Leveling the Playing Field

December 11, 2015

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June 2003 to August 2007 (one year before the first hike to one year after the last hike)
Before Hike
- 2T ran up 1.50% in the three months leading up to the first hike, pushing from 1.50% to 3.00%
- 10T also ran up 1.50%, but started sooner than the 2T
- Fed Funds moved on June 30, 2004
Immediately After Hike
- 2T dropped nearly 0.50% in the next six months
- 10T dropped 0.70% in the next six months
- Fed Funds climbed 1.00% in the next six months
And Then
- 2T climbed 1.30% over the next four months
- 10T was range-bound
- Fed Funds climbed another 1.00% in the next six months
Takeaways
- Rates actually fell after the first hike
- This trend persisted until the market realized the Fed was going to continue hiking for longer
than originally anticipated.
- Front end rates, more closely tied to the path of Fed Funds, rose much more than expected.
- The yield curve flattened substantially as Fed Funds caught up to Treasurys.

Overview - Fed Funds, 2T, and 10T June 2003 August 2007
-

The 2T, in particular, waited for Fed Funds to catch up. Once it became apparent the Fed would
continue to hike, it started to climb again.

Steepness - Spread Between Fed Funds and 2 Year Treasury from June 2003 to August 2007
-

The spread between Fed Funds and the 2 year Treasury jumped 1.50% ahead of the first hike,
and then actually declined.
This doesnt mean that the 2T declined, but Fed Funds climbed so much the gap closed.

Steepness - Spread Between Fed Funds and 10 Year Treasury from June 2003 to August 2007
-

Just like with the 2T, the spread between Fed Funds and the 10T dropped after the first hike.

Conclusions about the 2004-2007 Tightening Cycle

-

The 10T did a pretty good job forecasting where Fed Funds would end up.
The 2T underestimated the final landing spot of Fed Funds, but continued to climb higher as it
became apparent the Fed would continue hiking.
The yield curve flattened substantially as Fed Funds climbed, meaning Treasury yields did not
increase 1-1 as Fed Funds pushed higher.

Overview 2015
Before Hike
- 2T ran up 0.50% in the three months leading up to the first hike
- 10T also ran up 0.30%, but had been elevated for some time before that
- LIBOR started climbing mid-November in anticipation of the hike

Steepness in 2015 - Spread Between Fed Funds and 2 Year Treasury

-

The spread between Fed Funds and the 2T recently jumped 0.50% as a hike became more
apparent.
Recall that the spread in 2004 had jumped 1.50% ahead of the first hike, which raises some
questions why the steepness is so much less significant this time around.

Questions
Is the market pricing in a more accommodative FOMC?
Is the market counting on a patient Fed?
Is the market factoring in a weaker economy than in 2004?
Does the market expect global factors to weigh on the Feds tightening cycle?

Is the market setting itself up for a painful correction?

Or is this a reflection of a more transparent Fed?

Steepness in 2015 - Spread Between Fed Funds and 10 Year Treasury

- The spread in 2004 was nearly 4.00% at the peak.
- The same spread today is about 2.00%.
Questions
Todays steepness is half of what it was in 2004 - is the market setting itself up for a painful correction?
Or is the markets pricing just a reflection of the fact that the FOMCs current projections suggest a
tightening cycle about half of the pace we saw in 2004?

Conclusions
-

A transparent Fed has helped reduced some of the volatility priced into the steepness of the
curve.
It appears as though the market is taking the Fed at its word for now, expecting about 1.00% of
hikes in 2016.
The market is factoring in a less than robust domestic economy, slow global economy, and low
commodity prices as factors keeping yields low.

Concerns of how this could impact Treasury yields

- Market complacency created from six years plus years of ZIRP, a transparent Fed, and the
downward pressure on yields from global QE may have set the stage for a painful correction in
US Treasury yields.
- Spreads to Fed Funds (2T and 10T) are significantly smaller than they were in 2004 is the
market offsides?
- The FOMCs forward guidance is meant to boost the economy, not the P&L of Treasury holders.
If slow and steady works, the economy will continue to grow. This in turn could result in the Fed
shifting forecasts higher, which in turn will push yields up (see the 2T movement in 2005).
- Will regulation have unintended consequences?

If the economic data changes market perceptions for the pace of hikes OR if the FOMC changes its
forward guidance, there could be an acute and painful correction as yields move higher in short order.
This type of move would likely require improvement in the economy or the threat of inflation.
This does not represent our base case scenario, but rather a scenario that could catch the market
offsides in 2016.

How Did Cap Prices Behave from 2004-2007?

