The Pensford Letter - 12.11.15

8/20/2019 The Pensford Letter - 12.11.15

1/11

Leveling the Playing Field December 11, 2015

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June 2003 to August 2007 (one year before the first hike to one year after the last hike)

Before Hike

- 2T ran up 1.50% in the three months leading up to the first hike, pushing from 1.50% to 3.00%

- 10T also ran up 1.50%, but started sooner than the 2T

- Fed Funds moved on June 30, 2004

Immediately After Hike

- 2T dropped nearly 0.50% in the next six months

- 10T dropped 0.70% in the next six months

- Fed Funds climbed 1.00% in the next six months

And Then…

- 2T climbed 1.30% over the next four months

- 10T was range-bound

- Fed Funds climbed another 1.00% in the next six months

Takeaways

- Rates actually fell after the first hike

- This trend persisted until the market realized the Fed was going to continue hiking for longer

than originally anticipated.

- Front end rates, more closely tied to the path of Fed Funds, rose much more than expected.

- The yield curve flattened substantially as Fed Funds caught up to Treasurys.


2/11

Overview - Fed Funds, 2T, and 10T June 2003 – August 2007

- The 2T, in particular, waited for Fed Funds to catch up. Once it became apparent the Fed would

continue to hike, it started to climb again.


3/11

Steepness - Spread Between Fed Funds and 2 Year Treasury from June 2003 to August 2007

- The spread between Fed Funds and the 2 year Treasury jumped 1.50% ahead of the first hike,

and then actually declined.

-

This doesn’t mean that the 2T declined, but Fed Funds climbed so much the gap closed.


4/11

Steepness - Spread Between Fed Funds and 10 Year Treasury from June 2003 to August 2007

- Just like with the 2T, the spread between Fed Funds and the 10T dropped after the first hike.

Conclusions about the 2004-2007 Tightening Cycle

-

The 10T did a pretty good job forecasting where Fed Funds would end up.

-

The 2T underestimated the final landing spot of Fed Funds, but continued to climb higher as it

became apparent the Fed would continue hiking.

-

The yield curve flattened substantially as Fed Funds climbed, meaning Treasury yields did not

increase 1-1 as Fed Funds pushed higher.


5/11

Overview – 2015

Before Hike

- 2T ran up 0.50% in the three months leading up to the first hike

-

10T also ran up 0.30%, but had been elevated for some time before that- LIBOR started climbing mid-November in anticipation of the hike


6/11

Steepness in 2015 - Spread Between Fed Funds and 2 Year Treasury

- The spread between Fed Funds and the 2T recently jumped 0.50% as a hike became more

apparent.

-

Recall that the spread in 2004 had jumped 1.50% ahead of the first hike, which raises somequestions why the steepness is so much less significant this time around.

Questions

Is the market pricing in a more accommodative FOMC?

Is the market counting on a patient Fed?

Is the market factoring in a weaker economy than in 2004?

Does the market expect global factors to weigh on the Fed’s tightening cycle?

Is the market setting itself up for a painful correction?

Or is this a reflection of a more transparent Fed?


7/11

Steepness in 2015 - Spread Between Fed Funds and 10 Year Treasury

-

The spread in 2004 was nearly 4.00% at the peak.

- The same spread today is about 2.00%.

QuestionsToday’s steepness is half of what it was in 2004 - is the market setting itself up for a painful correction?

Or is the market’s pricing just a reflection of the fact that the FOMC’s current projections suggest a

tightening cycle about half of the pace we saw in 2004?


8/11

Conclusions

- A transparent Fed has helped reduced some of the volatility priced into the steepness of the

curve.

-

It appears as though the market is taking the Fed at its word for now, expecting about 1.00% ofhikes in 2016.

- The market is factoring in a less than robust domestic economy, slow global economy, and low

commodity prices as factors keeping yields low.

Concerns of how this could impact Treasury yields

- Market complacency created from six years plus years of ZIRP, a transparent Fed, and the

downward pressure on yields from global QE may have set the stage for a painful correction in

US Treasury yields.

-

Spreads to Fed Funds (2T and 10T) are significantly smaller than they were in 2004 – is the

market offsides?

-

The FOMC’s forward guidance is meant to boost the economy, not the P&L of Treasury holders.

If slow and steady works, the economy will continue to grow. This in turn could result in the Fed

shifting forecasts higher, which in turn will push yields up (see the 2T movement in 2005).

- Will regulation have unintended consequences?

If the economic data changes market perceptions for the pace of hikes OR if the FOMC changes its

forward guidance, there could be an acute and painful correction as yields move higher in short order.

This type of move would likely require improvement in the economy or the threat of inflation.

This does not represent our base case scenario, but rather a scenario that could catch the market

offsides in 2016.


9/11

How Did Cap Prices Behave from 2004-2007?

