the pensford letter - 11.25.13

8/13/2019 The Pensford Letter - 11.25.13

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Leveling the Playing Field November 25, 2013 _______________________________________________________________________

Not all newsletters are created equal. Most are uninformed and boring, some injecthumor successfully, and some are written and subsequently scrapped because theweekend was one big birthday party for my youngest son turning six. That was the caselast weekend. I wasn’t comfortable putting my name on it, so I just skipped thenewsletter last week.

Every once in a while we send out a newsletter and say “you should read this one.”

Today’s is one of those newsletters. Average read time is just 3:45.

The week started smoothly after Yellen’s confirmation hearing soothed markets. Shemade it clear she intends to maintain an accommodative stance for as long as necessary.Stocks rallied and rates dropped. All was good in the world.

Then the FOMC minutes surprised markets somewhat, suggesting a more hawkish tonethan priced into expectations for tapering. The current consensus is for the Fed to beginslowing its pace of asset purchases beginning at the March 2014 meeting; however, the

minutes suggested that tapering could begin earlier and so markets are now pricing in adecent probability of tapering in December.

We disagree. Again. We see almost 0% chance of this happening. Liquidity tends to dryup at year end anyway, creating a mini-tightening in financial conditions. There’s noway the Fed piles on and shakes up markets heading into the holidays.

Bernanke mentioned the word “tapering” in May and the 10yr Treasury spiked more than

1.00% in the following month. This resulted in tightening financial conditions and wasfelt on main street vis a vis higher mortgage rates. Home sales plummeted. Bernanke

could point to higher equities all he wanted, but housing felt an immediate impact. Hewants to avoid a repeat. CNBC will keep talking up a December tapering, but it’s not

happening.

What IS clear is that the Fed is prepared to end QE, it’s simply a matter of when. That

may put some short term pressure on interest rates to move higher, but we don’t believe

tapering is necessarily going to result in a runaway train of interest rates. Let’s review



what happened to the 10yr Treasury from 6 months prior to the start of each round of QEthrough 6 months beyond the conclusion.

QE 1 December 2008 – March 2010

- total of $1.65B in Treasury and MBS purchases, averaging $110B per month

- 10yr Treasury down 1.50% 6 months after QE concluded

QE 2 November 2010 – June 2011

- $600B at a pace of $75B per month

- 10yr Treasury down 1.30% 6 months after QE concluded



Twist September 2011 – December 2012

Total of $667B in long term securities while simultaneously selling front end securities.

QE3 September 2012 – TBD

- $85B per month



This suggests that rates don’t HAVE to spike just because QE ends. They still could - butit’s no guarantee.

Secondly, in a speech this week, Bernanke identified three key reasons why rates spikedat the mention of tapering at the beginning of the summer:

1. “First, improvements in the economic outlook warranted somewhat higher yields – a natural and healthy development”

2. “Second, some of the rise in rates reportedly reflected an unwinding of leveraged

positions.”

3. “Third, market participants may have taken the communication in June as

indicating a general lessening of the Committee’s commitment to maintain a

highly accommodative stance of policy in pursuit of its objectives. In particular,it appeared that the FOMC’s forward guidance for the federal funds rate had

become less effective after June, with market participants pulling forward the timeat which they expected the Committee to start raising interest rates, in a mannerinconsistent with the guidance.”

That third one is Bernanke’s wheelhouse and rest assured he is going to do everything inhis power to remedy it before the Fed tapers. He said the market’s reaction “was neither

welcome nor warranted, in the judgement of the FOMC.”

But much of the confusion is strictly on the Fed’s shoulders. It has been tying Fed Fundshiking to unemployment, which continues to move lower. The fact that theunemployment rate is lower is largely attributable to the participation rate hitting a 35year low, which many (us included) believed would force the Fed to change its language.But it did not. And that has created unnecessary confusion.

Additionally, the median FOMC forecast actually implies a HIGHER Fed Funds thancurrently priced in by market expectations. Again, these mixed signals are to blame forthe market’s interpretation that tapering = tightening.

But that also means it is easily corrected – simply change the forward guidance

language.



Change to Forward Guidance on Fed Funds

The Fed controls short term floating rates like LIBOR and Prime through its traditionalFOMC rate actions. When the Fed said it would be reducing its target for Fed Funds,

LIBOR followed in lockstep. The only real disruption of this correlation occurred duringthe financial crisis in late 2008 when banks stopped lending to each other.

