Recently bond guru Jeff Gundlach has warned about the possibility that the ten year Treasury could gradually go up to 6% over several years. However, economists Dave Rosenberg and Lacy Hunt have warned that disinflation is likely and thus bond yields will decline. I certainly agree with Gundlach that the risk-reward trade off is bad in terms of chasing after high duration risk in a long duration bond. Trying to buy a ten year Treasury in hopes the yield (now at 2.56%) will drop as deeply as Germany’s did when it went down to 0.1% last year is far too risky, since the possibility exists that the U.S. ten year Treasury could revert to its old pattern of yielding close to nominal GDP, thus implying a yield of roughly 3.3% or even 4%.
Gundlach surprised me when he said a few months ago regarding Lacy Hunt that while he respects Hunt, he feels the Fed has some new tools in their tool box that could provide stimulus leading to higher rates and thus he feels Hunt is wrong about his disinflationary outlook. I disagree with Gundlach when he mentions the words “Fed’s toolbox” I think that ultimately the central banks try to manipulate people into stimulating the economy, but people (or at least high ranking business managers rather than retail consumers) can see through this and will refuse to go along. Trying to manipulate and fool people by creating ultra-low negative interest rates or a massive QE induced stock bubble doesn’t make business managers decide to borrow and invest in plant and equipment and increase employment. It may fool some retail consumers into over-consumption but there is a limit to how much debt people can be allowed to take even if they are unwise.
Hunt’s theme is that society is trapped in a debt-deflation trap where the massive debt load makes it too hard for people to consume since they need to pay monthly debt payments. This would be even more true if rates rise to more traditional levels that people were used to before 2008. The debt to GDP ratio is 345%, double the average ratio of the 20th century. The increased debt didn’t go into expanding the real economy, instead it went into consumption and speculation in stocks and real estate. To a certain extent Rosenberg’s opinions seem in line with Hunt’s although Rosenberg has a more optimistic view than Hunt.
The old tradition that after the economy had had several years to recover from recession then 10 year Treasury rates should be near the nominal GDP (implying a rate of 3.3% roughly) is no longer applicable after the great 2008 crash. Since then the number of investment grade bonds has declined by half, forcing mandated buyers like banks and insurance companies to engage in a bidding war to buy these. Also the business class of residents of EM countries in the past twenty years have produced and saved a lot of wealth that needs to be invested in safe liquid assets far away from corrupt kleptocratic governments. If an EM resident buys a trophy property in Vancouver or Seattle then the local person who sold the house may park the funds in G7 sovereign debt, thus pushing up bond prices and lowering interest rates.
The fact that the PE10 for stocks recently hit 30 (double what is fair value), and based on accounting manipulation could be even higher, means that we are now at almost the same comprehensive degree of a bubble as the great 2000 bubble. But in 2000 at least the real economy was earning and saving at a better rate than today and had a much higher real GDP than the current ten year average of 1.3%, which is close to the Great Depression’s rate. The contingent risk to the economy in 2000, if a crash happened then, was that there was less debt to service back then and rates were much higher thus facilitating deep rate cuts by the Fed if a recession started. By contrast, today we have low rates and huge debt balances thus negating the ability of the Fed to rescue the economy with rate cuts in a crash. Thus on a risk-adjusted basis, and a qualitative-adjusted basis the current stock market is even more over-priced than the one in 2000, since the 2000 fundamentals in the economy were better.
People assume if a repeat of the 2008 crash occurs that Congress would authorize a new TARP bailout of the Too Big To Fail banks. But what if there was a three-way civil war in Congress between Tea party types versus establishment types versus leftist anti-business populists? At least in 2008 Congress members from both parties quickly reached agreement to cooperate and fix things; such an agreement might not happen next time. Perhaps the rescue would not come in time and there would be a repeat of a scary Lehman-style crash.
Investors should avoid junk bonds, stocks, real estate until they are available at reasonable prices. Also avoid long duration bonds in case Gundlach is right and rates go up. I wouldn’t count on interest rates ever going down as much as they did in 2016 during the next recession, but I also feel the debt-deflation cycle that Hunt and Rosenberg have discussed is quite likely to be correct, rather than the idea that the ten year Treasury will go up to 6%. The rate for the 10y10y forward implies rates will take a decade to hit a mere 1% increase over the current yield, which implies a mere 0.1% annual increase. Of course, rates could fluctuate in a corridor on annual basis briefly moving 50 or even 100 basis points higher before reverting towards the trend line of the 10y10y forward rate. Investors need independent financial advice about the risk of a stock crash and the risks of being unduly afraid of bonds.