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Leveling the Playing Field August 5, 2013 _______________________________________________________________________ Volatility last week was certainly high given the

multitude of Fed decisions and important economic data points, but we failed to break out of the trading ranges. The 10T started the week at 2.60% and closed the week at 2.60%, but there was a big spike in between on Wednesday with the strong ADP report. Why in the world this is considered a forecaster of Non-Farm Payrolls (NFP) is beyond us its an accurate leading indicator about 50% of the timewhich means it isnt accurate at all. This led to a Paul Revereesque cry of the tapering is coming, the tapering is coming! The 10T spiked to 2.74% temporarily. Then came Fridays marginally disappointing NFP and the Unemployment Rate (UR). The economy added 162k jobs last month, about 25k below expectations. The last two reports were also revised lower. This is also below the six month rolling average, so it could be possible that sequestration is finally starting to show up in the labor data. Stocks, of course, went up. Because thats what they do when the Fed is backstopping every imaginable risk to the recovery. Although the UR dropped to 7.4%, it was mainly attributable to a decline in the participation rate. Weve been saying for more than a year now that the participation rate would tick back up as optimism reemerged. This would actually increase the UR despite improving labor market conditions. But this hasnt happened. The participation rate continues to push lower, and its starting to feel more like a permanent change to labor markets. Furthermore, were experiencing a dramatic surge in part-time work rather than full-time positions. In June, part time jobs jumped 360k while full time positions dropped by 240k. Fridays report revealed that only 35% of jobs gained last month were full-time positions. Of the 953k jobs created in 2013, only 23% were full time. If I were more cynical, I might wonder aloud how Obamacare could be correlated to this new developmentbut I suspect the actual impact of Obamacare is exaggerated for political purposes. This leads us to believe that the Fed will have to make some changes to how it forecasts an end to its commitment to QE and ZIRP (Zero Interest Rate Policy, for our purposes this is LIBOR at 0%). For QE, the Fed has targeted an exit when the UR is at 7%. For ZIRP, the Fed has targeted an exit no sooner than when the UR is at 6.5%. With the UR steadily marching lower driven by artificial means (lower participation, not improved hiring), the Fed is getting boxed into a corner. On Friday, St Louis Fed President Bullard made some remarks that suggest tapering is potentially not as imminent as the markets think. He indicated that labor markets may be judged to remain weak and that GDP has in fact been weak. He went on to say that

normally the Committee would not remove accommodation if real GDP growth was viewed as weak. Bullard concluded that he needs to see additional macroeconomic data from the second half of 2013 before he can feel comfortable with tapering. Talking heads, most economists, and markets are still pricing in a formal tapering beginning in September. This makes no sense to us. But as my ex-wife likes to remind me, Im wrong a lot more than I realize. Heres why we think December is the most likely start to tapering and we actually think there is a chance this will be pushed back into 2014: Labor markets are only moderately improving and the job quality is suspect The Fed got a pop in rates without even tapering Fiscal issues with YE September 30 Debt ceiling debate Fed chair nomination likely in September Weakening GDP

Why risk tapering too soon with all this uncertainty? Its clear the Fed wants to get out of the Treasury buying business (QE), so we believe it will make the tapering gradual starting in December and return to using ZIRP as the primary accommodation policy going forward.

LIBOR As a reminder, tapering is not the same as tightening. Tapering is the gradual reduction in bond purchases from the current monthly level of $85B. This is likely to happen at some point later this year and should translate into higher Treasury rates. Tightening is increasing the Fed Funds rate, and therefore LIBOR. The Fed is likely to keep this near zero (ZIRP) for at least another two years, which means floating rate debt should remain very cheap.

Fixed Rates Weve been range-bound for some time, with the 10T stuck between 2.45% - 2.85%. It will likely take major news relating to fiscal issues, debt ceiling, or tapering for rates to break out.

This Week The markets should be much calmer this week, with the only significant data point due out Monday with Non-Manufacturing ISM. More importantly, there are several Fed speeches scheduled which will likely be used to send more signals to the market about tapering.

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Economic Calendar

Economic Data Day Monday Tuesday Time 10:00AM 8:30AM 10:00AM 10:00AM Wednesday 7:00AM 3:00PM Thursday 8:30AM 8:30AM Friday 10:00AM 10:00AM Report ISM Non-manufacturing Composite Trade Balance IBD/TIPP Economic Optimism JOLTs Job Openings MBA Mortgage Applications Consumer Credit Initial Jobless Claims Continuing Claims Wholesale Inventories (MoM) Wholesale Trade Sales (MoM) $15.000B 336k 2945k 0.4% 0.7% Forecast 53.1 -$43.0B 47.5 3900 Previous 52.2 -$45.0B 47.1 3828 -3.7% $19.615B 326k 2951k -0.5% 1.6%

Speeches and Events Day Monday Tuesday Wednesday Time 11:45AM 1:00PM 1:40PM Report Fed's Fisher speaks on the Economy Fed's Evans speaks to Reporters Fed's Pianalto speaks on Monetary Policy Place Portland, OR Chicago, IL Cleveland, OH

Treasury Auctions Day Tuesday Wednesday Thursday Time 1:00PM 1:00PM 1:00PM 3-year Treasury 10-year Treasury 30-year Treasury Report Size $32B $24B $16B