The Pensford Letter - 5.6.13

Leveling the Playing Field May 6, 2013 _______________________________________________________________________ Im rethinking that decision to put Michael Jordan in charge of the
Quail Hollow greens Despite the incredible amount of data last week, it was a relatively sedate week in rates until Fridays labor reports. The 10 year Treasury remained within a 3bps intraday range and traded as low as 1.62% before spiking to 1.74% on Friday after the jobs report. This puts the 10 year Treasury close to the top of the range (1.80%-ish), but unless it breaks through higher we would expect it to encounter resistance here. The news of Israel attacking Syria may give traders an excuse on Monday morning to buy Treasurys. Regardless, we dont think 10 year rates are poised to spike just yet. Labor Data Even for a skeptic like me, Fridays labor data looked reasonably positive. Not only did the workforce add a respectable 165k last month, but March was revised higher and February was revised up to a gain of 332k jobs. That is the first 300k + print in three years. Surprisingly, the Unemployment Rate dropped to 7.5%, and more surprisingly, this wasnt the result of a weakening participation rate. Construction and manufacturing suffered a bit as expected following the post-Sandy slowdown; however, retail, healthcare, and tourism all contributed positively to the data. Unfortunately, these jobs are typically of lower quality. The UR for high school grads dropped from 7.6% to 7.4% while the UR for college grads actually increased from 3.8% to 3.9%. These stats tie out nicely with the total number of hours worked, which dropped by 0.4%. The U6 rate increased from 13.8% to 13.9%. Lets face it, 165k gain in jobs isnt anything to write home about. But, given the fiscal headwinds and the global struggles, it is a reassuring sign that the US economy continues to hold its own. But heres a key takeaway at the current pace, the Unemployment Rate will reach 6.5% sometime in mid to late 2014. This could put the Fed in a bind. This probably means the Fed will monitor the UR over the next several months and be prepared to amend its language around QE and Fed Funds, if warranted. Any increased uncertainty around a
possible Fed move could translate into increased volatility not just in long term interest rates, but near term rates as well. This will directly impact the cost of interest rate caps, which are historically cheap due to the transparency around Fed Funds (and therefore LIBOR) for the next two years. FOMC Meeting As expected, last weeks FOMC meeting was largely a non-event. But this is only the sterilized formal policy statement. With all the recent chatter about tapering, we wonder if there is a growing internal divide amongst the voting members. The statement itself reiterated the same old slow and steady message, but the minutes released in a few weeks could reveal more. The statement did note that fiscal policy is restraining economic growth, which not only shifts some of the emphasis from the Fed to Congress, but also lays cover fire for a cautious approach to QE; We were ready taper but felt like we shouldnt given the antics in Congress. The statement also indicated that the Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. This is a way to put tapering on the table but also says it could actually increase QE, particularly if inflation turns to deflation. The Fed probably wants to see 2-3 consecutive quarters of 2.5% + GDP plus 200k per month NFP gains before tapering begins, therefore we see no changes to the current pace of $85B in long term securities any time soon. Separately, Bernankes impending retirement hasnt gotten much press yet, but we would expect markets to get jittery pretty soon. His term is set to expire on January 31, 2014. All signs indicate that he is not planning to stay on (we heard he isnt even attending the Jackson Hole meeting this summer) and that Janet Yellen will take the helm. Bernanke has trained the markets to expect full governmental backstop at all costs. He is buying up $85B in long term securities each month with no end in sight. We can argue the efficacy of QE, but the economy has avoided sliding back into the 2009 crisis and stocks are at all-time highs. Yellen is likely to continue this policy, but until she is formally nominated and confirmed markets may worry, particularly if Congress makes noise about not approving her (or another candidate).
LIBOR Outlook The Unemployment Rate could reach 6.5% before the Fed is comfortable raising Fed Funds (and therefore LIBOR). We believe the Fed would amend its language well ahead of a drop to 6.5%, but for the first time in a long time there is at least some potential for volatility in short term rates. The short end of the curve, from LIBOR up through 2 year Treasurys, has been anchored for some time with the Fed committed to ZIRP. Transparency has made short term hedging very inexpensive. An increase in uncertainty would lead to higher costs. This is important to note if you anticipate buying 1-3 year caps in the coming quarters.
Fixed Rate Outlook As discussed last week, the FOMC meeting had little impact on rates but Fridays job data created a 12bps pop on Friday. This puts the 10 year Treasury close to the top of the range (1.80%-ish), but unless it breaks through higher we would expect it to encounter resistance here. The news of Israel attacking Syria may give traders an excuse on Monday morning to buy Treasurys. Regardless, we dont think 10 year rates are poised to spike just yet.
This Week Pretty slow week for data, but several Fed speeches planned to reiterate and clarify the Feds policy.
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Economic Calendar
Economic Data Day Monday Tuesday 10:00AM 3:00PM Wednesday Thursday 7:00AM 8:30AM 8:30AM 10:00AM Friday 2:00PM IBD/TIPP Economic Optimism Consumer Credit MBA Mortgage Applications Initial Jobless Claims Continuing Claims Wholesale Inventories Monthly Budget Statement 335k 3018k 0.4% $106.0B 47.3 $16.000B 46.2 $18.139B 1.8% 324k 3019k -0.3% Time Report Forecast Previous
Speeches and Events Day Wednesday Thursday Time 8:30AM 8:00AM 1:15PM Friday 8:25AM 9:30AM 2:00PM Report Fed's Stein speaks at Chicago Fed Conference Fed's Lacker speaks on Financial Stability Fed's Plosser speaks on Monetary Policy Fed's Evans speaks at Chicago Fed Conference Fed's Bernanke speaks at Chicago Fed Conference Fed's George speaks on the Economy Place Chicago, IL New York, NY New York, NY Chicago, IL Chicago, IL Jackson, WY
Treasury Auctions Day Tuesday Wednesday Thursday Time 1:00PM 1:00PM 1:00PM 3-year Treasury Auction 10-year Treasury Auction 30-year Treasury Auction Report Size $32B $24B $16B

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Leveling the Playing Field May 6, 2013 _______________________________________________________________________ Im rethinking that decision to put Michael Jordan in charge of the

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