Onward Impulses

2013 US Interest Rate Forecast from Cardea Partners

© 2013 Cardea Partners

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1m LIBOR

3m LIBOR

SIFMA

Fed Funds

Prime

Rates in the Coming Year

The world owes all its onward impulses to men ill at ease. The happy man inevitably confines himself within ancient limits.“ -Mr. Holgrave, from The House of Seven Gables by Nathaniel Hawthorne, 1851

Charging dramatically into 2013 (Happy New Year!), we are pleased with our prognosticative powers last year, as we called a low rate level at 1.50% on the 10-year and an upward trend to follow, which was pretty close to reality. The move upward to close the year has not been quite as dramatic as we expected, and short term rates have settled to fractionally lower levels, as the Federal Reserve pushed out its timetable for hiking the fed funds target rate in highly publicized commentary and extended its portfolio duration. Future moves by the Fed will be tied to economic data, so short term rates may move faster than markets expect if the economy outperforms and unemployment dips.

The EU scared markets into a frenzy in the middle of 2012, with liquidity and debt write-downs aiding a teetering Greece and the Spanish banking sector, but Italy and Portugal hung in there. Equities regained their footing both here and abroad, and inflation and rates tempered, from both lower default probabilities and continued purchasing support from the Federal Reserve and other central banks. Scandal broke with LIBOR rigging allegations at international banks, but the loss of confidence in the rate-setting process failed to push LIBOR higher. Massive fines ($2 billion already), class-action settlements to aggrieved swap end-users, and greater oversight will improve confidence in LIBOR, but the fiasco is another reason for everyone to question their banks, their fees, and their motivations.

The Fed’s balance sheet in 2013 is on pace to hit $3 trillion, the 3-year net slackening of demand from a timid private sector. With Europe likely to improve to a ‘stagnation state’ in 2013, we look for Asian economies to help the United States maintain a recovery that will be driven by housing improvement and more lending. The Federal Reserve won’t raise its target rate in 2013, so short term rates aren’t moving much higher in the near term. With tax rates rising for higher income earners, look for tax-exempt ratios to normalize and fall as the yield curve reflates in the second half of 2013.

Historical Short Term Rates and 2012 Forecasted Levels

The Federal Reserve has tied its overnight target rate settings to improvement in economic data going forward, such as having the unemployment rate fall below 6.5% before a hike.

Short Rates Current Q1 2013 Q2 2013 Q3 2013 Q4 2013

Fed Funds Target 0.25% 0.25% 0.25% 0.25% 0.25%

1m LIBOR 0.21% 0.23% 0.25% 0.32% 0.35%

3m LIBOR 0.31% 0.36% 0.35% 0.39% 0.45%

Prime Rate 3.25% 3.25% 3.25% 3.25% 3.25%

SIFMA 0.13% 0.18% 0.14% 0.19% 0.21%

© 2013 Cardea Partners

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2-Yr Treasury

5-Yr Treasury

7-Yr Treasury

10-Yr Treasury

30-Yr Treasury

Reflating the Balloon

Treasury yields have been compressed (-20 bps on the 10-year yield YoY) by the demand from the Federal Reserve and the investment community in general. But global holders of US debt securities have begun a diversification process as the dollar’s weakness has expanded in the last decade, with the greenback now 20% below its 50-year average relative to other major currencies. A move back into equities by global investors (and the domestic retail investor) could dramatically impact the Treasury market in 2013 certainly, but a first-half dip should give many borrowers one last chance at near-record low interest expense. With real yields still negative, a move higher won’t necessarily feel restrictive to the economy or consumer sentiment, particularly for the growing class of citizens and pension funds reliant upon fixed income yields for income generation.

We do expect another panic early in the year at the 2013 debt ceiling negotiation, which will likely result in spending reductions that should have accompanied the fiscal cliff talks. Entitlement programs will need to be reworked and resized, and a split Congress is the most likely to accomplish a task that has limited popular support and is ultimately beneficial to a stable country. This contentious debate in the first quarter and the modest uptick in taxes from a mini-deal of the fiscal cliff will cut GDP early in the year. But spending has to stabilize, and austerity’s structure mustn't stall economic growth, so a balanced resolution, one that could include significant tax code reform, should give markets and businesses in the United States a boost in the medium term.

Good news from Washington should have a greater impact on longer term yields, so we continue to stress taking advantage of value at the long end of the curve by opportunistically hedging long durations while floating or cheaply capping shorter-dated interest rate exposures. Historical US Treasury

Yields and 2013 Forecasted Levels

Improved quality in the recovery and confidence in the economic advancement and state of taxation may lead the 2s-10s spread to widen to nearly 2% over the coming year, with the front end steepening and the back end flattening from further Fed Twist operations.

Treasury Yields Current Q1 2013 Q2 2013 Q3 2013 Q4 2013

2-yr Treasury 0.25% 0.18% 0.25% 0.30% 0.40%

5-yr Treasury 0.72% 0.60% 0.95% 1.15% 1.40%

7-yr Treasury 1.18% 1.05% 1.30% 1.50% 1.80%

10-yr Treasury 1.76% 1.55% 1.75% 2.00% 2.30%

30-yr Treasury 2.95% 2.75% 3.00% 3.25% 3.50%

© 2013 Cardea Partners

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2-Yr Swap

5-Yr Swap

7-Yr Swap

10-Yr Swap

30-Yr Swap

Split Decision

Like much of the Treasury market, swap rates found new lows in the mid-summer panic of 2012. The swap curve fell and stayed flat, even though what was contagion risk from liquidity concerns in Europe dissipated, thanks primarily to the three year structure to LTRO funding for Euro-zone banks and additional willingness from the ECB to use ‘whatever it takes’ solutions to keep the monetary union in place and its member nations and their banks from defaulting. The two-year LIBOR swap rate was actually cut in half over the course of the year, proving to many that rates can always go lower, and that the expectation of rising rates can be dangerous. Typically, this type of prognostication should be left to fixed income hedge funds. Government bond rates in Germany and Switzerland were negative at the two-year point for a good part of 2012 as Europeans paid for principal protection without any yield. Almost all pay-fix swap trades remain underwater.

