US Economic Outlook / Commentary By: Paul Curtis on October 29, 2015

Spot On™ 1 10/29/2015

ARE YOU WORRIED ABOUT INFLATION? FUHGEDDABOUDIT

Data Check and Commentary:

Despite a recovery in equity prices over the last month, long term bonds remain near the bottom of their recent trading

range with 10yr hovering around 2.05% as growth continues to remain subdued. The recent weak 3rd quarter GDP print of

1.5%, places the 4 quarter average around 2.0% and the 12 quarter average around 2.2%. These averages continue to show

no sign of upward momentum and have continued to move sideways over the past 3 to 4 years at historically weak levels.

More broadly, economic data continues to surprise to the downside as noted by the Bloomberg economic surprise index

which continues to hover well below zero (currently at -.55). Of the six categories tracked, survey / business,

retail/wholesale and labor indicators have been the weakest versus market expectations. The other three categories

(industrial, personal and housing), appear more balanced with a mix of positive and negative surprises. Overall, the index

has remained below zero for the last 10 months (the longest period since the end of the recession).

With the release of the FOMC statement this week, the FED is clearly anxious to begin the rate normalization process (or

should I say, reloading the monetary gun) whether or not they are truly confident about the path of the economy. I must

express some surprise in their addition, in September, and then quick removal, in October, of the following statement:

“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further

downward pressure on inflation in the near term”. They seem uncertain or maybe just frustrated that recent global events

temporarily slowed their hand. Either way, they seem prepared (sooner rather than later) to very gradually begin nudging

rates upward

Away from the FED, central bank activity abroad has reinforced the belief that additional measures will be prescribed as

necessary to combat any growth concerns. China actually acted with a rate cut and lower reserve requirements while the

ECB indicated more actions are imminent and most believe that Japan is right behind them. The actions already in place,

coupled with their indications that they ready to do more, the concern about inflation is a valid one but not necessarily

realistic.

Should You Be Worried About Inflation? Short Answer: NO

INFLATION. The mere mention of this word causes the heart of a bond investor to skip a beat followed by full-blown

panic as they read though recent economic commentary warning about the eventual impact of easy global central bank

policies and investing at historically low nominal rates. Now they start wondering why the ever bought fixed rate bonds in

the first place. I say hold on, don’t panic let’s think this through.

Over the last few years, I have focused on the lack of upward momentum in GDP, non-farm payroll and Core PCE as the

reasons why low rates will persist. These measures continue to remain weak by historical standards (see my October 19

commentary for more details on these measures) with no signs that something is about to change. So, why is this? I

continue to believe the answer is simple: lack of wage growth. Without it, our economy will continue to muddle along as

it has for the last 5 years until the next recession. Given our economy is 70% consumption based, wage growth is the only

path towards sustained upward momentum in GDP, job creation and ultimately inflation.

So what is the outlook for sustained upward wage growth? Not good! Therefore, it is unlikely that inflation will ruin the

bond party anytime soon. I still recommend being overweight duration.

Tracked Indicators (12 Period Moving Averages)

GDP 2.20%, Core PCE 1.50%, NFP 229k Source: Bloomberg & Paul Curtis

Bloomberg Surprise Index

7/28/15 10/28/15

Tenor Yld Yld Chg Level 10 Yr 30 Yr

1Y 0.32 0.31 (0.01) 3rd 2.29 3.22

2Y 0.67 0.70 0.03 2nd 2.17 3.10

3Y 1.02 1.00 (0.02) 1st 2.11 3.01

5Y 1.59 1.47 (0.12) Current 2.10 2.88

7Y 1.98 1.83 (0.15) 1st 1.96 2.75

10Y 2.25 2.10 (0.15) 2nd 1.82 2.61

30Y 2.97 2.88 (0.09) 3rd 1.38 2.21

Source: Bloomberg & Paul Curt is

Resistance / Support

US Economic Outlook / Commentary By: Paul Curtis on October 29, 2015

Spot On™ 2 10/29/2015

The table below shows the US population, number of those full-time employed, employed / population (E/P ratio) and core

PCE over each of the decades dating back to 1950. In addition, changes in each decade is calculated (overall and

equivalent annual change). Obviously, the last decade (2010) only contains five years of data. Over the last 65 years in the

United States:

The non-institutional population has grown by 145mm people or 138%

Total full-time employment has increased by 90mm people or 155%

On average for every person added to population (145mm), 62% converted to employed (90mm)

Core PCE ran exceptionally high during the 70s and 80s at ~5.5% per year versus an average of 3.2% over the last

65 years. Coincidently, we saw a historically sharp rise in employment participation (from 56% to 63%) between

the 60s and the end of the 80s.

Starting in 1950s, the E/P (full time employed / total population)

ratio steadily climbed from 56% all the way up to 63% by the end

of the 80s. This represent sustained demand for workers that lead

to sustained increases in wages and robust consumption (in the mid

60s GDP was near 7%) which eventually fueled inflation.

Said another way, the sharp rise in employment participation in the

70s and 80s was likely at the root of stubbornly high inflation

during this time. It is interesting to note that during the 60s,

despite the E/P ration increasing by 2%, we still only realized

annual Core CPE increase of 2.3%. It took well over a decade of

robust job growth to eventually cause inflation to spike higher.

During the 90s we saw a much small increase in E/P followed by a

significant drop of 6% in the 2000s bringing the E/P ratio all the

way back down to 58% (last seen at the end of the 70s). Since

then, we have only recovered about 1% of the drop in the last ½

decade.

I will concede that increase in the E/P of 1% over the last decade is

encouraging, but I suspect is will take another 1.5 decades of this

type of growth to eventual start to push inflation higher. The real

question is, will we continue to see this type of job growth?

