Leveling the Playing Field

February 15, 2016

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Markets closed today as Panthers fans try to figure out if they should back to being Seahawk
fans. Panther Nation is slowly retreating back from whence they came...trying to save face (15-2
is a great season! Peyton was a sore loser in the Super Bowl, too! We have a great core group
and will make a deep run for the next five years!) while they backpedal from all that furious talk
about being one of the best teams ever. I pulled for the Panthers, but a small part of me was
happy to see little brother (Philly vs Charlotte) get put in his place. just a small part.
Yellen spent her testimony to Congress this week suggesting a hike was still on the table at the
FOMC meeting in March. Let us be totally clear there is no way the Fed hikes in March.
Zero. They werent going to hike before the panic trade last week and there is absolutely no way
they hike after those gyrations. So why did she expend so much energy reiterating the Fed was
open to hiking in March?
One simple answer.
She is trying to manage the retreat.
Sound familiar Panther fans?
FOMC An Orderly Retreat
Yellen is in a tough spot. The FOMC spent 18 months warning us about a hike. We felt like
they missed the boat last summer and waited too long. How does a self-described datadependent Fed justify a hike in December when the data had weakened since the summer? But
they hiked nonetheless.
And now they are stuck. The market is in turmoil. Traders are describing last weeks moves to
the 2008 meltdown. Im skeptical as to whether we are really seeing the beginning stages of a
sharp reversal, but markets are clearly on edge. There is no way the Fed hikes while the market
is oscillating so wildly because it would just compound the problem.
Furthermore, taking a hike completely off the table is the first step in admitting it erred in hiking
at the December meeting. It suggests the economy is too weak to absorb another hike, which
could also induce more panic. Even the Fed, THE FED, knows the economy is in trouble!
But the Fed desperately wants to get off the zero bound. We are in unchartered waters here.
Countries that have hiked off of 0% have had to cut again in short order. Yellen may want to get
two hikes in just to prove its possible. Roger Bannister had to break the four minute barrier
before people believed it could be done, now high schoolers do it. Yellen wants to go down in
the econ textbooks as the first central bank leader to lift off the zero bound.

And perhaps this turmoil will settle in the coming months and a full blown collapse will be
avoided. The Fed cant afford to say now, All hikes are off because of the lead time for reengaging hikes is so long (18 months leading up to December). If the Fed says no hikes, it really
means no hikes until the end of 2017. She cant make long term decisions like that based on
short term disruptions (if thats what this ends up being).
Yellen et al continue to talk about being open to a hike. But we will need to see an extended
period of calm before they can hike. What part of the global situation suggests that is right
around the corner?
The Fed is on hold for now, probably until at least the summer. And they need a lot of things to
break their way for that to happen.
Here is where things get really tricky. Most economic forecasts called for a slowing economy at
the end of this year even before this recent mess. Toss in a presidential election with polarizing
candidates and business could really slow down. In other words, the longer the Fed waits to
hike, the harder it becomes.
But..Yellen is like Colonel Jessep on his Code Red ordershe wants to hike. And she
wants to tell us she is hiking again. I think shes pissed she has 4.9% unemployment and cant
hike again. I think she wants to say she made a command decision about hiking in December
and thats the end of it.
(Imitating Jessup): She eats breakfast 300 yards away from 400 politicians that think they are
smarter than her. And nobody is going to tell her how to run her Fed, least of all the Ivy league
bureaucrats with no economic experience and a state schooler in Charlotte.
So yes, I think the Fed has a bias towards hiking, but cant hike in the face of global panic. And
if they can squeeze just one more hike in, Yellen can say we got off 0% and then pause. And I
would bet money a hike in that environment would come with some sort of assurances that there
isnt another hike for an extended period of time. We got to 0.75% and we are staying her until
at least the end of 2017.
We believe March is off the table, but April or June could potentially bring another hike if
markets settle down and domestic data comes in reasonably strong.
The next FOMC is March 15/16 and will bring an updated Summary of Economic Projections
(SEP aka blue dots) forecast for the economy and Fed Funds. As part of the orderly retreat, we
suspect the blue dots will show a slower pace of hikes. They will still be overly optimistic, but
the Fed needs to gradually back down expectations.
Retreat in an orderly fashion is still a retreat, no matter how you dress it up.

