Leveling the Playing Field

December 1, 2014
______________________________________________________________________________
In last weeks newsletter, I concluded by saying that if the Cowboys were able to keep it within
24, they should consider it a moral victory. Let me be the first to congratulate the Boys on
doing just that. I suspect the 23-point win was quite a letdown in the Eagles locker room. I
know it was at my house.
Rates were quiet Monday, but bonds kicked off a rally on Tuesday following the 5 Year
Treasury auction with very strong demand. Then the floodgates opened on Wednesday with soft
data and an announcement from OPEC that production would not be changed.
This wasnt the same panic trade we saw 6 weeks ago, but rather a shift in mentality. The weak
economic reports werent catastrophic, but more of a suggestion that the domestic outlook looks
marginally less strong. The drop in oil has quieted inflation hawks and could buy the Fed some
time before choosing to move forward with a hike. The market is generally pushing back
expectations for a hike from mid-2015 to late 2015, early 2016.
From the Department of Beating a Dead Horse, we see nothing inherently wrong with this
conclusion. Where we diverge from the majority is that we dont believe the Fed needs
rocketing inflation to hike (although all of our developers have been complaining about inflation
for a year now). Remember, the Feds dual mandate is inflation and full employment. Inflation
is not rampant, but the Fed still believes it will move towards the long term goal of 2%. It also
believes it can control inflation quickly by hiking rates. That is debatable, but lets all agree that
inflationary pressures are not going to force the Fed to act anytime soon, good? Instead, lets
look at the labor market.
The current unemployment rate is 5.8% (although consensus forecasts call for a tick up to 5.9%
on Friday). This has declined by 1.4% in the last twelve months. Fast forward to next summer.
If the unemployment rate is sub-5%, regardless of job quality, the labor market is doing ok.
Maybe it isnt rewriting the record books, but it isnt recessionary either.
Critics point to the labor force participation rate, which is an anemic 62.8% and the lowest
reading since the early 1980s. However, the labor force participation rate was north of 66% in
the middle of the recession (December 2007 June 2009) and north of 65% in mid-2010. At
those same times, the unemployment rate was 7.5% and 9.5%, respectively. Raise your hand if

you would trade places right now with either of those time periods. Bueller? Bueller? Todays
labor force participation rate is not ideal, but it is also higher than any period pre-1977.
Even without inflation, the labor market improvements justify a slightly less accommodative
FOMC. We think Yellen just wants to move away from 0%. Thats it. Get Fed Funds (and
LIBOR) up to 0.25% - 0.50% and pause. Or if shes feeling lucky, go for 0.50% - 0.75%. We
really believe the Fed wants off the zero-bound range and will give the market time to adapt to
(gasp!) non-0% interest rates for the first time in over 6 years. Will your business collapse if
LIBOR skyrocketed to 0.50%? Didnt think so.
PS GDP was revised upward to 3.9%, so wtf rates?
We are holding the line while the market backpedals. We still think mid-2015 is a good estimate
for the first hike assuming economic trends continue. The good news, if we are wrong, is that
we have said this so many times that you wont have to look hard to find old newsletters and
send an email pointing out how wrong we were. Also, you will keep benefitting from 0%
interest rates. Youre welcome.
Long Term Yields
This leads us to a discussion on long term rates, which finally broke through the tiresome range
of recent memory. Fridays trading volume was too illiquid to allow us to definitively say a new
range (2.14% - 2.30% on 10yr Treasury) has been established. Theres a chance we could
rebound above 2.30% once everyone shakes the turkey coma off on Monday, but we doubt it.
We are heading into year end and the concerns over the global economy (not to mention the
attractiveness of US yields to European yields) should keep a leash on rates. This is more of a
short term view, however, and believe the 10yr Treasury is likely to climb higher over the next
couple of months absent negative news.
The biggest driver of rates in the near term will be (in chronological order)
1. December ECB meeting Thursday December 4th
a. Eurozone unemployment is 11.5%
b. Inflation is spiraling down from a peak of 3% and looks to go negative soon
c. Im not a licensed economist, but neither of those sound positive
d. Draghi has expressed the need to raise inflation as fast as possible. Get ready,
the ECB spigots are about to be turned on high. This will likely come in the form
of QE, probably where the ECB buys sovereign bonds similar to the way the Fed
bought Treasurys.

