us rates update jul13

8/22/2019 US Rates Update Jul13

1/12

US Interest Rates: Market Update

Strictly Private and Confidential

Citi Institutional Clients Group | Global Markets

July 08, 2013


2/12

1.63%

2.58%

1.5%

1.7%

1.9%

2.1%

2.3%

2.5%

2.7%

Jan 2013 Feb 2013 Mar 2013 Apr 2013 May 2013 Jun 2013

10-Year UST Min Max

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%

Swap Rates Have Had a Volatile 2013

10-Year UST Histogram (Last 10 years)

CurrentMedian

Bottom 10th Percentile

Interest rates have been highly volatile so far in 2013 with rates rallyingthroughout early May and then selling off dramatically in the last sevenweeks as markets have reacted to:

Renewed European concerns (rates lower)

Six consecutive quarters of economic recessionRescue package for Cyprus

Lack of progress in Italy, Spain

Reduced global and domestic growth forecasts and the impactofUS federal spending cuts on an already tepid recovery (rateslower)

Perceived improvement in the US labor marketand thepossibility for the Fed to begin to taper its asset purchaseprogram in the near future (rates higher)

June 19th FOMC Statement: no change to policy stance butacknowledged downside risks have diminished; also noted labormarket conditions have shown further improvement

Bernankes Remarks/Q&A: Fed expects to begin scaling backasset purchases later this year and end the program by mid 2014

Several potential market movers lie ahead:

US economic data: can the momentum in labor markets continue?

Fed decision to taper asset purchase program

Stimulus withdrawal would signal the Feds confidence in the

recovery, but will markets remain stable with less Fed support?

Geopolitical risks

Further deterioration in Europes peripheral countries, or freshconcerns over Europes core

US debt ceiling continues to present near-term fiscal challenges

Will the Treasury be able to find alternative methods to keepitself funded while Congress works towards a solution?

10-YEAR UST

Current: 2.58%

Minimum: 1.39%

Median: 3.82%

Maximum: 5.29%

Economic and Market Analysis: Port Strat Excerpt, What are Rising Rates Telling Us?; June 6th,2013

10-Year UST (YTD)Market Drivers in 2013

5-Year Sw ap

Rates Lower

19.4% of the Time

1 Market Update


3/12

Federal Reserve expects to begin scaling back its massive economicstimulus later this year and end the program by mid 2014

The tone of the message reflected a somewhat more confident view ofrecovery in labor markets and the broader economy

However, Bernanke stressed that Fed officials will adjust their timetablefor ending the bond purchases to the realities of the recovery. He

expects unemployment to be about 7% when the Fed stops the program

Officials also underscored that a tentative timetable for ending QE doesnot signal anything more hawkish or aggressive about exit strategies onrates. Fourteen of 19 officials don't expect the first rate hike until 2015

Overall, the Fed sounded more optimistic note, it pointed out that therisks to the economy have diminished since the fall

Fed Sets Conditional Timeline for Ending QE

FOMC Update: Are We Ready for Less QE?Fed Commentary Indicates Reluctance to Taper QE

More confidence in the outlook, or diminished downside risks, wouldbe required before slowing the pace of purchases Minutes from AprilFOMC meeting (released May 22nd)

Because the outlook is uncertain, I cannot be sure which way up ordownthe next [monetary policy] change will be New York FedPresident William Dudley, May 21st

Currently we have the appropriate monetary policy in place ChicagoFed President Charles Evans, May 20th

It will take further gains to convince me that the substantial

improvement test for ending asset purchases has been met SanFrancisco Fed President John Williams, May 16th

Fed Chairman Bernanke Latest Remarks from Bloomberg, June 20th, 2013

Fed Regime 10y UST S&P 500 TIPS B/EMarketRegime

QE1(Nov '08 - Apr '10)

+50 bps 37% +206 bps Risk On

No Asset Purchases(Apr '10 - Aug '10)

(135 bps) (10%) (69 bps) Risk Off

QE2(Aug '10 - Jul '11)

+68 bps 26% +81 bps Risk On

No Asset Purchases(Jul '11 - Sep '11)

(122 bps) (9%) (46 bps) Risk Off

Operation Twist(Sep '11 - Sep '12)

(18 bps) 20% +47 bps Liquidity On

QE3(Sep '12 - Present)

+55 bps 19% (14 bps) Risk On

Fed Worried About a Pullback?

