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Marsh 25, 2014

2014:Will This Time FINALLY be Different?

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Presented to:

Table of Contents

Section

I. Economic Outlook

II. Interest Rate Outlook

III. Investment Strategies

2

SECTION IECONOMIC OUTLOOK

4

Employment

Despite the recent weather related slowdown, February’s employment report was solid and we look for March and April to show further strength the further we get from Winter Storm “I can’t believe we name these things”

Inflation

With employment being the largest variable cost for many industries, recent upticks in wage growth point to increasing pressure on wage inflation

Housing

Housing being the driver of economic recovery following most recessions, the run up in home prices and decrease in supply is a positive that the housing market has finally found it’s footing

2014, An Inflection Point: the Economy

3%

4%

5%

6%

7%

8%

9%

10%

62.5%

63.5%

64.5%

65.5%

66.5%

67.5%

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

LFP (LHS) UNR (RHS)

3%

4%

5%

6%

7%

8%

9%

10%

200

250

300

350

400

450

500

550

600

650

700

Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

Initial Jobless Claims (4wk MA, 000, LHS) UNR (RHS)


5

Employment continues to improve

We look for the unemployment rate to continue declining using the weekly initial jobless claims as an indicator

While much is being made of the drop in Labor Force Participation, in reality this trend has been in place since 2000

Unemployment Rate v. Initial Jobless ClaimsLabor Force Participation v. Unemployment

Rate

R2 = 0.53

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14


6

Wage inflation is on the rise

While inflation continues to run below Fed’s preferred range, wage pressures are slowly beginning to mount as the labor market improves

Average hourly earnings are at their highest level since the end of the recession and NFIB compensation index continues rising

Average Hourly Earnings YoY% NFIB Compensation Index

-5

0

5

10

15

20

25

30

Mar-04 Mar-06 Mar-08 Mar-10 Mar-12

0

2

4

6

8

10

12

14

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

Existing Homes New Homes

95%

100%

105%

110%

115%

120%

125%

Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13

S&P Case Shiller FHFA Purchase Only CoreLogic


7

Housing continues to rebound

Despite a recent pause, prices having risen 15 – 25% since bottoming at the end of 2011

The supply of new and existing houses has returned to their prerecession average of 4 – 5 months

National HPI (Jan 2012 = 100) Months Supply of Housing

8

Can we expect any major changes?

Will Janet Yellen view chronic unemployment as a personal challenge and maintain her dovish stance and push the FOMC in that direction?

Will the Fed’s focus shift from unemployment to inflation?

“…if inflation is persistently running below our 2 percent objective, that is a very good reason to hold the funds rate at its present range for longer.”

Can the Fed effectively communicate qualitative guidance?

The change to qualitative guidance has been made, how well will the FOMC get the message across to markets?

Does tightening mean hiking the Fed Funds rate? Not necessarily, the Fed has multiple tools to employ before hiking Fed Funds

2014, An Inflection Point: the Fed

0

45

90

135

180

225

U.S. 2002 - 2007 U.K. 2002 - 2007 Japan 1985 - 1990 China 2008 - 2013

t - 6 t - 5 t - 4 t - 3 t - 2 t - 1

Is a credit bubble in China the next global risk

China is following the lead of the U.S., U.K. and Japan in growing domestic private credit as a percentage of GDP, currently at 196%

Looking at the six years leading into a credit bubble blowing up:

Risks: A Credit Bubble in China?

9

Domestic Credit to Private Sector (% of GDP)

Is there an asset bubble on the horizon?

Looking back to 1985, the times when the Fed was behind the curve have resulted in asset bubbles

Over time, nominal GDP and Fed Funds tend to converge, when there is a positive gap, that is the Fed pumping liquidity into the market

Risks: The Next Asset Bubble?

10

Nominal GDP – Fed Funds

-4

-2

0

2

4

6

8

Mar-85 Mar-88 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06 Mar-09 Mar-12

Asia Bubble

.com Bubble

Credit Bubble Bubble yet to be Named?

SECTION IIINTEREST RATE OUTLOOK

In Uncertain Times, Trust the Ranges

12

Multi-decade bull trends

10Yr UST monthly major support sits at 3.50%

30Yr UST monthly major support sits at 4.05%

Monthly 10 Yr UST 1995 - Today Monthly 30 Yr UST 1995 - Today

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-130.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13

10Yr and 30Yr UST remain range bound

3.0% on the 10Yr UST and 4.0% on the 30Yr are major resistance levels which are likely to attract significant interest from liability sensitive investors

1.00

1.50

2.00

2.50

3.00

3.50

4.00

Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-142.00

2.50

3.00

3.50

4.00

4.50

5.00

Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14


13

Monthly 10 Yr UST 1995 - Today Monthly 30 Yr UST 1995 - Today

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Inflation adjusted 10Yr yield

10Yr UST yields are fairly valued based on their 10Yr average


14

10Yr UST yield – Core PCE YoY Change

10Yr Average = 1.72%

20Yr Average = 2.82%

The yield curve as an indicator

The 2’s – 10’s curve topped out 40 months prior to the 1994 tightening cycle and 18 months prior to the 2003 tightening cycle

Currently at an inflection point

Markets Anticipate, the Fed Reacts

15

Fed Funds v. 2’s – 10’s Curve (bp)

-100

-50

0

50

100

150

200

250

3000.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12

Fed Funds (LHS) 2s - 10s (RHS, Invesrse)

