DoubleLine Capital CEO Jeffrey Gundlach joined Yahoo Finance’s The Final Round on Wednesday, February 13 to talk about Fed policy, the state of the economy , risks facing the markets , and developments in American politics ahead of the 2020 elections .
Below is the transcript of his live appearance on Yahoo Finance.
(NOTE: Following Gundlach’s live appearance, our conversation with the bond king continued for another 35 minutes. Click here for the video and transcript .)
JULIA LA ROCHE: Jeffrey, thank you so much for having us here.
JEFFREY GUNDLACH: Sure, thanks for coming in.
Outlook for Fed policy
JULIA LA ROCHE: OK, so I want to start with the Fed, because Fed chair Powell has continued to reiterate that the Fed is desiring to remain patient. And many are interpreting that as the Fed is reluctant to hike rates, and that they might even ease. Do you think the market's getting this right? That they may, in fact, actually ease next?
JEFFREY GUNDLACH: I'm not so sure that the market has an opinion where the Fed's going to is ease next, or just-- I think it might go stay where they are. When the Fed says patient, what they mean is I think they're not going to do anything unless they say something first. So patient just means that we communicate something different, we're not doing anything with interest rates. And that's obviously a massive change from the December press conference that Jay Powell gave, after the Fed meeting when he said that quantitative tightening was on autopilot.
In fact, I just read the other day that the Fed admits that they're having discussions about doing quantitative easing again, which is a radical change from saying that quantitative tightening is on autopilot. They're saying that they might-- they're discussing-- they haven't drawn a conclusion yet. They're discussing the idea that quantitative easing will be a regular policy tool, not one that is used only during emergencies or when you've already gone to the zero interest rate lower bound. Which suggests that-- so the market does think the Fed's going to do a thing with interest rates. They also aren't sure whether going to quantitative easing or quantitative tightening.
So the Fed is kind of I'd say, lost its way in terms of having an articulated direction, which isn't necessarily bad. That's where it used to be but under Alan Greenspan. He was famous for saying, if you think you understood what I said, I wasn't being vague enough.
Major risks facing the market
JULIA LA ROCHE: Right. Well, a lot certainly has changed, as you mentioned. And you're someone who's known as someone who always looks at risk. You look at various risks. So I'm curious, what is on your radar right now? What are you focused on?
JEFFREY GUNDLACH: Well, I think the biggest risk-- and it may not materialize for a little while longer-- is that when the next recession comes, there's going to be a lot of turmoil because the corporate bond market is extraordinarily leveraged. The ratings of the corporate bond market are very low. There's a study by Morgan Stanley research that said that if you use leverage ratios alone-- and there are other variables that the rating agencies used, but the most important, of course, is leverage ratios of a corporation. And if you use leverage ratios alone, that 45% of the investment grade bond market would be rated junk right now. Right now.
So if there's a recession, obviously, these ratings will have to be lowered. For now, the rating agencies are listening with sympathetic ears to reassuring statements by some large corporations that they're aware that their leverage ratios are kind of high, but they plan on addressing that sometime in the next few years. If there's a recession, it's obvious that the leverage ratios will not be addressed, and the ratings will have to go. So that's a really big risk.
Also, during the next recession, we're going to have an extraordinary national debt problem, because the national debt is growing at a very rapid rate already. And we're supposedly, if I listen to Larry Kudlow and the president, they keep telling me that it's the best economy ever. I know that they know that they're being hyperbolic. But it is a growing economy. Real GDP is 3% year over year of the most recent reading. And yet, the national debt in fiscal 2018, which ended September 20, was increased by $1.27 trillion.
Now the government tells you that the deficit was a little under $800 billion, but they're not really telling you the truth. Because the national debt is the debt. And what's missing from the 800 to $1.27 trillion are things like war expenditures that are deemed to be off budget. National relief for natural disasters. And loans from the social security system, which obviously, are not real. I mean, that's just one such branch of the government funding another branch of government. You can't finance yourself.
