Leveling the Playing Field June 2, 2014

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Do they make photoshop for newsletters? Im on a nasty streak over the last month,
repeatedly expecting the short squeeze on rates to run its course and for rates to finally
start heading back upand I am repeatedly proven wrong

In last weeks newsletter with the 10T at 2.54%, I said I thought the rally had stalled and
wouldnt be surprised to see it close at 2.60%. It closed Friday at 2.48%. Ugh.

Q1 GDP contracted 1.0%, largely attributable to the brutal winter and an inventory
correction, but that was already priced into expectations. Most economists still expect a
large correction in Q2 GDP that would put us on track for 2014 GDP of about 2.0%.
Perhaps the issue here is that the Fed itself has been forecasting 2014 GDP at 2.9%,
which is keeping with the central banks tradition of being overly optimistic in just about
every regard.

The Feds preferred measure of inflation is the core personal consumption
expenditures, or core PCE. Sticking the word core means it excludes volatile food and
energy pricesbecause who needs to pay for those? The idea is that it excludes prices
that can be influenced by futures markets so that short term market volatility doesnt
dictate Fed policy.

Core PCE came in at 1.4%, up quite a bit from last months 1.1%. Headline PCE came in
at 1.6%, up considerably from last months 1.2%. In other words, inflation just moved
sharply towards the Feds long term target of 2.0%.

While this may pull forward expectations for the first rate hike, we wouldnt overreact to
this number. The Fed is looking for long term inflation of 2.0% as a desired target, not
necessarily the trigger to begin hiking rates. With rates being so low for so long, we
would expect the Fed to be comfortable with inflation readings north of 2.0% before they
actually begin hiking. Without upward pressure on wages (wage expectations remain
near all-time lows), its challenging for inflation to really take off. Long term inflation of
2.0% is probably a 2016 event, not a 2015 event.

One wild card here is the changing composition of the voting members of the FOMC.
Loretta Mester replaces Sandra Pianalto today and brings a much more hawkish view. In
fact, her speech on Friday sent several hawkish signals, including a concern that current
inflation measures may paint a more benign view of recent inflation, suggesting that
readings are understating the inflation. If thats the case, then a hike may come sooner
than expected.





ECB Decision Thursday June 5

Rarely are the job reports relegated to the undercard, but this weeks headliner will be
Thursdays ECB meeting. Eurozone inflation is forecasted at 0.7%, which is below
Draghis 1.0% danger zone. Markets fully expect a bold move from the ECB,
including cuts across the board on interest rates and taking the deposit rate negative,
effectively charging banks for keeping deposits at the central bank. The intent here it to
encourage banks to lend out money rather than sitting on it as Eurozone business loans
are down 3% over the last year.

Draghi is setting the stage for Bernanke-style QE later this year by initiating an ABS
purchase facility now. Remember central banks are cartels and serve banks, not us.
Draghi is likely going to facilitate the purchase of quasi-toxic assets from banks so they
can start recording profit.

The near term risk is that Draghis announcement is viewed as too timid, but we view
that as highly unlikely as the ECB has done nothing to squelch the market consensus
leading into this meeting.

Job Reports

Last months report of 288k gain looked strong on the surface, but rates actually declined
after traders read the details. Part of that spike was probably attributable to the late
Easter. We think Fridays report will likely come in around the long-term trend of 200k
new hires last month. The unemployment rate would probably tick down to 6.2%.


This should be another volatile week and so I will just refrain from making any more
predictions on rates that will backfire.










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Economic Data
Day Time Report Forecast Previous
Monday 10:00AM ISM Manufacturing 55.5 54.9
10:00AM ISM Prices Paid 57.0 56.5
10:00AM Construction Spending (MoM) 0.6% 0.2%
Tuesday 9:45AM ISM New York 50.6
10:00AM Factory Orders 0.5% 1.1%
10:00AM IBD/TIPP Economic Optimism 46.5 45.8
Wednesday 7:00AM MBA Mortgage Applications -1.2%
8:15AM ADP Employment Change 210k 220k
8:30AM Trade Balance -$40.6B -$40.4B
8:30AM Nonfarm Productivity -2.9% -1.7%
8:30AM Unit Labor Costs 5.0% 4.2%
10:00AM ISM Non-manufacturing Composite 55.5 55.2
Thursday 8:30AM Initial Jobless Claims 310k 300k
8:30AM Continuing Claims 2623k 2631k
Friday 8:30AM Change in Nonfarm Payrolls 218k 288k
8:30AM Change in Private Payrolls 210k 273k
8:30AM Unemployment Rate 6.4% 6.3%
8:30AM Underemployment Rate (U6) 12.3%
8:30AM Avg Weekly Hours All Employees 34.5 34.5
3:00PM Consumer Credit $15.000B $17.529B
Speeches and Events
Day Time Place
Monday 3:00AM Fed's Evans speaks on Monetary Policy Istanbul
Tuesday 1:50PM Fed's George speaks on US Economy Breckenridge, CO
Wednesday 2:00PM Fed releases Beige Book
Thursday 1:30PM Fed's Kocherlakota speaks on Interest Rates Boston, MA
Treasury Auctions

Day Time Size
Report
Report