Leveling the Playing Field

May 11, 2015

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Rates jumped on Wednesday following a presentation by Fed Chair Janet Yellen in which she
said Long-term interest rates are at very low levels. We could see a sharp jump in long-term
rates. For someone that majored in ambiguity, this is a shockingly clear message.
Yellen then further set the stage for the movement higher in rates by reiterating that the Feds
assessment is that risks to financial stability are moderate instead of elevated. She based this on
the fact that they are NOT seeing:
1. Increase in leverage
2. Rapid expansion in credit
3. Substantial increase in maturity transformation (long term commitments funded by short term
deposits)
In general, her comments suggest an absence of a bubble while also confirming the Feds
commitment to remaining accommodative. In other words, Were going to keep rates low but
not because we are scared of a bubble popping. The combined effect was to encourage risk
taking, which translates into dumping Treasurys and searching for yield elsewhere. Higher
yields.
On the topic of Treasurys, she started off by noting that term premia are low (flat yield curve)
but this can move dramatically in short order, such as the infamous May Taper Tantrum. We
need to be attentive to the possibility of these term premia moving up, Yellen said, which is
why the Fed is so focused on clearly communicating policy. Sometimes Fed-speak can have
more of a tightening effect than an actual hike itself.
When the Fed Chair says rates could move sharply higher, markets listen. But the straw that
broke the camels back was the German bund getting dumped as we walked in on Thursday.
Two famous hedge fund managers called bunds the short of a lifetime and markets listened.
The yield at the start of the week was around 0.03%-0.06%. On Thursday morning, the 10yr
Bund shot up to 0.80%. Thats not a misprint. Traders we spoke with were getting called in the
middle of the night to come in to the desk. Panic was setting in for government bonds.
Weve been describing the low Eurozone yields as a leash on US yields. The market has been
largely keeping the spread between USTs and German Bunds around 2.00%. As German yields
move up or down (mostly down until last week), US yields follow suit to keep the spread the
same.

Pension/insurance/hedge funds have trading algorithms that place buy/sell orders based on the
spread to USTs. As German yields took off, automatic sale orders were placed. The race up
was underwayright up until another algorithm order was triggered that ordered the purchase of
these same government bonds.
Markets were very jittery, but ultimately settled down. Throughout the wild swings, we kept
noting to ourselves nothing has actually changed in the economy, right?
Then Friday brought the latest batch of job data. As you may recall, last months report was
significantly weaker than expected. That put a lot of focus on Fridays number. Were we seeing
a weakening trend? Or was that last set of data simply a result of a nasty winter?
The market got its beloved Goldilocks number. The economy gained 223k jobs last month, right
on top of expectations. It was a strong enough number to calm jitters about a slow Q1 but weak
enough to keep June off the table for a hike. As markets reviewed the report, last months
revision stuck out because the gains were only 85k, the weakest since June 2012.
The 10T settled in at 2.15%, well off the high of 2.31% but also well above the recent technical
high of 1.99% from a week prior.
Europe is going to be driving the UST yields this week. Greece is a predictable mess, with that
pesky 770mm loan payment due to the IMF from a previous round of bailouts. Tsiparis is stuck
between a rock and a hard place, with his creditors refusing to budge and his diehard leftist
backers rejecting any talks of austerity measures. His finance minister has said Greece can make
the payment without an extension, but he has absolutely no credibility in the market. There is
not a lot of optimism right now for a resolution by Tuesday.

Front End Rates and Cap Costs

Last week, we included a section on how clients with required caps should be preparing
themselves for extreme price swings. If you are buying a cap, brace yourself for extreme
volatility and the likelihood that the price could jump dramatically in short order. Apparently
not everyone reads our newsletter because several cap buyers were stunned when cap prices
swung by 20% during the week.
The Fed is data-dependent, which means each data release carries increasing significance
because investors try to figure out if it means a higher/lower likelihood of a hike. This will
translate into large swings in cap prices. This will be exacerbated around Fed meetings.
Get used to cap prices moving around quite a bit heading into a closing. These arent appraisals,
costs move around as markets move. Dont say we didnt warn you.

Economic Data
Day

Time

Wednesday

7:00AM

MBA Mortgage Applications

Thursday

8:30AM

PPI Final Demand MoM

8:30AM

Initial Jobless Claims

270K

265K

8:30AM

Continuing Claims

2255K

2228K

8:30AM

Empire Manufacturing

4.3

-1.19

10:00AM

University of Michigan Sentiment

96.3

95.9

Friday

Report

Forecast

Previous

-4.60%

0.10%

0.20%

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