Leveling the Playing Field July 15, 2013 _______________________________________________________________________ Apparently there are four certainties in life.

Death, taxes, rain in Charlotte, and stocks only go up. It started raining again this morning and my five year old summed it up succinctly, Aww man, its raining come on! Eloquent he is not, but he is nonetheless an effective communicator. He says things like You make me happy or not good, but more recently he has taken to going a step further and actually trying to proactively manage my response. When he wants to tell me something serious and doesnt want me to laugh, hell say This isnt funny and then he tells the story. (Segue alert!) Bernanke has adopted a similar strategy. Financial markets got the soothing reassurance from Helicopter Ben it so desperately wanted last week, when the lame duck chairman reminded everyone that he would rather over accommodate than to withdrawal too quickly. Stocks rose 3% over the week and the S&P closed at an all-time high. If you had listened closely, you might have heard him say, This isnt funnythe Fed is going to keep on accommodating Make no mistake, Bernanke intentionally sent a message to the markets to help manage expectations on the tapering of QE and investors liked his message. He made it clear that the Feds dual mandate (employment and inflation) and data is what drives Fed decisions, not ensuring market stability. To quote Bernanke, if financial conditions were to tighten to the extent that they jeopardize the achievement of our inflation and employment objectives then we would have to push back against that. As we discussed several weeks ago following the sudden spike in rates, the Fed has gone out of its way to send a dovish message. We suspect Bernanke was surprised by size of the market reaction, which quickly exceeded his pain threshold.

Tapering Bernanke may be best remembered for him commitment to increasing Fed transparency. Greenspan would not have allowed tapering comments to begin 6-9 months ahead of the actual tapering. But this Fed is committed to giving markets plenty of time to digest potential moves.

Increasingly, Fed members are concerned about market complacency and that ongoing QE could create another bubble. So last month they rattled some cages by publicly discussing tapering and mortgage rates spike north of 4.50%. The Fed minutes revealed that many members indicated that further improvement in the outlook for the labor market would be required before it would be appropriate to slow the pace of asset purchases. While Junes report may have met some internal threshold, Fed members backed off their focus on just labor, some added that they would, as well, need to see more evidence that the projected acceleration in economic activity would occur, before reducing the pace of asset purchases. This suggests a potential divide amongst voting FOMC members. On the one hand, the voting hawks concerned about market complacency (QE addiction), inflation, asset bubbles will focus on items like the unemployment rate. Alternatively, the doves will want to see improving labor markets translate into improving GDP before they agree to tapering. Unfortunately, many economists are again downgrading their forecasts for Q2 driven by the sequester, rising mortgage rates, and a jump in oil: BNP: lowered from 1.0% to 0.8% Barclays: lowered from 1.0% to 0.6% Goldman: lowered from 1.6% to 1.3% Should this slowdown materialize, we think it provides the necessary cove-fire for the Fed to maintain QE until December. Alternatively, should we see more data points like the most recent labor reports and an uptick in GDP in Q3, we think September is the likely announcement for a tapering. The media made a big deal about the minutes reading about half of [the] participants indicated that it likely would be appropriate to end asset purchases late this year. But this reflects the thoughts of all 19 FOMC participants, including some hawks that have never agreed with QE. The actual voting members represent a more likely scenario where tapering begins in December and ends mid-2014. Bottom line: tapering likely in December, with a bias towards September rather than January 2014.

Humphrey Hawkins Testimony This week Bernanke takes center stage again as he delivers his (final) semi-annual monetary policy to Congress on Wednesday and Thursday, known as HumphreyHawkins.

At an appearance last week at the National Bureau of Economic Research, Bernanke suggested more discussion on tapering will take place this week during the Q&A at his Congressional testimony. Bernanke made it clear that any tapering will be driven by data, and we expect more of the same this week. We also think hell remind markets that the Fed stands just as willing to increase accommodation should conditions deteriorate. Also, we would expect his parting shots to remind Congress that monetary policy isnt a panacea and that fiscal policy is required to help ensure long term economic security. Congress has long ignored Bernankes pleas, preferring to let him play the role of bad guy. In fact, while Congress has a lower approval rating among US adults than North Korea, its members are comfortable questioning the Chairmans decisions. The June minutes highlighted that some FOMC voters need[ed] to see more evidence that the projected acceleration in economic activity would occur, before reducing the pace of asset purchases.