2. Fridays labor data

a. Strong NFP could push yields higher, but probably not a trend setter. A
surprisingly weak number, however, could push rates lower quickly.
3. FOMC meeting on December 17th
a. First meeting post-QE, will be interesting to see how the Fed addresses the
considerable period language. This is the phrase that Yellen told a reporter
meant six months after the conclusion of QE would begin the next tightening
cycle. If youve been living under a rock, QE ended last month. Is the clock
ticking?
b. Summary of Economic Projections (SEP) also released, aka the dreaded Blue
Dots. The Fed has said nothing about changing the time horizon for the mid-2015
liftoff. That feels significant. If they change that language and the dots push out
expectations, then we are all in on a delay to the first hike.
i. Check out our Blue Dots graph at the end of the newsletter, this can help
illustrate how the Fed has become more hawkish since June.
c. We think the Fed is about to embark on a mission to clearly change the way it
defines the timeline for the first rate hike. And to accomplish that, it will need to
change the language it is using. We expect a transition away from time horizons
(mid-2015, considerable period, etc) to data dependency. The time horizon was
originally used to calm markets and let everyone know the Fed was going to be
accommodative for a really long time. But that was needed to guide the US
through the turmoil of 2008. We dont think the Fed wants to be pigeon-holed
into a specific timeframe because it wants to adapt as needed. It also wants to
avoid incessant questioning about mid-2015 when we have seven more labor
reports to come out before then. What is the point of promising a rate hike next
summer when the economy could reverse course and start losing jobs in January?

This Week
Busy week ahead as noted above, with the ECB meeting and Fridays job reports making the
headlines. We would expect rates to be relatively range-bound into these reports as traders dont
want to be positioned to far one way or the other ahead of significant news. Monday may cause
some shuffling as liquidity returns and vacationing traders square up their books, but most of the
rate movement is likely to come later in the week and the significance of these releases and
meetings should allow us to clearly determine if this is the new range for yields or just a
temporary retracement.

FOMC Blue Dots as of September 14

5
Minutes Sep-14
Sep-14 Median
4

Jun-14 Median
OIS

0
2014

2015

2016

2017

Longer Term

Sep-14 Median

0.125

1.375

2.875

3.75

3.75

Jun-14 Median

0.25

1.125

2.5

3.75

Economic Data
Day

Time

Monday

10:00AM
10:00AM

Tuesday

10:00AM

Wednesday

Thursday

Friday

Report

Forecast

Previous

ISM Manufacturing

58.0

59.0

ISM Prices Paid

52.8

53.5

Construction Spending MoM

0.50%

-0.40%

7:00AM

MBA Mortgage Applications

-4.30%

8:15AM

ADP Employment Change

223K

230K

8:30AM

Initial Jobless Claims

8:30AM

Continuing Claims

8:30AM

Change in Non-Farm Payrolls

225K

214K

8:30AM

Change in Manufacturing Payrolls

8:30AM

Unemployment Rate

8:30AM
10:00AM

13K

15K

5.70%

5.80%

Trade Balance

-$41.0B

-43.0B

Factory Orders

-0.20%

-0.60%

Speeches and Events

Day

Time

Report

Monday

12:15PM

Fed's Dudley Speaks on Economic Outlook

Wednesday

12:30PM

Fed's Plosser Speaks on the Economic Outlook

2:00PM

US Federal Reserve Releases Beige Book

Place
New York, NY
Charlotte, NC
Washington, DC

Treasury Auctions
Day

Time

Report

Size

None

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