Market Reaction to Previous Fed Policies

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

$0.8 TN

$1.1 TN

$1.4 TN

$1.7 TN

$2.0 TN

$2.3 TN

$2.6 TN

$2.9 TN

$3.2 TN

$3.5 TN

2008 2009 2010 2011 2012 2013

Fed Balance Sheet (Left) S&P 500 (Right)

Shown in green are the periods where theFed was not in Risk On mode . Equity

indices have suffered greatly when the Fedis not an active asset purchaser.

2 Market Update


4/12

56%

58%

60%

62%

64%

66%

68%

1950 1960 1970 1980 1990 2000 2010

Labor Force Participation

2%

4%

6%

8%

10%

12%

14%

1950 1960 1970 1980 1990 2000 2010

Headline Unemployment

Adjusted Unemployment (Constant LFPR)

Fed Target

The Path to 6.5% UnemploymentAt Decembers FOMC meeting, the Fed announced its hike guidance would no longer be calendar based (e.g.

mid-2015) and would instead be contingent on headline unemployment falling below 6.5%.

Without the recentunprecedented drop inlabor force participation,todays unemployment

rate would be over 11%

62.9% participation

Lower unemployment can be achieved by increasing the number ofemployed persons or shrinking the labor force

Unemployment Rate = 1 (Total Employed / Labor Force)

How Can Headline Unemployment Improve?

So How Far Away Are We?

Outlook

The Fed projects 6.5% unemployment in 2015, implying a significantrebound in the labor force participation rate

If the labor force participation rate continues to decline as it has overthe past several years, then any amount of job additions could bring usto 6.5% much earlier than the Fed projects

From a jobs perspective, quite far:

1.6 million jobs required today to reach 6.5%

To offset expected population growth over the next two years, 4million job gains would get us to 6.5% without any change in the

labor force participation rate

But from a labor force participation perspective, not so far at all:

Without adding a single job, unemployment could fall to 6.5% simplyby the labor force participation rate dropping to 62.9% (currently63.3%)

Since the onset of the financial crisis in 2008 and the subsequenteconomic downturn, the labor force participation rate has beendeclining at a pace of roughly 0.5% per year

At this pace, the US will reach a 62.9% LFPR within 12 months

3 Market Update


5/12

0

10

20

30

40

50

60

70

80

90

Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Apr-15

Projected Monthly Asset Purchases

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Jun-13 Jun-14 Jun-15 Jun-16 Jun-17 Jun-18 Jun-19 Jun-20

Treasury Agency MBS Agency Debt

Federal Reserve Tapering TimetableCitis economists forecast tapering to commence in September and end by mid-2014; Citi expects a FederalFunds rate hike during the second half of 2015.

Citis Projections For Fed Tapering

Projected Evolution of the Feds Security Holdings

Citis Timeline For Fed Tapering

Net Treasury Issuance Expected to Rise 10% By 2H-14

Junes FOMC Statement was largely in line with Citi expectations

Tapering is announced at the September 18 FOMC, with assetpurchase reductions beginning in October

Citis current projections forecast:

Three tapering steps with the termination of purchases announced atthe April 29 FOMC and with final net purchases occurring in mid-May

Treasury and MBS paydowns and maturities are re-invested tomaintain constant portfolio sizes for 8-months following the end ofnew net QE purchases

All purchases cease at the end of 2014, prior to the Fed Funds hike in

2H-15 From mid-2016 to mid-2019 $25 bn/mo in sales take place - $15 bn

Treasury and $10 bn in MBS

Tsy QE(bn)

Agency QE(bn)

Net TsyIssuance (bn)

Net AgencyIssuance (bn)

Net Tsy+AgencyIssuance (bn)

Q1 2013 120 135 381 315 696

Q2 2013 120 135 381 295 676

Q3 2013 120 135 381 195 576

Q4 2013 75 110 408 190 598

Q1 2014 30 68 438 233 671

Q2 2014 10 20 443 280 723

Q3 2014 0 0 444 300 744

Q4 2014 0 0 444 300 744

InBillions

PurchasesperMonth(bn)

Cit i forecasts the Fed wil l taper in th ree

major waves, with the f irst wave

commenc ing in September

++

++

+

+

++

==

==

=

=

==

During the Ju ne FOMC meeting, the Fed stated it wil l

l ikely begin curtai l ing purc hases later during the year,

but did not out l ine a defin i t ive timetable for doing so

Source: Citi Research, Bloomberg

Cit i projects a steady state size of

$1 tri l l ion to be reached by late 2019

Cit i ant ic ipates a Fed Funds

Rate hike in mid 2015

~ 1yr Pause

4 Market Update


6/12

In Feb 13 Congress suspended the debt ceiling to 5/19, when the debt

limit was scheduled to automatically increase to include all outstandingdebt (at $16.7 TN)

