Leveling the Playing Field

February 24, 2014

_______________________________________________________________________ Remember when CMBS was going crazy between 2005 and 2007? Well just as you were locking in 10yr swaps + 0.65% on interest only, three Barclays traders were manipulating LIBOR to help inflate their P&L. But Im sure your swap salesperson is being completely forthright... Last week was a pretty quiet one on the interest rate front, with interest rates bobbing up and down but remaining within a 3-5bps range all week. The data mostly came in as expected with a few notable weak prints like new home sales and manufacturing. FOMC minutes revealed several participants observed that temporary factors had helped boost real GDP during the second half, pointing specifically to the substantial contributions from net exports and increased inventory investment. As a result, participants generally did not expect the recent pace of economic growth to be sustained. Most economists are scaling back GDP forecasts closer to 2.0% from last years 2.7%. Forward Guidance on Fed Funds (and therefore, LIBOR) The FOMC needs to change its forward guidance language and I guess I shouldnt be shocked it still hasnt at this point even though the UR could dip below 6.5% next month. The minutes showed that the FOMC discussed several options for amending its language after all members agreed to retain the thresholds-based language. Some participants favor quantitative guidance while others prefer qualitative measures. One option mentioned included the Summary of Economic Projections as a communication tool. Most notably, several participants noted that financial stability risks (read: stock market) should be more explicitly factored into the decision. Any remaining thread of doubt about whether the Fed is swayed by equities is rapidly evaporating. The minutes also indicated several participants argued that the forward guidance should give greater emphasis to the Committees willingness to keep rates low if inflation were to remain persistently below the Committees 2% longer-run objective. With most

forecasts for annual CPI coming in around 1.7% and Core CPI around 1.3%, it is likely that inflation will remain on the back burner for some time. Furthermore, over the last twelve months, both measures have come in at 1.6%, the smallest annual increase since May 2011. In other words, the Fed is willing to remain committed to keeping Fed Funds low well beyond the UR dropping below 6.5% and that the guidance will be based on linking the UR with other measures as well as stocks (financial stability). Tapering The minutes also confirmed the FOMCs commitment to tapering $10B per month barring a substantial deviation in economic data. Although a number of participants noted if the economy deviated from its expected path, the Committee should be prepared to adjust the pace of tapering, they added it would require an appreciable change in the economic outlook to deviate from the current pace. The tapering marches on and markets are generally coming around to the idea that tapering does not equal tightening, so the Fed will likely continue at the current pace despite the recent disappointing economic data. That being said, a weak jobs report in two weeks could force the Fed to remind markets it remains poised to reinitiate QE if needed.

This Week Very busy week ahead. Manufacturing data, housing data, durable goods, and GDP. At least six scheduled Fed speeches and Treasury auctions should create a much more volatile week than last week.

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