EDITOR'S NOTE: To most investors, the bond market is like a weather forecast. Turn on CNBC or Bloomberg and you’ll receive an update on the 10-year yield after hearing the latest stock market news. That’s fine for most people. You want to know whether we’re expecting sunny skies, chill, or rain up ahead. But for specialists like Jeffrey Gundlach, aka “the Bond King,” you’ve got to look at the micro climate: the 2-year, 3-year, 5-year, and more. These all make up the smaller strands of the “yield curve,” a word we hear only when the 10-year is higher than the 30-year. From Gundlach’s perspective, there are many inversions, all pointing to higher short-term rates versus long. What might this spell? R-E-C-E-S-S-I-O-N. How soon? Read on.
Bond king Jeffrey Gundlach has a lot on his mind as it pertains to markets when Yahoo Finance sits down with the DoubleLine founder at length inside his California estate on the first trading day of 2022.
China isn't a great market to be investing in, contends Gundlach. Stock valuations as measured by the DoubleLine favorite the CAPE ratio appear too rich, says Gundlach.
But it's Gundlach's warning on the path of the U.S. economy — in part caused by looming interest rate hikes by the Federal Reserve — that perhaps warrants the most attention by investors large and small after a strong run-up in equity prices last year.
"We have the highest two-year yield of the past year. We have the highest three-year yield. We have basically a high on the five-year yield. And so what's happening is the yield curve is sending a bonafide recessionary signal. You have interest rates going up at the short end and going down at the long end," explains Gundlach ahead of his third annual 'Roundtable Prime' investing panel at DoubleLine's headquarters.
The basic mechanics of a flattening yield (which could then lead to an inverted curve) as a recession predictor goes a little something like this: markets start to worry the Fed will slowdown an overheated economy by increasing interest rates which in turn triggers an economic slowdown. That then leads to a period of renewed lower interest rates from the Fed as they attempt to stave off a recession.
To wit, a yield curve inversion has preceded every recession of the past 50 years.
Indeed this junction may be where markets are at present as the Fed seeks to turn into an inflation fighter inside of a global health pandemic by 1) winding down its quantitative easing (QE) campaign; and 2) signaling a path of higher interest rates in 2022 and beyond.
As Factset recently pointed out, the spread between the 10-year and two-year Treasury yield narrowed to 79 basis points at the end of 2021. In March of last year — or well before the Fed signaled it would move into a period of tighter policy — that spread tallied 160 basis points. Looked at another way, the yield curve is flattening ... starting the clock on a key recession indicator used by pros such as Gundlach.
Gundlach believes the bond market is suggesting an economic slowdown is in the cards this year. And as such, the yield curve is a must watch for investors right out of the gate.
Adds Gundlach, "I think the bond market is already showing enough of a recession indicator that by 2023 it's seems pretty likely. And I, like I said earlier, I don't think a lot of Fed officials, economists and investors appreciate the fact the economy keeps buckling at lower and lower interest rates. So I think the Fed only has to raise rates four times and you're going to start seeing really a plethora of recessionary signals. I think it's certainly a non-zero probability that you get a recession in the latter part of 2022. That's going to be dependent again on how aggressive the Fed is. One thing that we did notice in 2018 is the Fed stopped QE, they started quantitative tightening — letting the bonds roll off. And then they started raising interest rates and we got an instantaneous bear market."
Originally posted on Yahoo Finance.