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Leveling the Playing Field JP Conklin 704-887-9880 office jp.conklin@pensfordfinancial.com www.pensfordfinancial.com

Leveling the Playing Field

JP Conklin 704-887-9880 office jp.conklin@pensfordfinancial.com www.pensfordfinancial.com

October 24, 2011

The passing of one of longest tenured dictators has many celebrating, but not me. I am one of those fortunate souls that can run a sub-4.30 40 yard dash, and with no more Al Davis, who will draft me? Oh, what’s that? You thought I was talking about Gaddafi? No, I’m glad he’s gone.

Rates are under some upward pressure lately, in part to Europe refusing to collapse. Nothing dramatic, but rates moved slightly higher on the week. Take a look at the section below on “Melt Up” and it may help explain why we think rates are headed higher through year end.

Fed Speak

Although recent data has been generally better than expected and suggest moderate growth, Fed speakers have reinforced that unemployment remains at unacceptably high levels. We expect a more formal policy framework to be unveiled at the November FOMC meeting with specific inflation and unemployment thresholds.

Fed Vice Chairman Yellen reiterated Chicago Fed President Evans’ earlier statement that the Fed will keep rates at 0% until the Unemployment Rate falls below 7% or outlook for inflation. She also noted that additional securities purchases “might become appropriate” if her forecast for a modest pickup fails to materialize.

Additionally, Evans/Rosengren/Tarullo have all signaled they would support additional quantitative easing. Tarullo said “there is need, and ample room, for additional measures to increase aggregate demand in the near to medium term.” He also called the current labor market a “crisis” just like those fans of a certain South Bend team might be experiencing.

But what happened to the Fed’s plan (mainly Bernanke) of leaning on Washington to enact fiscal policies to help with the economy? Tarullo said this is still ideal but “the absence of such policies cannot be an excuse for the Federal Reserve to ignore its own statutory mandate.”

For these reasons, we believe QE3 will be rolled out at the December or January FOMC meeting.

On Tuesday, Tim Geithner said the “US cannot ove rhaul tax code in two months”.

On Tuesday, Tim Geithner said the “US cannot overhaul tax code in two months”. If the past is any indicator, we should have a brand new tax code by year end. Now if I could just get Timmy to say “The Eagles will NEVER make the playoffs” just like he assured us the US would never lose its AAA rating.

From the Department of WTF, Merkel canceled her EFSF statement on Thursday and markets didn’t seem to care. So, the only country strong enough to bail out the entire Eurozone continues to send mixed signals about its desire to provide a bailout and markets react nonchalantly? Maybe people are just tired of being negative? And then on Friday the German Parliament limited the country’s bailout commitments and rejected any deal that would effectively transform the EFSF into a commercial bank. And what was the result? US equities were up 2%. WTF?

Moody’s announced it is set to review French triple-A rating, and like we’ve been saying all along, we expect a downgrade at some point. Moody’s also said there is “no way for Greece not to default”. Meanwhile the Misery Index is up to 13.0, the highest reading since 1983.

Melt Up

I learned a new phrase this week from TBTIEK (The Best Trader I’ve Ever Known). I heard PIMCO had sold equities and bought fixed income in “insane size” from one of my contacts. When I contacted TBTIEK to ask what he thought, he said he wished he was big enough to take the other side and save PIMCO the transaction costs.

When I asked him to explain why he felt this way, he responded:

“I'm pretty agnostic here believe it or not…I still think there's a significant non-zero chance that we have a risk melt-up into year-end as everyone is negative and no-one is positioned for a bounce…could see 1350-1400 S&P…been buying some out of the $ calls and I'm short the euro against the swiss franc as i think the market’s going to test the SNB's resolve around defending the 1.20 level. Rates are a super boring trade to me here…the Fed's buying coupled with dealer's risk aversion is going to keep the market contained on the downside (as dealer's aren't going to aggressive trade until 2012), but I still can't see owning fixed income at negative real rates as an investment…clearly pensions/ins companies/fed have buying mandate but anyone that doesn't have to own fixed income is better off not owning treasuries in my view.”

When I asked him to explain (because I’m slow) what he meant by “melt-up” he suggested that everyone still remembers the lessons from three years ago. We tend to forget what happened a decade ago, but not just three years ago. So the European crisis has everyone on edge and short the markets. As Europe continues to avoid implosion, short positions get squeezed out and markets actually move higher. Hence, a melt up.

He’s up 29% since he started his own fund a few months ago , so

He’s up 29% since he started his own fund a few months ago, so I listen to what he says. I should have him draft my fantasy football team, which has one win and is a 41 point dawg this weekend.

Year End Trade Idea

If you need to free up some cash flow heading into year end, you may want to consider modifying an existing swap to drop the rate lower for the next two months and pay a higher rate at a later date.

For example, let’s assume you have a $10mm swap at 5.00% and could use some short term cash flow relief. If we can negotiate a temporary 2.00% reduction for two months, that would save $33,000 in November and December. Now, you have to add this back in at some later point in the swap, but the point is we can defer interest to help with cashflow for 2011.

And if you’re one of the lucky companies out there that would actually like to reduce net income this year, you can do the exact opposite. You could increase the rate over the next two months and in exchange lower the rate at some other point of the swap.

Please give us a call to discuss these cash flow ideas.

LIBOR Outlook

Our projection is for 3m Libor to rise as high as 45 bp by late October, and push above 55 bp by year-end.- BNP Research 10.17.11

From the same report:

In periods of little market stress, the distribution of the quotes tends to be skewed upwards - meaning the difference between the highest quote and the setting is greater than the difference between the lowest quote and the setting. As funding pressures have escalated, the quotes now have a pronounced downward skew - the lowest quotes are much farther below the setting than the highest quotes are above it.