So if we're growing at 6% of GDP, which is what we're really growing at in terms of national debt during fiscal '18, during a 3% real economy, what's the debt going to grow by during a recession. Well, typically the debt to GDP ratio goes up by about four percentage points during a recession. So it suggests that the national debt would grow at around a 10% annual rate if we go into a normal average type of recession. That's obviously a really big problem.
There's also tons of bonds maturing. The corporate bond market has $700 billion of bonds maturing this year. That's a significant number. In future years, we're going to have lots of high yield bonds, bank loans. And of course, the treasury's quantitative tightening program is issuance of bonds that were never floated during the deficits of the past.
So it's quite possible that the next recession-- and I've been talking about this for a while now-- that what we're used to happening, which is, it's a bad economy, it's the treasury rates fall-- maybe that will only happen at the short end. Maybe long term interest rates won't fall during the next recession because of the tremendous amount of bonds that will be put into the market.
So I think those are the things in the longer term that are the big risks. And the short term risks sometimes don't really matter. It's really what's the big problem. I mean, I try to go back to kind of the cornerstone principle when I think about the starting point for asset allocation. Like back in 2006, the only thing that mattered was you understood there was a credit crisis coming. I think this time the only thing that really matters is this problem with the corporate bond market and the national debt issue when the next recession comes. And that's really going to trump any kind of short term movements.
So the real key, I think, is to think about that looming problem on the horizon with the next recession.
JULIA LA ROCHE: I think we're going to get a question in from New York real quick.
JEN ROGERS: Hey, Julia, thanks so much. It's Jen Rogers. Jeffrey, I lost count of how many times you said the next recession, which brings me to the question of, when do you see the next recession coming? Are there any signals that you're looking at that are scaring you?
JEFFREY GUNDLACH: A little bit more than it was a year ago, what was really interesting about entering 2018 was that there was this narrative of a synchronized global expansion. That was true. Everything was really flashing green lights for the economy entering 2018. And yet, what's interesting about that when things were flashing green light, most people don't understand that it means it's kind of the end of the game for risk assets. The global stock market peak January 26 of 2018. The US hung on until October, but the global stock market peaked January 26 of 2018.
Entering 2019, there was a narrative developing that is also true of some synchronized global slowdown. Yet the indicators that we look at for a recession are not even flashing fully yellow yet. It's more of a yellowish green right now. We look at things like the leading economic indicators, kind of the granddaddy of them all that's put out by the conference bureau. That year over year always has gone negative before the front end of a recession. And while it's weakening from a very high level, it's still pretty high at around 5% year over year. And the stock market being up in the last couple of months means that probably, the leading indicators will hang in there.
What is signaling recession a little bit more are sentiment surveys. The PMI surveys typically collapse in a very observable way before the front end of recession comes. They are collapsing sort of right now, but they're still at high levels. Consumer sentiment same sort of thing. Unemployment rate is starting to flash yellow a little bit. Unemployment claims, the report every Thursday, have bottomed out and appear to be in a rising trend. And the unemployment rate now is above its 12 month moving average unemployment rate. And that's a necessary condition to be talking about potential recession.
What would really be a major indicator would be if the unemployment rate would go above its 36 month moving average, which right now, rests at 4.3%. Unemployment rate right now is at 4.0%, so it's not terribly far away from that moving average. But we have to watch that very carefully, because if that cracks above, then I think we would say that we're starting to flash yellow for a recession.
Another indicator that's very important are junk bond spreads. Junk bond spreads before the last two recessions really blew out by several hundred basis points before the front end of the recession came. We had a scare on that during December, just like the stock market went down 20% plus in most of the indices. But the rebound has been all the way back to the breakdown point. So high yield spreads are starting to look a little less scary.
So to look for a recession in the very near term, I think you have to look very hard, and look with a jaundiced eye. I think right now it's too early to say that we have the necessary conditions in place for a recession on the foreseeable horizon, which is good news. But the bad part of that news is the foreseeable horizon is typically no longer than six months-- usually, more like four to six months. So for now, that seems to be OK.
