Leveling the Playing Field

February 10, 2014

_______________________________________________________________________ Last week we made a joke about Omaha! Omaha! and then the Seahawks made a joke of the Broncos. But this week my six year old son had a helmet on and was running around the house yelling Omaha! Omaha! He was borderline panicked. When I asked him what that phrase meant, he said It means were losing! Speaking of losing... Fridays job reports disappointed once again, coming in weaker than expected with a gain of just 113k jobs last month. We dont like to beat a dead horse, but two consecutive weak prints is precisely why we were surprised by the December tapering. The tapering announcement led to the emerging market unwind which led to rates plummeting and now markets are spooked once again. Spooked markets mean increased volatility and not surprisingly the VIX continued to hit recent highs. The 10T finished the day at 2.67%, but dipped below 2.60% earlier in the week. The unemployment rate dropped to 6.6% and at some time around 8:31am President Obama held a press conference reminding the nation that Our unemployment rate is the lowest its been since before I was elected. Yeah, so is the participation rate chimed someone from the peanut gallery (maybe Romney), who was promptly added to the NSAs list of domestic targets. Also, somewhere a lowly analyst within the Fed spent the weekend rewriting the forward guidance language for the next FOMC meeting. Why the Fed has refused to budge from its 6.5% commitment is beyond me, but it has really eroded the Feds credibility. Whats the point of having an objective threshold when it is rendered useless? The Fed expected the unemployment rate to hit 6.5% in mid-2015, so why hasnt it simply addressed the participation rate effect and moved on? While no one actually challenged the president on the participation rate, it should be noted that it actually increased slightly last month to 63%. The real unemployment rate (U6) dropped from 13.1% to 12.7% as workers working part time for economic reasons dropped sharply.

Surprisingly, the BLS made no mention of the weather impact. Construction showed a surprising gain of 48k jobs following last months 22k loss in jobs, while manufacturing added 22k jobs. Retail was down 13k jobs, which is about right following the holiday season. The federal government laid off 12k jobs and state and municipalities laid off 17k workers, both slightly more than in recent months. The January report is generally a volatile one as the BLS makes adjustments, weather tends to impact hiring, and seasonality filters through. The December and January average show a gain of 94k jobs while October and November were an average gain of 254k jobs. I wonder if Bernanke wishes he had a mulligan on tapering...either way, the news is less positive than we would hope, but not necessarily bad either. We think it continues to paint a picture of a slow recovery. It is unlikely that the Fed amends its current pace of $10B tapering per month; however, if markets refuse to settle and next months jobs reports disappoint again, we may see the Fed press pause on tapering in an attempt to calm jitters and see where the economy is headed. Zerohedge had an interesting article last week and I apologize for not including the link here as I am writing this on a plane, but I will attempt to summarize its points. It compared todays employment recovery to the last recovery that involved the unemployment rate dropping from 10%+ to 6.6%, which occurred during the Reagan administration. - The Reagan Recovery lasted 43 months. The Obama Recovery lasted 52 months. - The Reagan Recovery added 10.5 million jobs. The Obama Recovery added 7.5 million jobs (despite the workforce being 30% larger) - The Reagan Recovery added an average of 244k jobs per month. The Obama Recovery has added an average of 145k jobs (population growth is 230k per month today). - During the Reagan Recovery, the total number of Americans eligible for work increased by 7.4 million while the labor force increased by 6.7 million. In other words, most people that were eligible for work actually worked or looked for work - because, you know, thats what people do after they are done with school. During the Obama Recovery, the total number of Americans eligible for work increased by 10.4 million while the labor force has added just 1.7 million people.

This cant be shocking news. The government is making handouts more readily available and providing incentives to not working. Heres a graph provided by the Secretary of Public Welfare in my home state of PA illustrating why a single mom is better off with a job that pays $29,000 than to work multiple jobs and earn $69,000.

The articles conclusion if we normalize for participation rate and population growth? The real unemployment rate in post-Lehman 2009 was 11.2%. Today is it 11.1%.

The new Welfare System hard at work (at least one part of it is working hard). Work less for equal or greater benefits. Bridge the gap by taking from the rich, who can afford it. Debt Ceiling

Both sides of the aisle refuse to participate in negotiations at this point, forcing the Treasury to announce that it will begin to use its extraordinary measures funds since the debt ceiling suspension period officially ended Friday. These funds are expected to run out toward the end of the month, so the government has about two weeks to reach an agreement or risk putting the US into default on its obligations. The likelihood of this actually happening is near 0%, but the closer we get to that deadline the more jittery markets will become. In a brilliant negotiating tactic, Boehner promised to not allow the government to default on its obligations...leaving the Dems little reason to compromise. What Boehner et al really want is a full repeal of Obamacare, but that isnt going to happen. So what they may ultimately target is a one year delay in some aspects of the implementation AND approving the Keystone XL pipeline. The pipeline is actually supported by most Americans (around 60% depending on the poll), but the Democrats refuse to concede on climate change grounds. As for any concessions on Obamacare, dont hold your breath. The CBO released report cards on the government as well, most notably the fact that the budget deficit in 2015 will should be the smallest in a decade at just 2.6% of GDP. We say should because the government is worse at forecasting growth than I am at forecasting tapering. Republicans will likely hone in on the fact that the CBOs report also expects Obamacare to cost the workforce two million full time employees over the next four years. The law provides a subsidy for low-income individuals, so some workers may decide they receive enough healthcare with the help of the subsidy and simply stop working altogether. Shocking! No lessons learned from the 99 week unemployment benefit experiment I see... The report goes on to suggest that Obamacare could reduce GDP by 1% between 20172024. I suspect Republicans will leave the time horizon component out of their grandstanding and simply focus on the economic impact forecasted by the independent CBO. This raises an interesting scenario - perhaps the right wing decides to forego the haggling on the debt ceiling and claims the high ground. This preserves some political capital heading into mid-term elections where they hammer on Obamacare. Obamacare is creating a 1% drag on the US economy and costing hard working Mericans two million jobs! Humphrey-Hawkins Testimony Twice a year the Fed Chair goes before Congress to provide two days of testimony known as Humphrey-Hawkins. During Greenspans tenure, these were two of the most

