GUNDLACH: The Federal Reserve is on the 'knife's edge'

DoubleLine Capital’s Jeff Gundlach thinks an interest rate hike from the Federal Reserve in December is a 50-50 proposition.

“The message of the market is more suggestive of the Fed raising rates in December,” Gundlach said in a webcast on Monday.

“We had a 50-50 setup at the short-end [of the bond market] a few weeks ago and now it’s up to around 70%, which I think is right on the knife’s edge.”

Gundlach noted that the market reaction to Friday’s October jobs put the chances of a December rate hike right around 70% as measured by the WIRP, or “world interest rate probability,” function on Bloomberg Terminals.

But in his view, Gundlach thinks that this probability would probably need WIRP to increase for the Fed to be comfortable raising rates.

“The Fed probably needs to see WIRP higher than 70%, but certainly 70% is more likely to have the Fed comfortable than 50%,” Gundlach said.

Fed funds futuresBusiness Insider/Andy Kiersz, data from BloombergThe chances of a Fed rate hike spiked on Friday.

On balance, Gundlach said Friday’s jobs report was “pretty good in a number of ways.” Friday’s report showed that in October the US economy added 271,000 jobs as the unemployment rate fell to 5%.

Additionally, average hourly earnings rose 2.5% over the prior year, the highest increase in about five years and the first real “breakout” of this measure after several years of wages languishing at annual growth closer to 2%.

Back in May, Gundlach said that more than anything else, the Fed would need to see wage growth in order to feel comfortable raising rates. And now it seems like we’re starting to see this play out.

The theme dominating the economy and the labour market over the last couple years has been solid job gains and lacklustre wage growth. As part of its dual mandate, the Fed wants “full employment” and “price stability,” which it defines at 2% inflation on a year-over-year basis.

Employment gains have more or less brought the labour market into the Fed’s “full employment” window over the last couple months, but inflation pressures have been lagging. And wage figures have been in focus as inflation — which is simply too much money chasing too few goods — can’t really perk up until there’s more money going into the pockets of consumers.

But now with wages growing 2.5% over the prior year in October, it seems like we might be here. Or there. Or close, at least.

Though of course, as Gundlach noted on Monday, this narrative shifted rather quickly.

“I find it interesting,” Gundlach said, “that with the pop-up in average hourly earnings it didn’t take long — one day — for commentators to start talking about the Fed being ‘behind the curve.'”

(“Behind the curve” is markets short-hand for folks thinking the Fed has kept interest rates too low for too long, thereby sending inflation spiking and requiring the Fed to raise rates quickly in response.)

As for his broader comments on the bond market and the economy, Gundlach thinks that the US dollar bears watching over the next couple weeks as a strong dollar could derail any Fed plans for a rate hike.

“If the dollar gets stronger we may see further volatility in markets which might get the Fed nervous,” Gundlach said on Monday.

In hindsight, it seems clear that August’s stock market chaos was one of, if not the leading factor, in the Fed opting to keep rates near 0% at its September meeting.

Speaking about the 30-year bond — the “Long Bond” — Gundlach said were the Fed to raise rates following a strong November employment report (perhaps one similar to Friday’s), the Long Bond could be under pressure as the narrative that the Fed is “behind the curve” could pick up steam.

If the Fed raises rates following a lacklustre November jobs report, the Long Bond could rally as markets believe the economy isn’t growing faster than the markets are currently pricing.

And as for what happens when the Fed raises rates?

“I do believe the Fed raising interest rates will increase volatility and will weaken the economy,” Gundlach said.

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