Maybe You'll Listen If Jeff Gundlach Says It

Summary

Jeff Gundlach delivered his latest webcast on Tuesday, and it's worth taking a closer look at his musings on fiscal policy, the dollar, stocks and Treasurys.

On fiscal policy, suffice to say Gundlach is not amused with deficit-funded, late-cycle stimulus.

On the dollar, Jeff thinks the next move might be lower.

On stocks, he's in the camp that thinks the divergence between the U.S. and EM is probably unsustainable.

And on Treasurys, he's (still) warning about a "monumental" short squeeze.

Let me just kick this off by delivering my boilerplate caveat when it comes to posts critiquing the prognostications of "name brand" money managers. This time it applies to Jeff Gundlach, but I've said something similar in previous posts about, for instance, Ray Dalio and Bill Gross.

Gundlach is Gundlach. He occupies rarefied air among market mavens, and barring some kind of truly dramatic turn of circumstance, I'll never breath whatever air Jeff is breathing up there, nor will I ever speak with the same authority as Jeff speaks. I'll also never be as rich as Jeff, which, actually, is fine with me because I live around some folks who, while not quite on Gundlach's level when it comes to wealth, are somewhere in the same ballpark, and I can say definitively that I have no desire to shoulder the burden that goes along with controlling that amount of money, whether my own or other people's.

So, there's the requisite disclaimer and flattery that Jeff would almost surely want (and probably demand) from someone writing a blog post about him.

With that out of the way, let me say this about Gundlach's frequent webcasts: these days, he rarely says anything that everyone doesn't already know.

That's not to say he's wrong (in fact, he's very often right), it's just to say that I stopped pre-registering for his webcasts because, generally speaking, they are comprised of charts I've either already seen or, in many cases, used myself, and they are also chock-full of talking points that either echo things other people have said recently or else echo Jeff's own public tweets - so it's not entirely clear to me why I should spend the time, especially considering I can always review the slide deck later.

Well, Gundlach held another one of his webcasts on Tuesday, and it was no exception. Despite a lack of "new" information, I did want to highlight some of the points he made for my readers here, because one thing about Jeff is that when he speaks, people listen. To the extent he's right about something as important as U.S. fiscal policy, he's doing the world a service by talking about it. To the extent he's wrong about something like, say, speculative positioning in 10-year Treasurys, well then explaining why he may be wrong is worth the effort, because having his name attached to the analysis tends to focus people's attention.

Ok, so Gundlach has been arguing for months that the combination of deficit-funded stimulus and hawkish monetary policy is a disaster waiting to happen. And no, I'm not being hyperbolic there. In fact, my "disaster" characterization is far more measured than Jeff's own take. Here's what he said in a June webcast:

It’s pretty much unprecedented that we’re seeing this level debt expansion so late in an economic cycle. Increasing the size of the deficit while we’re raising interest rates almost seems like a suicide mission.

In case that wasn't clear enough, he reiterated the point a month later in an interview with Barron's as follows:

The strangest thing is that Congress passed a $280 billion tax cut and spending increases so late in the cycle, and with interest rates rising. It’s like a death wish. The U.S. is taking on hundreds of billions of dollars of debt while raising rates, which means our debt-service payments are going to be under serious pressure to the upside.

Any questions? I'll answer that: No, of course you have no questions. Because that's self-evident, and that's what I mean about Jeff's tendency to state the obvious. Literally every analyst and economist on Wall Street has said the same thing at one time or another this year, and below you can find probably the best color and chart on the subject from a Goldman note out in February (more here):

The US also appears to be headed into uncharted territory - at least for US fiscal policy - regarding the relationship between interest expense and the debt level. As shown in Exhibit 11, interest expense considerably exceeded the current level during the late 1980s and early 1990s, though the debt level was moderate. By contrast, the debt level was slightly higher during and just after World War II than it is today, while the level of interest expense was similar. However, we project that, if Congress continues to extend existing policies, including the recently enacted tax and spending legislation, federal debt will slightly exceed 100% of GDP and interest expense will rise to around 3.5% of GDP, putting the US in a worse fiscal position than the experience of the 1940s or 1990s.

But as widely discussed as this has been among economists, analysts and market participants, and as self-evident as it is to anyone who has ever taken a basic economics course, you can be absolutely certain that the majority of Americans aren't fully apprised of why this is an issue. That's why it helps for someone like Gundlach (who grabs headlines simply by opening his mouth) to pound the table on the issue.

And pound the table he did on Tuesday. In fact, he called his webcast "Miracle Grow", an allusion to debt-financed growth. Here's the opening slide:

(DoubleLine)

He went on to (again) criticize U.S. fiscal policy and question the relative wisdom of further juicing a late-cycle economy with stimulus. Recent economic gains catalyzed by the deficit-funded tax cuts are likely to prove ephemeral, Gundlach argued. Here's another chart he used that will probably serve as some fodder for good conversation in the comments thread of this post:

(DoubleLine)

Jeff is unequivocally right about this, and maybe now that he's spending so much time talking about it, people will listen.

