Double Line's Gundlach says Fed has NO Exit Strategy: Will Not Sell Debt it Bought under QEx

No Win Scenario for the U.S. Economy?

By The Curmudgeon

At a Double Line sponsored lunch seminar yesterday in San Francisco, the firm's CEO/CIO Jeff Gundlach stated that the Fed doesn't ever plan to sell the U.S. Treasury notes, bonds and mortgage securities it bought under its various QEx and Operation Twist monetary stimulus programs.


Several times in the last year,  the Fed Chairman has stated that to head off consumer price inflation, the Fed would sell some of the U.S. Treasury and Mortgage Backed Securities it bought under its quantitative easing program (the total is almost $3 Trillion and growing by over $40B each month).  During a September 13th press conference (after QE Infinity was announced), Bernanke stated: "Ultimately, the Federal Reserve will normalize its balance sheet by selling these financial assets back into the market or by allowing them to mature."


When the Curmudgeon asked Mr. Gundlach about the implications of that, he answered that the Fed would never sell the debt it had monetized and really had no exit strategy.   That is, it has no plans to reduce its bloated (and growing) balance sheet.


The Curmudgeon respectfully disagrees. When money velocity increases as banks relax credit requirements and start to lend money, the real economy will grow but inflation will become an important issue again as monetary inflation (caused by debt monetization) will translate into headline consumer inflation.  That will precipitate a tough decision for Bernanke.


If the Fed doesn't sell the US govt debt it monetized under QEx, then consumer inflation will accelerate and the US $ will CRASH. Foreign investors will lose confidence in the U.S. and sell $'s very quickly.


If the Fed does sell those securities to head off inflation in a rising interest rate environment, the realized loss taken will add to the US national debt, which already is over $13 Trillion and increasing exponentially with $1T+ budget deficits.


With sharply rising rates, interest on the national debt will become an issue again, just as it was in the mid to late 1980s when long term Treasuries yielded over 10%. That will require Congress to cut other budget items, such as military spending, entitlements, or raise taxes/eliminate deductions (e.g. mortgage interest).  The CURMUDGEON claims that's a NO WIN SCENARIO for the U.S. economy and that ultimately QEx will have done much more harm than good!


Separately, Mr. Gundlach said that he thinks interest rates bottomed this summer and could rise very sharply in coming years - independent of whether the U.S. budget deficit was reduced meaningfully.  He has positioned his Double Line Total Return and Hedge fund accordingly, with durations of 1.3 and 0 years, respectively.


Editorís Note: Duration is a measure of a portfolio's sensitivity to changing interest rates.  With the Double Line Total Return fund's average duration of 1.3 years, a 1 percentage point rise in interest rates (using the 10 yr T-Note as a benchmark) would lead to an estimated 1.3% decline in the share price.  For Double Line's hedge fund, any change in interest rates would have no impact on its Net Asset Value.


Mr Gundlach pointed out that US employment divided by the total population was at or near a post WWII low. But what is more striking is that the LABOR PARTICIPATION RATE is at a multi decade low, and has declined during the so called economic recovery that started in June 2009. That's more relevant as it counts ONLY those over 16 that are actively looking for work. In every other economic recovery, the labor participation rate increased. But not this one!


Here's a graph to prove this point:



Civilian labor force participation rate


Closing Comment:   Double Line is to be commended and complimented for holding seminars and conference calls that provide very valuable economic and financial background information for investment professionals.  There are no commercials and no advertising.  Their products sell themselves based on stellar performance.


Till next time.......................




The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.