Leveling the Playing Field

June 1, 2015
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Rates continued to be range bound, with the 10yr Treasury stuck in the 2.10%-2.20% range. On
Friday, the 10T closed at 2.12% following a Q1 GDP revision to just negative 0.7%. Since
market expectations for a negative 1.0% print, there was some mild optimism that Q1 could be
written off to transitory factors, which probably helped prevent a larger drop in yields. Most
economists are still calling for an annualized Q2 GDP print around 2.5%, but the variance is
pretty wide. Low ends forecasts are 1.0% with one high end outlier at 5.0%. In any event, the
FOMC didnt see anything on Friday that would change its current tone.
Speaking of which, Yellen seems to be growing increasingly frustrated that the market isnt
listening to her. This week she flat out said that the Fed expects to hike rates this year. Weve
been singing this tune for nearly a year now, so nothing has changed in our mind about the path
of LIBOR. But the market is going to have to catch up at some point and close the gap between
Fed forecasts and futures. This probably means a flattening yield curve, with most of the
movement attributable to a front end selloff.
Front End Correction and the Impact on Caps
I am worried that we are heading for a period of extreme volatility in the front end, which will
most directly impact cap buyers. The Fed has said we need to treat every meeting as a live one
for a potential rate hike, but the market has a 0% probability priced in for a hike in June. I dont
think they will hike in June either, but can we really make that statement with 100% confidence?
Sooner or later, something has to give. If we are wrong (which happens a lot), then no real risk
exists. Front end rates stay low, volatility is minimal, LIBOR stays unchanged for a while, and
cap costs dont bounce around much. Business as usual continues and hopefully everyone
forgets that I typed this.
But if we are right, a correction is overdue. The front end will selloff, directly pushing 2 and 3
year swap rates higher. The effect on LIBOR shouldnt be as dramatic. LIBOR will start to
climb, but mostly in an orderly fashion. Youll notice your monthly invoices start reflecting
higher interest expense as it moves from 0.18% to 0.30% to 0.50%. But it shouldnt be all over
the map.
Where we will see the biggest impact is on interest rate caps. Caps are driven by two main
factors swap rates and volatility. Swap rates will move higher as we indicated above, which
will push the cost of the cap higher. Keep in mind that if the Fed says or does something that
even changes expectations by just two hikes over the next two years, it will push up two years
swaps by about 25bps. Thats around a 40% increase over current levels. Imagine the 10yr
Treasury moving from 2.20% to 3.00% - thats a big jump, right? And yet when it happens on
the front end of the curve, everyone acts shocked that cap prices jumped so dramatically.

Volatility is the second component of the cap cost and we think this will spike during a
correction (if it comes). Volatility is mostly just uncertainty. When the Fed told markets no hike
was coming until at least mid-2015, volatility evaporated because there was so little uncertainty.
This, along with ZIRP, made caps historically cheap. And we have all gotten comfortable with
cap costs being largely negligible in the overall scheme of the costs of a loan closing.
But without a consensus around Fed Funds, uncertainty will increase. And this means volatility
increases and the cost of a cap jumps. If front end rates jump 40% and volatility spikes, cap
costs could easily jump by 25%+ in very short order and catch a lot of borrowers off sides during
the 11th hour of a closing.
Yellen et al are actively trying to avoid this scenario with all the Fed-speak around the upcoming
rate hike, but markets just arent listening. If she can get her message across, we might be able
to avoid a painful adjustment, but if not we could experience some short term pain.
We think the timeframe for this sort of adjustment, if it comes, is within the next 90 days.
Something would probably trigger the correction, markets would extrapolate the uncertainty over
the first three years of the curve, FF futures will bounce around, and cap pricing will get choppy
and expensive.
Paradoxically, once the first hike actually occurs, we could see markets settle shortly afterwards
and the uncertainty premium diminish. We think Yellen might be nearly as explicit as Bernanke
with language to provide transparency around the path of Fed Funds. It may not be quite as
concrete as until at least mid-2015, but she is going to send some very strong signals that the
Fed is not about to embark on a lengthy and rapid tightening cycle. Better to be too slow than
too fast.

Fixed Rates
That turns our attention to the long end of the curve. Quite a bit of panic a few weeks ago as the
10T ran up to 2.36%. As we said over and over, there was absolutely no change to the
underlying economic data, so the movement was a trading one.
We learned just how closely tied US yields are to Eurozone yields. The leash that had kept US
yields so low for so long could also work in reverse, pushing US yields up quickly when
Eurozone yields (most notably German bunds) spiked. Eurozone issuance was dramatically
oversold last month, which coupled with historically high corporate bond issuance simply proved
too much for markets to digest.
Eurozone issuance this month will turn net negative. Econ 101 taught us that restricting supply
drives up prices, and that should be the case this month. And as those Eurozone yields move
lower, we expect the same to happen domestically. Also, shorts have probably been covered by
now and longs gradually added.

We wouldnt be surprised if the 10T tests 2.00% this month, particularly with each day that
Greece goes unresolved. Im not sure how dramatic rates will swing ahead of Fridays job
reports, but that is just one of the major economic data release in what is a jam-packed week.

Economic Data
Day

Time

Monday

8:30AM

Report

Forecast

Previous

Personal Income

0.30%

0.00%

8:30AM

Personal Spending

0.20%

0.40%

10:00AM

Construction Spending MoM

0.70%

-0.60%

10:00AM

ISM Manufacturing

52

51.5

Tuesday

10:00AM

Factory Orders

-0.10%

2.10%

Wednesday

7:00AM

MBA Mortgage Applications

-1.60%

8:15AM

ADP Employment Change

8:30AM

Trade Balance

2:00PM

US Federal Reserve Releases Beige Book

8:30AM

Initial Jobless Claims

8:30AM

Continuing Claims

8:30AM

Change in Nonfarm Payrolls

224K

223K

8:30AM

Unemployment Rate

5.40%

5.40%

8:30AM

Labor Force Participation Rate

62.80%

Thursday

Friday

198K

169K

-$44.3B

-$51.4B

275K

282K

2222K

Speeches and Events

Day

Time

Report

Place

Monday

9:05AM

Fed's Rosengren Speaks at Employment Event

Hartford, CT

9:30AM

Fed's Fischer Speaks on Financial Crisis

Tuesday

10:00AM

Fed's Brainard Speaks on Monetary Policy

Washington

Wednesday

2:15PM

Fed's Evans Speaks at Banking Symposium

Chicago

Thursday

12:00PM

Fed's Tarullo Speaks at Financial Conference

New York

Friday

12:30PM

Fed's Dudley Speaks on Economy and Policy

Minneapolis

Day

Time

Report

Size

Monday

1:00PM

Toronto

Treasury Auctions

6-month US Treasury Bill

$24B

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