Leveling the Playing Field

December 7, 2015
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Fridays job report was positive and came in slightly stronger than expected. The economy added 211k
jobs last month against the forecasted gain of 200k. The last two months were revised upward by a
combined 35k as well. The unemployment rate held steady at 5%, while the U-6 actually climbed 0.2%.

The news wasnt unambiguously positive, however; the number of people working part-time
involuntarily rose from 5.77mm to 6.099mm an increase from 3.7% to 3.9%. But the market will likely
shrug this off for now and chalk it up to holiday seasonality.

In our last newsletter, we speculated that average hourly earnings were starting to show possible signs
of creeping upwards, a potential foreshadowing for inflation. They came in at 0.2%, as forecasted, but
that was after rounding up from 0.16%. This is a noticeable drop off from Octobers reading of 0.4%, so
for now the hourly wage canary in the coal mine doesnt seem to be a pressing concern as the y/y
increase is back down to 2.3%.

The only thing that could stop a hike at this point would probably be a major exogenous shock. Barring
that, the FOMC is set to hike next week.

Perhaps the most anticipated news at the FOMC meeting on the 16th isnt the actual hike (which is a
foregone conclusion), but the Summary of Economic Projections (SEP), aka the Blue Dots. The market
will be very interested in the Feds own forecasts for Fed Funds for the next 12-18 months. The Fed will
continue to use these forecasts as a method to provide forward guidance.

We expect the FOMCs blue dots will suggest a total of 1.00% in hikes in 2016. As we have been
suggesting all year, we think a pattern of hike/pause/hike/pause will be used. LIBOR has already
climbed to 0.2775% ahead of the anticipated hike, which means LIBOR could be about 1.25% this time
next year. The risk that the Fed hikes more than that is low and would probably require that inflation
starts showing up in the data, not just that the economy is doing well.

The odds the Fed hikes less than 1.00% is greater since there are countless factors that could contribute
to a slowdown. In general, the Fed is overly optimistic about projections and so the most likely outcome
is probably two or three hikes, putting LIBOR around 1.00%.

Why Did Rates Spike This Week?
If you werent watching rates closely, you may think they popped up after Fridays job report. In fact,
they actually fell after the report. The big move came Thursday when Draghi announced the extension
of QE in the Eurozone but disappointed markets by not making a bigger commitment. The 10T jumped
up to 2.36% before buyers came in (2.35% is a key resistance level). The 10T closed at 2.27% Friday
afternoon. The 10T will be impacted by actual Fed-speak, but more likely from outlying data reports
that the market then extrapolates over 10yrs as a change in policy.

The 2T was calmer, closing at 0.94%, but the rise over the last two months has been more dramatic.
Since the beginning of October, the 2T is up from 0.58%. If the 10T is driven more by data, the front end
is controlled directly by Fed-speak.

Expectations were so high heading into Fridays job data that the market had set itself up for
disappointment. Its basically like being a Cowboys fan every year, except if that were true than the
actual report would have shown a job loss rather than a nice gain.

While stocks started the holiday party early and pushed back toward all-time highs, JPM and Citi came
out with depressing reports. Citi put the odds of a recession at 65% and JPM raised them to 76%.

JPMorgans Mike Feroli wrote, Our longer-run indicators, however, continue to suggest an elevated risk
that the expansion is nearing its end, and our preferred model now puts the probability of recession
within three years at an eye-catching 76%.

Barclays put out an interesting research article that suggests a high correlation between large drops in
corporate profit margins and a subsequent recession.

Yellen was specifically asked about the odds of a recession during Thursdays Humphrey-Hawkins
testimony and she concluded that the odds were not anything close to that. Thats reassuring.

This Week
Rates feel range bound, with 2.35% on the 10T and 1.00% on the 2T serving as current ceilings.
Its a relatively quiet week ahead of next weeks FOMC meeting. It would take something
dramatic to get a trader to take a big position right now. P&L goals have probably been met and
traders are shutting down the books, just trying not to give the boss an excuse to cut their
bonuses. Big moves this week are probably attributable to illiquidity as much as some economic
data point.

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