Leveling the Playing Field April 14, 2014 _______________________________________________________________________ Theres a twenty year old leading the Masters

as I type this. When I was twenty I was __________________ and __________________ and there was that one time I ________________ and man my parents were so mad when I __________________. Good luck to him! In our newsletter three weeks ago we touched on the fact that long term rates (Treasurys and swaps) dont necessarily spike once the Fed starts a tightening cycle. The primary reason for this is that long term rates price in the hikes. By the time the Fed actually begins moving Fed Funds (and thereby LIBOR) up, the long end of the curve needs to wait and allow those rates to catch up. We looked at the last three tightening cycles to see what happened to 10 year rates as the Fed started hiking. With Yellens comments that considerable period could really mean as little as six months, markets are trying to get in front of the first Fed hike. Before we dig into this analysis, lets first review the FOMC minutes released Wednesday for hints about the first hike. FOMC Minutes The minutes revealed a highly accommodative Fed that is poised to keep short term floating rates low for the foreseeable future. One of the first headlines to hit the Bloomberg tape was Several Fed officials said forecasts overstated rate rise pace. Translation you guys overreacted to Yellens Q&A and were on hold. For a long time. Enjoy 0% LIBOR. Youre welcome. Most FOMC members agreed to revise the forward rate guidance One member wanted to retain the 6.5% threshold until it was actually broken, fearing the market would interpret the change as a less accommodative Fed One member wanted a 5.5% UR threshold and 2.5% inflation target A few members wanted language reiterating the Feds commitment to an accommodative stance if inflation remains persistently below 2%

The Feds challenge is that its own members FF expectations (aka dots) show a hike coming in mid-2015. In other words, individually they are expecting a hike next year, but collectively they remain highly accommodative. This makes perfect sense to us because the Fed is worse at forecasting than Jim Furyk is at winning golf tournaments.

With inflation running below Fed forecasts and sluggishness in prices, perhaps the slack in the labor market is also present in other areas of the economy. If inflation and wage growth have a lot of room for upward movement, it will be a long time before the Fed starts considering a policy change. So what does this mean for long term fixed rates? The yield curve is already pretty steep, with the premium to convert to fixed for 10 years costing about 2.75%. We looked at the last three tightening cycles for clues about what may happen to 10 years rates in the upcoming tightening cycle (whenever that may be). 2004 Tightening Cycle First Hike June 2004 Last Hike June 2006 Total Increase approximately 4.00% To put this into perspective, a LIBOR + 2.00% borrower is paying 2.15% today. If the Fed starts hiking mid-2015, this same borrower would be paying 6.15% by mid-2017. LIBOR Graph

The question our clients are asking themselves do I lock in at 4.75% today for 10 years and pay up quite a bit for this protection? Or can I wait and watch LIBOR and lock in later?

10 Year Swaps Graph

With the benefit of hindsight, long term fixed rates bottomed out about a year before the first hike. The 10 year swap increased by about 1.50% from bottom to top leading up to the first hike. If we knew the Fed would hike exactly one year from today, this would imply the 10 year swap climbing from 2.75% to 4.25% over the next year. For the same LIBOR + 2.00% borrower, the fixed rate available to lock for 10 years would be more like 6.25% in mid2015. But note that 10 year swaps actually decreased 0.75% in the three months following the first hike. Again, the 10 year increase had already happened, so the long end is waiting for the front end to catch up. But the 10 year rate never got closer than 1.00% from the bottom.

1999 Tightening Cycle First Hike August 1999 Last Hike May 2000 Total Increase approximately 1.50% To put this into perspective, a LIBOR + 2.00% borrower is paying 2.15% today. If the Fed starts hiking mid-2015, this same borrower would be paying 3.65% by early 2016. LIBOR Graph

10 Year Swaps Graph

Again, with the benefit of hindsight, long term fixed rates bottomed out about a year before the first hike. And again, the 10 year swap increased by about 1.50% from bottom to top leading up to the first hike. And again swap rates actually decreased in the three months following the first hike. Unlike the 2004 cycle, 10 year rates never fell more than about 0.50%. Said another way, 10 year rates never got within 1.00% of the bottom. Again. Conclusions from the last two tightening cycles? 10 year rates bottomed out about a year ahead of the first hike 10 year rates fell after the first hike, but the decline stopped 1.00% above the previous bottom

