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1 June 2010

Economy
Beyond the cycle
www.sgresearch.com

American Themes
Will Europe delay the Fed?
Stephen Gallagher Chief US Economist (1) 212 278 4496
stephen.gallagher@sgcib.com

Fed officials are being pulled in opposite directions. The US recovery is growing deeper roots and may require scaling back exceptional policy measures. However, the European debt crisis has forced the Fed to take a small step back by reopening FX swap lines. It has also pushed back market expectations for rate hikes. But how much is Europe really worth to the Fed?
Q Europe unlikely to derail US recovery

Aneta Markowska Senior US Economist (1) 212 278 6653


aneta.markowska@sgcib.com

Martin Rose Research Associate (1) 212 278 7043


martin.rose@sgcib.com

So far, economic evidence shows no signs of

spillover of the European troubles into the US economy. Employment growth has finally materialized and income gains are shoring up the consumer. Meanwhile, businesses are restarting their capex plans and we see a lot of room for further gains in business investment. Our baseline scenario is that the European turmoil will have limited impact on the US economy. The Fed would then still be in a position to hike in December.
Q Whats Europe worth to the Fed?

The key risk on the Fed outlook is not the economy, but financial conditions. In an effort to quantify the potential impact of market turmoil on the Feds decisions, we have created an empirical Taylor rule which captures economic as well as financial conditions. If financial conditions remain as stressed as they are today, this would shave about 40 bps from the neutral fed funds rate relative to our baseline scenario and would delay the Fed by about a quarter. A further deterioration in financial conditions could shave a full percent from the neutral fed funds rate and delay the Fed by two to three quarters.

Financial conditions in the Taylor rule


SG Financial Conditions Index
2.0 % 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 -6.0 -7.0 -8.0 87 89 91 93 95 97 99 01 03 05 07 09 11 13 Baseline Scenario Alternative Scenario #1 * Alternative Scenario #2 * -2.0 87 89 91 93 95 97 99 01 03 05 07 09 11 13 0.0 2.0 Fed Funds Rate Baseline Scenario Alternative Scenario #1 * Alternative Scenario #2 * 4.0 -10% 8.0 10.0 %

Taylor Rule Scenarios

6.0

* Alternative Scenario #1: Financial conditions do not im prove * Alternative Scenario #2: Financial conditions deteriorate further SG Financial conditions index is comprised of 14 market variables which include: TED spread, 2y-ff spread, 10yr-2yr Treas spread, 10y-3m Treas spread, 10y3m Treas spread, 6m swap spread, BAA corp spread, HY corp spread, Muni spread, Mtg spread, SPX detrended, VIX, money supply growth, bond-eqty correl The augmented Taylor Rule includes starndard economic variables plus the SG Financial Conditions Index. Coefficients are fitted on post-1989 Fed decisions
Source: Global Insight, Bloomberg, SG Cross Asset Research

Macro

Commodities

Forex

Rates

Equity

Credit

Derivatives

Please see important disclaimer and disclosures at the end of the document

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Economic outlook and monetary policy


The Bernanke sequence 1. Test tools for draining liquidity (reverse repos, term deposits) 2. Scale up liquidity draining operations 3. Increase Interest Paid on Reserves (no explicit mention of the fed funds target, but likely to be hiked simultaneously) #2 and #3 may occur simultaneously if developments were to require a more rapid exit
Source: SG Cross Asset Research

Despite further improvements in the economic performance, the Fed continues to talk softly. At the latest FOMC meeting on April 28, the Fed chose to maintain its commitment to an extended period of low rates. Two weeks later, the Fed was forced to take a step back in its exit plan by reopening FX swap lines with foreign central banks. European debt problems may have temporarily delayed the Feds exit plan, but we see recent market turmoil as a re-pricing of risk rather than a re-pricing of economic expectations. Our baseline view is that European debt problems will slow European growth, but will have only limited impact on the US. As the US recovery continues, the Fed will be pressured to normalize its policy setting. Back in March, Bernanke outlined the following sequence of exit steps: (1) test tools for draining liquidity (2) scale up liquidity draining operations and (3) increase interest paid on excess reserves (IOER). While still in testing stages with respect to reverse repos and Term Deposit Facility (TDF), the Fed has already used its SFP (Supplemental Financing Program) on a small scale to achieve some liquidity withdrawal. Of course, the timing and speed with which the sequence is implemented will depend largely on the economic outlook. Logically, this is the starting point of our discussion on the Fed outlook. Later on, we will incorporate financial conditions into our fundamental framework. This allows us to estimate the potential impact of recent market turmoil on the Feds decisions.