volatile trading days of the year as markets swung wildly attempting to interpret his remarks. With the commitment to transparency, those days are largely behind us, but nonetheless the testimony this week will give us a chance to hear new Chairperson Yellens view on the disappointing labor data and equities selloff. We doubt she wavers on the current tapering path and she will likely discount the two most recent NFP reports, attributing the swings to unusual volatility due to seasonality and weather. She may reinforce the Feds position on emerging markets (its our currency but its your problem). Perhaps, just perhaps, she will finally concede ground on the 6.5% unemployment rate threshold and move to a different metric. We would expect a broader approach that factors in more aspects of the employment data and perhaps a reduction in the UR threshold to 6.0%, but dont be surprised if she completely abandons a singular metric. Pop Quiz time. Vice Chairman of the Federal Reserve Stanley Fischer said which of the following last week: A. If you give too much forward guidance you do take away flexibility B. We dont know what well be doing a year from now. Its a mistake to try and get too precise. C. You cant expect the Fed to spell out what its going to do because it doesnt know. D. All of the above. The only way I got through school with passing grades was by taking All of the above whenever I encountered it, and thats the right play here as well. Note that these statements are in direct contrast to Yellens repeated commitment to an objective threshold. Either there is dissent within the ranks already or Yellen sent Fischer out to begin sending a message. Jeffrey Lacker added fuel to the speculation fire by noting, We will have to reformulate it and provide some qualitative way of providing an assessment of what time horizon we think is most likely. Perhaps her testimony this week will shed some light.

Why Does This Matter? Because markets have been betting that tapering = tightening. As we approached the Feds 6.5% UR threshold, the Fed remained silent. This raises the possibility that maybe, just maybe, the Fed may hike soon. So traders got shorter and shorter on the front end of

the curve. In other words, they started betting that short term rates would go up. In fact, the total net shorts on eurodollar contracts has never been bigger.

Jim Lee, head of US derivative strategy at RBS said last week, the path of most pain is lower rates. These positions are likely to be squeezed out if rates fall further. Lower rates beget lower rates. Traders cover short positions by going long - which only exacerbates the movement lower. Toss in disappointing job growth, a Fed silent on short term interest rates, and a painful emerging markets unwind and you have a formula for plummeting rates. Thats why rates have continued to push lower over the last few weeks. If Yellen commits to keeping short term rates low for an extended period of time, it may relieve some of the downward pressure on rates. But investors are nervous. And when in doubt, buy Treasurys and push rates lower.

Economic Data Day Tuesday Time 7:30AM 10:00AM Wednesday 7:00AM 2:00PM Thursday 8:30AM 8:30AM 8:30AM 8:30AM 10:00AM Friday 8:30AM 8:30AM 9:15AM 9:15AM 9:55AM Report NFIB Small Business Optimism Wholesale Inventories (MoM) MBA Mortgage Applications Monthly Budget Statement Initial Jobless Claims Continuing Claims Retail Sales (MoM) Retail Sales ex Auto (MoM) Business Inventories Import Price Index (MoM) Import Price Index (YoY) Industrial Production (MoM) Capacity Utilization University of Michigan Confidence -$28.5B 330k 2968k 0.0% 0.1% 0.4% -0.1% -1.0% 0.2% 79.3% 80.5 331k 2964k 0.2% 0.7% 0.4% 0.0% -1.3% 0.3% 79.2% 81.2 Forecast 93.5 0.5% Previous 93.9 0.5% 0.4%

Speeches and Events Day Tuesday Time 9:00AM 10:00AM 8:00PM 8:10PM Wednesday Thursday 8:45AM 10:30AM Report Fed's Plosser speaks on Economic Outlook Fed's Yellen delivers Monetary Policy Report to House Fed's Lacker speaks on Financial Stability at Stanford Fed's Fisher speaks on Economic Outlook Fed's Bullard speaks on Monetary Policy Fed's Yellen testifies before Senate Banking Committee Dallas, TX New York, NY Washington, DC Place Newark, DE Washington, DC

Treasury Auctions Day Tuesday Wednesday Thursday Time 1:00PM 1:00PM 1:00PM 3-year Treasury 10-year Treasury 30-year Treasury Report Size $30B $24B $16B

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