Why Would Long Term Rates Move Higher?

They probably wont. At least in the near term.
China data continues to come in weak. Brazil is in a depression. Russia is expected be in a
recession through at least this year. Further easing in the Eurozone is expected. Negative rates
in Japan and several European countries. The World Bank has turned negative GDP revision
forecasts into a cottage industry. US corporates are warning of slowing profits in the coming
quarters. German bunds closed Friday at 0.26%. Japans 10yr sovereigns are at 0.09%. USTs
look very appealing vs those yields.
As we predicted last week that we could see a short term reversal following the plummet to
1.50% on the 10T, we could continue to see short-lived jumps in Treasury yields. But a
sustained climb higher feels very unlikely right now.
German bunds that pesky leash that started yanking US yields around last year could do the
same in the coming months. With more QE coming in the Eurozone, it seems unlikely bunds
will experience strong upward pressure on yields. As you can see in the graph below, the spread
between USTs and Bunds is at 1.48% right now. Over the last year, thats about 10bps above
the low and 10bps below the average, the definition of range bound. A dramatic swing here
seems unlikely.

China Devalue Currency if China pursues further devaluation, it will exert short term, upward
pressure on USTs. But as you can see below, the dreaded Selling out of China! following the
August 11th announcement never materially impacted our rates materially.

Notice how the line goes screaming lower at the end of that graph? That was when the Fed
hiked in December.
Good call.
Steepness
With the front end up 0.25% following the December rate hike, the steepness between LIBOR
and 10yr swaps is at a three year low. In other words, the premium to go from floating to fixed
is low right now. Heres a graph showing we are back to 2013 levels.
.

Where Do We Go From Here?

There could be room to move lower if the market really starts to worry about a recession. We
dont think its the most likely scenario, but can anyone say with certainty that 10yr rates cant
go to 1.00% if things continue to deteriorate?
Its difficult to get a grasp on short term rate movements right now because so much of the price
action lately has been emotional. Traders are scared and pricing tends to gap in that sort of
environment. It appears there are far more reasons for US yields to remain here or lower than to
spike. Moves higher are likely short term trading oscillations rather than a shift in sentiment.
We are still in the camp that the sharp movement last week was overdone (too low too fast), but
we also dont think the 10T needs to run up above 2.00% in the next few weeks.
For T10 to break below 1.50%, we probably need to see oil move lower or more concerns in
bank stocks. If bank stocks plummet and/or CDS spikes, the resulting panic will lead markets
right into the welcoming bosom of the US Treasury market, also known as the Worlds Mattress.

Alternatively, a sustained move higher will likely require an extended period of calmness before
markets can start factoring in fundamentals again. Would you want to be the trader betting on a
sell-off in this type of environment? Better to sit on the sideline and now ruin your entire 2016
P&L budget because of one bad run.
Should I Swap to Fixed?
The premium to convert to fixed for 10 years is about 1.17%, which is basically four rate hikes.
That feels highly unlikely in the next 24 months. But I cant say four hikes over the next ten
years wont happen.
A lot of this newsletter has been spent on trader mentality, but it is important to highlight the
difference between a trader and a borrower. The single biggest difference is time horizon.
A borrowers time horizon is frequently 5-10 years until they sell or refinance. A trader, even
when buying or selling 10yr rates, can reverse their position within two seconds. They arent
committed to holding that hedge for the next ten years - they simply sell the other side and move
back into a neutral position. Hey, I was wrong. Time to change my position.
Borrowers, however, are living with these decisions for perhaps the next decade. While we talk
about trader mentality and the short term impact it has on rate movements, be sure to carefully
consider yourselves as hedgers, not traders. You cant reverse your decision in two seconds
when new information becomes available.
Thats why we encourage you to diversify your rate risk. Find a mix of fix/float that works for
your business and risk tolerance.
Jonathan Stewart is sitting next to me on the plane while I write this. Thankfully hes been
asleep the whole time because he may not enjoy my thoughts on the Panthers.
Or 10yr rates for that matter.

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