Leveling the Playing Field

May 4, 2015
______________________________________________________________________________
Maybe rates are finally interesting again. Two weeks ago we wrote that we expected to be
range-bound until Wednesdays FOMC meeting, and that IF the 10T broke out of its range
before then, it was more likely to be to the downside.
All appeared well on Monday morning with rates stuck right in the middle of their respective
technical ranges. The 10T was at 1.94%. Then rates popped up across the curve, well ahead of
the FOMC meeting and without any dramatic headline news that would suggest a jump in rates.
So what happened?
Before we dig into the technical factors, a couple of news stories broke that provided some
framework for higher rates. Firstly, Greek Finance Minister Yanis Varoufakis was replaced as
the lead negotiator in the debt talks. Greek stock markets rallied 4% on the news, as he was seen
as being an ineffective negotiator and strongly disliked (and not respected) by his Eurozone
counterparts. Tsipras isnt much better, but Varoufakis had really created a lack of trust among
committee members. This news, as well as some strategically timed leaks about optimism
around a deal being reached, created an environment for some additional risk taking.
Around the same time, two of the most well-known fund managers (Gross and Gundlach) both
called German bunds the short of a lifetime. This put upward pressure on German yields,
which were trading right at 0%.
This is when the technical stuff started to happen. A German auction failed to attract enough
investors to take down the entire issuance. Can you imagine Rick Santelli breaking in to say a
US Treasury auction had failed to sell out? Me neither, but investors apparently arent satisfied
with 0% coupons from Germany anymore, and this pushed German rates up.
What does that have to do with domestic yields? Weve been saying for about a year now that
Eurozone yields have a leash on US yields. Any time US 10Ts leak higher, the spread between
German and US yields widen and US yields look more attractive on a relative basis. This pushes
money back into USTs, which in turn brings the rates here back down.
The same thing happened, only in reverse. The spread narrowed, making USTs look less
attractive, and money flows out of USTs. This pushed our yields higher.
Additionally, corporate issuance was incredibly heavy and the Treasury had three auctions. That
is a lot of paper to hit the market all at once, and investors clearly had a tough time digesting it
all. We also heard from IG desks that May issuance is expected to one of the heaviest issuance
months in recent memory. Its likely that insurance and pension funds were selling some
Treasury holdings in order to free up cash to buy higher yielding investment grade debt this
month.

If issuance comes in as high as expected, that should keep pressure on the long end of the curve.
The FOMC on Wednesday basically stayed out of its own way, which an incredibly benign
statement. The Fed did drop all remaining references to calendar-driven timelines for a hike,
putting us fully in data-dependency mode.
"Although growth in output and employment slowed during the first quarter, the Committee
continues to expect that, with appropriate policy accommodation, economic activity will expand
at a moderate pace, with labor market indicators continuing to move toward levels the
Committee judges consistent with its dual mandate."
This is the Feds way of saying it believes Q1 GDP was soft because of weather and not some
new trend. The Fed will get two more job reports before the next meeting, so a June hike isnt
entirely off the table even if the market is pricing it that way. Two blockbuster NFP or a
dramatic movement toward 5% on the UR could put June in play. This is unlikely, but it cant
be completely ignored when two Fed officials spent the day Friday telling markets that a June
hike is still an option.
Oil and the dollar have stabilized, and by its own admission the Fed believes inflation is firming
up. That is two out of the three pillars the Fed has been citing as the key determinants for the
first hike. The missing piece is the labor markets. Guess what we have coming up on Friday?
We continue to believe the market is underestimating the probability of at least one rate hike this
year. Futures markets are putting the greatest probability for a hike occurring in early 2016,
while we still believe it is July/September with a bias towards September.
That puts a tremendous amount of pressure on Fridays report. Last months gain of just 126k
jobs was the weakest since Dec 2013. But again, most believe that was weather driven. The
consensus forecast is for a gain of about 220k jobs this month. Another weak print on Friday
and we bet rates fall and the market pushes a hike even further into 2016. But a strong job
report, and the market will be forced to backpedal a bit on its pricing for rate hikes.
Required Caps
Two and three year rates are the most impacted by changes in expectations for rate hikes. Two
year rates jumped about 8bps last week. That may not sound like a lot, but its a 15% increase in
five days. And we are still about 15bps away from the highs in March when expectations for a
hike were at their highest. A strong job report on Friday could move the front end of the yield
curve higher by as much as 15bps. If you are buying a cap, brace yourself for extreme volatility
and the likelihood that the price could jump dramatically in short order.

Economic Data
Day

Time

Monday

10:00AM

Factory Orders

Wednesday

7:00AM

MBA Mortgage Applications

8:15AM

ADP Employment Change

8:30AM

Initial Jobless Claims

277K

262K

8:30AM

Continuing Claims

2253K

8:30AM

Change in Nonfarm Payrolls

230K

126K

8:30AM

Unemployment Rate

5.40%

5.50%

8:30AM

Labor Force Participation Rate

62.70%

10:00AM

Wholesale Inventories MoM

0.30%

0.30%

Thursday

Friday

Report

Forecast

Previous

2.10%

0.20%

-2.30%

190K

189K

Speeches and Events

Day

Time

Report

Place

Monday

12:25PM

Fed's Evans Speaks on Economy and Monetary Policy

Wednesday

9:15AM

Fed's Yellen, IMF's Lagarde Speak on Panel

Washington

1:15PM

Fed's George Speaks on Credit Markets Panel

Washington

1:30PM

Fed's Lockhart Speaks on Monetary Policy

Indiana

Louisiana

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