problems down the road.

The last time zero interest rates and sustained negative interest rate policies were implemented was a mistake. The economy appeared to be running well on the surface, but the budget deficit reached $2 trillion. When a recession hits, the budget deficit will rise because tax revenues fall, and transfer payments and unemployment benefits increase.

In the recent recession, our budget deficit increased more than the average during the last three recessions. The last budget deficit severely distorted this fact, averaging 9% of GDP. Excluding the COVID-19 pandemic, it was about 7% of GDP. If we add 7% of GDP to the budget deficit in the next recession, the budget deficit will reach $20 trillion, or $2.5 trillion, totaling $4.5 trillion.

We discussed this issue in our investment team meeting. Interest rates have already begun to rise, both in Europe and the United States. Many believe this trend is developing.

Why? What was the catalyst for the significant rise in interest rates from last Friday to yesterday? People are concerned about this issue due to worries about debt and its financing methods.

Past experiences may no longer apply in the current economic environment

Jeffrey Gundlach:

Experience may not be a positive factor at this moment, as you and I have experience. You think you understand how relationships work and can apply past economic experiences to the present. But I want to draw your attention to this. After 2021, interest rates generally trended downward. Although they may rise at times, in the long term, they fell from 15% to 2.2%.

Therefore, people believe they understand the changes during a recession. I think this view is no longer applicable because our interest rates are no longer declining. From 2022 to 2023, interest rates rose from below 1% to over 5%. Interestingly, some relationships that were very effective before 2021 are now completely reversed.

I invented a well-known industry indicator, the copper-gold ratio. Dividing the copper price by the gold price, it has been an excellent starting point for determining long-term government bond yields for 40 years. If you arrange it, it has almost always remained consistent. Any deviation at any time is temporary, and they eventually converge again.

Since 2021, this indicator has almost lost its effectiveness. By the end of 2021, the lifetime government bond yield had risen by about three-quarters, which we can call 5% The copper-gold ratio indicates that government bond yields should be below 1. Why is this the case? I believe it’s because we are not insurers.

The rise and fall of interest rates are different. In the past, people often bought gold. During deflation, no one wants gold. During inflation, everyone wants gold. There is a certain connection; people buy gold for speculation or other reasons.

I believe people have almost permanently removed gold from their asset allocation. They are worried that our institutions are collapsing, that no one can get along, that we are embroiled in two major wars and will soon be in a third. They are concerned about our massive budget deficits and that elections are being interfered with. Agencies like the Department of Justice and the CIA seem to be investing in some way to change the situation.

I think people are worried about this and concerned about inflation policies. Because when the next economic recession comes, I don’t know what they can do besides the usual playbook. The typical plan is to lower interest rates and borrow large sums of money.

In fact, I predict that when Treasury yields exceed 5%, rates will drop to the mid-3% range. I have been criticized for this, but I am right. I believe it will happen because when weakness starts to appear, people will say they have seen this before. It becomes weak, rates drop, you make money from bonds, and then this situation occurs.

But I think the next phase is that when the meeting starts, they will say we will not be able to finance these things. Three years ago, the UK had to sell some bonds, and at that time, some policy made investors hesitant and not fond of the concept. Overnight, the yield on long-term UK government bonds rose by 150 basis points, which is a huge loss.

This means a 30% loss overnight. Then they said it was just a joke. Sorry, rates eased and started to decline. But what if this happens in the U.S. as well? It would expose many issues.

Therefore, I firmly believe that interest rates have secretly bottomed out. I think rates will rise again, and some past relationships will completely reverse. People often say that the dollar will rise during a recession; I believe that everything will fall in the next recession. In a recession, emerging markets usually lag far behind the U.S. stock market. But I think it will be the opposite because when the dollar falls, if you are a dollar-based investor, you will want non-dollar investments. Ironically, currencies like the peso may actually be more valuable.

Due to the issuance of a large number of low-quality bonds and the lowering of interest rates, the corporate bond default rate may be higher than ever

Jeffrey Gundlach:

There’s one more thing about corporate bonds; people think it’s important to understand how corporate bonds work. They may default during an economic downturn. Historically, these companies close to bankruptcy have delayed problems through refinancing. Even if investors demand a higher junk bond yield premium, the benchmark rate is still lower compared to U.S. Treasuries

Therefore, the company borrows at an interest rate of 8%. When U.S. Treasury yields drop by 300 basis points and the spread widens by 1%, they can still refinance at a rate of 7%. But now, even if interest rates drop, with a large issuance of low-quality bonds, the rate they pay is 3.5% . Such low rates are no longer possible, especially for low-quality bonds. So this time, the default rate may be higher than expected.

From experience, I remember the first year the market rose, and interest rates fell from 15% to 7%. At that time, I thought it was a bit crazy. ICE sold long-term Treasuries, and I felt lucky to sell at the absolute highest price. Four months later, the interest rate was 7%, and another four months later, it was 10.43%. I was still young then and lacked experience.

I spoke with a broker who told me that I sold stocks at a 7% discount. At that time, I was selling top tech stocks. He said I lacked experience, and now I understand he was right because experience can make thinking rigid. At that time, I looked at the charts, saw the buying in Japan, and sold the stocks, which was the best trade of my life.