Also, lastly, the yield curve that got a lot of play-- you know, the 2s, 10s yield curve is about 17 basis points. That's pretty low. That's a little bit of a concern. And there is no yield curve at all from basically, LIBOR out to the five year treasury. You're all at about 2.5%. That suggests that the market is looking for no movement from the Fed frankly, for years to come. I'm sure that won't be the case. But that's the message from the mathematics of the yield curve right now.
Political climate and buyback regulation
MYLES UDLAND: Jeffrey, Myles Udland here in New York. I want to ask you about share buybacks, which has gotten a lot more play among a number of politicians recently. You were just talking a moment ago about leverage ratios in the corporate bond market. Does anything about the conversation about buybacks concern you, just in terms of politicians I suppose, being a little bit more hostile towards corporate America?
JEFFREY GUNDLACH: Well, it's pretty clear that the rhetoric from presidential hopefuls for 2020, on the left side anyway, has gotten very, very hostile. Obviously, to have legislators telling privately companies or public companies in this case, what they should be doing with their profits is a little bit disconcerting, to say the least.
So on the margin, you have to take legislation prohibiting or limiting buybacks as a negative for the stock market. It's pretty clear that the leverage ratios in the corporate bond market have driven-- have been hand in glove with buybacks. And the corporate economy is very leveraged. So I think what the politicians want is-- their thought processes stop enriching the wealthy who are already disproportionately-- wealth inequality is pretty bad-- stop enriching them with boosting up stock prices. The idea might be to have more money for workers wages, which is obviously part of the wealth inequality problem.
So I can kind of see how all this-- all different parts of the same picture viewed from different angles. But the politicians clearly are talking about socialism, democratic socialism. Just puts the word democratic in front of the word socialism, because it sounds good, that at least you're voting for it, instead of being forced into it. But you know, socialism is not a very good way of building wealth, as shown by millennial-- you know, hundreds of years of history, most recently down in Venezuela. That's all you have to look at. I remember there was a thing called the Soviet Union, which had five year plans, and I don't think they're around anymore. So not a really good idea.
But it's all part of the cycle that we're in, where the technology has gotten way ahead of the society's ability to adapt to it. This is classic ebb and flow of history. And as I said during the 2016 election, when I predicted way back January 2016 that Trump would win, I said, if you think this election is weird in 2016, you ain't seen nothing yet. And here we are, we're already pretty-- feels like we're already pretty far into the 2020 race, even though it's only February of 2019. And we even have the possibility for a third party candidate. And we might even, in my view, have four candidates that get electoral votes, or at least have decent polling in the election.
I think the biggest thing that might be a worrisome development relative to politics is it's just possible-- I'm not saying this is a base case, but I'm open-- I say it's plausible that the next election is decided by Congress. Because it's possible that no one gets the majority of the electoral college delegates. And if you think that Congress is dysfunctional now, and that there's anger and vitriol, just imagine what it would be like if Congress actually picks the next president and vice president of States.
That would be something the House would pick, the president and the Senate would pick the vice president. And you could just imagine if they were picked candidates from different parties, how that would go. So we're in very difficult political waters. We have been for a while. And I don't think it's going to get any better anytime soon.
Fiscal policy and the national debt
ANDY SERWER: Hey, Jeffrey, one more from New York. It's Andy Serwer. I actually want to ask you a little bit more about Washington, if you can stomach that. What is it about Washington that actually concerns you the most, I mean, in terms of-- I mean, you talk a lot about monetary policy. Is it fiscal policy? Is it infrastructure? Number one. And number two, is there anything that anyone in Washington is doing right?
JEFFREY GUNDLACH: Well, there's always some people somewhere in the government that are doing things right. But the biggest problem is that we have a growing economy, and yet, we have decided that debt doesn't matter one bit. You know, Dick Cheney was famous for saying Ronald Reagan proved that deficits don't matter. But the national debt just went over $22 trillion dollars yesterday, and it's growing at over a trillion dollars a year during a growing economy.
And our taxation versus GDP has gone from around 20% a few years ago to about 15%. So 15%-- it's not the lowest level ever, it's just the lowest level since 1949. So we have decided to run a large government with huge deficits and it seems that nobody's interested in collecting the taxes for that. I wish government were smaller. I think it's not a problem of taxation. But once you're going to establish the size of spending the way it is, you've got to pay for it. And we've gone very, very far away from that.