1994 Tightening Cycle First Hike February 1994 Last Hike February 1995 Total Increase nearly 3.00% To put this into perspective, a LIBOR + 2.00% borrower is paying 2.15% today. If the Fed starts hiking mid-2015, this same borrower would be paying 5.15% by mid-2016. LIBOR Graph

10 Year Swaps Graph

With the benefit of hindsight, long term fixed rates bottomed out about six months before the first hike. This hike caught markets off guard, however, and the 10 year swap spiked 2.00% in the following three months. Swaps were still relatively new instruments at this point and the Fed was far less transparent than it is now, hence the markets response. We would probably discount the 10 year swap movement of this cycle for these reasons.

Fixed Rates One client sent us an email Friday morning Marc Fabers claim that the 10yr Treasury was headed to a new range of 2.00% - 2.25%. The first thing I had to do was check to see if he was referring to the billionaire Swiss investor or the blowhard CNBC reporter. Since it was the investor, I gave the statement some consideration. From a technical standpoint, 10yr Treasury could run down to 2.40% if equities keep getting punished. The current bottom end of the range would basically become the new top end of the range. We do NOT think this will happen, but just know that 2.60% is a key resistance level and, if broken, could result in a rapid drop of another 0.20%. The range Faber is suggesting would probably require an exogenous shock or an imminent recession. I have no crystal ball on either, but shocks wouldnt be shocks if we could predict them. And I dont see anything in the data that suggests a recession is on the horizon. The data is all sending the same signal 2% growth. And the twelve month average monthly job gain is 187k per month. Like GDP, thats not gang busters, but its not contractionary either. And consumer confidence is at its highest level since last summer. That being said, the tone in the stock market has changed this year. Were seeing more selling on upticks and stocks seem to require more positive news to sustain a rally. Hopefully this is just a healthy correction and nothing more. And while we dont discuss trading positions in this newsletters because our attorney would have a seizure, you can stick the following into the Put Your Money Where Your Mouth Is folder I just locked in the rate on my home mortgage because my hold period is greater than five years and I think fixed rates are near or at the bottom. I might leave 0.25% on the table if rates keep backing up, but they could swing up by 1.50% over the next year. Asymmetric risk.

Markets closed Friday for Good Friday, have a happy Easter everyone!

Economic Data Day Monday Time 8:30AM 8:30AM 10:00AM Tuesday 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 9:00AM 9:00AM 10:00AM Wednesday 7:00AM 8:30AM 8:30AM 9:15AM 9:15AM 2:00PM Thursday 8:30AM 8:30AM 10:00AM Friday Retail Sales Retail Sales ex Auto Business Inventories Empire Manufacturing Consumer Price Index (MoM) Consumer Price Index (YoY) CPI Core (MoM) CPI Core (YoY) Net Long-term TIC Flows Total Net TIC Flows NAHB Housing Market Index MBA Mortgage Applications Housing Starts (MoM) Building Permits (MoM) Industrial Production (MoM) Capacity Utilization Fed releases Beige Book Initial Jobless Claims Continuing Claims Philadelphia Fed Business Outlook Markets closed for Good Friday 315k 2786k 10.0 300k 2776k 9.0 7.5% 0.6% 0.4% 78.7% 50 Report Forecast 0.9% 0.5% 0.5% 8.00 0.1% 1.4% 0.1% 1.6% $30.0B Previous 0.3% 0.3% 0.4% 5.61 0.1% 1.1% 0.1% 1.6% $7.3B $83.0B 47 -1.6% -0.2% 7.7% 0.6% 78.8%

Speeches and Events Day Monday Tuesday Time 2:00PM 8:30AM 8:45AM 4:00PM 8:00PM Wednesday 8:00AM 12:15PM 1:25PM 2:00PM Report ECB's Noyer, Fed's Tarullo speak Fed's Lockhart speaks at Stone Mountain, Georgia Conference Fed's Yellen speaks at Financial Markets Conference Fed's Rosengren speaks Fed's Kocherlakota speaks Fed's Stein speaks on Quantitative Easing Fed's Yellen speaks to Economic Club Fed's Fisher speaks on the Economy Fed releases Beige Book New York, NY Austin, TX Bangor, ME Fargo, ND Place New York, NY

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