Leveling the Playing Field

September 8, 2015
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Have you ever bought tickets to an upcoming sporting event, say to your favorite college football
team? You make plans to take the whole family, book a hotel, make travel arrangements, and of
course buy tickets. And then that team has its opening game and loses to a team for the first time
in like 70 years, gives up 118 sacks, and doesnt cross mid-field after the first quarter. You can
think of nothing else you would want to do less than to load up your family of seven to go watch
that team put up about a hundred yards of offense, but its too late. Penn States best player is
apparently John Dalys sonI kept waiting for a cameraman to catch him on the sideline with a
cigarette dangling through his facemask and chugging a Bud Light. If you havent seen him,
hes a very conservative 259lbs and a very generous 510. Actually, now that I think about it,
he was probably the highlight of the game for me.
Biggest news from last week was Fridays job reports. Immediately preceding the release,
Richmond Fed President Jeffrey Lacker reiterated the strong case for a hike at the September 16th
and 17th meeting, suggesting that a disappointing job report would not be enough to change the
Feds mind. He also argued that the developments in China would have a limited impact on US
fundamentals.
Guess what?! The headline job data was disappointing! Gasp! Shock! Could the FOMC have
possibly known that ahead of the releaseonly if you believe in conspiracies and the notion of
coordinated government actions behind closed doors
The economy added just 173k jobs last month against the consensus forecast of 205k and our
expected 230k-240k gain. Additionally, April and May were revised lower by a combined 60k.
Manufacturing data, in particular, suffered a setback which can only be interpreted as a result of
the strengthening dollar and weakness in China.
The unemployment rate dropped to 5.1%, the lowest reading since April 2008. But the
percentage of long-term unemployed increased to 27.7% (up from 26.9%) and the median
duration of unemployment increased from 12.1 weeks from 11.3 weeks. Additionally, the
underemployment rate (U6) decreased, but less than the UR itself.
Cue government coordination! The Labor Department released a statement reminding markets
that August has the largest average upward revision of any month, with a five year average of
+79k. If that trend holds, the August gain would be around 250k, much more in line with the
sort of data the Fed wants to see before a rate hike.
Why would the Labor Department take the highly unusual step of proactively pointing out how
August NFP revisions are likely to push the number much higher next month? And why would
Lacker preempt the job release with a hawkish statement? A true conspiracy theorist would
argue the Fed plans on hiking next week. I would put myself in the camp just shy of that step.

The likelihood of a hike at the September meeting is low, but not 0%. Yellen has various players
injecting enough uncertainty to keep markets guessing.
Yellen doesnt want markets to be caught off guard when she does hike, so she cant allow
expectations to backslide now. Hence, multiple government hawkish comments.
Why Did the Front End Jump?
Following the release, the front end of the curve actually jumped as markets priced in more
probability of a rate hike. Why the jump after the big NFP miss? Heres a graph showing
market expectations for a September hike over the course of the year.

There are several reasons for the jump in expectations:

- Lackers aforementioned preemptive strike
- US Labor Departments preemptive August revision
- The UR approaching a 4-handle and below the FOMCs blue dot forecast
- June and July NFP were both revised upward to +245k
- Full time employment has surpassed its pre-recession peak
But the number one reason rate hike expectations jumped was the surprise increase in average
hourly earnings, which rose 0.3%, the biggest jump since January. This puts the y/y wage
increase at 2.2%. And since Yellen has admitted the UR is no longer an accurate measure of
employment slack (and therefore inflation), wages are viewed as the best measure. The Fed has
indicated is does not need to actually see inflationary pressures to hike, but needs to be
reasonably confident that inflationary pressures exist.

The Feds dual mandate is full employment and price stability. In laymans terms, the former is
UR of 5.0% - 5.5% and the latter is 2.0% inflation. Regardless of the quality of jobs, a 5.1% UR
strongly suggests the first condition for a hike has been met.
That leaves inflation. With wages stuck in a tight range over the last three years, the first hint of
upward pressure forced a market response.
Furthermore, the Fed has reiterated a commitment to the data. With a data-dependent Fed,
markets are slaved to every piece of data, particularly inflationary data. And when one of those
pieces of data comes out higher than expected, the market reacts.
Will the Fed Hike Next Week?
We still put a low probability of a hike next week, perhaps around 20%. Despite the strong
case for a September hike, we just dont believe the Fed will hike given the market volatility
right now.
Most economists are calling for a December hike at this point, but we think October is still in
play if the data supports it. If August is revised upward AND if October NFP comes in strong,
the US could have 5 consecutive months of 250k+ gains. Compare that to the six months
preceding the last tightening cycle where the average job gain was 133k not too shabby. And
what if the UR drops to 4.9%? And does the Fed really want the first hike in over a decade to
come in December when market liquidity is already an issue? And Yellen indicated in the spring
that a rate hike could come at any meeting, not just the ones with a scheduled press conference
(like September and December)? And will I keep asking rhetorical questions and improperly
starting sentences with the word and?
Does it even matter when the first hike comes at this point? Whenever it comes, we expect it to
be the most dovish hikes of all time.
Long Term Fixed Rates
Its common for the yield curve to actually flatten as the Fed initiates a tightening cycle. The
long end has been waiting for the front end to catch up. If Yellen couples the first hike with a
statement reassuring markets that the Fed will not be hiking rapidly, the market realizes it has
priced in eight rate hikes and backs out some of those expectations. And dont forget last week
we discussed another round of QE (a la Operation Twist) in conjunction with a hike, which
would also help keep a lid on 10yr rates. The Fed doesnt want long term rates to run up and
knows they can exert some control over that through communications.
Following Fridays job reports, the market failed to make a decisive move. The low end of the
technical range for the 10T is 2.075%-ish, which if broken would put 2.00% firmly in play.

Although 10Ts and 30Ts are somewhat protected from vacillations attributed to Fed-speak, the
belly of the curve will likely experience the most volatility. Five years is a short enough time
period that expectations about hikes flows through the forward curve, pushing Treasurys and
swaps higher/lower.
5Ts are experiencing the biggest short in seven years thats right, since the Great Recession.
Everyone is betting on 5yr rates pushing higher, which means a dovish Fed could cause a painful
short squeeze and push rates back down, perhaps substantially.

We sometimes see exacerbated movements following a long holiday as traders reposition

following their early departure the preceding Friday. We will also be keeping an eye on the
VIX, which peaked a few weeks ago at 52 but has since retraced and closed Friday at 27. As a
general rule of thumb, +50 foreshadows a dramatic market movement while +80 foreshadowed
the collapse in 2008.
Check out the following three graphs:
1. S&P net shorts have not been this negative since the summer of 2012, right before the S&P
lost about 17%.
2. Vix net longs are at an all-time high. Traders are betting on high volatility to the tune of 2x
what we experienced following 2008. Also, note the net shorts in 2012-2013 when the Fed
sucked volatility out of the market by promising to keep rates low for the next three years. Its a
graph like this that makes us think the Fed may provide a similar statement this tightening cycle
it combats dreaded volatility.
3. This has inverted the VIX curve, a rare occurrence, as traders bet that volatility will be lower
in the future than it is today.

We have a relatively quiet week ahead without meaningful data and muzzled Fed ahead of the
FOMC meeting next week. Treasury auctions may have more impact than usual, particularly
given how weak the front end auction was two weeks ago.
Although the Fed has made us slaves to data, unprecedented coordinated intervention has
distorted markets to the point that technical factors are driving movements more than
fundamentals. Whether the VIX speculators are right or there is a painful unwind ahead, it
seems the only certainty is uncertainty.

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