Since May 19th, the Treasury has used a number of extraordinary

measures available to keep the government running in absence of

further debt issuance

Given the current situation, it appears the hard ceiling will be reachedsometime in October or November

Citi estimates $287 BN in headroom available

Citi expects cuts will reduce spending by $7 BN/month as comparedto late 2012, while revenue may increase by $19 BN/month overJune, July, August

On May 9th, Fannie Mae reported a record first-quarter profit andannounced that it will pay a $60 billion dividend to the U.S. Treasury,increasing the Treasurys flexibility

Citi forecasts that Freddie Mac will follow suit with a $30 BN dividendto the U.S. Treasury next quarter

Agency Dividends Likely Push Ceiling to Oct / Nov

15,000

15,250

15,500

15,750

16,000

16,250

16,500

16,750

17,000

Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13

Debtoutstanding($B

illion)

Debt Subject to Limit Debt L imit

When Will Treasury Reach The Hard Debt Ceiling?

The Debt Limit Automatically Rose May 19 th

Maneuvers to Increase Debt Headroom

Headroom ($BN)

Civil Service Retirement and Disability Fund Redemptions 18

Civil Service Retirement and Disability Fund Contributions 6

Civil Service Retirement and Disability Fund Interest 16

Civil Service Retirement and Disability Fund June 30 Matures 67

Postal Service Retiree Health Benefits Fund Interest 1

Government Securities Investment Fund (G-Fund) Matures 156

Exchange Stabilization Fund Redemption 23

Total $287 BN

Source: Citi, Estimates based on 2011 experience and Dec. 2012 Treasury estimates.

Februarys debt ceiling suspension expired May 19th; the U.S. Treasury is now undertaking extraordinary

measures to avoid a possible government default.

Debt Ceiling Update

Source: Citi Research

0

100

200

300

400

500

600

June July Aug Sept Oct Nov

CumulativeDeficit($Billion)

2012 Cumulative Deficit 2013 Proj. (no Div.) 2013 Proj. (w / Div.)

Estimatedheadroom

5 Market Update


7/12

10-Year UST Cur re nt 3Q13 4Q13 1Q14 2Q14 3Q14

Citi Forecast 2.27% 2.50% 2.70% 2.90% 3.08%

Street Consensus 2.15% 2.35% 2.50% 2.70% 2.80%

Fed Funds Cur re nt 3Q13 4Q13 1Q14 2Q14 3Q14

Citi Forecast 0.25% 0.25% 0.25% 0.25% 0.25%


LIBOR Cur re nt 3Q13 4Q13 1Q14 2Q14 3Q14

Citi Forecast 0.30% 0.34% 0.40% 0.50% 0.60%


10-Yr UST Citi Forecast Current 2013F 2014F 2015F 2016F 2017F

Citi Forecast 2.58% 2.20% 3.00% 3.25% 3.50% 3.75%

2.58%

0.00-0.25%

0.28%

1.0%

2.0%

3.0%

4.0%

Jan 2009 Jan 2010 Jan 2011 Jan 2012 Jan 2013 Jan 2014

10 Year UST Citi Forecast Economist Consensus

Treasury Market Conditions and Forecasts

Citi forecasts from June 19, 2013. Street forecasts from June 14, 2013.

10-Year Treasury Yield Forecast

Yields are forecasted to rise by the end of 2013

Real Yields Have Become Positive Over the Past Month

Real yields move into positive territory as inflation concerns abate

Rate Forecasts

Recent Comments From Fed Officials

To the extent that the markets are seeing mixed messages, it simplyreflects the debate thats going on among colleagues on the FOMC..

The bigger picture is that any adjustment is not a major policy shift, Atlanta Fed President Dennis Lockhart (6/3/2013)

Its clear that the labor market has improved since September. We

could reduce somewhat the pace of our securities purchases, perhapsas early as this summer San Francisco Fed President John Williams

(5/16/2013)The Fed seems to be unable to improve real growth, despite striving

mightily over the last few years, and further increases in the size of ourbalance sheet raise the risks associated with the exit process when its

time to withdraw stimulus Richmond Fed President Jeffrey Lacker(5/3/2013)

We would continue to reduce the pace of purchases in measured steps

through the first half of next year, ending purchases around mid-year Fed Chairman Ben Bernanke following the FOMC meeting (6/19/2013)

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Mar-08 Jan-09 Dec-09 Oct-10 Aug-11 Jul-12 May-13

10yr Nominal Yield 10yr Real Yield

2.1% in f lat ion

0%

inf lat ion

The 10yr Real Yield has moved up

dramatically over the past month

6 Market Update


8/12

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13

10yr UST Yield vs. Growth 10yr UST Yield vs. $/

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2007 2008 2009 2010 2011 2012 2013

10y UST Yield US GDP

Treasury Yields Shift in Focus from Europe to GrowthOver the past several years, US treasury yields have ignored the improvement in fundamentals and have beendriven by Euro concerns.