Our expectation is for swap rates to drop as the debt ceiling fight intensifies in early 2013, but to rise thereafter with both base Treasury yields and spreads assisting the ascent. The 30-year swap spread should go positive once again. LIBOR will continue to rise modestly, but we expect the market upheaval to be concluded by tax day. One risk to LIBOR remaining low is a potential change to its calculation methodology by the BBA in response to the LIBOR rigging scandal of 2012. If a more market-based method is incorporated, greater volatility could creep into the daily resets in periods of turmoil. Even still, hedging entities obviously have resets on both sides of their equation (the hedge and the hedged item), so the biggest impact would come from all swap rates rising as a result of a more volatile reset mechanism. 2013 should be a year to explore or revisit interest rate options instead of swaps as the cheapest hedging solution, particularly on the shorter-dated exposures.

Historical 3m LIBOR Swap Rates and 2013 Forecasted Levels

Another year of gains in credit markets and bank lending should push the back end of the curve higher, and five year debt costs could double. Treasuries remain the market of last resort, however, so unexpected disasters or upheavals can quickly compress all US yields.

Swap Rates Current Q1 2013 Q2 2013 Q3 2013 Q4 2013

2-yr LIBOR Swap 0.39% 0.30% 0.38% 0.45% 0.58%

5-yr LIBOR Swap 0.86% 0.75% 1.10% 1.35% 1.60%

7-yr LIBOR Swap 1.31% 1.10% 1.45% 1.70% 1.95%

10-yr LIBOR Swap 1.84% 1.65% 1.85% 2.15% 2.45%

30-yr LIBOR Swap 2.80% 2.60% 3.00% 3.30% 3.60%

© 2013 Cardea Partners

2013 New Year’s Regulation—Dodd-Frank in Practice

New regulation for swap dealers, major swap participants, and end-users of swaps are here to stay in 2013 with the implementation of Dodd Frank. What does this mean to most of our clients? Well, the DF Protocol produced by ISDA will be presented to clients in a show of greater compliance for banks, clients will need registration and certification for new trades, many will be providing documentation and proof of hedging motivations to qualify for end-user clearing exemptions, and we expect stricter processes from bank counterparties. Entities with a public component (municipalities, utilities, county hospitals, etc.) will be required by their swap counterparties to have proper advisory representation prior to entering into new OTC derivative transactions. Security-based swaps are governed by the SEC, while all other types of swap and options fall under the oversight of the CFTC. Foreign exchange swaps and forwards are exempt from the new clearing and reporting regulations. While most trading will be more transparent, eligible contract participant (ECP) rules will make it potentially impossible for special purpose entities with limited financial value to be party to transactions, and all swap guarantors will be required to meet ECP guidelines as well. Give us a call to find out how this could affect your organization or clients in the coming year. Many dealers will be providing daily mark-to-markets, reporting transactions in near real-time, and clearing trades through exchange structures. Independent valuation is still an import component of any thorough process of accounting for your derivatives—let us know if you have trades that need to be reviewed. As always, more transparency doesn’t mean you are getting the best deal or the correct structure for your organization and its risk profile, so please consult experts before entering into any OTC derivatives transactions—we are here to help, and the cost of our services is always exceeded by the value gained from of competitive pricing and impartial advice in the hedge structuring process. Don’t hedge without us!

Cardea Partners (Cleveland Office)

Christopher Hunt Office: (440) 892-8000

(San Francisco Office)

Joe Momich/Rex Evans Office: (925) 988-0703

www.cardeapartners.com

Knowing What You Don’t Know

Other Markets Current Q1 2013 Q2 2013 Q3 2013 Q4 2013

Dow 13100 13200 13500 14000 14100

S&P 500 Index 1425 1440 1460 1500 1525

GDP QoQ 2.60% 1.90% 2.40% 2.60% 2.80%

EURUSD 1.32 1.33 1.34 1.35 1.37

VIX 23% 25% 20% 18% 17%

Gold ($/oz) 1665 1725 1700 1675 1650

© 2013 Cardea Partners

Disclosure

Any projections, forecasts, opinions or estimates, including without limitation any statement using “expect” or “believe” or “predict” or any variation thereof, contained in this document are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that Cardea Partners East, LLC or Cardea Partners West, Inc. (collectively “Cardea”, “we” or “us”) considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by Cardea or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements in this document reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. Cardea Partners has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of any or all investors. This report is intended for informational purposes only and should not be construed as a solicitation or offer with respect to the purchase or sale of any security. Further, certain information set forth above is based solely upon one or more third-party sources. No assurance can be given as to the accuracy of such third-party information. Cardea disclaims any liability should the information or opinions contained in this or future documents change or subsequently become inaccurate. All information is subject to change without notice. Past performance is never a guarantee of future results. All rights reserved.