The importance of the output gap


Timing policy exits is never easy, but there are many complicating factors in this cycle. Among them is the uncertainty about the size of the output gap. Whether measured as deviation of GDP from potential, or deviation of unemployment from NAIRU, estimating the output gap requires making an assumption about the underlying capacity of the economy. Some think that the crisis has not altered the path of potential growth or the level of NAIRU: others believe that potential output has been altered significantly.
Evolution of Feds NAIRU Estimates
6.5 % 6.0

Given the wide range of assumptions about the output gap, the estimates of the neutral fed funds rate have also varied enormously in the past year. The Congressional Budget Office, whose estimates are used routinely by economists, still assumes NAIRU near 5%. This assumption translates to a neutral fed funds rate of -1.75% and suggests no rate hikes until Q1 2012 (or when unemployment falls below 8.5%). Yet, many economists, including some at the Fed, have shifted their NAIRU estimates higher since the onset of the crisis. The Fed began publishing its long term economic Unemployment Rate Cyclical vs. Structural

5.5

5.0

4.5

Lines represent the Fed's range; boxes represent central tendency

projections in February 2009, and since then its long term unemployment forecast range has increased from 4.5%-5.5% to 4.9%6.3%.

12 % 10 8 6 4 2 0 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10
Source: Global Insight, SG Cross Asset Research

4.0 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10

Source: Federal Reserve

Our own view lies at the upper end of the Feds range. We see the rise in unemployment as partly cyclical, partly structural. Many of the jobs lost in this downturn e.g. in construction and finance have been lost permanently. The BLS

UR UR excluding LT unemployment Linear (UR excluding LT unemployment)

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(Bureau of Labor Statistics) data shows that 42% of the unemployed have been out of work for more than six months. That accounts for 4.2% out of the 9.9% official unemployment rate. These displaced workers many of them in construction, real estate and finance are not necessarily competing for job openings in other sectors. As such, their downward impact on wages should not be overestimated. Using BLS figures on long-term unemployment, we have
Standard Taylor rule results under various NAIRU assumptions
NAIRU Fed's low Fed's high Prescribed Rate First rate hike

backed out a short-term unemployment rate which essentially eliminates structural changes in the economy. This adjusted figure currently stands at 5.6% vs. a long term average of 4.9%. We conclude that NAIRU has moved substantially above the CBOs 5% estimate. Our own estimates derived from an HP (Hodrick-Prescott) filter on unemployment data put NAIRU closer to 6.3%. This happens to be the upper end of the Feds range. Our estimate suggests the neutral fed funds rate is currently around -0.5% and will turn positive in the first half of 2011.
The importance of NAIRU and the potential policy pitfalls
12.0 % 10.0 8.0 6.0 4.0 2.0 0.0 58 20.0 % 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12

5% 6%

-1.75% -0.45%

Q1'12 Q2'11

Source: SG Cross Asset Research

UR NAIRU (CBO) NAIRU (SG - HP Filter)

Fed Funds Rate TR (based on CBO NAIRU)

15.0

TR (based on SG NAIRU)

10.0

5.0

0.0

-5.0 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12

Source: Global Insight, SG Cross Asset Research

The standard Taylor rule was created to give a simple rule-based approach to policy, not to forecast the Feds actual decisions. Indeed, during the modern era of monetary policy making, the Fed has tended to undershoot the standard Taylor Rule during economic downturns. To capture the Feds actual, rather than hypothetical behaviour, we have estimated empirical Taylor Rules on post-1987 data - that is when Greenspan took over the Fed. The results show a much greater sensitivity to the output gap. Projecting forward the Feds asymmetric behaviour during economic downturns, we estimate that the Fed would currently be targeting a fed funds rate between -1.1% and -2.1%.

