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Transcript Understanding an Inverted Yield Curve

With: Jeffrey Gundlach, CEO and CIO, DoubleLine Capital Portfolio Manager, Litman Gregory Masters Alternative Strategies Fund

Date: November 14, 2019

Jeffrey Gundlach: The one thing about the yield curve that people grossly misunderstand – and this is something you see all the time on CNBC –

Jeremy DeGroot: I don’t watch it.

JG: I use them as a placeholder for the financial media. But it’s certainly not restricted to them. You have this thing that if in the morning you walk in and suddenly they focus on this relationship between the 2-year and the 10-year, and you walk in and if the 10-year yield is half a bps more than the 2-year, nobody cares about it.

Then at lunchtime, suddenly the 10-year goes half a bps below the 2-year, and suddenly, it’s “Recession Alert!” “Recession Signal!” The crawler is, “Recession Warning,” flashing in the market!”

An hour before the close, suddenly it goes half a bps positive again, and it’s like, “Ah! Recession – we dodged that bullet!”

Jeremy: Yes.

JG: What actually matters is really overnight money to the 10-year and the 30-year. That’s the Fed’s (Federal Reserve’s) Fund Rate to the 10- or the 30-year. That did get inverted fully across the curve.

Jeremy: For several months.

JG: For several months. Usually it happens well in-advance at the front-end of a recession.

The alarm bells that go off in the financial media on the day that it happens are completely false signals. It’s usually something like 18 months before the recession comes; maybe even two years.

Jeremy: There’s a wide range; right?

JG: There is a range. Right.

What actually does happen before the recession – this is where the financial media gets it all wrong. The curve steepens out before the front-end of the recession comes. Because the Fed starts to wake up to the fact that they’re not really in-sync with the market. Then they start easing.

They start easing usually too late.

What actually is more predictive of a recession is first the inversion and then the de-inversion. That’s exactly where we are right now.

Jeremy: The reason why the inverted yield curve may not be as strong of a signal – there are I think some valid reasons. Not to say –

JG: No, no. It’s the opposite.

When rates are super-low –

Jeremy: If the 10-year is depressed because of quantitative easing and because of negative yields –

JG: But they weren’t doing quantitative easing. They were doing quantitative tightening this year when the curve inverted. So there was no quantitative easing.

Jeremy: But I mean the whole curve is much lower.

JG: I know. But my viewpoint is that the lower rates are, the more powerful an inversion signal is. Let’s just say we’re old-school. It’s the good old days when interest rates were up at 8% on treasuries.

Let’s just say that the 10-year treasury yield’s 8% and the Fed funds rate is 8.5%. I don’t think it’s imprudent to buy the 8% 10-year if the inflation-rate is below 4% and there doesn’t seem to be any inflation pressure. And your actuarial assumption on your pension plan is 7.5% and you can get 8%. And if you’re a foundation, you can actually get 4% real. I get it. Why would you buy the 10-year instead of overnight money or the 2-year?

However, when the 10-year treasury yields 1.44% and overnight money is at 2.25%, I think you’re board-certified insane to own the 10-year. It doesn’t satisfy any investment needs. It’s below the rate of inflation. It’s below anybody’s real earning needs. Particularly after-tax. Because it’s also taxable.

What backs up my idea that the inversion signal is more powerful where rates are is the case of Japan, which has not had an inverted yield curve since 1991.

Why? Because their rates are at nothing!

There is no way for me to believe that inverted yield curve means less at low interest rates. I think it means much more.

Japan has not inverted since –

They’ve had serial recessions.

Jeremy: The term premium being negative – that argument – that seems –

It’s related to the yield curve, but the point is that historically, if we didn’t have a negative term premium we have now, the yield curve –

JG: I don’t know. That’s kind of – that’s a really academic argument. I mean I don’t like academic arguments. I like Joe Lunch Pail. You know? “What do you want? Do you want overnight money at 2.25% or do you want 1.4% on a 10-year?” The guy’d be like, “I think I’ll take that 2.25%!”

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A basis point is a value equaling one on-hundredth of a percent (1/100 of 1%)
A Below Investment Grade bond or Junk Bond is a bond with a rating lower than BBB
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. Changes in the CPI are used to assess price changes associated with the cost of living; the CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.
Curve Steepener A strategy that uses derivatives to benefit from escalating yield differences that occur as a result of increases in the yield curve between two Treasury bonds of different maturities. This strategy can be effective in certain macroeconomic scenarios in which the price of the longer term Treasury is driven down.
Drawdown is the peak-to-trough decline during a specific record period of an investment, fund or commodity.
Gross Domestic Product (GDP) is the market value of the goods and services produced by labor and property in the United States.
A Leverage Ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obligations. 
The NYSE Composite Index is an index that measures the performance of all stocks listed on the New York Stock Exchange. The NYSE Composite Index includes more than 1,900 stocks, of which over 1,500 are U.S. companies.
The Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. It summarizes whether market conditions, as viewed by purchasing managers, are expanding, staying the same, or contracting. 
Quantitative Easing (QE) is a monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Quantitative tightening (QT) is a contractionary monetary policy applied by a central bank to decrease money supply within the economy. 
A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price. That small difference in price is the implicit overnight interest rate. Repos are typically used to raise short-term capital. They are also a common tool of central bank open market operations.
Yield Curve: A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. The curve is used to predict changes in economic output and growth.

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