The Pensford Letter

The Interest Rate People

October 23, 2017

I know I promised you no newsletter this week, but with the nomination of the next Fed chair likely coming before month end, I couldn’t resist.

Here’s a snapshot of the growing discrepancy between market expectations for LIBOR and the Fed’s own projections for LIBOR. A Fed Chair nominee could change these dramatically.

LIBOR Futures FOMC Difference December 2017 1.50% 1.38% 0.12% December 2018 1.85% 2.13% -0.28% December 2019 2.01% 2.69% -0.68% December 2020 2.15% 2.88% -0.73%

FOMC Dove – Hawk Spectrum

Even without any vacancies filled, the FOMC is set to become more hawkish in 2018.

The Interest Rate People

Fed Chair Ramifications Odds of Initial knee-jerk market reaction becoming Fed Once the dust Hawkish Outsiders: US yield Equity markets Glen Hubbard chair curve bias settles PredictIT 19% John Taylor Bear steepen Negative Game-change? Bloomberg 20% Rules-based monetary policy Curve shifts up with Sharp bond market Requires major US pioneer. May look to quickly Senate Fairly long-end risks due to sell-off will dampen and global political deflate the Fed's balance sheet conf. odds high quick QE unwind risk sentiment buy-in to work

PredictIT 7% Kevin Warsh Bear flatten Mildly negative Look to fade Bloomberg 22% "Taylor-lite". Proposal to lower May raise policy rate Stocks trade lower Talks a good game but

inflation target would only give a Senate Some quicker but to a lower initially as investors in reality may not More Hawkish More short-run lift to US rates conf. odds issues end-point expect higher rates change much

PredictIT 60% Jerome Powell Relief rally Mildly positive Look to fade Bloomberg 29% Continuity candidate. Seen as Partly lifts a cloud of Gradual Fed policy Despite some noise, steadying the ship and making Senate Very uncertainty over short- tightening hopes good the Fed is likely to market happy term US rates for stocks continue as it is

More Dovish More conf. odds high

PredictIT 16% Janet Yellen Neutral Mildly positive Status Quo Bloomberg 20% Looks like Yellen wants to pass on US curve unlikely to Dovish Yellen will be Benign Fed remains a the baton having started US Senate Fairly alter as we remain in welcomed by risk subplot for the monetary normalization conf. odds high flattening mode assets globally broader USD outlook Dovish outsiders Neel Kashkari, Gary Cohn Source: ING Economics Yellen – avoids the spotlight, likes low rates (good for real estate and stocks), but firm believer in banking regulation. Trump wants to streamline Dodd-Frank, and Yellen doesn’t fit into those plans.

Taylor – would likely push interest rates dramatically higher, causing equity sell-off. Cohn and Mnuchin have probably made that very clear to Trump and is the main reason Taylor may not be selected. The Taylor Rule, created by John Taylor in 1993 to create a mathematical formula to set interest rates, would have Fed Funds at 3.75% today.

Warsh – would likely push interest rates higher and has been very wrong, very publicly, about inflation pressures repeatedly over the last decade. His nomination would also likely cause a sell-off in the equity markets.

Powell – similar views to Yellen on interest rates, wants to streamline banking regulations.

The ramifications of a Taylor or Warsh nomination could be significant, particularly on the front end of the curve. Cap prices could increase significantly in a short amount of time.

Trump is expected make the announcement by the end of October.

The Interest Rate People

Pensford’s bet – Jerome Powell. We included his name last month as the most likely candidate and nothing has changed our mind since then. He’s Yellen without the pesky regulations.

This Week

News on tax reform and Thursday’s ECB meeting are the most significant driver of long term interest rates this week. The ECB is set to announce tapering of its QE program, with the market expecting a reduction from €60B per month to about €20B-€20B per month. Deviations from these expectations will drive yields.

The other big driver will be any announcement about the next Fed chair. This announcement could dramatically impact the front end of the curve, and therefore cap prices, in very short order. A Powell announcement would likely be the most well received and result in minimal market disruption.

Somehow lost in all of this is Friday’s GDP and inflation data. It should be a busy week.

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