And that's an issue that is going to get a lot of attention because the deficit is going to continue to grow, and the Fed has been ripping interest rates. They've stopped for now. But the debt expense, the interest expense is at 1.25% of GDP right now, but the CBO says that by the mid 2020s, it's going to be at 3%, which is a 1.74% increase relative to GDP. Which in a very simplistic framework means that GDP, all things being equal, will be 1.75% slower in the mid 2020s.
And we're already struggling under insufficient economic growth. Think about the nominal GDP that the most recent one that was announced, which is through September 30, which is fiscal 2018. You know, the growth of nominal GDP was 5.3%. But the growth of the national debt was 6% of GDP. And part of economic growth is the delta in government spending so with the national debt growing by 6% GDP, and nominal GDP go up by 5.3%, it means if you had a balanced budget, the economy would have been negative during fiscal 2018.
So everything that we're doing is based upon debt expansion. And it is not insignificant. And it is not true when you hear politicians-- I listened to Elizabeth Warren's speech when she said she was running for president. She looked right into the camera and lied to the American people, that it is not true that we can't afford Medicaid for all, and free college tuition, and all the other goodies that the socialists want to bring out. She says, it's just simply not true that we can't afford them.
And I hear other politicians say, oh, it's just World War Ii all over again. Well, taxes were raised massively during World War II. And not just taxes on the wealthy the taxes on the middle class and the lower middle class were raised massively to pay for World War II. Going into the 1930s, the tax rate for the average American household was 1.5%. By the 1944, it was 25%. So this is a massive tax increase. Taxation during World War II went from 5% of GDP to 20% of GDP.
So no, we cannot afford these things without having a complete collapse of our standard of living as we know it. So broadly speaking, what's going on in Washington is very much on the wrong track. But we all need to have an awareness of the problem before we get the intestinal fortitude to make changes. And unfortunately, our political system is one that does things in response to crisis. And so we're going to have to have a crisis of the fiscal situation. And it's probably going to happen before 2025 before we finally make the changes that need to happen to the level of spending versus the level of taxation.
Outlook for interest rates
JULIA LA ROCHE: OK, Jeffrey, before we've sent us back to New York, let's get a prediction from you. Where do you think the 10 year will end this year?
JEFFREY GUNDLACH: I've long ago learned not to fall into that trap. There was one year when I said the 10 year would end at x, and it actually ended five days before year end exactly at x. And then there was a big move the last five days. And so, [? ended up being ?] off by like, 35 basis points or something. And I remember people saying I was wrong because I was off by 35 basis points when in fact, I was only off by five days.
I think-- let me put this way. I'm not going to put a number on it. But I think long term interest rates are headed higher. I think what we had in response to the weakness in risk assets in the stock market-- I think we had the Pavlovian reaction of oh, I've seen this movie. When stocks get weak, you buy long term treasuries. And we had a decent rally, about 50 basis points, in long term treasuries. But now, we're basically drifting higher again.
And I think that what I said earlier is going to start finding its way into people's psyche, which is when the next weakness comes, there's going to be so much debt, so many bonds, that it's possible that short term rates drop if they're manipulated by the Fed, and flight to safety leads people to find a 250 2 year to be OK. But I'm not really sure if people will find the 280 10 year to be OK when you're staring down the barrel of trillions of dollars of bond issue.
And so I think interest rates are headed higher. I really didn't think they would get back below 3% on the 30 year treasury. They did for a minute. And now they're back above 3%. But I think when and if long term interest rates move up towards about 350 on the 30 year, I think you could see them accelerating higher. And so a nice round number to think about would be around 4% on the long term sort of treasury as we move towards the latter part of this year.
JULIA LA ROCHE: Jeffrey, Gundlach CEO DoubleLine Capital. Thank you so much, and back to you all in New York.
Julia La Roche is a finance reporter at Yahoo Finance. Follow her on Twitter .