Leveling the Playing Field November 3, 2014

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Markets are happy to have October in the rearview mirror, as are Penn State fans. The first half
of October was full blow panic mode, culminating on October 15
th
with a flash crash that
spiraled the 10yr Treasury down to 1.86%. The world was ending. QE and ZIRP was not
enough, we needed negative interest rates to prevent a Great Depression! Dear Fed save us
from ourselves!!!

Then one Fed hawk mentioned delaying the end of QE4EVA, the ECB made some
accommodative comments, and the risk on trade was back in play! Everything is fine, the
economy is great, dogs and cats getting along together.

QE still ended on schedule. The Fed had a chance to change its tune about hiking next year at its
October 29
th
meeting, but it didnt. Q3 GDP came in at 3.5%. Richmond Fed President Lacker
said the risk to hiking too soon was not a big one because the economy is doing well enough.

Stocks have basically retraced the entire sell-off, but yields are only about 50% of the way back
to previous levels. Markets are still on alert for depressing news, but the 10yr Treasury appears
to be climbing back toward a range of 2.40% - 2.60%. We would not expect a dramatic
movement ahead of Fridays job reports, but if those numbers come in strong we could see yields
establish a new range. Consensus forecasts call for a gain of 240k jobs and a drop in the
Unemployment Rate from 5.9% to 5.8%. Regardless of whether rates break higher this week,
the end of QE probably translates into increased volatility in the coming months.

Fed Funds
On October 1, the market had a LIBOR at 0.75% at the end 2015. Following the crash on Oct
15
th
, almost all hikes had been backed out of expectations. The Fed hadnt changed course, but
the market was front-running the probability that the FOMC would have to adapt to changing
market conditions. After the Fed rate decision, it was clear that Yellen is fine with the current
path of the US economy and hikes are still in play for the middle of next year. Markets have
responded accordingly and we are back close to levels pre-Oct 15
th
.

Interesting dynamic heading into next years FOMC meeting schedule as two of the more
hawkish members, Fisher and Plosser, rotate out and are replaced by more dovish members.
There is no doubt that the makeup of the voting members is transitioning to a more dovish



stance, which may help keep markets calm as we move into the first tightening cycle in more
than a decade.

I know it may feel like we are beating a dead horse here and many of our readers have emailed
us to say they disagree, but we believe the Fed will begin hiking rates next year. I think the
market is underestimating the path of LIBOR and that the Feds own forecast is overstating the
path of LIBOR.

For example, the market has LIBOR at 0.50% at the end of 2015. The Feds own forecast says
1.50%. I think we end up somewhere in between. Given the increasingly dovish position of
voting members, I would err on the lowside and estimate 0.75% - 1.00% based on current
economic projections.

As we have discussed ad nauseam, the Fed typically hikes 0.25% per meeting for 18-24
consecutive months. With 8 meetings per year, that translates into an increase of LIBOR by
2.00% per annum. With the dovish composition of the FOMC, global headwinds, and a
domestic economy hooked on accommodation, we see two alternative strategies for the
tightening cycle:

1. Slower pace of hikes, perhaps one hike every other meeting rather than one hike per
meeting.
2. Hikes to get us off of the zero-bound range, and then stop. For example, hike until
LIBOR is at 0.75% and then pause. Yellen wants out of ZIRP, so just getting away from
0% and then allowing markets to adjust to the new rate environment may accomplish her
goal.

One thing is certain the Fed is going to be sending us a lot of signals over the next 6 months.
So far, they have given no indication that the plan has changed.

Our takeaway until further notice, the Fed is hiking next year.










Economic Data
Day Time Report Forecast Previous
Monday 9:45AM Markit US Manufacturing PMI 56.2 56.2
10:00AM ISM Manufacturing 56.2 56.2
10:00AM Construction Spending MoM 0.70% -0.80%
Tuesday 8:30AM Trade Balance -$40.0B -$40.1B
10:00AM Factory Orders -0.50% -10.10%
Wednesday 7:00AM MBA Mortgage Applications - -6.60%
8:15AM ADP Employment Change 220K 213K
Thursday 8:30AM Initial Jobless Claims 285K 287K
8:30AM Continuing Claims 2355K 2384K
Friday 8:30AM Change in Nonfarm Payrolls 234K 248K
8:30AM Change in Manufacturing Payrolls 10K 4K
8:30AM Unemployment Rate 5.90% 5.90%
8:30AM Average Hourly Earnings MoM 0.20% 0.00%
8:30AM Labor Force Participation Rate - 62.70%
Speeches and Events
Day Time Report Place
Monday 12:40PM Fed's Fisher Speaks on Monetary Policy New York, NY
Wednesday 9:15AM Fed's Kocherlakota Speaks on Monetary Policy Washington, DC
9:30AM Fed's Lacker Speaks on Financial Stability Washington, DC
Thursday 1:30PM Fed's Powell Speaks on Derivatives Clearing Chicago, IL
Friday 10:15AM Fed's Yellen Speaks on Policy Since the Crisis Paris, France
Treasury Auctions

Day Time Report Size
None




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