We have spent considerable time over the last year explaining why we thought two year caps on three
year financings made sense. We will not rehash that discussion here, but rather wanted to look at how
that strategy would have worked for a cap buyer on June 30, 2004 the day of the first hike.
With that in mind, here are the rough terms we used for this analysis:
- $50mm financing
- Three year maturity (6/30/07)
- Borrower deciding between two year cap with an agreement to buy a cap for the third year at
some point in the future OR just buying a three year cap at closing
- I rounded slightly just to keep the numbers simple, but the outcome is materially similar
Where were rates on 6/30/04?
- LIBOR was at 1.10%
- 2yr swap rate was 3.00% (1.90% above LIBOR)
- 3yr swap rate was 3.50% (2.40% above LIBOR)
To determine a comparable strike, we set the strike of this cap at 4.50%. This would have been about
1.00% above markets expectations for LIBOR during that third year.
To put that into todays terms, this cap would have a strike of about 2.15%.
Here is what a cap on LIBOR at 4.50% on 6/30/04 would have cost:
2 year cap: $167,000
3 year cap: $475,000 ($308k more than the 2yr)
The borrower would have needed to decide if the $308k in savings was worth the risk that the cap
would cost much more in the future. Keep in mind that the borrower was facing the exact same
scenario many of you are facing right now. Its a tough call to make in the face of a Fed about to start
hiking rates, right?
In order to track the price, we priced up a one year cap from 6/30/06 6/30/07 for the twenty four
months leading up to the 6/30/06 deadline to buy another cap. In other words, we looked at the caps
cost at the end of each month just like we have recommended to many of you.
As you will see in the graph below, the cap on that third year was less expensive every single month
after closing until about month 21, when LIBOR actually exceeded the strike. Even when LIBOR was as
high as the strike, you would have been better off not paying for year three at closing.

Cap Cost Graph

- The blue line represents LIBOR over the twenty four months from 6/30/04-6/30/06.
- The red line represents the monthly cost over two years to cap the third year.
- The black horizontal line representing the breakeven point.
o When the red line is above the black line, you spent more than you would have if you
bought a three year cap at closing.
o When the red line is below the black line, your combined costs of buying the two caps
are less than the $475k it would have cost at closing.

$700,000.00

$600,000.00

6.00%

Depsite LIBOR climbing from 1.10% to over 4.50%, the cap on year three
would have been cheaper to buy anytime up until Month 21, when
LIBOR exceeded the strike.

5.00%

$500,000.00
4.00%

$400,000.00
3.00%

$300,000.00
2.00%
$200,000.00

1.00%

$100,000.00

$0.00

0.00%

Forward Cap Cost

Breakeven

Actual LIBOR

For those of you facing this situation, we believe this makes a compelling case for buying a shorter term
hedge as long as you are committed to monitoring the price going forward. Do not buy a two year cap
and then just check back in 24 months. Make this an ongoing, dynamic hedging strategy.
Perhaps the biggest risk to this strategy would be a dramatic shift higher in expectations for Fed Funds.
As we can see from the analysis above, the cap got more expensive once LIBOR actually exceeded the
strike. A comparable strike today would be about 2.15%, which is much closer to todays LIBOR than the
4.50% strike was in 2004. Again, the flatness of the yield curve today relative to 2004 likely reflects a
transparent and patient FOMC, but could set the stage for a correction if conditions change. If the strike
of the cap you are buying is higher than 2.15%, you likely have some additional cushion to absorb a shift
in expectations.
And be prepared to buy the cap if the environment changes hope is not a hedge.

Economic Data
Day

Time

Tuesday

8:30 AM

Wednesday

Thursday

Friday

Report

Forecast

Previous

CPI MoM

0.002

8:30 AM

CPI YoY

0.006

0.002

8:30 AM

CPI Ex Food and Energy YoY

0.02

0.019

7:00 AM

MBA Mortgage Applications

0.012

8:30 AM

Housing Starts MoM

0.066

-0.11

8:30 AM

Building Permits MoM

-0.01

0.041

2:00 PM

FOMC Rate Decision (Upper Bound)

0.005

0.0025

2:00 PM

FOMC Rate Decision (Lower Bound)

0.0025

8:30 AM

Initial Jobless Claims

282K

8:30 AM

Continuing Claims

10:00 AM

Leading Index

11:00 AM

Kansas City Fed Manf. Activity

2243K

0.001

0.006

Speeches and Events

Day

Time

Friday

1:00 PM

Report
Fed's Lacker Gives 2016 Economic Outlook

Place
Charlotte

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