With most economies around the world worried about their own

growth, don’t count on it. I have no doubt that the leveling off and

subsequent decline in the E/P ratio between 1990 and 2010 was

partially attributed to the growth of emerging market economies,

particularly China who now finds its own growth slowing below

its targeted level.

In conclusion, even if the labor improvements we have seen over the last 5 years continue, it is unlikely that inflation starts

to become an issue anytime soon (next 10 years).

Era

Start

Date

End

Date

Y

r

End

Pop

Δ

Pop

%Δ

Pop

End

Emp

Δ

Emp

%Δ

Emp

End

E/P

Δ

E/P

%Δ

E/P

End

PCE

Δ

PCE

% Δ

PCE

%Δ

Pop

%Δ

Emp

% Δ

PCE

ΔEmp

/ Pop

ΔEmp

/ ΔPop

1/50 105 58 55% 14

50s 1/50 1/60 10 116 12 11% 65 7 13% 56% 1% 2% 18 4 26% 1.1% 1.2% 2.3% 7% 65%

60s 1/60 1/70 10 135 19 17% 79 13 21% 58% 2% 3% 22 4 25% 1.6% 1.9% 2.3% 11% 69%

70s 1/70 1/80 10 166 31 23% 100 21 27% 60% 2% 3% 39 17 78% 2.1% 2.4% 5.9% 14% 69%

80s 1/80 1/90 10 187 21 13% 118 18 18% 63% 3% 5% 66 26 67% 1.2% 1.7% 5.3% 10% 86%

90s 1/90 1/00 10 209 22 12% 135 17 14% 64% 1% 2% 83 17 26% 1.1% 1.3% 2.4% 8% 77%

00s 1/00 1/10 10 237 28 13% 138 3 3% 58% -6% -10% 100 17 20% 1.3% 0.3% 1.8% 2% 12%

10s 1/10 1/15 5 249 12 5% 147 9 7% 59% 1% 2% 108 8 8% 1.0% 1.3% 1.5% 4% 78%

Summary: 65 145 138% 90 155% 94 667% 1.3% 1.4% 3.2% 62%

Source: US Bureau o f Labor Stat is t ics , research.s t louis fed .o rg , Paul Curt is

Other Stats

Historical Changes in Population and Employment vs Core PCE - Table 1

Dates Population (mils) Employed (mils) CorePCE Pr Ind Annual Chg % 'sEmploy / Popul

10

5

11

6

13

5

16

6

18

7

20

9

23

7

24

9

58

65

79

10

0

11

8

13

5

13

8

14

7

55%56%

58%

60%

63%

64%

58%59%

50%

52%

54%

56%

58%

60%

62%

64%

66%

0

50

100

150

200

250

300

1/1/50 1/1/60 1/1/70 1/1/80 1/1/90 1/1/00 1/1/10 1/1/15

Nu

mb

er

(m

ils)

Source: US Bureau of Labor Statistics, research.stlouisfed.org, Paul Curtis

Population vs. Employed vs. % Employed

Population Employed

Employed / Population Linear (Population)

2.3% 2.3%

5.9%5.3%

2.4%1.8% 1.5%

1.0%

2.8%

4.8%

7.6%

9.1%

2.9%

3.9%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

Jan-60 Jan-70 Jan-80 Jan-90 Jan-00 Jan-10

% C

ore

PC

E

Source: US Bureau of Labor Statistics, research.stlouisfed.org, Paul Curtis

Cumulative Change in the E/P Ratio vs. Core PCE

Annual %Chg in Core PCE

Cumulative Change in the E/P Ratio

US Economic Outlook / Commentary By: Paul Curtis on October 29, 2015

Spot On™ 3 10/29/2015

Technical Analysis Update for the UST 10yr:

The 10yr yield first broke through the key support of 2.16% back in early August and then spent the next two months

oscillating around 10bps either side of 2.16%. Finally, a few weeks ago the 10yr gained downward momentum and

powered through both the 2.16% level as well as the 200-day moving average of around 2.11%. Since then, like back in

August, the 10yr has lost momentum and has spent the last few weeks oscillating between 2.00 to 2.16%. At this point

most technical momentum measures have turned neutral making it difficult to determine near term direction. So what is

next?

On the first page, I have listed the 1st, 2nd and 3rd support and resistance levels for both the US treasury 10 and 30yr bond.

With the FED out of the way until December, the market should continue to be influenced by incoming economic data

which has generally been surprising to the downside (weaker than expected data). With the release of 3rd quarter GDP

(anemic 1.5%) and non-farm payroll next week, it is possible that the market will break free of the tight range we have been

in over the last few weeks.

Here is what I expect. As mentioned in my last update of 10/29/15 the big trading range lies between 1.82 and 2.29% and

we could easily test either side of that over the next two weeks. Given the recent continuation of below consensus

economic data, I am leaning towards a test of the lower end (1.82%) of the big range soon. Should that be the case, expect

reasonable support at 1.96 before a legitimate test of 1.82%. Then to the extent we get a weekly close below 1.82%, expect

a test of 1.63% in December followed by a test of 1.38% sometime next year.

Strategy:

Begin cautiously adding duration when the 10yr yield is between 2.17 and 2.29, if 2.29 fails to hold the market, expect a

trade as high as 2.85 (I don’t see this happening) before turning lower. Lighten up on duration when the 10yr trades

between 1.96 and 1.81, but begin adding on a sustained (weekly close) below 1.81 with an eventual test of 1.38 likely.

Ultimately, I believe the momentum lower in yield that began in January 2014 will continue whether or not the FED begins

to raise rates later this year. In fact, there action may be exactly what drives yields lower as US growth concerns emerge

from their actions.