Gundlach expects the Fed to cut rates again by the end of the year

Drew Watson:

What is your assumption about the number of rate cuts before the end of this year?

Jeffrey Gundlach:

I think there might be one rate cut. This year’s Fed expectations are the most unstable. At the beginning of the year, it was generally believed that the Fed would lower rates by 2.25% in 2024. But by the end of March, people began to worry about inflation returning, with unexpected growth in the first quarter and growth in the second quarter, but not as severe as in the first quarter. Growth in the third and fourth quarters is normal. Therefore, my forecast dropped from 7 to almost zero, with almost no rate cuts.

Then the situation weakened, and we received some bad employment reports. Rate expectations were no longer aimed at 2024 but rather the next 12 months. For a while, the market expected 10 rate cuts totaling 250 basis points, and the Fed felt panic. The market pushed down rates, and they didn’t like the gap between overnight rates and two-year Treasury yields. They followed the two-year Treasury yield.

We don’t need the Fed; we need Bloomberg terminals because the two-year U.S. Treasury yield leads the Fed. They deny this, but in reality, they follow Treasury yields. The gap exists, so two days before the Fed meeting, I predicted they would cut rates by 50%. On July 31, they cut rates by 50% on multiple occasions, and they indeed did. Now, we have better employment reports.

Many people are worried that inflation has not yet subsided. I don’t think so. According to my forecast, the CPI will remain below 3% at least until mid-next year. This should give the Fed more confidence.

Government employment reports and statistics are "manipulated"

Jeffrey Gundlach:

I believe these numbers are exaggerated, and a lot of data seems to be manipulated.

There is one more thing that cannot be ignored, as there are two different employment reports. One is the establishment employment report, released on the first Friday of every month. In recent years, this report has been revised downward multiple times, raising concerns. It undergoes an annual revision. Recently, they cut 818,000 jobs, so the initial numbers are not accurate.

The other is the household survey report, which is more accurate than the establishment survey at economic turning points. The household survey for the first nine months of this year shows that there has been no cumulative increase in jobs, and the cumulative number of unemployed over the past nine months is negative. Full-time jobs have been negative every month. As for part-time work, although there have been ups and downs, the employment growth so far this year is also negative.

I am curious why there is such a large discrepancy between these two surveys. But I do believe the Federal Reserve may cut interest rates. Unless the market recovers further, they may cut rates, and there are only two weeks until the next Federal Reserve meeting.

Regarding the federal funds rate, the gap between it and the term rate is the largest in the history of the U.S. financial market. The term rate has never been this low compared to the federal funds rate, creating a significant gap. This further indicates that there is some catching up to do.

Finally, the Federal Reserve cut rates by 50 basis points, but in previous meetings, they did not take any action to cut rates by 50 basis points, and the two-year Treasury yield fell by 62 basis points. They cut rates by 50 basis points. This means that no matter how far behind the curve they were on July 31, they are now even further behind. Rates have recently rebounded, but as of the last Federal Reserve meeting, they were actually 50 basis points behind the curve. So we will see what happens, but the Federal Reserve will cut rates.

The scale of U.S. government debt is enormous and growing rapidly, potentially facing huge interest payment pressures in the future

Jeffrey Gundlach:

I really do not like long-term government bonds. I have taken some measures to protect clients from certain market reactions that I am concerned about. We have seen quite a few such reactions over the past 20 to 25 years.

The earliest was during the early stages of the economic crisis, when the auto industry was over-leveraged, leading to Ford's bankruptcy and General Motors being on the brink of bankruptcy. General Motors was heavily indebted, with some of that debt prioritized over others. The government's approach was to place General Motors' pension system ahead of the secured bondholders, thereby rescuing the pension system. According to the law, these bonds should have been in the highest priority, but they were placed below the pension system, causing bond prices to plummet. Although this was illegal, it may have been for voter reasons.

Subsequently, we encountered mortgage issues involving a large number of pay-as-you-go mortgages and zero down payment loans. These loans were packaged into securities and publicly traded. The prospectus clearly stated that the terms, interest rates, and durations of the mortgages could not be modified. Many investors believed these guarantees, but I was not one of them. When home prices fell by 35% and loan-to-value ratios exceeded 100, they decided to modify the terms, despite threats of lawsuits from several investment firms, but could not stand against the government In 2020, in response to the lockdown, the corporate bond market collapsed. According to the Federal Reserve Act of 1913, it is illegal for the Federal Reserve to purchase corporate bonds. However, during the global financial crisis, there was intense debate within the Federal Reserve on this matter, ultimately deciding against it. But this time they purchased corporate bonds, leading to a rapid rebound in market prices. The Federal Reserve committed to repurchasing bonds at face value, causing prices to surge significantly within just a few weeks.

