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STRATEGIC REPORT Rates, Growth, and Inflation

June 2013

Since bottoming in late July 2012, core rates have been in a gradual 10-month uptrend. Through the entire month of May 2013, they shot higher in a compressed, powerful advance. The US 10-Year Treasury yield, for instance, rose from 1.60% to 2.23%, an effective increase in the base cost of capital of nearly 40%. In the context of four decades of falling rates, an entire generation accustomed to a low-rate world, and central bankers that have been spoiled by getting everything they want (with no consequences), the May 2013 rise in rates naturally raised questions. Earlier in the year, academias always-bigger monetary experiments finally hit the inevitable demographic and structural debt brick wall when the Bank of Japan committed to radical policy changes designed to ultimately grow the Japanese economy. The G-7 nations then issued carefully-timed joint statements proclaiming such a move was not considered currency manipulation, and everyone walked away with a sense of accomplishment. Academics believed (and still do) that the Japanese monetary move would cause the global economic pie to grow. Unfortunately Japan would not create growth, but borrow it from virtually every other major exporting nation on the planet. Simultaneously, Japanese policy temporarily raised the global cost of capital in such a profound (and historic) way (through a major selloff in its bond market which contaminated other core nations rates), that any sustainable global economic improvement will more likely be reversed. These effects should slowly emerge over the next weeks/months, but the full impact will probably only become obvious (i.e. too late to do something) by late 2013 potentially contributing to an eventual global crisis and/or recession. Costly unintended consequences at a time when the allowable margin for error has never been lower weve seen this movie before. In this report, we present an initial framework for conceptualizing the relative cost of capital (hurdle rate), and apply it to the US economy. We look to history for context and consequences of rising rate environments. At what point does a rising rate environment become unsustainable? What is the system capacity for higher rates? When do high rates lead to a deteriorating economic outcome, and consequently, the need for the MARKET to self-adjust to lower rates (notice we have purposefully not mentioned central bankers)? Are we at the brink of a structural shift in the global cost of capital? It does not yet appear so but context, as always, is the keystone of analysis.

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The 1998 Incident

From 1995-1998, the Dollar rallied 85% against the Japanese Yen. At the time, world GDP growth was around 3.2%, and US growth was around 4%. The US was the worlds largest consumer, and cheap Japanese exports had a major impact on rest-of-Asia growth. Subsequently, over the months between Q1-Q3 1998, the slowing Asian tiger economies collapsed under the weight of their high debt loads, creating a series of aftershocks that roiled global markets. The table below shows the percentage fall of eight select Asian currencies versus the US Dollar from 1997-1998 (we include Russia in Asia for this comparison):

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Below is a sample chart of the move in the Indonesian Rupiah (IDR) at the time, which was the worst-performing currency in the table:

The only gainer in 1998 was the Yen, and by late 1999 it retraced two-thirds of the entire decline vs US Dollar:

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The 2013 Incident From Oct 2011 through May 2013, the Dollar rallied almost 40% against the Yen, roughly half of the move from 1995-1998. The World and the US have both been growing at 1.8%, or roughly half the growth rate they enjoyed in the lead-up to the 1998 crisis. The US remains the worlds largest consumer.

From the Wall Street Journal, May 24: Debt loads in Asia's emerging economiesgauged by public and private debt as a percentage of gross domestic productnow exceed what they were in 1997, when Asia went into a financial crisis that lasted for several years. Much of the run-up has come over the last four years. The overall debtto-GDP ratio rose to 155% in mid-2012, from 133% in 2008, according to the most recent data from McKinsey Global Institute, a unit of consulting firm McKinsey & Co. Bulls argue that Asia is much less exposed to foreign currency borrowing today than in the late 1990s. They do not recognize the multi-year, massive cumulative investment flows that have piled into the emerging nations, willing to pay a growth premium, and/or reaching for yield. These nations now depend on continued flows to sustain what has become in many ways a failed boom capital squandered in real estate bubbles, massive consumer leveraging, and failed infrastructure projects. Courtesy of central banks, cheap capital did what it inevitably does. First it sought productive investment, and when those destinations ran out, it sought ever-more-unproductive ends. With the one size fits all investment premise now challenged as growth wanes, capital will begin its long retreat out of emerging Asia (and likely all emerging markets). The butterfly flapping its wings is the Yens decline. As repeated in history, this cycle would naturally end only when the cost of capital, or hurdle rate, moved high enough relative to the global economys , and levered/speculative capitals, ability to tolerate it.

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Presented for posterity, below is a chart of the Japanese 10-Year Yield. From April 4 2013 to May 29 2013, it rallied from 0.442% to 0.937% (more than doubling):

Financial markets dont move in a vacuum. Presented for posterity, below we see the 10-Year Yields in the G-4 Countries (US, Japan, UK, Germany) from 2012-2013. Japanese yields are separated on the right-most vertical axis.

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Next we compare the rise in yields in these four countries, since the majority troughed (July 2012). While the previous chart showed how dramatic Japans yield rally was in April 2013 (more than doubling), since July 2012 Japanese yields are up roughly the same in percentage terms as Germany and the UK the US has actually had it worse. For the concepts and many conversations that led to the creation of this chart, we thank our friend, macro thinker, successful money manager, and client DC.

Next we show why this is important.

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The 1994 Incident The price of capital is not linear. An increase in the price of capital (interest rates) from 5% to 8% is not the same thing as an increase from 1% to 4%. The first represents an increase of 60%, the second a quadrupling. Unfortunately, the linear spread is how virtually every rates market is taught, traded, and quoted. It is a convention designed to simplify communication among market participants. But it is not reality.

