The Federal Reserve faces a conundrum: It does not want interest rates to fall, but it does not want the U.S. dollar to rise.
“If the dollar goes higher, the Fed is not likely to raise rates,” said DoubleLine Capital CEO Jeffrey Gundlach, on a call with investors Tuesday afternoon.
“Clearly the Fed is cognizant of [the impact of] the strong dollar, and that gave the short-term yield curve a bit of a boost recently,” he explained. “If the dollar rises further, maybe the Fed stays on hold. It could be.”
For companies that sell goods overseas, the higher dollar can weaken sales and thus negatively impact corporate earnings.
“The dollar’s rise has to have consequences,” said Gundlach, who is also DoubleLine’s chief investment officer, noting that he doesn’t see it going up further in the short term.
If the U.S. currrency softens, the Fed “can relax, and then it would raise rates, and then the dollar will [get] stronger [again],” he explained. “It’s a tug of war, so the dollar should not make much progress in the short-term.”
If the Fed raises rates, for instance, three times by year-end, “We will see it is a mistake ..,” Gundlach stated. “If the Fed raise rates as forecast, it will have to reverse course. I think it’s too much.”
As for other market trends, the fixed-income specialist says liquidity in the bond market is “now reasonably high.”
He’s generally steering clear of investment-grade corporate bonds due to high valuations, but is positive on municipal bonds thanks to their high yields. “Municipals are fairly valued and have gotten cheaper in the past few months,” he noted.
As for high-yield bonds in the short run, they are fairly valued compared with where they were in January 2014, when they “were the most overvalued in history,” the CEO says.
Still, he recommends investors “stay tuned,” because it’s “very unlikely that corporate growth will be uniform [going forward], and we could see problems.”
The issue is how the high-yield bond market will act in a rising-rate environment. “The high-yield bond market has never experienced it, and it could change the market [vis-à-vis] what we are used to.” Looking a few years ahead, he expects defaults to “be much higher” than they’ve been historically for high-yield bonds and other fixed income assets that pay higher interest rates than their peers.
A large amount of high-yield bonds come to maturity between 2019 and 2022. “I will discuss this more publicly in the coming months,” Gundlach added.
In terms of year-to-date performance, convertible bonds in the first quarter are up 3.3%, while high-yield bonds have improved 2.4%. Bank of America-Merrill Lynch (BAC) index returns for the CCC-rated high-yield category ticked up about 1.4% in Q1’15, and the AAA-rated credit group increased 2.2% in the period,.
‘Cute’ Energy Plays
Gundlach says he is not bullish about the high-yield bonds issued by energy companies, energy funds or energy stocks, despite the fact that oil prices dropped recently from $100 a barrel to $40.
The Energy Select Sector SPDR ETF (XLF), he points out, went from around $100 to $80. “It’s not dropped nearly enough,” he said. “It’s like too many people think it’s cute to make an energy play.”
Asset prices in the sector “do not reflect the truth,” since it is not likely oil will bounce back to $90 a barrel by year-end, Gundlach adds. “$50 is a sensible expectation for where oil will settle in – as it has.”
DoubleLine says its open-end mutual funds had inflows of roughly $1 billion March and $5.7 billion in Q1’15.
Gundlach shared the latest quarterly performance figures for the group’s Core Fixed Income Fund (DLFNX): 1.9% vs. 1.6% for the Barclays U.S. Aggregate Index. For the full-year 2014, it improved 5.9% vs. 5.7% for the index.
The DoubleLine Flexible Income Fund (DLINX) rose 1.4% in the first quarter. Its benchmark is the LIBOR U.S. dollar three-month interest rate, which ticked up 0.06%.
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