Leveling the Playing Field

November 4, 2013

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Rates climbed modestly across the curve with the 10yr T up about 0.11% on the week following the FOMC meeting on Wednesday. The statement was basically unchanged from the last meeting - the Fed is data dependent, it is focused on jobs and GDP, and it would like to see inflation at 2%, etc. But markets were slightly spooked by the bullish tone and interpreted that as tapering, which in turn translates into tightening, and suddenly rates are higher because a butterfly flapped its wings in the Vatican and the NSA heard it.

With each passing meeting, the Fed risks fueling asset/inflation bubbles by focusing on its dual mandate of employment and inflation (and, I would argue, high equities). And this is why markets react so strongly to every hint of tapering. Is the economy really doing so well that stocks should be at all time highs? Stock Bubble? Hedge fund manager Doug Kass pointed out last week, Since 1990, the P/E multiple of the S&P 500 has appreciated by about 2% a year; in 2013, the S&Ps P/E has increased by 18%.

Bond Bubble? If Treasurys are a bubble, we are in for a painful exit from QE next year. Just the mere hint of tapering sent long term rates skyrocketing, which in turn cooled the mortgage market. But it goes beyond just US government bonds. Bloomberg reported last week that the Fed sent a letter to large banks cautioning them against loosening their credit underwriting on leveraged loans. Fed Governor Jeremy Stein has publicly worried about this loan market.

These graphs are what keep Bernanke & Co up at night. On the one hand, the economy is in a precarious position, with modest GDP growth and hiring just middling along. Rising interest rates had an immediate impact on a variety of sectors, most notably housing. The threat of tapering caused market conditions to tighten. Congress is a mess and appears to be relying on Bernanke to bail themselves out.

On the other hand, there are plenty of signs that we are creating more bubbles. And Bernanke would rather deal with the concrete reality of today than the hypothetical of the future. Plus, he leaves office after just one more FOMC meeting... Ben to Janet: Bubbles? Thats a YOU problem, not a ME problem. He might even insert a snide Stocks were at all-time highs when I left, not sure what happened after that... If smart money front runs bubbles by pulling the rip cord before mainstreet realizes it needs to sell, than when do stocks pull back? For our clients, when do rates spike?

TBTIHEK I tend to think that the bearish thesis which has been so popular (and wrong) for the past 5 years might finally bear fruit over the next 18 months. I really feel the Fed is trapped here, they want out (or at least to pivot to forward guidance) and the #s are going to make it difficult on them. I think the market has grown complacent that liquidity will continue to pump risk assets even as rev growth slows and valuations stretch. I see a significant chance of a 15-20pct 'correction' in risk asset prices in the next 18 months.

Interest Rate Outlook Tapering is likely off the table until at least March 2014. Traders will want to front run this without exiting too early, so we think there is some risk that rates jump heading into year end if we continue on the current path. Obviously, data/Congress/etc can change all that, but in a vacuum why wouldnt you start selling Treasurys before the Fed gets out of the bond buying business? Couple this with the possibility that maybe Treasurys are a bubble waiting to be popped...just not yet.

Short term: Treasurys are range bound and there is a lid on rates. Longer term (year end and Q1 2014): we could see the 10T above 3.00% if the data picks up, but this is unlikely given the government shutdown and the subsequent drag to growth.

This Week October job reports are due out on Friday and economists we like are expecting a much lower number, possibly a gain of around 100k. As you may recall, the release a few weeks ago was a disappointing 148k. The advance GDP reading for Q3 is due out and likely down substantially from Q2s 2.5% print, possibly as low as 1.5%. Numerous Fed speeches will help providence guidance on tapering and we doubt the speakers do anything to spook the markets that tapering could happen prior to year end.

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Economic Calendar
Day Monday Time 9:45AM 10:00AM Tuesday 10:00AM 10:00AM Wednesday 7:00AM 10:00AM Thursday 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM Friday 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 9:55AM ISM New York Factory Orders ISM Non-manufacturing Composite IBD/TIPP Economic Optimism MBA Mortgage Applications Leading Index Initial Jobless Claims Continuing Claims GDP (QoQ) GDP Price Index Personal Consumption Core PCE (QoQ) Change in Nonfarm Payrolls Change in Private Payrolls Unemployment Rate Underemployment Rate (U6) Avg Weekly Hours All Employees Personal Income Personal Spending PCE Core (MoM) PCE Core (YoY) University of Michigan Confidence 34.5 0.3% 0.2% 0.1% 1.3% 74.5 0.6% 335k 2880k 2.0% 1.4% 1.6% 1.5% 125k 130k 7.3% 1.8% 54.0 41.8 54.4 38.4 6.4% 0.7% 340k 2881k 2.5% 0.6% 1.8% 0.6% 148k 126k 7.2% 13.6% 34.5 0.4% 0.3% 0.2% 1.2% 73.2 Report Forecast Previous 53.6

Speeches and Events Day Monday Time 11:40AM 4:00PM Tuesday 1:15PM 5:00PM Wednesday Thursday Friday 1:10PM 1:50PM 12:00PM 3:30PM 4:00PM Report Fed's Powell speaks on Monetary Policy Fed's Rosengren speaks on Economy Fed's Lacker speaks on Labor Market Fed's Williams speaks to Reporters Fed's Pianalto speaks on Housing and Economy Fed's Stein speaks on Securities Transactions Fed's Lockhart speaks on the Economy Bernanke, Fischer, Summers speak on Financial Crises at IMF Fed's Williams speaks on Monetary Policy Los Angeles, CA Place San Francisco, CA Boston, MA North Carolina San Francisco, CA Columbus, OH Chicago, IL Oxford, MS

Treasury Auctions Day Time Report Size