War Room 30 May 2013

The End of QE

War Room• Monthly macro discussion

• Using tools in context

• Update on HiddenLevers Features

• Your feedback welcome

The End of QE

I. QE – History + Analysis

II. QE – Current Fed Posture

III. Exodus from Bonds?

IV. Scenarios + Macro Themes

HiddenLevers

QE – HISTORY + ANALYSIS

Fed Mandate: Room to Run

Employment Mandate:

Above target 6% region

Unemployment still ugly

7.7%

Interest Rates Mandate:

Record low rates

No problems here

Source: HiddenLevers

Source: HiddenLevers

QE + Interest Rates

Rates have fallen at the tail end of previous QE cycles, as fear trade set

in – has the cycle broken?

May 29: 2.13%

source: AdvisorPerspectives.com

QE + Equities

Previous QE rounds ended with a market top or significant correction. Either this time is different – or we’re not yet at QE ending.

source: AdvisorPerspectives.com

QE + US Dollar

- QE1 + QE2 drove down USD, as Fed fought deflation- Japan aims to double money supply in next year – USD strong

QE 1 QE 2 QE 2.5 (Twist) + QE3

Japan QE =

stronger USD

source: HiddenLevers

QE + Housing

QE’s downward pressure on mortgage rates (via benchmark 10y) has had a positive impact

Will this impact be dampened by the recent spike in rates, or has the housing recovery become self-sustaining?

source: HiddenLevers

Stocks versus Bonds – Yield Reversal?

Bond yields recently topped equity (S&P 500) yields for the first time in a year – this is the historical norm outside of the Great Depression and Great Recession.

QE – CURRENT FED POSTUREHiddenLevers

It ain’t over til its over

Fed May Minutes: The Skinny

…continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.

Fed Speak Translation

…as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal…

QE ain’t over til its

over

No rate hikes

anytime soon

Vote on maintaining actions – 11-12-3 votes against =

revolt

FED MINUTES

Exiting QE: choices for the Fed

stop recycling matured assets into purchases

purchase only shorter end maturities

taper down $85b in monthly purchasing

hike discount rate

10y 2y

Timing of Exit – When will QE End?

2015 Official Fed line, based on 6.5% unemployment achieved

2016 Big bond dealers + Goldman Sachs chief economist John Hatzius

2025 “Assumption that Fed balance sheet will be normalized by 2025” -Janet Yellen, likely Bernanke replacementAkin to drugs, withdrawal from QE will not be without pain.

HiddenLevers

EXODUS FROM BONDS?

Bond Exodus: The Great Rotation?

playing the field with equities

sitting it out in bonds

Great RotationInvestors confident in economy leave safety of bonds, shedding residual fear of financial crisis

great

rotation

Bond Exodus: The Great Rotation?

take a chance in equitiesplay what works in bonds

No Great RotationThis is NOT happening. Money Market funds cash is flowing into both bonds and equities.

+

Bond Exodus: The Great Rotation?

Bond Fund inflows

Bond Exodus = overblownMoney Market Funds, yielding zilch, give way to bond inflows.

$64 billion

Bottom LineCash for Equities is NOT coming at expense of bonds

Equity Fund inflows

$68 billion

$76 billion

$14 billionJan/Feb 2012

Jan/Feb 2013

Bond Exodus: Redux of 1994 Massacre?

8.0%

5.25%

50% rise

- $1.5 Trillion global bond market losses- yields spiked 275 basis points in 6 months- long term treasuries lost over 10% in 1994- current lower rates = losses would be greater

What about Stock Exodus?

What happens to stocks after the Fed begins to tighten policy?

Average 1Y S&P Return post-tightening:

1965: S&P -12.2% 1972: S&P 4.8% 1987: S&P -6.2%

1994: S&P -4.6%

1.5%

SCENARIOS + MACRO THEMESHiddenLevers

GoodEconomy

back on track

BadStagflation

UglyDeflation

strikes back

End of QE: Baseline Scenarios

S&P up 6% since March scenario intro

Fed made clear that QE-Infinity preferable to Deflation

BOJ: doubling Yen money supply to fight deflation

10Y treasury yields up 70bp from 2012 lows

New QE Scenarios: Bond Exodus + QE-Infinity

Fed continues QE for years to stoke GDP and employment

Melt-up scenario with irrational spike to upside

Only possible if inflation stays down, freeing Fed’s hand on QE

Bond market traders try to front run Fed tightening

Patterned on 1994 bond crash – equities were volatile but stable that year

Speed of rate move could surprise investors if this scenario unfolds

source: HiddenLevers

HiddenLevers – Product Update

• Scenarios Library – Proper Grouping

• Scenario Library – Images

• Reports – Lever Icons

• Reports – Improved Risk Profile

Coming soon:

1. Stress Test Lead Generator – v2

2. Screener – Find securities non-correlated to portfolio

3. Integration - Envestnet