Deep Recession to Force Full Percentage-Point Fed Cut, DoubleLine Warns

26 Jul 2023

DoubleLine Capital's Jeffrey Sherman is warning that the market should prepare itself for a significant economic downturn in the United States. This predicted recession is deemed serious enough to necessitate a significant reduction in interest rates by one percentage point by the Federal Reserve.

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Which parties are in favor of maintaining hiking rates and which parties aren't? Analyzing the Federal Reserve's perspectives.

The blog section presents a courageous prediction supported by declining economic information, suggesting a high possibility of a recession in Sherman in the upcoming year. This prediction stands despite the anticipated further increase in interest rates by the Federal Reserve this week. The financial markets have already placed their bets on a cumulative reduction of 130 basis points from the Fed in 2024. However, Sherman believes that policymakers will hesitate to take action promptly, ultimately leading them to implement the most significant cut since the advent of the pandemic.

"Many economic measures we examine are showing either cautionary or recessionary signs," stated Sherman, the assistant head of investment at DoubleLine, a company specializing in managing assets, during a conversation. "When they eventually take action, it will be a decrease of 100 basis points."

The intensifying clash between Federal Reserve members who favor higher interest rates and those who favor lower interest rates is muddying the future perspective on rates.

Sherman, famous for his bond indicator measuring the vulnerability of interest rates, is getting ready for this result by pursuing the security of government bonds with extended maturity. He is purchasing Treasury bonds with a duration of 10 years and 30 years, confident that even if the Federal Reserve decides to increase rates this week, he believes long-term yields have already reached their maximum point.

The current ten-year US yields stand at 3.9%, experiencing a slight decrease after surpassing 4% on multiple occasions within the previous year. This is because the market is uncertain about when global central banks will cease their aggressive monetary policy tightening, which is considered to be the most drastic cycle in many years. On the other hand, shorter-term yields remain significantly higher, which historically indicates an approaching economic downturn. Sherman, being well aware of this, is deeply concerned about the situation.

Bond traders are placing their bets on a state of total bliss, as they interpret the yield curve in a new and exciting way.

Sherman stated that the Federal Reserve has received a clear message from the bond market, indicating that they have implemented an excessively strict monetary policy and therefore need to lower interest rates. However, Sherman believes that the Federal Reserve will not act promptly and will potentially call for an emergency meeting before implementing any rate cuts. Moreover, the notion that a reduction of 25 or 50 basis points by the Federal Reserve will be the ultimate solution to rectify all economic issues is highly unlikely.

His strategy aligns with his own bond measure. The Sherman ratio, which measures the yield relative to the duration, indicates that now is a favorable moment to invest in bonds. On the Bloomberg USAgg Index, this ratio has risen from 0.21 two years ago to 0.77 at present. This means that a 77 basis-point increase in interest rates within a year would be required to nullify the income generated from bonds.

Sherman mentioned that the proportion in his investment portfolios is nearing 1.00, which is the highest it has been in almost six years. DoubleLine, which was established by Jeffrey Gundlach, oversees a whopping $92 billion in assets.

In addition, he possesses corporate bonds with shorter maturity periods that are considered to be of high investment grade. His reasoning is that it is premature to forgo the reliable returns and be concerned about the possibility of default, as numerous reputable companies have prolonged the duration of their debt. This suggests that he does not anticipate the occurrence of a recession in the present year.

"He mentioned that there are numerous indicators suggesting that within the forthcoming year and a half, we might achieve our goals. The market will have a proactive approach. He also mentioned that the barbell framework enables us to feel secure while investing in credit at the moment."

In spite of the strength seen in certain economic indicators, specifically in regards to employment in the United States, signs of weakness are beginning to emerge elsewhere. The US recession indicator from the New York Fed reached its highest level in June, a record not seen in four decades.

Sherman cautioned that this time, it is anticipated that the loan market, rather than high-risk corporate bonds, will spearhead the default cycle. He mentioned that the high-risk corporate bonds market will not witness a surge in refinancing until the latter part of the upcoming year. As for investment-grade credit, it is unlikely to experience such refinancing until 2025, according to Sherman's remarks.

In the current month, Moody's Investors Service predicts that the rate of default for high-risk companies across the globe is anticipated to reach 5.1% in the forthcoming year. This projection indicates an increase from the previous rate of 3.8% recorded over the past 12 months until June. In a worst-case scenario, the default rate could potentially surge to a staggering 13.7%, surpassing the level experienced during the credit crash of 2008-2009.

Sherman expressed his belief that a crucial indicator to monitor at the moment is the increasing rate of loan defaults. He pointed out that these loans have variable interest rates and have already experienced the complete consequences of the Federal Reserve's interest rate hikes, unlike the fixed-rate market that still has some time before its rates are adjusted.

—With the help of Aline Oyamada and Gem Atkinson.