Eurozone Portuguese 10yr government bond yields spiked to 7.51% following the resignation of the finance minister. Greece is going to miss the austerity measurements it had agreed to in exchange for a bailout. Italys unemployment rate is at a 35-year high, north of 12% and S&P downgraded its debt from BBB+ to BBB. Fitch has downgraded France from AAA to AA+. Just food for thought now that weve gone so long without mentioning concerns about Europe

LIBOR We said a few weeks ago that we disagreed with futures markets, which put the first Fed hike in Q4 2014 we felt thought the Fed would stick to its word. Following Bernankes comments last week, we feel more confident about this assertion. We expect Bernanke to use HH to reiterate the intention to keep Fed Funds (and therefore LIBOR) close to 0% until mid-2015. Just as notably, Bernanke suggested the Fed could tighten only marginally rather than in large increments.

Fixed Rates Long term rates are range bound, with the 10yr Treasury stuck between 2.55% and 2.85%. Bernankes testimony certainly has the potential to make rates break out, but we dont expect that to happen this week. He set the stage last week and will reinforce that message this week, but we doubt he says anything surprising enough to create a strong move one way or the other. The bias remains towards higher rates. Maybe the economy slows down more than expected, but the Fed reiterated its intention to intervene as necessary. Maybe Europe collapses, but if it hasnt before now is that a realistic outcome? But if you hold Treasurys, the end of QE is nigh. It may come in September, or December or maybe even in early 2014, but why pick up pennies in front of a steamroller?

This Week Busy busy busy. As noted above, Bernankes testimony will be the headliner. Theres a lot of data, but nothing as important as Bernankes final Humphrey-Hawkins.

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Economic Calendar
Economic Data Day Monday Time 8:30AM 8:30AM 8:30AM 10:00AM Tuesday 8:30AM 8:30AM 8:30AM 8:30AM 9:00AM 9:00AM 9:15AM 9:15AM 10:00AM Wednesday 7:00AM 8:30AM 8:30AM 2:00PM Thursday 8:30AM 8:30AM 10:00AM 10:00AM Friday Report Empire Manufacturing Advance Retail Sales Retail Sales less Autos Business Inventories Consumer Price Index (MoM) Consumer Price Index (YoY) Core CPI (MoM) Core CPI (YoY) Total Net TIC Flows Net Long-term TIC Flows Industrial Production Capacity Utilization NAHB Housing Market Index MBA Mortgage Applications Housing Starts (MoM) Building Permits (MoM) Fed releases Beige Book Initial Jobless Claims Continuing Claims Philadelphia Fed Leading Indicators 340k 2959k 7.8 0.3% 360k 2977k 12.5 0.1% 5.0% 1.5% 0.3% 77.7% 51 Forecast 5.00 0.8% 0.4% 0.0% 0.3% 1.7% 0.2% 1.6% Previous 7.84 0.6% 0.3% 0.3% 0.1% 1.4% 0.2% 1.7% $12.7B -$37.3B 0.0% 77.6% 52 -4.0% 6.8% -3.1%

Speeches and Events Day Monday Tuesday Wednesday Time 8:00AM 2:15PM 10:00AM 12:00PM 1:00PM 2:00PM Thursday 10:00AM Report Fed's Tarullo speaks on Banking Regulation Fed's George speaks on Economic Conditions and Agriculture Fed's Bernanke delivers Semi-annual Policy Report to House Fed's Stein delivers Opening Remarks at Fed Conference Fed's Raskin speaks at Exchequer Club Fed releases Beige Book Fed's Bernanke delivers Semi-annual Policy Report to Senate Washington, DC Washington, DC Washington, DC Place Washington, DC

Treasury Auctions Day Time Report Size