Leveling the Playing Field July 28, 2014

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Spent the last week in LA for meetings and many of the discussions revolved around the
labor market. The prevailing question seems to be, Does a 5.5% unemployment rate
really translate into inflation if the quality of jobs is weak?

Its a legitimate question and we think the answer is sort of.

Now thats the kind of hard hitting, in-depth analysis youve come to rely on from the
Pensford Letter!! Am I right?!

In 50 years, I suspect economic historians will be writing about the structural change to
the US labor market during the recent crisis. A 5.5% unemployment rate probably means
less now than it did 20 years ago; however, its still a good number. We were at 9% a
few years ago when the economy was shedding 750k jobs per month. Were averaging a
gain of 272k job per month over the past quarter, and regardless of the quality of jobs that
is not contractionary.

Of course, weaker quality probably mitigates wage pressures and that translates into less
inflation than in a typical recovery. And that is why we believe the answer to the initial
question is sort of.

But declining unemployment means on some level we are working through the slack in
the labor market, and that should ultimately translate into wage pressures. And wage
inflation is really what the Fed is watching. If that starts to pick up as the UR approaches
5.5%, we would expect the Fed to start seriously considering a hike.

This is our third newsletter in a row warning about the possibility of rate hikes next year.
We have gotten complacent with discussions about LIBOR, but it is time to start raising
the threat level from DEFCON 5 to DEFCON 4.

Why the FOMC May Hike in Spring 2015

1. With the release of the FOMC minutes a little over a week ago, the Fed clarified
that the end of QE is coming in October, not December. The conclusion of QE
isnt a big deal at this point (it started getting priced in around May 2013), but its
important because of Yellens remark that rate hikes could come about six months
following the end of QE. With tapering definitively concluding in October, that
puts the March 2015 FOMC meeting in play for the first rate hike.




2. The UR is at 6.1%, down 1.4% in the last twelve months. At that pace of
improvement, the US could be at 5.5% by the end of this year. The Fed will have
a tough time justifying 0% interest rates with unemployment at that level,
regardless of the quality of jobs.

3. The minutes also suggested the Fed is committed to providing a simple and clear
approach to normalization later in the year. If Yellen is committed to waiting as
long as possible before making hawkish statements, that could put a hike in play
in early 2015.

4. Capital Economist Paul Dales said on Wednesday that there is less slack in the
market than the Fed thinks, which goes a long way to explaining why we think
that the first rate hike will take place in March. He also indicated that their
revised forecast calls for Fed Funds (and therefore LIBOR) to be at 1.25% by the
end of 2015 and 3% in 2016. Other economists are pulling forward their forecasts
as well, but most are still in the mid to late 2015 timeline.

We doubt Wednesdays FOMC rate decision will have much impact in the markets, with
Yellen refusing to give too much away at this point. But if the Feds statement is
hawkish, we could see a jump in rates of 10-15bps across the curve.

We think the more likely market mover will be Fridays job reports. The consensus
forecast is a gain of 288k jobs and for the UR to hold steady at 6.0%. A strong number
could certainly push rates higher, particularly if the UR drops below 6.0%.

Russia, concerns over the Eurozone economy, and Chinese demand are keeping a lid on
long term US interest rates; however, domestic data is leading us towards a tightening
cycle and a shift higher of the curve within the next year if we continue on the same
trajectory.










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Economic Data
Day Time Report Forecast Previous
Monday 9:45AM Markit Us Composite PMI - 61.00
9:45AM Markit US Services PMI - 61.00
10:00AM Pending Home Sales MoM 1.00% 6.10%
10:00AM Pending Home Sales YoY - -6.90%
10:30AM Dallas Fed Manufacturing Activity 12.00 11.40
Tuesday 10:00AM Consumer Confidence Index 85.5 0.19%
Wednesday 7:00AM MBA Mortgage Applications - 2.40%
8:15AM ADP Employment Change 225K 281K
8:30AM GDP Annualized QoQ 2.90% -2.90%
8:30AM Personal Consumption - 1.00%
8:30AM GDP Price Index 1.80% 1.30%
8:30AM Core PCE QoQ - 1.20%
2:00PM Fed QE3 Pace $25B $35B
2:00PM Fed Pace of Treasury Purchase $15B $20B
2:00PM Fed Pace of MBS Purchases $10B $25B
2:00PM FOMC Rate Decision 0.25% 0.25%
Thursday 7:30AM Challenger Job Cuts YoY - -20.20%
7:30AM RBC Consumer Outlook Index - 50.50
8:30AM Employment Cost Index 0.50% 0.30%
Friday 8:30AM Change in Non-Farm Payroll 223K 288K
8:30AM Change in Private Payrolls 220K 262K
8:30AM Change in Manufacturing Payrolls 14K 16K
8:30AM Unemployment Rate 6.10% 6.10%
8:30AM Average Hourly Earnings MoM 0.20% 0.20%
8:30AM Average Hourly Earnings YoY - 2.00%
8:30AM Average Weekly Hours All Employment 34.5 34.50
8:30AM Change in Household Employment - 407.00
8:30AM Underemployment Rate - 12.10%
8:30AM Labor Force Participation Rate - 62.80%
8:30AM Personal Income 0.40% 0.40%
8:30AM Personal Spending 0.40% 0.20%
8:30AM PCE Deflator MoM 0.30% 0.20%
8:30AM PCE Deflator YoY 1.80%
8:30AM PCE Core MoM 0.20% 0.20%
8:30AM PCE Core YoY 1.50%
10:00AM ISM Manufacturing 55.5 55.30
10:00AM ISM Prices Paid 58.00
10:00AM Construction Spending MoM 0.50% 0.10%
Speeches andEvents
Day Time Report Place
Tuesday Federal Reserve FOMC Meeting Washington, DC
Treasury Auctions

Day Time Report Size
Monday 1:00PM 3-Month Treasury Bill TBD
1:00PM 6-Month Treasury Bill TBD
1:00PM 2-Year Treasury Note TBD
Tuesday 1:00PM 4-Week Treasury Bill TBD
1:00PM 5-Year Treasury Note TBD
Wednesday 1:00PM 7-Year Treasury Note TBD