We have spent considerable time over the last year explaining why we thought two year caps on three

year financings made sense. We will not rehash that discussion here, but rather wanted to look at how

that strategy would have worked for a cap buyer on June 30, 2004 – the day of the first hike.

With that in mind, here are the rough terms we used for this analysis:

- $50mm financing

- Three year maturity (6/30/07)

- Borrower deciding between two year cap with an agreement to buy a cap for the third year at

some point in the future OR just buying a three year cap at closing

- I rounded slightly just to keep the numbers simple, but the outcome is materially similar

Where were rates on 6/30/04?

-

LIBOR was at 1.10%

-

2yr swap rate was 3.00% (1.90% above LIBOR)-

3yr swap rate was 3.50% (2.40% above LIBOR)

To determine a comparable strike, we set the strike of this cap at 4.50%. This would have been about

1.00% above market’s expectations for LIBOR during that third year.

To put that into today’s terms, this cap would have a strike of about 2.15%.

Here is what a cap on LIBOR at 4.50% on 6/30/04 would have cost:

2 year cap: $167,000

3 year cap: $475,000 ($308k more than the 2yr)

The borrower would have needed to decide if the $308k in savings was worth the risk that the cap

would cost much more in the future. Keep in mind that the borrower was facing the exact same

scenario many of you are facing right now. It’s a tough call to make in the face of a Fed about to start

hiking rates, right?

In order to track the price, we priced up a one year cap from 6/30/06 – 6/30/07 for the twenty four

months leading up to the 6/30/06 deadline to buy another cap. In other words, we looked at the cap’s

cost at the end of each month just like we have recommended to many of you.

As you will see in the graph below, the cap on that third year was less expensive every single month

after closing until about month 21, when LIBOR actually exceeded the strike. Even when LIBOR was ashigh as the strike, you would have been better off not paying for year three at closing.


10/11

Cap Cost Graph

-

The blue line represents LIBOR over the twenty four months from 6/30/04-6/30/06.

- The red line represents the monthly cost over two years to cap the third year.

- The black horizontal line representing the breakeven point.

o

When the red line is above the black line, you spent more than you would have if youbought a three year cap at closing.

o When the red line is below the black line, your combined costs of buying the two caps

are less than the $475k it would have cost at closing.

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

$0.00

$100,000.00

$200,000.00

$300,000.00

$400,000.00

$500,000.00

$600,000.00

$700,000.00

Forward Cap Cost Breakeven Actual LIBOR

Depsite LIBOR climbing from 1.10% to over 4.50%, the cap on year three

would have been cheaper to buy anytime up until Month 21, when

LIBOR exceeded the strike.

For those of you facing this situation, we believe this makes a compelling case for buying a shorter term

hedge as long as you are committed to monitoring the price going forward. Do not buy a two year cap

and then just check back in 24 months. Make this an ongoing, dynamic hedging strategy.

Perhaps the biggest risk to this strategy would be a dramatic shift higher in expectations for Fed Funds.

As we can see from the analysis above, the cap got more expensive once LIBOR actually exceeded the

strike. A comparable strike today would be about 2.15%, which is much closer to today’s LIBOR than the

4.50% strike was in 2004. Again, the flatness of the yield curve today relative to 2004 likely reflects a

transparent and patient FOMC, but could set the stage for a correction if conditions change. If the strike

of the cap you are buying is higher than 2.15%, you likely have some additional cushion to absorb a shift

in expectations.

And be prepared to buy the cap if the environment changes – hope is not a hedge.


11/11

Economic Data

Day Time Report Forecast Previous

Tuesday 8:30 AM CPI MoM 0 0.002

8:30 AM CPI YoY 0.006 0.002

8:30 AM CPI Ex Food and Energy YoY 0.02 0.019

Wednesday 7:00 AM MBA Mortgage Applications - 0.012

8:30 AM Housing Starts MoM 0.066 -0.11

8:30 AM Building Permits MoM -0.01 0.041

2:00 PM FOMC Rate Decision (Upper Bound) 0.005 0.0025

2:00 PM FOMC Rate Decision (Lower Bound) 0.0025 0

Thursday 8:30 AM Initial Jobless Claims - 282K

8:30 AM Continuing Claims - 2243K

10:00 AM Leading Index 0.001 0.006

Friday 11:00 AM Kansas City Fed Manf. Activity - 1

Speeches and Events

Day Time Report Place

Friday 1:00 PM Fed's Lacker Gives 2016 Economic Outlook Charlotte

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to change without notice. This material may contain information that is privileged, confidential, legally privileged, and/or exempt from disclosure under applicable

law. Though the information herein may discuss certain legal and tax aspects of financial instruments, Pensford Financial Group, LLC does not provide legal or tax

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The Pensford Letter - 12.11.15