The overwhelming majority of forecasters in late 2013, believed that interest rates in 2014 would rise. They were wrong. Rates mostly went down. Two leading bond fund managers (Bill Gross and Jeff Gundlach) believed rates would remain low. They were right. Once again, most economists and primary Treasury dealers, and some Fed governors, expect that the Fed will begin raising the Fed Funds rate sometime in 2015 – that is at the very short-term end of the yield curve. While central banks are lowering their short-term benchmark rates in countries such as China and Japan, and suggesting they may do so in Europe, the generally expected direction of short-term rates in the US is up.

However, with US Fed Funds rate near zero, an expected rise is far from expecting punishing rates. Both Bill Gross (formerly of PIMCO and currently of Janus) and Jeff Gundlach (of DoubleLine) each expect interest rates at most maturities to remain below historic normal levels. Gross says “lower for longer.” More important that the level of interest rates, is the shape of the yield curve. A normal curve sloping up from left to right (short-term to long-term) is stimulative of lending and the economy. An inverted curve (sloping down from left to right) puts the breaks on lending and the economy.

Today, Gundlach said in an interview that “the yield curve will flatten at a low level previously thought unthinkable.” He not only sees rates low for an extended period, but actually lower than they are now.

One of Gundlach’s key arguments is that with a strong US dollar and other key nations with lower Treasury rates, our current rates will continue to attract foreign investors, preventing the intermediate and long end of the curve from rising. In fact he expects them to decline.

Remember the Fed can only directly control the extreme short end it lends to banks. The market decides the other rates. Let’s think about the Gundlach scenario.

This chart of the actual US Treasury yield curve at different times shows a steep and an inverted yield curve, as well as the evidence of the Gundlach hypothesis.

The gray line was the yield curve at the height of the 10-year rate in 2007. The cure was inverted, which was a signal that the breaks were being applied to the economy (and to a sizzling mortgage market at that time).

The red line is the steep, stimulative yield curve as it stood in May of 2013, when the 10-year Treasury hit its cycle low – and short-term rates were nailed to the floor by the Fed.

The green line is the shape of the yield curve as we began 2014; and the black line is the yield curve today.

You will note that while there is a slight increase in the 1-yr to 3-yr rates from the beginning of the year, the whole curve is flatter and lower than when the year began.

The Fed said they expect to incrementally raise their extreme short end to gradually more than 1%, maybe even 2%, over a couple of years. Gundlach, expects the middle and long end of the curve to come down part way to meet up with the short end to create a flat curve at previously unheard of low levels.

Investment Implications:

If the Gundlach hypothesis comes true, what are some of the investment implications? Here is a partial list:

1. Banks will increase profits by adding and increasing fees for services to make up for inability to get as much yield spread on loans as they desire – (sounds like airlines charging for bags, pillows and peanuts)
2. High quality bonds won’t take the price dip so many (including us) have been expecting, suggesting that extending duration (longer maturities basically) would help
3. High yield bonds won’t be getting negative price pressure from rising Treasury rates (although this does not speak to the business and economic risks to low credit quality companies in that low rate scenario).
4. Defensive, high dividend stocks, which have been used by many as bond alternatives, will not see the kind of negative price pressure that rising bond yields could cause (this also applies to high yield investments such as pipeline MLPs and equity REITs)
5. Carry trade investments (borrow short-term to invest long-term) using Dollar based debt will be more difficult to make work (although the carry trade borrowing Yen to invest will probably still work)
6. Mortgages will continue to be affordable per Dollar borrowed
7. Corporations won’t be able to float as many bonds at super low rates to then sit on the cash in interest bearing investments at a positive yield spread.
8. If earnings can continue to grow, stocks are still the best game in town, particularly high quality, dividend paying stocks. 

Well, Gundlach may or may not be right in his “previously unthinkable” yield curve belief, but given his industry prominence; the foreign rates logic; the empirical yield curve evidence so far; and his bond fund performance, he needs to be given some credence.

Here are the YTD performances of the Gundlach’s total return bond fund (DBLTX shown in red) year-to-date and over the past 3 years, versus the Vanguard Aggregate Bond Fund (BND shown in black):

Whether Gundlach is right or wrong, overweighting high quality assets among stocks and bonds is probably the best policy. And, as a bit of a hedge against most adverse scenarios, owning dividend paying stocks with market or better yields, and a history of uninterrupted payment and above inflation rate dividend growths is also probably a good idea.