There are obviously long-term consequences for setting the country on this kind of trajectory, and I think it's important for folks to understand why so many smart people have spoken out against current U.S. fiscal policy. It's not that anyone is trying to suggest that America wasn't already on a potentially dangerous path. In other words, nobody is placing the blame solely (or even mostly) on the current administration. Rather, the problem with this round of fiscal stimulus is that it's unnecessary. The U.S. economy was already doing well. It didn't need this extra boost, and even if you want to make the argument that there's never a "bad" time to overhaul an antiquated tax code, funding stimulative tax cuts with debt at the tail end of one of the longest expansions in U.S. history and at a time when the Fed is raising rates is, to quote Gundlach, a "suicide mission". But more importantly, it will be seen in retrospect as a self-inflicted wound.

If you want to read more about the potential long-term consequences of U.S. fiscal policy, you might want to read some excerpts from a Wednesday Bloomberg interview with someone who has even more clout than Gundlach: Ray Dalio.

It's critical that investors understand how the dynamic Gundlach is warning about has the potential to become a self-fulfilling prophecy. The Fed was already hiking rates and running down the balance sheet. That latter effort means that private investors will need to shoulder a greater share of the burden when it comes to absorbing the increased supply of Treasurys necessitated by the tax cuts and increased spending. Private investors are price-sensitive. While Steve Mnuchin has had little trouble selling the debt he needs to fund the administration's stimulus push, the piper will have to be paid eventually - and by that I mean at some point, unless the U.S. swerves back on course when it comes to sustainable fiscal policy, the market for new Treasury issuance will clear at lower prices, especially if the factors that have been weighing on the term premium for years finally dissipate.

In the meantime, the near-term effects of the stimulus put the U.S. economy at risk of overheating, which in turn forces the Fed to raise rates faster. After the August jobs data (released last week) tipped the swiftest pace of annual wage growth since 2009, the market began to take more seriously the idea that two more hikes are in the cards in 2018. In other words, folks are starting to believe the dot plot. As Bloomberg noted yesterday, “the implied yield on January fed funds futures on Tuesday climbed to an unprecedented 2.36 percent, indicating around 44 basis points of additional tightening by the end of December.”

(Bloomberg)

Meanwhile, the threat that tariffs will eventually push up consumer prices in the U.S. only adds to the case for preemptive rate hikes. Goldman's Jan Hatizius released a note this week that carried the title: "More growth, more tariffs, more hikes". Whether or not the Fed will reach the end of the road in terms of their capacity to raise rates sometime in 2019 is the subject of vociferous debate and I won't broach that subject here. For our purposes, the point is simply that piling stimulus atop a late-cycle dynamic forces the Fed into hawkishness.

That's dangerous because it has the potential to create a false sense of confidence among, for instance, small-business owners, who may not appreciate the finer points of what's going on. On Tuesday, the NFIB said small-business confidence (as measured by their optimism index) hit the highest level in its 45-year history in August.

(Bloomberg)

I'm going to go out on a limb and say that a lot of the people polled aren't considering the possibility that the Fed is effectively being forced to invert the curve.

Ok, so steering back to Gundlach's Tuesday webcast, Jeff contended that the dollar (UUP) has likely peaked - or at least in the near term. For reference, here's the Bloomberg dollar index:

(Bloomberg)

Jeff's contention that we've seen the highs for the greenback is at odds with the dynamic at play between fiscal stimulus, tariffs and the Fed. If the Fed is pigeonholed into hiking, the dollar will be supported, and trade frictions have played USD-positive since April, not only because the threat of tariffs has the potential to make the Fed more concerned about inflation but also because the more tension there is on the trade front, the more investors will favor USD assets over those issued by countries that might be affected by the trade war and whose economies aren't being buoyed by stimulus.

So what is Gundlach basing his dollar call on? Well, on the President and on stretched positioning. Here's what he said on the webcast:

I don’t think we’ll have new highs in the dollar without first seeing new moves to the downside. We’ll probably end with the dollar lower at year-end than it is right now. It seems that the U.S. president wants a weaker dollar. Speculative positioning is way long the dollar and now they’re wrong.

Although spec positioning came off for the second week in a row through last Tuesday (the net long was trimmed by $2.6 billion), folks are still the most bullish since January 2017, when “long USD” was one of the consensus trades. Here's the Bloomberg dollar index plotted with the net speculative position:

(Bloomberg)

Again, Gundlach could be right, but there's no guarantee that stretched positioning in the greenback is a contrarian indicator. Monetary policy divergence between the Fed and the rest of the world is USD-positive, and again, trade frictions have been a boon to the greenback for months on end.