Shifting Correlation Suggest US Market Separation GDP vs. Treasury Yields

Between 2010 and early 2013, increased Eurozone risk resulted in aflight to quality (lower UST yields); the market largely ignored theimprovement in US economic fundamentals

Recently, the UST/Eurozone correlation has decreasedFor the first time in the past two years, US Treasuries are morecorrelated with US growth than European risks

Fed officials announced during their June 19th meeting that they areready to move forward with tapering asset purchases soon

Even though the Fed has stated policy is in no way predetermined(and will depend on incoming data and outlook), the market hascome to expect an end to the program by mid 2014

As a result, 10 year treasury yields have increased 75+ bps in thelast seven weeks

10-Year UST Approaching Fair ValueGrowth / Yield Correlation At Multi-Year Highs

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

Mar-10 Oct-10 Apr-11 Nov-11 May-12 Nov-12 Jun-13

10yr UST Yield 10yr UST Model "Fair Value"

58 bps

Source: Bloomberg

Based on Citis Fair Value Model

7 Market Update


9/12

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Jan 2011 Jul 2011 Jan 2012 Jul 2012 Jan 2013

1m LIBOR

3y Swap Rate

5y Swap Rate

0 bps

50 bps

100 bps

150 bps

200 bps

250 bps

Jan 2011 Jul 2011 Jan 2012 Jul 2012 Jan 2013

3y Steepness

5y Steepness

The yield curve has flattened meaningfully over the past year

Difference between LIBOR and term swap rates reduced as swap rates have rallied lower

Curve is flatter than it has historically been, with a difference of 15 to 20 bps per year between swap rates as tenors increase

The initial cost of hedging (i.e. the difference between LIBOR and the swap rate) has therefore fallen significantly

A Flat Yield Presents an Opportunity to Hedge

As Short Term Rates Have Converged, the Initial Cost of Fixing Out Has Reduced

A Flatter Yield Curve Has Reduced the Initial Cost of Hedging

8 Market Update


10/12

Swap Performance is Driven by Underlying LIBOR Forwards

Citi does not provide accounting advice. Please consult your own advisors.

Forwards tend to underestimate the path of LIBOR prior to tightening cycles. However, swaps to fixed executedjust before a tightening cycle tend to produce positive NPV over the life of the trade.

9

2%

4%

6%

8%

10%

12%

Dec-88 Dec-91 Dec-94 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Dec-15

LIBOR Current LIBOR Forwards

Note: Green coloring represents positive savings on a swap to fixed performance; Per annum savings represent the difference between the fixedswap rate and the average realized 3-Month LIBOR settings

Source: Bloomberg, Citi

Paying fixed (locking in interest rate protection) has historically been more expensive than floating (due to theimplied risk premium for certainty), except for shorter-dated swaps executed prior to tightening cycles

The forward curve tends to overestimate the future path of LIBOR in upward-sloping yield curve environments

However, forwards tend to underestimate the path of LIBOR prior to tightening cycles, making swaps to fixedexecuted in those times more likely to perform well

Market Update


11/12

Hedging Alternatives

Description Considerations

Do Nothing No hedges added to the portfolio Low current interest expense given low LIBOR today

May face interest expense volatility and potentially higher cost if rates moveupwards as Fed tightening approaches

Spot Starting Swap Add hedges that begin today Add new hedges at historically low absolute rates

Interest expense certainty for desired tenor

Negative current carry vs. LIBOR

Forward-Starting

Swap

Add hedges on a forward-starting basis Lower current interest expense if LIBOR stays low in the forward period (until

swap effective date)

Capture current rate environment for the fixed rate

Interest rate certainty after the forward start date

Forward-starting rate will be higher than a spot rate

Interest expense volatility until forward date

Step-Up Rate Swap Add hedges in the form of a series ofswaps to fixed

Gradually increasing fixed rates basedon the forward curve

Average rate is similar to a vanilla spot-starting swap rate

Lock in historically low absolute rates

Immediate interest expense certainty to desired tenorLower interest expense than vanilla swap in early periods

Gradually increasing interest expense, but at known levels

Citi does not provide accounting advice. Please consult your own advisors.

Company has an array of hedging alternatives it can use in order to address its floating rate exposure. Recentlymost companies have used spot and forward starting swaps.

10 Market Update


12/12

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us rates update jul13

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