War Room 30 May 2013 The End of QE

War Room Monthly macro discussion Using tools in context Update on HiddenLevers Features Your feedback welcome

The End of QE I.QE – History + Analysis II.QE – Current Fed Posture III.Exodus from Bonds? IV.Scenarios + Macro Themes

HiddenLevers QE – HISTORY + ANALYSIS

Fed Mandate: Room to Run Employment Mandate: Above target 6% region Unemployment still ugly 7.7% Interest Rates Mandate: Record low rates No problems here Source: HiddenLevers

QE + Interest Rates Rates have fallen at the tail end of previous QE cycles, as fear trade set in – has the cycle broken? May 29: 2.13% source: AdvisorPerspectives.com

QE + Equities Previous QE rounds ended with a market top or significant correction. Either this time is different – or we’re not yet at QE ending. source: AdvisorPerspectives.com

QE + US Dollar - QE1 + QE2 drove down USD, as Fed fought deflation - Japan aims to double money supply in next year – USD strong QE 1QE 2 QE 2.5 (Twist) + QE3 Japan QE = stronger USD source: HiddenLevers

QE + Housing QE’s downward pressure on mortgage rates (via benchmark 10y) has had a positive impact Will this impact be dampened by the recent spike in rates, or has the housing recovery become self-sustaining? source: HiddenLevers

Stocks versus Bonds – Yield Reversal? Bond yields recently topped equity (S&P 500) yields for the first time in a year – this is the historical norm outside of the Great Depression and Great Recession.

QE – CURRENT FED POSTURE HiddenLevers It ain’t over til its over

Fed May Minutes: The Skinny …continue purchasing additional agency mortgage- backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. Fed SpeakTranslation …as long as the unemployment rate remains above 6- 1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal… QE ain’t over til its over No rate hikes anytime soon Vote on maintaining actions – votes against = revolt FED MINUTES

Exiting QE: choices for the Fed stop recycling matured assets into purchases purchase only shorter end maturities taper down $85b in monthly purchasing hike discount rate 10y 2y

Timing of Exit – When will QE End? 2015 Official Fed line, based on 6.5% unemployment achieved 2016 Big bond dealers + Goldman Sachs chief economist John Hatzius 2025 “Assumption that Fed balance sheet will be normalized by 2025” -Janet Yellen, likely Bernanke replacement Akin to drugs, withdrawal from QE will not be without pain.

HiddenLevers EXODUS FROM BONDS?

Bond Exodus: The Great Rotation? playing the field with equities sitting it out in bonds Great Rotation Investors confident in economy leave safety of bonds, shedding residual fear of financial crisis great rotation

Bond Exodus: The Great Rotation? take a chance in equities play what works in bonds No Great Rotation This is NOT happening. Money Market funds cash is flowing into both bonds and equities. +

Bond Exodus: The Great Rotation? Bond Fund inflows Bond Exodus = overblown Money Market Funds, yielding zilch, give way to bond inflows. $64 billion Bottom Line Cash for Equities is NOT coming at expense of bonds Equity Fund inflows $68 billion $76 billion $14 billionJan/Feb 2012 Jan/Feb 2013

Bond Exodus: Redux of 1994 Massacre? 8.0% 5.25% 50% rise - $1.5 Trillion global bond market losses - yields spiked 275 basis points in 6 months - long term treasuries lost over 10% in current lower rates = losses would be greater

What about Stock Exodus? What happens to stocks after the Fed begins to tighten policy? Average 1Y S&P Return post-tightening: 1965: S&P -12.2%1972: S&P 4.8%1987: S&P -6.2% 1994: S&P -4.6% 1.5%

SCENARIOS + MACRO THEMES HiddenLevers

Good Economy back on track Bad Stagflation Ugly Deflation strikes back End of QE: Baseline Scenarios S&P up 6% since March scenario intro Fed made clear that QE-Infinity preferable to Deflation BOJ: doubling Yen money supply to fight deflation 10Y treasury yields up 70bp from 2012 lows

New QE Scenarios: Bond Exodus + QE-Infinity Fed continues QE for years to stoke GDP and employment Melt-up scenario with irrational spike to upside Only possible if inflation stays down, freeing Fed’s hand on QE Bond market traders try to front run Fed tightening Patterned on 1994 bond crash – equities were volatile but stable that year Speed of rate move could surprise investors if this scenario unfolds source: HiddenLevers

HiddenLevers – Product Update Scenarios Library – Proper Grouping Scenario Library – Images Reports – Lever Icons Reports – Improved Risk Profile Coming soon: 1. Stress Test Lead Generator – v2 2. Screener – Find securities non-correlated to portfolio 3. Integration - Envestnet