You can make your own decision about that, but Gundlach goes on to reiterate (or at least allude to) a point I've made here on too many occasions to count of late. Namely that in order for U.S. stocks (SPY) to move higher from here, emerging market equities (EEM) and FX need a break, and the best news EM assets could get right now is a weaker dollar. The following disconnect, Gundlach says, simply isn't sustainable:

(DoubleLine)

If that argument sounds familiar, it's because literally everyone has been making it for the better part of two months, including, notably, JPMorgan's Marko Kolanovic, who flagged the "unprecedented" divergence between U.S. stocks and the rest of the world in an August note on the way to suggesting that the disparity will have to resolve itself and the only benign way for that to happen is for the dollar to take a break, perhaps in response to a Fed pause.

Gundlach went on to talk a bit about his August 17 tweet regarding the purportedly "massive" short in long-end Treasurys (TLT). Here is that tweet:

And here is the short position in the 10Y:

(Bloomberg)

Lots of market participants like to point to stretched speculative positioning as a contrarian indicator. In fact, that's such a popular way to describe stretched spec positioning that it borders on the cliché. Given that, there was nothing particularly novel about Jeff's tweet, nor was there anything particular insightful about his comments on Tuesday's webcast. Here's what he said:

What could get you there is a monumental short squeeze, because the speculative short positioning in the 10-year is off the charts. If something’s a catalyst to get a rally, you can just imagine the stampede to cover those shorts.

Gundlach conceded that there's no rule that says yields have to drop just because a lot of people are short, but he also said that if the short squeeze he's been talking about for the better part of a month materializes, it could push 10Y yields all the way down to 2.25% and might ultimately invert the curve. If this weren't Jeff and if he didn't include the caveats he included, that would be a rather alarming call, especially if it's meant to apply to the near-term outlook.

But here's the thing: You might not be seeing what you think you're seeing in that chart of the Treasury short. Over the past couple of weeks, Deutsche Bank has variously suggested that this is actually indicative of a large basis trade. Here's the bank's Steven Zeng:

The strongest evidence comes from our beta analysis of CTA returns. After controlling for curve changes, the partial beta of CTA returns to duration changes does not capture a large outright short bias. In fact, the beta has rose into positive territory since August, which suggests that CTA funds are either modestly long or at least neutral on duration. This diverges from the positioning data for leveraged funds which show near-record short positions. Our analytics show that the net basis for the front WN contracts has steadily cheapened since late spring, which is consistent with the timing of divergence in the CTA beta and positions data series. The same basis cheapening is also observed for FV and TY contracts.

Those interested can find more detail on that here, but suffice to say there might not be a large-duration short at all, in which case, Jeff's thesis comes across as looking rather simplistic.

That's one counter-argument to Gundlach's "monumental" Treasury short squeeze pseudo call. If you're looking for a fundamentals-based reason why he could be wrong, I recommend "Gundlach Proves a Short Squeeze Excites Everyone" by Bloomberg's Brian Chappatta.

Coming full circle and tying all of this together, Gundlach is doing the world a service by throwing his weight behind the criticism of late-cycle, deficit-funded fiscal stimulus. It's an economically dubious policy lean (and that's not subjective - it is literally dubious from a textbook perspective), and is likely to create a false sense of confidence in the near term ahead of an inevitable day of fiscal reckoning. When it comes to the potentially actionable bits of his webcast, I want to note that I've only covered three things here: the dollar, the disconnect between U.S. equities and emerging markets, and Treasurys. If you want to review the entire webcast, eventually DoubleLine will upload it here and the full slides are available here.

On the dollar, it seems to me that Gundlach's contention that we've seen the near-term top should be weighed against the prospect of two additional Fed hikes into year end and the possibility that further escalations in the trade war will likely play USD-positive.

On the disparity between U.S. equities and the rest of the world, that gap has to close one way or another, and if Jeff is right and the dollar takes a breather, you could see some relief for EM.

On the Treasury short, I'm going to go out on a limb here and say that the idea of 10Y yields diving to 2.25% is far-fetched. Obviously, I could be wrong, and again, Gundlach didn't necessarily "predict" that per se. But he did suggest that's where things could end up in the event the squeeze plays out. If you're inclined to go along with the "speculative positioning is a contrarian indicator" line, do yourself a favor and consider the linked posts above (with regard to the basis trade theory and the Bloomberg piece by Chappatta) before you take a position.

Hopefully, that was a (very) useful and reasonably concise summary of Jeff's latest presentation. It's hard not to hear Gundlach when he talks, but even if you're inclined to tune him out on Twitter and even if you're not inclined to try and trade on any of his latest musings, do at least listen to what he's saying about U.S. fiscal policy. And do note that while his voice may be the loudest, the number of people saying the same thing approximates a veritable choir at this point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.