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

3M 1Y 2Y 3Y 5Y 10Y 30Y

Oct-93 Feb-94 Jun-95

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

3M 1Y 2Y 3Y 5Y 10Y 30Y


With 2’s – 10’s being historically steep

We would expect the yield curve to bear flatten in anticipation of the Fed beginning a tightening cycle

Using the 1993 – 1995 rate hiking cycle as an example:

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

3M 1Y 2Y 3Y 5Y 10Y 30Y



16

The 10Yr backed up

75bps by the time the Fed

started tightening

The 2Yr backed up 65bps by the time the Fed started tightening

The 10Yr backed up

7bps by the time the Fed

was done tightening

The 2Yr backed up 114bps by the time the

Fed was done tightening

The 5Yr backed up 82bps by the time the Fed started tightening

The 5Yr backed up 36bps by the time the

Fed was done tightening

Fed Funds futures continue to flatten

After pushing tightening out for six months, Yellen’s “six months” comment, Fed Funds futures pulled hiking up from November to August 2015

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

Aug-14 Nov-14 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16

09/17/13 01/17/14 03/14/14 03/21/14


17

Fed Funds Futures Curves

Sep 2013 – Apr 2015

Jan 2014 – Aug 2015

Mar 2014 – Nov 2015

Back to Jan Projection

SECTION IIIINVESTMENT STRATEGIES

19

Considering the current environment

The economy is better, but risks remain

As we wait for the economy to reach “escape velocity”, interest rates are likely to remain range bound

We look for rates to grind higher during the year, but remain range bound and recommend buying as we get to those support levels

What can portfolio managers do?

Know the risks in your portfolio

Look for the “alpha” trade

Our recommendations:

Relative value in CMOs over collateral

Reduce duration risk with rates at the low end of ranges

2014, An Inflection Point: Portfolios

20

Key rate duration analysis

You may not have an interest rate opinion, but your portfolio does

How does your asset value change to non-parallel shifts in the yield curve?

Example using a 15Yr pass-through

Parallel shift up of 100bps:

OAD = 4.43, a projected 4.43% loss

10Yr yield goes up 50bps:

(-0.5 x 1.33) = -0.67% loss in market value

2Yr yields go up 50bps and 7Yr yields down 10bps (bear flattening)

(-0.5 x 0.31) + (0.1 x 0.93) = -0.06% loss in market value

Know Your Risks

Key Rate Durations Eff. Dur. 3Mo 1Yr 2Yr 3Yr 5Yr 7Yr 10Yr 15Yr 20Yr 25Yr 30Yr

15Yr Pass-Through 4.43 0.02 0.16 0.31 0.52 0.72 0.93 1.33 0.44 0.00 0.00 0.00

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10Yr MBS v. CMO off seasoned 15Yr collateral:

2.50% pass-through FHR 4278 HG* v. 2.50% 10Yr FNMA pass-through

Advantages to CMO over collateral:

CMO is cheaper by ~1 point

Pick up 21bps yield

Pick up 34bps spread to treasuries

Pick up 15bps OAS

All this for a bond with very similar A/L profile

Value in CMOs v. Collateral

Price Yield iSpread A/L +300bps LOAS LOAD LOAC

CMO 102-06 1.78% +86bps 3.33 4.59 -9 3.44 -0.50

10Yr 103-04 1.57% +52bps 3.69 4.26 -22 3.17 -0.42

* Passes FMED* Passes FMED

22

15Yr MBS v. CMO off of hi-LTV 30 Yr collateral:

3.0% sequential FHR 4291 K* v. 3.0% 15Yr FNMA pass-through

Advantages to CMO over collateral:

CMO is cheaper by 1-7/32 points

Pick up 23bps yield

Pick up 43bps spread to treasuries

Pick up 40bps OAS

All this for a bond with a shorter A/L profile

BONUS! At 100PSA, the CMO is shorter by almost 1 year, great extension protection

Value in CMOs v. Collateral

Price Yield iSpread A/L +300bps LOAS LOAD LOAC

CMO 101-18 2.63% +96bps 4.79 5.66 +29 4.49 -0.19

15Yr 102-25 2.40% +53bps 5.34 6.23 -11 4.44 -0.61

* Passes FMED* Passes FMED

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Low vol and at the bottom of rate ranges

This period of low volatility has presented an opportunity to reduce exposure to bonds with extension risk

Both the MOVE index and 1Yr x 10Yr swaption vol are near recent lows

Portfolio Restructuring

40

60

80

100

120

140

160

180

200

2009 2010 2011 2012 2013 2014

MOVE Index

40

60

80

100

120

140

160

180

2009 2010 2011 2012 2013 2014

1Yr x 10Yr Swaption Vol

24

Example restructure

Sell callable agency bonds that are at a loss and offset the losses by selling pass-through MBS and corporate bonds that have gains

Reinvest back into cheaper pass-through and ARM securities

Agency securities had a $1MM loss and with the gains in the pass-through and corporates, the overall loss was only $1k

With reinvestment, the client was able to reduce overall effective duration by 1.58 years and WAL by 3.45 years

The downside was in loss of market yield, which was 1.0%

Portfolio Restructuring

25

2014: an inflection point

The economy is poised to continue improving, but escape velocity is likely to be a 2015 or 2016 story

Despite Yellen’s “six months” comment, we still believe the next Fed tightening cycle will not begin until late 2015 at the earliest

With the short end anchored, we look for rates to remain range bound and portfolio managers should look to support levels as opportunities to invest

Portfolio managers should seek opportunities to add alpha, two trades we like are CMOs over collateral and duration reduction strategies

Conclusion

Standard Disclosure

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