Market Extra: Bond King Jeff Gundlach says there is a simple reason Treasury yields are so low even as inflation surges

“Yields are this low because of all the liquidity in the system,“ Gundlach told the business network.

The 10-year Treasury note
TMUBMUSD10Y,
1.306%
was yielding around 1.32% Thursday afternoon after touching around 1.7% just about two months ago.

In theory, yields should be higher because the Federal Reserve has signaled that it is considering ending its asset-purchase program, which includes some $80 billion in Treasurys a month. The Fed’s quantitative easing, or QE, has helped support financial markets during the worst of the pandemic-driven disruptions last year.

But the prospect of the cessation of QE and surging inflation, which erodes a bond’s fixed value, should be sparking selling in Treasurys and pushing yields higher and prices lower.

Gundlach, however, said that buying from pension funds, foreign buyers and other investors continues to be robust and is providing substantial support for lower yields, even as the Dow Jones Industrial Average
DJIA,
-0.20%,
the S&P 500 index
SPX,
-0.68%
and the Nasdaq Composite
COMP,
-1.17%
are trading near record highs.

Gundlach said “banks are so flush with deposits” and that is creating dislocations in areas of financial markets. Indeed, demand in the New York Federal Reserve’s overnight reverse repo program (RRP) has begun flirting with record levels around $1 trillion.

The Fed’s reverse repo program lets eligible institutions, like banks and money-market mutual-funds, park large amounts of cash overnight at the Fed, at a time when short-term funding rates have fallen to next to nothing, and finding a home for cash has become harder.

The repo operations have been soaking up some of the excess liquidity currently overwhelming U.S. money-market funds, which have been flooded with cash this year, market participants note.

On Thursday, Federal Reserve Chairman Jerome Powell told Senate lawmakers, as a part of a semiannual report to Congress, that inflation has been a bit of surprise for monetary policy makers.

“This is a shock going through the system associated with reopening of the economy, and it has driven inflation well above 2%. And of course we’re not comfortable with that,“ Powell said.

That said, Powell, and other Fed officials, have characterized rising prices as temporary, highlighted by the consumer-price index climbing 0.9% in June, with the rate of inflation in the 12 months ended in June rising to 5.4% from 5%, marking the fastest climb since 2008, when oil
CL.1,
-1.31%
hit a record $150 a barrel.

Gundlach says that pension funds aiming to invest the liquidity provided by fiscal stimulus during the pandemic have been increasingly turning to longer-dated Treasury buying.

Still, despite the anomalies taking shape in the market, the DoubleLine boss said that he was still a buyer of stocks. “I think you’re OK holding,” he said, noting that he has reduced his levels of cash and dialed up his equity holdings.

He said doing so was sensible until such time as the market gets more clarity on future federal spending plans.  

He said that he didn’t think inflation was going away but described a precarious situation for the U.S. central bank which may remove its accommodative measures to tamp down inflation only to risk seeing the still-unsteady labor market wobble.

Gundlach said that the Fed thus far has already proven itself wrong about one thing: its definition of “transitory.” He said that policy makers had initially described “transitory” as one or two months but “now transitory is six to nine months.”

I think that some Fed officials are coming around to the view that this “inflation is going to stay around longer than they thought.”

“Jay Powell is still wishing, hoping, praying that this [inflation thing] goes way,” Gundlach said.

“The bond market seems to be thinking that the Fed is going to get religion…about inflation,” he said.