In his monthly must-see live webcast this week, DoubleLine CEO Jeffrey Gundlach made one very specific call (among others) that stood out to many listening in on the call.
Having explained that the combination of rising U.S. interest rates and fiscal deficits is like a “suicide mission” – which notably escalated the intensity from last month when he referred to the trend as a “pretty dangerous cocktail” – Gundlach concluded that the debt burden will rise to such a level that borrowing costs will surge.
To be specific, Gundlach said, the 10-year Treasury yield would rise to 6% by 2020 or 2021 adding that “we’re right on track” for that.
That would be the highest yield since 2000..
Bear in mind Gundlach alternatively signaled that a recession is possible by 2020, which could make the next presidential election “a wild ride,” and notably reduce interest rates.
Judging by the record short positioning across the Treasury complex, there are plenty that agree with him…
However, not everyone agrees. Lacy Hunt, the well-known bond bull at Hoisington Investment Management, told Bloomberg in an interview that:
“I believe that we’re closer to the peak – or at the peak – at the longer end of the market.”
“You come in and undertake a massive increase in debt, and the economy gets a transitory boost in economic activity. The consumer has already spent a lot of the tax cut, but the debt lingers.”
And additionally, this week saw someone place a large $75 million options bet that Gundlach is dead wrong and in fact 10Y Treasury yields tumble back to 2.60% first.
As Bloomberg reports, over the first three days of this week, traders paid more than $75 million combined to buy almost 200,000 call options on 10-year futures.
Monday saw the purchase of 100,000 contracts in a call-option spread on 10-year futures, for a premium of $45 million, targeting a drop to about 2.6 percent before the contracts expire on Aug. 24.
Traders plowed into bullish options bets again Tuesday, purchasing 50,000 calls for a premium of about $20 million, targeting a drop in yield to 2.9 percent or lower by July 27.
And on Wednesday, traders added to that bet by purchasing 40,000 call-spread contracts for a premium of $12.5 million, with maximum upside reached on a drop to 2.6 percent.
Overall the position has around a $3m/DV01.
Coming just weeks after 10-year yields set an almost seven-year high above 3 percent, the bets amount to a bold call targeting a drop to as low as about 2.6 percent before the biggest chunk of the contracts expire Aug. 24.
And whoever this bullish bond options BSD is – putting 10s of millions on the line that Gundlach is dead wrong – Bank of America’s rates strategy team agree, seeing rates notably lower ahead.
Last week, the 10-year Treasury yield reached as low as 2.7578% – a 37bp decline from the most recent peak of 3.1261%. This move confirmed that a multi-month rally is under way.
As discussed last week, we expect an 11-16 month rally that will eventually lead the 10-year Treasury yield down to at least 2.30% or possibly even below 2%.
Our targets, however, require a change in Fed posture during the next few months. As such, the Fed meeting next week will be pivotal. The Fed is widely expected to deliver a 25bp rate hike, though the market is mostly concentrated on a forward posture. With the 5/30 curve poised to take out the 25bp low in May (see Exhibit 1), the meeting is an opportune time for the Fed to evaluate whether it should drive the curve to a flat – or even inverted – shape.
Prior to the financial crisis, each Fed tightening cycle ended with an inverted Treasury curve. Given the structural issues with the global economy, we believe the Fed should avoid driving the curve down that much – though forward development after the June hike may not be something the Fed can control.
We believe the recent problems in Europe and emerging markets are just a prelude. More issues can be expected in the summer and onward. Typically, after problems affect emerging markets, generally the high yield market is impacted next. The Treasury market rally would increasingly look like a flight to quality as the market progresses.
Our suggestion of a possible Fed dovish turn is also based on an observed, long-standing Fed/ECB dance. We recall that the Fed announced QE tapering in 2013, completed QE tapering in 2014 and eventually hiked rates in 2015. During the same period, the ECB walked an opposite path, cutting rates aggressively, discussing possible QE and then eventually entering QE in 2015. The ECB QE is scheduled to end this September. This “dance” of central banks has been one of the main reasons the global economy and markets have been in a steady growth mode. Now that the ECB is ready exit QE, it is perhaps time, too, for the Fed to think about exiting its tightening program.
Such a switch of roles of central banks would be decisive for our rates view.
Time will tell.