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Empirical Taylor Rules


20.0 % Fed Funds Rate TR (based on CBO NAIRU) 15.0 TR (based on SG NAIRU)

10.0

5.0

0.0

-5.0 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15

Source: Global Insight, SG Cross Asset Research

The importance of financial conditions


Another drawback in using traditional Taylor rules is that they only consider the economic backdrop while completely ignoring financial conditions. Financial conditions matter tremendously because they can enhance or disrupt the Feds efforts to manage the economic cycle. Indeed, since financial conditions are pro-cyclical (i.e. they tighten during economic downturns and ease during expansions), they tend to undermine the Feds efforts to either stimulate or restrict growth. This implies that the Fed needs to overreact to the economic evidence in order to compensate for tight or easy financial markets.
SG Financial Conditions Index 1
2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 89 91 93 95 97 99 01 03 05 07 09

Including financial conditions as a variable in the Taylor rule produces slightly lower prescribed rates during economic downturns and higher rates during economic expansions. For the latest downturn, this expanded Taylor Rule would have done a much better job anticipating the Feds moves. As of Q1, our expanded Taylor Rule was putting the neutral fed funds rate at -0.6%. Financial conditions, which were on the accommodative side, were boosting the otherwise prescribed rate by about 50bps. Assuming that financial conditions continue to improve along normal cyclical patterns, the prescribed rate would turn positive in the first half of 2011, end the year at 0.8% and rise to 3.3% by end of 2012.

Source: Bloomberg, SG Cross Asset Research

SG Financial conditions index is comprised of 14 market variables which include: TED spread, 2y-fed fund spread, 10yr-

2yr Treas spread, 10y-3m Treas spread, 10y-3m Treas spread, 6m swap spread, BAA corp spread, HY corp spread, Muni spread, Mtg spread, SPX detrended, VIX, money supply growth, bond-eqty correl. The FCI index is a weighted average of the first three principal components. The weights are determined by regressing GDP on these components.

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Taylor rules with financial conditions


SG Financial Conditions Index
2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 -6.0 -7.0 -8.0 87 89 91 93 95 97 99 01 03 05 07 09 11 13 Baseline Scenario Alternative Scenario #1 * Alternative Scenario #2 * %

Taylor Rule Scenarios


10.0 % 8.0 Fed Funds Rate Baseline Scenario Alternative Scenario #1 * Alternative Scenario #2 *

6.0

4.0

2.0

0.0

-2.0 87 89 91 93 95 97 99 01 03 05 07 09 11 13

* Alternative Scenario #1: Financial conditions do not im prove * Alternative Scenario #2: Financial conditions deteriorate further
Source: Global Insight, SG Cross Asset Research

Of course the Greek crisis, which has mushroomed from a regional problem to a global financial problem, has altered the picture significantly. The deterioration in financial conditions over the past few weeks is worth about 50bps in terms of the fed funds rate. In other words, if the contagion is not broken and financial markets continue to deteriorate, the Fed would likely delay its exit. The charts below show two alternative scenarios, one in which financial conditions do not improve, and another where they deteriorate further. The impact on Fed policy is not negligible, and could potentially be even more pronounced if the deterioration in the financial markets has knockon effects on the real economy. Producing prescribed policy rates is one thing, but interpreting them is another thing, particularly in light of the negative prescribed rates. In a simple world, the Fed would fully drain excess reserves by the time neutral rate returns to zero. Rate hikes would come next. A more likely scenario is that there will be some overlap between the liquidity drain and rate hikes. In other words, the Fed may have to begin hiking ahead of schedule in order to offset the impact of excess reserves in the system and to stop inflation expectations from breaking out.
YE 2012 1.90 3.00

Summary of Taylor Rule Estimates as of Q1


Q1'2010 Standard Rules CBO NAIRU SG NAIRU Em pirical Rules CBO NAIRU SG NAIRU Em pirical w ith FCI CBO NAIRU SG NAIRU -1.75 -0.44 YE 2010 -1.90 -0.58 YE 2011 -0.46 0.79