Considered one of the most aggressive rate rallies in history, and lasting almost precisely 12 months, between Oct 15 1993 and Nov 7 1994 the US 10-Year Treasury Yield rose from 5.165% to 8.03%. This linear increase of 2.865% was effectively a 55% increase in the base cost of capital (above). Over the same period, the US 30-Year Treasury Yield rose 41% (below).

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From Jul 25 2012 to May 30 2013, almost precisely 10 months, the US 10-Year Treasury Yield rose from 1.379% to 2.2318%. This linear increase of 0.8528% was effectively a 62% increase in the base cost of capital. Over the same period, the US 30-Year Treasury Yield rose 38% (both charts below). Therefore, and with all due respect to 1994, we carefully note that the 2012-2013 yield advance is already identical in percentage terms, and nearly identical in time (with only two more months to go). On an annualized basis the current rise in the cost of capital has actually been worse. Rates need only stay flat through July 2013, for the 1993-1994 and 2012-2013 moves to become identical in percentage increase and time:

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Rate Velocity Armed with the previous comparison between 2013 and 1994, let us take a complete look at historical rate velocity. The blue line is the quarterly US 10-Year Treasury Yield. The red line shows its 1-year Rate of Change. In gray we project the Rate of Change through the end of June 2013, if 10-Year Yields remain near the May 2013 high:

If the US 10-Year Treasury Yield stays the same through the end of June 2013, its 1-year Rate of Change will be almost 36%. As the shaded region above shows, since 1962 [the start of our data set] there have been only a dozen instances where this rate of change exceeded 25%. Nine of these led to immediate and major tops in Yields (Treasury Bonds rallied). Since the 1981 peak, seven out of eight led to an immediate top in yields. Keep in mind the above chart uses end-of-quarter prices, but yields bottomed in late July 2012. And as we showed previously, the 10-Year Treasury Yield is already 62% higher than it was then. Either way one looks at it, this has already been one of the largest increases in rates in history. Are we looking at a paradigm shift or just another yield top? Lets look deeper.

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The Cost of Capital in Context In the next chart, the blue line is the same quarterly US 10-Year Treasury Yield. As weve argued the linear spread (linear change in yields) fails because it lacks context. In red we take the linear spread (1-year linear change in yield) and DIVIDE it by 1-Year CPI INFLATION. We are normalizing the linear shift in the 10-Year Yield, sizing it in the context of the prevailing inflation environment. Here too, the shaded region shows that most of the time since 1962, and almost every time since 1981, whenever US Yields rose linearly over a one-year period by more than 25-75% of prevailing inflation [Median = 35% or roughly a THIRD. Well call this rule of thumb the Third of Inflation going forward ], they were out of alignment with the general price level, and required market self-adjustment (lower yields). [*Editors note: late 2008/early 2009 produced a brief spike, as inflation was very low we chose to remove it from the chart] Remarkably, the Third of Inflation relationship has held firm for decades, consistently calling important turns (both up and down) throughout the rate chaos of the 1981-1987 period, and then throughout the 1990s, 2000s, and 2010s. At current prices, if yields dont move until the end of June 2013, they will have risen the equivalent of almost 40% the inflation rate over the last year. Are yields now overpriced?

Having taken a look at yields relative to overpricing/underpricing of inflation, let us look at how rates treat growth.

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In the next chart, the blue line is the same quarterly US 10-Year Treasury Yield. In red we take the linear spread (1-year linear change in yield) and DIVIDE it by 1-Year NOMINAL GDP GROWTH. We are normalizing the linear shift in the 10-Year Yield, sizing it in the context of the prevailing growth environment. Here too, the shaded region shows that most of the time since 1962, and almost every time since 1981, whenever US Yields rose linearly over a one-year period by more than 10-30% of prevailing nominal growth [Median = 19% or roughly a FIFTH. Well call this rule of thumb the Fifth of Growth going forward], they were either overpricing growth expectations, or outright stealing from sustainable growth (or both), subsequently requiring market self-adjustment (lower yields). [*Editors note: late 2008/late 2009 produced spikes, as growth was very low we chose to remove both from the chart] Historically, an increase in the cost of capital by roughly a fifth of prevailing nominal year-on-year growth has usually produced a natural limit for yield advances. Likely, this limit marks a point where the increased cost of capital becomes a large enough indirect tax on the economy to matter. Remarkably, this relationship has held firm for decades, consistently calling important turns (both up and down) throughout the rate chaos of the 1981-1987 period, and then throughout the 1990s, 2000s, and 2010s. At current prices, if yields dont move until the end of June 2013, they will have risen the equivalent of 17% of the nominal growth rate over the last year. Are yields now acting as a direct headwind to growth, and are we set to see declining economic activity at the margin?

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In this report, we explored: The historic context and consequences of rising yield environments A comparison of historic yield advances and their velocity, or rate of change The limits and sustainability of yield advances: normalized for inflation and growth The market process of self-adjustment and rate mean-reversion throughout multiple cycles

With global systemic leverage at its highest in history, even a small rise in the cost of capital would likely be enough to exert significant downward economic pressure. Before we could calculate the threshold, in May 2013 the market gave us a historic increase. Time alone now controls the outcome, as pressure builds. As we carefully evaluate new incoming economic data and while rates markets may continue rising slightly before ultimately producing another important top history suggests this space is no longer a one-way bet, despite near-unanimous belief that the Treasury Bull is dead. One day we will know for sure. Until then, this beast is best approached with respect.

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