Leveling the Playing Field September 29, 2014

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After a slower week in the rate market, we thought we would use todays newsletter to dive a bit deeper
into the Feds message from last weeks FOMC meeting. What we found, historically, is that the market
underestimates the path of LIBOR by about 1.00% during a tightening cycle. Guess what we found when
we laid out the most recent FOMC forecast against LIBOR futures? Yep. The market is about 1.00%
below the Feds own forecast over the next three years.

Before we turn our attention to the front end of the curve, the increased volatility in the long end needs
some love. If you have a CMBS loan or other long term rate lock coming up, you are probably losing
some sleep with the swings on the 10yr Treasury from 2.66% down to 2.32% and then back up to the
2.50%s. If you have a relatively short time frame before you lock, there is a pretty cost effective to
hedge against an increase in 10yr rates swaptions.

Hedging an Upcoming Rate Lock

We get a lot of calls from clients looking to hedge 10yr rates in 2015 or 2016. Typically, a client
has a large refi at that time and they are worried the 10yr Treasury could be at 4%.

But thats a crowded trade. The market charges a fortune to hedge that risk in part because
everyone thinks 10yr rates will be higher then. In general, the interest to hedge this risk once our
client recovers from the sticker shock. But hedging a 10yr rate lock thats just a month or two
away is much more economical.

Here are some prices to hedge against an increase in 10yr swap rates. They are called swaptions.
If caps put a ceiling on LIBOR, swaptions put a ceiling on swap rates. We assumed the client
wants to hedge a $50mm CMBS financing, but the pricing should work as a good proxy for any
sort of 10yr financing.

Rate Lock on 10/25/14

2.75% strike: $95,000
3.00% strike: $21,000

Rate Lock on 11/25/14

2.75% strike: $250,000
3.00% strike: $ 70,000





In other words, lets assume our client expects to lock their CMBS loan in about a month. They
are comfortable with 10yr swaps pushing above 2.75%. Each basis point increase costs them an
additional $50,000 over the life of the loan, so they are very sensitive to each basis point
increase.

They could buy an option on 10yr swaps that protects against any movement above 2.75% for
about $95,000. Thats less than two basis points.

On 10/25/14, they cash settle the swaption and separately lock in their CMBS loan. If 10yr
swaps are below 2.75%, the option expires worthless and they lock in at the prevailing rate. The
$95,000 is a loss.

But if 10yr swaps are above 2.75%, they exercise the option and receive the present value
difference between 2.75% and the 10yr swap. Lets assume its at 2.90%. They would receive
the pv of 15bps, or roughly the pv of $750,000.

The CMBS loan still prices off a 2.90% 10yr swap, but they amortize the $750,000 gain over the
life of the loan and effectively have a 2.75% underlying base rate.

These are highly customizable, so if you have a specific scenario you would like to see please
contact us.

Fed Dots

The blue dots are the individual Fed members projections of Fed Funds. In other words, its
their way of telling us the how/when/why of the upcoming tightening cycle. Some takeaways:

a. 2015: the median moved higher, from 1.00% to 1.375%
The market has the average at 0.50%
b. 2016: the median moved higher, from 2.50% to 2.875%
The market has the average at 1.51%
c. 2017: this was the first time 2017 was released, and the median forecast for LIBOR
that year is 3.75%
The market has the average at 2.48%

The Fed is telling us markets are underestimating the path of LIBOR by about 1.00% per year.

When the very people in charge of hiking rates tell us how they expect those hikes to look, we
need to pay attention.

Below is a graph showing Septembers forecast (left side, green) to Junes forecast. The Fed is
getting more hawkish. If the Fed forecast plays out, todays rates will be very attractive with the
benefit of hindsight.






Last week, NY Fed President William Dudley cautioned against overreacting to the dots,
warning that they dont capture the uncertainty within the FOMC members forecasts. But it still
seems like they are trying to tell us something.

Yellen doesnt want to march in front of the cameras and tell markets when the Fed is hiking
next year because it causes a frenzy, so she needs to find more subtle ways to send signals. I
wonder if discussions behind closed doors over the last three months went something like Lets
really increase our forecast so that markets start pricing in the appropriate hiking path. In other
words, lets send a signal.

Moving expectations higher now accomplishes two things:

1. The market starts pricing in higher LIBOR in a more gradual way and is better prepared
for the 2015 tightening cycle. The Fed wants to avoid a shock.

2. If the Fed ultimately hikes by less than current forecasts, it can be interpreted as being
accommodative by the market. Remember, its all about expectations. If the market
expects LIBOR to be at 0.15% and the Fed puts it at 0.50%, theres a jolt and fears
abound that Fed policy could cripple the economy.

But if the market expects 1.50% and the Fed only takes it to 1.00%, its Hey, look how
accommodative the Fed is being!! Never mind that LIBOR is 0.50% higher than in the
previous scenario.

Im on to you Fed!







Market Expectations vs Reality with the 2004 Tightening Cycle

Markets typically underestimate the path of LIBOR by about 1.00% per tightening cycle, and I
wonder if the same is true this time around. Lets discuss the table below.

The first section covers the tightening cycle that began on June 30, 2004. Since we are
approximately a year ahead of the first rate hike, we backdated our trading curves to see what the
market thought would happen to LIBOR beginning a year before the first hike, or June 30, 2003.

As you can see, the market did a good job up to about a year forward, where it had LIBOR at
1.38%. But that was only one rate hike, so the potential variance was somewhat limited.

But take a look at two years forward and three years forward. The market ultimately
underestimated LIBOR by 0.93% at two years and 2.02% at three years. Thats a big miss.




LIBOR Futures Spot 1 Year Forward 2 Year Forward 3 Year Forward
6/30/2003 1.12% 1.38% 2.40% 3.31%
Actual 1.12% 1.34% 3.33% 5.33%
Difference -0.04% 0.93% 2.02%



What if the market is wrong by the same percentage this time around?

LIBOR Futures Spot 1 Year Forward 2 Year Forward 3 Year Forward
Today 0.15% 0.66% 1.68% 2.50%
Actual? 0.64% 2.33% 4.03%


LIBOR with a 4 handle seems outrageous, but is that just because weve become so complacent
over the last six years? But if LIBOR goes to 4%, thats 1.50% higher than expected and would
cost $150k on a $10mm loan.

Cost to cap LIBOR at 2.50% on a $10mm loan for three years? $58,000.

That $58,000 could be very cheap with the benefit of hindsight.


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