What happens when politicians do not talk about this issue? Four years ago, we faced the problem of interest expenses. The federal government's interest expenses were $300 billion per year. Today, it has reached $1.3 trillion and is still rising. The reason is that between this year, next year, and 2026, there are $17 trillion in bonds maturing. Many of these bonds have an average interest rate equivalent to that of five-year bonds issued in 2019, which was 0.2%. This rate is lower than it was not long ago but has risen by nearly 5%. So what you see is $17 trillion.

Not all bonds have such low rates, but I believe the average rate is around 3%. Even if we issue bonds at around 4% now, the rates are still rising. So people are talking about interest rate issues. What happens when the next economic recession hits and the deficit rises to $5 trillion? Some say, I won't buy 3% bonds because you issued $5 trillion and implemented inflation policies through deficit spending and lowering interest rates. I think there might be live auctions.

So I did one thing; I told myself that my backup plan is that investing has two undisputed pillars. The first is not to take risks unless you are compensated for it. The second is that if you can eliminate risk at little or no cost, then eliminate the risk.

All of this happened to me. I was in Toronto at the time, and I was going there tomorrow. I told myself, why don't we keep the term structure of government bonds exactly the same but switch to, say, buying 20-year bonds, selling 20-year bonds, and buying the bonds with the lowest interest rates, which we refer to as the bonds with the lowest coupon rates.

We took about two weeks because we were doing it stealthily. We didn't want this to leak out. Within weeks, we got our long-term bonds.

I am not predicting that this situation will occur, but if you can eliminate risk at no cost, then do it. In this case, I eliminated risk at a negative cost because this swap from one bond to another actually created a slightly higher yield due to what we call "stop runs." Liquidity decreased.

If they announce that due to our inability to bear the $40 trillion bond's 4% interest expenses, we will make some minor adjustments. We would say, if the interest rate paid by your bond contract is higher than 1%, then it is now 1%. If the interest rate you pay is lower than 1%, then it remains unchanged Due to interest expenses potentially being 4%, if you reduce it to 1%, you will cut interest expenses by 75%. This is a way to push the problem to the next government and the next Congress. Everyone will cry, except for me; I will sit there and say, wow, we are heroes. Because if that happens, some people will lose 30%, 40%, or 50% overnight.

Drew Watson:

So where are you positioned on the yield curve?

Jeffrey Gundlach:

Actually, I am shorting long-term bonds in and out by buying 2, 3, and 5-year bonds to gain interest rate exposure. So I actually have a quasi-trade. Right now, I am shorting 20% and 30% of U.S. Treasuries and going long on 2% and 3% U.S. Treasuries on a leveraged basis. This hasn't worked in the past few weeks, but it has worked well over the past few months.

I believe the bond market is different from the past. In the past, the trading volume in the bond market was very large. But then regulators introduced a series of regulations like the Dodd-Frank Act and the Elizabeth Warren Act, and electronic trading became more common, leading to a significant decrease in trading volume.

Sometimes liquidity is good. September was the largest bond issuance in U.S. history, especially the largest corporate institutional bond issuance, which was oversubscribed at that time. People wanted more, so liquidity was very large, but sometimes there are issues, and you can't even get a little. So you need to take advantage of those liquidity moments to shift to more liquid things while pairing them with things that have severe economic risks, like 3C corporate bonds, which are very expensive.

This is currently the most expensive non-energy moment; we take out energy because energy is really valuable. If you take energy out of corporate bonds, the extra yield you get from buying corporate bonds is the lowest it has ever been. I think there is a reason for this. I believe you may not be able to trust the government's debt management, which supports the idea that corporations should generate the least extra yield. Because when I started my career, some corporate bonds had yields lower than Treasuries because people did not trust the government.

The Meaning of Investment: Understanding What You Think You Understand and How to Do It

The meaning of investment is to figure out what you think you understand and how to do it. None of this can be taught. You either have an interest in this way of thinking and the ability to do it, or you don't like it or don't have the ability to do it. So I have done a lot of these things. Many people ask me why I have nothing but that bond. I say you don't understand investing. When you manage other people's money, you cannot take fatal risks.

The small thing I try to teach young people is to acknowledge, "I know I will sometimes make mistakes." Ensure that the mistakes are not fatal. If you only buy one-third of Treasuries, if you're right, you might get attention, but if you're wrong, you go bankrupt. Never take a portfolio with fatal risks

You need to start thinking about your investment portfolio, for example, how should I handle this issue? Suppose I'm wrong, it could be a disaster, but can we get through it? There is no fatal risk. This is what "double I" means. In the real world, there is something called "double line." It is referred to as a road you are not allowed to cross. If you cross the middle, you will be fined. But they don't really want the revenue; they are trying to protect you from being hit head-on when you turn. So the whole concept of "double line" is that there is no fatal risk. You cannot cross the double line. This also means you have to consider, if I do this specific activity in part of my portfolio, what can I do if I'm wrong, and will this work? This way, we can collectively mitigate overall volatility.

So I have been in this industry for 40 years. I am wrong 30% of the time. It has been 10 years now, actually more than 12 years that I have been wrong. So I often make mistakes. My competitors always like to point out when I'm wrong. I say, yes, of course. But I am right 70% of the time. If you can maintain that state, then it is a money-making machine. The job is to work hard to maintain that state