Leveling the Playing Field July 21, 2014

_______________________________________________________________________

Janet Yellen testified before Congress last week and largely stuck to the party line about
being data-dependent. But as we wrote last week, there is an increasing amount of saber
rattling coming from the Fed camp about hiking interest rates. Listening to Yellen talk
makes Bernanke look like a bundle of charisma, so I decided to up the ante and go all-in
on


Guarantee # 1 - Yellen will appear publicly dovish as long as possible but will be
privately hawkish.

Therefore, the first hike will not be telegraphed well in advance.

Yellens testimony implies that she would like to wait as long as possible because the
recovery is not yet complete. Yellen will continue to send her minions out to provide
tightening signals (like we discussed in last weeks newsletter), but she herself will stay
above the fray until shes ready to hike.

Coming out of a recession, talk of a hike doesnt really help the economy. And because
Fed-speak frequently results in the same impact as an actual hike, why risk investor
confidence until the last minute?

With little remaining ammunition, premature talk of a hike leaves the Fed will little other
than more Fed-speak about keeping rates low for the foreseeable future. The ECB hiked
rates in mid-2011 and the Eurozone had slipped back into recession by Q4 2011. Yellen
is determined to avoid that scenario. So she waits.

Perhaps this isnt a revolutionary thought. One of the lessons from prior tightening
cycles is that markets ALWAYS underestimate the magnitude of the upcoming rate
hikes. Given the complacency inherent in 6+ years of ZIRP, we suspect this will be true
again. But perhaps its true because the Fed intentionally follows this pattern?

Guarantee # 2 Asymmetric risk is keeping the Fed on hold as long as possible

If the Fed waits too long and inflation jumps above the targeted 2% level, does the world
come to a screeching halt? No. The Fed simply keeps hiking and maybe even threatens a
0.50% hike if necessary.




But if the Fed hikes too soon and the US is thrown into another recession, it could be
much harder to bring us out of it. This is especially true with interest rates already at 0%.

The FOMC would rather be too late than too early.

Guarantee # 3 The Unemployment Rate is a thorn in Yellens side

In December 2012, the Fed switched to quantitative forward guidance on Fed Funds,
saying it would likely keep FF at 0% until the UR hit 6.5%.

At that time, the Fed forecasts put the UR between 6.8% - 7.3% at the end of 2014. By
the end of 2015, the forecasts put the UR at 6.0% - 6.5%. These forecasts are where the
mid-2015 timeframe for the first hike derived from.

In other words, we are ahead of schedule by 18 months.




Junes forecast for the UR at the end of 2014 is 6.0%. It is already at 6.1%. Are you
telling me the Fed actually believes the UR is only going to decline an additional 0.1%
over the next six months? No way.

While underestimating the UR decline, the Fed has simultaneously overestimated GDP.
It is calling for 3% GDP over H2 of 2014, and yet only expects the UR to decline by
0.1%?

Call me skeptical, but I think Yellen knows a 5.5% forecasted UR by the end of 2014
would turn up the rhetoric on the need for a rate hike. And if she wants to remain dovish
for as long as possible, why invite that sort of trouble? After all, it is just a forecast



But wait, theres more!

Econ 101 taught us that there is an inverse relationship between unemployment and
inflation. Decreased unemployment translates into higher inflation. The problem is that
over the long run, it has been proven to be inaccurate (thank you Milton Friedman).

As our friends at BNP pointed out last week, there are really three Phillips curves
depending on the absolute levels of unemployment. Between 5.5% and 9.5% UR, the
relationship we were all taught in school holds mostly true. But check out the left hand
side of the graph below when the UR drops below 5.5%.



The Fed is referencing the Phillips curve as a guideline for how inflation will behave, and
it generally works in the short term assuming the UR is between 5.5% - 9.5%. But once
we break out of that range (either high or low), the relationship is far more dramatic than
an overly simplistic 1:1 ratio.

Yellen is an economic juggernaut and undoubtedly aware of this. It makes us wonder if
that 5.5% threshold is another reason the Fed refuses to lower its UR forecast

It also makes us wonder how Yellen will behave as the UR approaches 5.5%.










Guarantee # 4 - Heres what the tightening cycle look like

The FOMC has historically pegged a specific Fed Funds target rate, eg 0.25%. For the
last several years, however it has used a range of 0% - 0.25%. Step 1 therefore is to
revert to a pegged rate of just 0.25%.

Step 2 will be the first actual hike, an increase from 0.25% to 0.50%.

Step 3 will be the second full hike, an increase from 0.50% to 0.75%. LIBOR will likely
be around 0.85% at this time.

Right now we would estimate the timeframe for the first hike to be the middle of 2015,
but if the UR keeps pushing lower and wage inflation creeps up, it could come sooner.

The FOMC traditionally tightens 0.25% per meeting for an average of 2.00% per year.

That means LIBOR could be at 2.25% by spring of 2016 and 4.25% by spring of 2017.

And if LIBOR is at 2.25%, we seriously doubt the 10yr Treasury is at 2.50%.

We think the Fed will be even more cautious than in previous tightening cycles given the
depth of the recession and how slow the recovery has been. We may not see the nice
linear increase like we have in the past. We might see hikes followed by pauses - rather
than 2.00% per year, perhaps it hikes 1.00% per year (which is basically what the market
has priced in right now). Perhaps the Fed hikes 1.00% and then stops for a year to allow
the market to catch up. This last recession has been different, so we would expect the
tightening cycle to be different.

But it is coming.