The Fed has far better control of short term interest rates than long term interest rates likethe 10yr Treasury. In other words, if the Fed wants to keep LIBOR low, it can.

LIBOR vs FF

In the coming weeks, the Fed is going to pound into the collective heads of all market participants that “tapering is not tightening” in an attempt to avoid creating tighteningfinancial conditions once tapering commences. Unfortunately, the Fed now has acredibility issue, so this alone probably won’t reassure markets.

At the September 2012 meeting (14 months ago), the Fed announced it was likely to keepFF (and therefore LIBOR) low until at least mid-2015. We expect a similar

announcement in the coming months to help offset the tightening that could result fromtapering



Two papers published by the Fed’s own staff economists released last week strongly

suggested that the Fed should keep FF low until the unemployment rate hit 6.0% or even5.5%. It also argued that the Fed should keep short term rates low even if the economy

improves substantially. Therefore...

There is a very real possibility that LIBOR remains at current levels until 2017.

Disinflation is a greater risk right now than inflation, so there is little to worry about onthat front in the near term. BNP Paribas released a report this week calling for coreinflation (the Fed’s preferred inflation gauge) to remain below 2% beyond 2016.

The Fed is likely to change its forward guidance commitment AND Bernanke is likely

cracking the whip on member forecasts for Fed Funds to make them more accuratelyreflect plans going forward. I wonder if it’s a bit like voting for the best college teams.The first few are the most important and get the most attention (Fed Funds at 0%), but thefurther back you go the more lackadaisical you get with selections (“Fed Funds at 3% in

2016 feels about right…”)

Bottom line – if you are locking in swaps, you may want to consider locking in just a portion right now and monitoring the Fed’s forward guidance language, particularly if

your time horizon is less than 7 years. Floating rate debt is probably going to be cheapfor several more years. Caps are likely to get less expensive as well.

If your time horizon is 10 years or longer, fixed rate debt still makes sense.

But if your loan or time horizon is 5 years or less, we STRONGLY encourage retainingsignificant exposure to floating rates.

This Week

Turkey Day – Happy Thanksgiving!

Generally, this material is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of

any financial instrument or as an official confirmation of any transaction. Your receipt of this material does not create a client

relationship with us and we are not acting as fiduciary or advisory capacity to you by providing the information herein. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. This

material may contain information that is privileged, confidential, legally privileged, and/or exempt from disclosure under applicable

law. Though the information herein may discuss certain legal and tax aspects of financial instruments, Pensford Financial Group,

LLC does not provide legal or tax advice. The contents herein are the copyright material of Pensford Financial Group, LLC and shall

not be copied, reproduced, or redistributed without the express written permission of Pensford Financial Group, LLC.



Economic Calendar

Economic Data

Day Time Report Forecast Previous

Monday 10:00AM Pending Home Sales (MoM) 1.5% -5.6%

10:00AM Pending Home Sales (YoY) -1.0% 1.1%

10:30AM Dallas Fed Manufacturing Activity 3.8 3.6

Tuesday 8:30AM Housing Starts 920k

8:30AM Bu ilding Permit s 930k

9:00AM Case-Shiller 20-city Index 13.00% 12.82%

9:00AM House Price Index (MoM) 0.4% 0.3%

10:00AM Consumer Confidence Index 72.4 71.2

10:00AM Richmond Fed Manufacturing Index 3 1

Wednesday 7:00AM MBA Mortgage Applications -2.3%

8:30AM Initial Jobless Claims 330k 323k

8:30AM Continuing Claims 2858k 2876k

8:30AM Durable Goods Orders -1.8% 3.7%

8:30AM Durables ex Transportation 0.5% -0.1%

8:30AM Chicago Fed National Activity Index 0.10 0.14

9:45AM Chicago Purchasing Manager 60.0 65.9

9:55AM University of Michigan Confidence 73.0 72.0

10:00AM Leading Index 0.0% 0.7%

Thursday Markets Closed for Thanksgiving Holiday

Friday 9:00AM ISM Milwaukee 57.10

Speeches and Events

Day Time Place

Treasury Auctions

Day Time Size

Monday 1:00PM 2-year Treasury $32B

Tuesday 1:00PM 5-year Treasury $35B

Wednesday1:00PM 7-year Treasury $29B

Report

Report

the pensford letter - 11.25.13

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