Leveling the Playing Field July 14, 2014

_______________________________________________________________________

LeBron I am a huge fan. I never got mad about The Decision. It was poorly executed,
but I never doubted your motives. I knew you werent trying to injure Cleveland. You
decided to join a team that could help you win titles and got to play with some buddies at
the same time. No issues. But the decision to go back to Cleveland stuns me. Dan
Gilbert is an atrocious owner and posted a nasty letter about you that he left up online for
four years! He has done nothing to demonstrate an ability to build a winner. The Cavs
have had three #1 picks in the last four drafts. Thats almost statistically impossible.
Maybe they are on the verge of putting a strong young team together, but history says
otherwise. A year or two from now, I dont want to hear about you opting out because
management isnt doing enough to build a championship caliber team around you. I hope
you tear it up and bring Cleveland a title, but dont say we didnt warn you.

XOXO
JP

We are starting to think the Fed might be saying the same thing a year from now. And
our complacency, fostered by nearly 8 years of a zero interest rate environment, will be
punished. Before we touch on that, lets discuss the drop in rates last week.

Rates pushed lower across the curve by 0.10%-0.14% last week on concerns over
Portugals Banco Espirito Santo missing payments on some short term debt instruments.
Is the eurozone headed for another crisis? Or is this just a minor blip?

We believe it is the latter. While the Portuguese government may need to step in, it
already has a 6.4 billion fund established under the Bank Solvency Support Facility
established in 2012 to deal with bank recaps. Additionally, Banco Esprito Santo appears
to have limited interconnectivity with other banks in the region, so contagion seems
unlikely. The movement lower in US rates is probably attributable to a combination of:

1. Knee jerk reaction to possible contagion
2. Abundant liquidity (have to put the money somewhere)
3. Summer trading doldrums

While the damage to the Eurozone should be contained, this news does serve as a
reminder of the link between banks and governments and the challenges they encounter
when dealing with a jittery market. Allianz CIO Maximilian Zimmerer said at a
Bloomberg conference in London, The fundamental problems are not solved and
everybody knows it. He warned that the euro crisis is not over.




Dont Say We Didnt Warn You

Fridays speech by Philly Fed President Charles Plosser went largely unnoticed due to
concerns in the Eurozone, but he stated the Fed should hike rates sooner rather than later.
We have to take what he says with a grain of salt because he is more hawkish than most
FOMC voters. Plosser dissented against the March 2008 75bps cut, the April 75bps cut,
and Operation Twist.

But when we couple this sentiment with St Louis Fed President Bullards remarks on
Thursday that the Fed is likely to raise rates sooner than expectedand KC President
Esther Georges comments on Thursday that she is anxious to move towards
normalization.and the fact that the recent FOMC minutes indicated the Fed believes
the market is not pricing in enough uncertaintywe think the Fed is starting to send
signals that we should be paying attention to. One year from now they could easily
defend a rate hike by pointing to all the comments made beginning in the summer of
2014

From a BNP Paribas report on Friday:

The Feds persistently dovish stance is reminiscent of the Bank of Englands stance
almost exactly a year ago. Likewise, the US money-market curve is priced almost exactly
as the UK curve was priced last August.

Although there are some differences between the state of the US economy and monetary
policy today and that of the UK last August, the similarities are significant. They suggest
that current market pricing is underestimating the probability of an erosion of the Feds
dovish stance.

As the labour market continues to improve and inflation has been surprising to the
upside, it will be increasingly hard for the Fed to remain so dovish.

Therefore we expect the US curve to re-price, bringing forward the timing of the first rate
hike. Next weeks Humphrey-Hawkins testimony may not be the catalyst for this re-
pricing, but risks around the testimony are asymmetric, in our view.

Hence, we recommend trades that imply a re-pricing of the US curve, following the
pattern of the UK.

In late spring 2013, the UKs 10yr bond was around 1.60%. It was at 2.77% a week ago.

If US data comes out strong in the second half of 2014, there is a very real chance of the
curve correcting as traders become more bearish on rates. A 0.50%-0.80% jump isnt
inconceivable if markets begin pulling forward rate hikes.





Yellens Humphrey-Hawkins testimony this week probably wont include any earth
shattering information; however, we are reminded of Bernankes HH testimony in May
2013 when he first publicly suggested an end to QE was on the horizon. Its hard to
believe now, but the 10yr Treasury was in the 1.60%s prior to his testimony. Within
about one month, it was more than a full point higher, trading north of 2.60%. Can we
really say with full confidence that long term rates will remain flat through year end? Its
starting to feel like complacency to us

The Fed is also considering a change to the calculation of Fed Funds to include
Eurodollars, which should make it a more accurate representation of front end cost of
funds. We would expect the immediate impact to be most negligible and any resulting
pass through to LIBOR inconsequential. For now. How it could impact forward curves
(and therefore swaps) is less certain. There are a LOT of variables to this equation, so we
will keep an eye on this as the story develops.

On the data front, this weeks biggest data will be retail sales. Additionally, going
forward the most important information is probably inflation. CPI has come in higher
than expected the last two months, and another surprise to the high side on July 22
nd
will
only feed the growing sentiment that hikes are coming sooner than expected.






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Economic Data
Day Time Report Forecast Previous
Tuesday 8:30AM Retail Sales Advance MoM 0.60% 0.30%
8:30AM Empire Manufacturing 17.00 19.28
8:30AM Retail Sales Ex Auto MoM 0.50% 0.10%
8:30AM Retail Sales Ex Auto and Gas 0.50% 0.00%
8:30AM Retail Sales Control Group 0.50% 0.00%
8:30AM Import Price Index MoM 0.40% 0.10%
8:30AM Import Price Index YoY 1.10% 0.40%
10:00AM Business Inventories 0.60% 0.60%
Wednesday 7:00AM MBA Mortgage Applications - -
8:30AM PPI Final Demand MoM 0.20% -0.20%
8:30AM PPI Ex Food and Energy MoM 0.20% -0.10%
8:30AM PPI Final Demand YoY 1.80% 2.00%
8:30AM PPI Ex Food and Energy YoY 1.70% 2.00%
9:00AM Net Long-Term TIC Flows 25.0B -24.2B
9:00AM Total Net TIC Flows - 136.8B
9:15AM Industrial Production MoM 0.30% 0.60%
9:15AM Capacity Utilization 79.30% 79.10%
9:15AM Manufacturing (SIC) Production 0.40% 0.60%
10:00AM NAHB Housing Market Index 50.00 49.00
Thursday 8:30AM Housing Starts 1020K 1001K
8:30AM Housing Starts MoM 1.90% 6.50%
8:30AM Initial Jobless Claims 310K -
8:30AM Building Permits 1030K 991K
8:30AM Continuing Claims 2583K -
8:30AM Building Permits MoM 2.50% -6.4%
10:00AM Fed Business Outlook 0.16 17.80
Friday 10:00AM Leading Index 0.50% 0.50%
Speeches and Events
Day Time Report Place
Wednesday 2:00PM US Federal Reserve Releases Beige Book
Thursday 1:35PM Fed's Bullard speaks on monetary policy Owensboro, KY
Treasury Auctions

Day Time Report Size