Since funding stress re-emergerd in mid-July, the dispersion of 3m Libor quotes has also become quite "gappy," and the rank order of the bank quotes has shifted considerably. The contrarian signal to the steadily rising 3mL setting is coming from HSBC, which has recently been lowering is quoted borrowing rate. Shorter-term unsecured rates such as 1mL are under less pressure, and the spread between 1mL and 3mL is likely to continue to widen.

The recent Euro sovereign downgrades will likely put additional pressure on the ratings, credit spreads and financing conditions for Euro-area financials, particularly those banks in the affected countries or with considerable exposure to them.”

Although we almost never recommend one year swaps, it may make sense to swap a
Although we almost never recommend one year swaps, it may make sense to swap a

Although we almost never recommend one year swaps, it may make sense to swap a portion of your debt through December 2012 at approximately 0.50% to protect yourself in the event of a LIBOR run up.

Fixed Rate Outlook

We’re at the top end of the range over the last two months, but keep in mind what TBTIEK said about a risk melt up heading into year end. If he’s right, that means rates can move higher from here. As people pull money out of Treasurys to chase risk assets, rates move higher. A 10yr Treasury at 2.50% seems entirely reasonable by year end.

Operation Twist is doing an effective job of flattening the yield curve. Check out what has happened to the spread twixt 10T and 30T in the graph below. Thursday and Friday are bringing about a reversal and the curve may steepen in the near term, but I’m wary about fighting the Fed and would expect the spread to compress over the long term.

This Week Very full week of data ahead, most notably the advance release of GDP
This Week Very full week of data ahead, most notably the advance release of GDP

This Week

Very full week of data ahead, most notably the advance release of GDP for Q3, which should come in around 2.3%. Durable Goods should see a boost from Boeing orders and hopefully Consumer Confidence will rebound from historically low levels and reflect the recent uptick in data strength. Unfortunately, there are also a several data points on housing which will likely remain very weak.

Biggest speech of the week is on Monday when NY Fed President Dudley gives his views on the economy, policy, and Eurozone issues.

Treasury auctions beginning Tuesday.

Wells Fargo mixed up about 4,000 monthly statements between customers and then blamed it on a faulty printer, which has since been decommissioned according to the bank. That surprises me, because WFC tends to decommission the good printers and promote the broken ones…

ECONOMIC CALENDAR Economic Data Day Time Report Forecast Previous Monday 8:30AM Chicago Fed Nat

ECONOMIC CALENDAR

Economic Data

Day

Time

Report

Forecast

Previous

Monday

8:30AM

Chicago Fed Nat Activity Index

 

-0.43

Tuesday

10:00AM

Consumer Confidence

 

46.0

45.4

10:00AM

House Price Index MoM

 

0.8%

10:00AM

Richmond Fed Manufacturing Index

-6

Wednesday

7:00AM

MBA Mortgage Applications

-14.9%

8:30AM

Durable Goods Orders

 

-0.7%

-0.1%

8:30AM

Durables Ex Transportation

0.5%

-0.1%

10:00AM

New Home Sales

 

300k

295k

10:00AM

New Home Sales MoM

 

1.7%

-2.3%

Thursday

8:30AM

GDP QoQ (Annualized)

2.3%

1.3%

8:30AM

Personal Consumption

1.9%

0.7%

8:30AM

GDP Price Index

 

2.4%

2.5%

8:30AM

Core

PCE QoQ

2.2%

2.3%

8:30AM

Initial Jobless Claims

 

403k

8:30AM

Continuing Claims

 

3719k

10:00AM

Pending Home Sales MoM

 

0.3%

-1.2%

10:00AM

Pending Home Sales YoY

 

13.1%

11:00AM

Kansas City Fed Manufacturing Activity

 

Friday

8:30AM

Personal Income

 

0.3%

-0.1%

8:30AM

Personal Spending

0.6%

0.2%

8:30AM

PCE Deflator (YoY)

 

2.9%

8:30AM

PCE Core

(MoM)

0.2%

0.1%

8:30AM

PCE Core

(YoY)

1.7%

1.6%

9:55AM

U. of Michigan Confidence

 

58.0

57.5

Speeches and Events

 

Day

Time

Report

Place

Monday

8:45AM

Fed's Dudley speaks on the Economy in the Bronx

 

Bronx, NY

9:00AM

Fed's Fisher speaks in Toronto on U.S. Economy

Toronto, Canada

1:00PM

Fed's

Dudley speaks to Bronx Chamber of Commerce

Bronx, NY

Wednesday

5:15PM

Bank of Canada Governor Carney speaks

 

New York, NY

Treasury Issuance

Day

Closing

Issues

Size

Tuesday

1:00PM

2 year Treasury

$35B

Wednesday

1:00PM

5 year Treasury

$35B

Thursday

1:00PM

7 year Treasury

$29B

BLOOMBERG SURVEY RESULTS Fed Funds 3.50% 3.00% 2.50% Median 2.00% Average 1.50% High Forecast 1.00%

BLOOMBERG SURVEY RESULTS

Fed Funds

3.50% 3.00% 2.50% Median 2.00% Average 1.50% High Forecast 1.00% Low Forecast 0.50% 0.00% 4Q
3.50%
3.00%
2.50%
Median
2.00%
Average
1.50%
High Forecast
1.00%
Low Forecast
0.50%
0.00%
4Q 2011
1Q 2012
2Q 2012
3Q 2012
4Q 2012
1Q 2013
2Q 2013
10 Year Treasury
6.00%
5.50%
5.00%
4.50%
Median
4.00%
Average
3.50%
3.00%
High Forecast
2.50%
Low Forecast
2.00%
1.50%
1.00%
4Q 2011
1Q 2012
2Q 2012
3Q 2012
4Q 2012
1Q 2013
2Q 2013

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