Guarantee # 5 Fed Credibility will be questioned

If the Fed hikes too soon, it risks a recession and we all complain that Bernanke
wouldnt have let the Dow close below 17,000 Hike too late (or even just not talk
about a hike soon enough), and risk being called out for being behind the curve. Now
that the horses have escaped, thank you for closing the barn doors. Its a lose-lose
fueled by years of free money and complacency.

But as we pointed out in #2, the Fed shares the blame. It continues to call for slowing
declines in unemployment while simultaneously predicting increasing growth. Thats not
going to happen, so stop saying it.






Delay in hiking also creates the perception that the eventual tightening will have to be
even more significant to make up for the late arrival to the party. That has ripple effects
in interest rates and volatility, which usually translates into higher interest rates.



Elsewhere in the News

The SEC is proposing new regulations on money market accounts, some of which include
redemption fees and gates to mitigate a run on the market. Thanks you regulators.
Heres the unintended consequences that could impact the broader interest rate market
while the government figures out how to protect us from ourselves:

- Institutional investors pull money out ahead of the regulations, and that money
needs to go somewhere. Since money markets are supposed to be liquid and short
term in nature anyway, front end Treasurys and even bank deposits may be the
final destination.
- Overnight rates could go negative, eg Treasury repo rates
- High grade corporate yields would also be an alternative, pushing these yields
abnormally low

The effect may be negative interest rates on the front end of the curve and increasing
incentive for yield grab. With the UR falling faster than Fed forecasts and inflation close
to 2%, it will become increasingly challenging for the Fed to maintain its ZIRP in the
coming months.


Buying Out of Asia

On the trading floor we had a multitude of standard explanations when we had no idea
why rates were moving lower. As long as you yell these with conviction, they must be
true. The top three in no particular order were 1. Convexity buying, 2. Buying begets
buying, and 3. Buying out of Asia. Turns out #3 has been contributing to the summer
rally in US Treasurys. Rates down, you need to lock in before this buying out of Asia
dries up!!!

China has helped force the 10yr Treasury down about 0.50% over the first half of the
year by buying up Treasurys at the fastest pace ever, more than $107B through May. In
all of 2013, China bought $81B in US Treasurys. Of course, all of these reported
holdings only reflect the official Chinese balance sheet, not the Treasurys bought through
third party accounts. The real number is higher.

For as long as I have been in the interest rate game, one prevailing concern has been over
the risk of China slowing the pace of Treasury purchases and the resulting spike in yields.
And yet we have never seen this risk materialize. What alternative investment provides



as much liquidity as the US? And while European bonds are trading on top of (Ireland)
or inside US bonds (Germany), our returns look pretty attractive. And lets not forget
that Chinas intentions arent entirely about yield, but about keeping the yuans value low
to encourage exports.



Summary

If the economy continues along the same trajectory, a rate hike is coming in the spring or
summer of 2015.

The first movement in Fed Funds in over six years will be a big deal. Expect volatility
and upward movements in rates. The yield curve will flatten, but it can do so while
shifting higher.

Yellen will remain publicly dovish as long as possible.

Long term rates (eg 10yr Treasury) are restrained by technical factors rather than
underlying fundamentals right now. Alternative markets off similar or lower yields than
the US, so where else is the record liquidity going to go? This wont last forever.




Quiet week ahead, with some inflationary data being the most significant on the calendar.
The Fed should be pretty quiet ahead of next weeks meeting. Obviously, keep an eye on
the Russia/Ukraine conflict. Shooting down civilian airliners will not go unpunished by
the international community, and at a minimum that usually translates into an economic
drag as severe sanctions are imposed.










Generally, this material is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of
any financial instrument or as an official confirmation of any transaction. Your receipt of this material does not create a client
relationship with us and we are not acting as fiduciary or advisory capacity to you by providing the information herein. All market
prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. This
material may contain information that is privileged, confidential, legally privileged, and/or exempt from disclosure under applicable
law. Though the information herein may discuss certain legal and tax aspects of financial instruments, Pensford Financial Group,
LLC does not provide legal or tax advice. The contents herein are the copyright material of Pensford Financial Group, LLC and shall
not be copied, reproduced, or redistributed without the express written permission of Pensford Financial Group, LLC.




Economic Data
Day Time Report Forecast Previous
Monday 8:30AM Chicago Fed Nat Activity Index 0.15 0.21
Tuesday 8:30AM CPI MoM 0.30% 0.40%
8:30AM CPI ExFood and Energy MoM 0.20% 0.30%
8:30AM CPI YoY 2.10% 2.10%
8:30AM CPI ExFood and Energy YoY 2.00% 2.00%
8:30AM CPI Core IndexSA 238.227 237.776
8:30AM CPI IndexNSA 238.542 237.9
9:00AM FHFA House Price IndexMoM 0.20% 0.00%
10:00AM Richmond Fed Manufacturing Index 5 3
10:00AM Existing Home Sales 4.99M 4.89M
10:00AM Existing Home Sales MoM 2.00% 4.90%
Wednesday 07:00AM MBA Mortgage Applications -- -3.60%
Thursday 8:30AM Initial Jobless Claims 308K --
8:30AM Continuing Claims 2513K --
9:45AM Markit US Manufacturing PMI 57.5 57.3
10:00AM New Home Sales -- 504K
10:00AM New Home Sales MoM 480K 18.60%
11:00AM Kansas City Fed Manufacturing Activity -4.80% 6
Friday 8:30AM Durable Goods Orders 0.50% -1.00%
8:30AM Durable ExTransportation 0.50% -0.10%
8:30AM Cap Goods Ship Nondef ExAir 1.50% 0.40%
8:30AM Cap Goods Orders Nondef ExAir 0.40% 0.70%
Speeches and Events
Day Time Report Place
None
Treasury Auctions

Day Time Report Size
None