-2.04 -1.10

-2.10 -1.10

-0.63 0.25

1.97 2.69

-1.52 -0.63

-1.71 -0.82

-0.19 0.67

2.37 3.16

Underlying Economic Assumptions UR 9.70 Core PCE 1.30


Source: SG Cross Asset Research

9.40 1.00

8.70 1.49

6.80 1.80

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Can the US decouple from Europe? And will Europe Delay the Feds exit?
When the US economy collapsed on the back of the sub-prime crisis, Europe could not escape the fallout. Is the US economy equally vulnerable to a European debt crisis? Some market observers have drawn comparisons between the current situation and the sub-prime crisis that morphed into a full blown financial meltdown. Of course, the key similarity between the two crises is the transmission of potential losses through the banking sector, which is already showing liquidity strains. Yet, it may be worthwhile to consider some key distinctions. 1. Asymmetric bank exposure: Sub-prime assets were held in equally large amounts by both US and European banks, therefore transmitting a problem that originated in the US to the European economy. This time, US banks do not have any significant exposure to European sovereign debt. 2. Asymmetric trade flows: The sub-prime crisis was also transmitted to Europe via the export markets which suffered heavily from the collapse in US demand. This process is also asymmetric, because the US is not as dependent on exports to Europe as Europe is on the US. 3. Household balance sheets not at risk: The last difference is that the sub-prime crisis was transmitted to the US economy not only via bank balance sheets, but also via household balance sheets which suffered strong negative wealth effects. This time, US households do not have any exposure to the troubled assets. Of course, that does not mean that the US economy is completely immune to further deepening of the European debt crisis. We see two potential transmission channels: 1. Equity market losses could put pressure on household balance sheets and spark a rise in the savings rate. However, the negative wealth effects are unlikely to be as pronounced as in 2008 in the absence of further house price deflation. 2. Wider credit spreads could increase the cost of capital for businesses and restrain business investment. This adverse impact may be partially mitigated by the impact of safe-haven flows on the Treasury market which have pushed yields down. 3. Stronger dollar Although the US can live with weaker exports to Europe, it could experience a growth slowdown due to weaker external demand and loss of competitiveness. We estimate that a drop in the EUR-USD to parity would produce a direct effect of shaving US GDP by about 0.3%. However, contagion is also pushing the dollar higher against nearly all currencies, which could amplify the damage inflicted on US exporters. In conclusion, the US economy is not completely immune from financial contagion, but there is a considerable asymmetry in the sub-prime episode which originated in the US and the sovereign debt episode which originated in Europe. The transmission mechanisms in this case are not as pronounced. In this sense, the current situation is more like the 1997-98 series of emerging market crises rather than the sub-prime crisis in reverse. The emerging market debt crises which culminated with the Russian debt default amounted a significant market event, but one that had a limited impact on the real economy. The Fed responded to tighter financial conditions by easing monetary policy in 1998, but was forced to reverse course and hike aggressively in 1999. Similarly, the European debt crisis may delay the Feds exit plans, but if the impact on the US economy is limited, the Fed may have some catching up to do in 2011.

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Fed balance sheet action moves to liability side


Nearly all balance sheet expansion programs have ended
Program Expiration Date March 8, 2010 (last 28day auction) February 01, 2010 February 01, 2010 February 01, 2010 February 01, 2010 October 30, 2009 June 30, 2010 for CMBS collateral, March 31 for all other collateral closed February 1, 2010, reopened May 10 February 01, 2010 February 01, 2010

Prior to the European debt crisis, the Fed has closed all but one balance sheet expansion programs and the Feds assets were expected to level off around $2.3 trln. Reopening the FX swap lines could trigger further expansion, although to participation in the program has been small so far. In the first week, FX swaps added only $9bln to the Feds assets and by the third week the amount has shrunk to just $1.2 bln. The low participation by European banks is due to prohibitively expensive rates charged on the loans which, at OIS+100bp, are currently 69 basis points above 3m Libor. We do not anticipate much growth in the Feds balance sheet from the current $2.3 trln. Going forward, the action is clearly moving from the asset side to the liability side. The latest FOMC statement reaffirmed that liquidity and asset purchase programs will not be renewed. The only program still in operation is TALF, but only for loans backed by newly issued CMBS collateral. This program is set to expire in June, and it is unlikely to add substantially to the Feds assets between now and then. The Feds next focus will be normalizing liquidity and unwinding extraordinary policy measures. In a perfect world, cleaning up the Feds balance sheet would be done by unloading assets, but outright sales could lead to dislocations in the still-fragile credit markets. We think that asset sales are unlikely in the near-term. The balance sheet will shrink only gradually as cash flow on the Feds investment is not reinvested back into the market.

TAF TSLF PDCF AMLF CPFF MMIFF TALF

FX swaps Treasury purchases MBS purchases

Source: SG Cross Asset Research

Fed balance sheet


USD bln 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10
Source: Global Insight, SG Cross Asset Research

Fed Assets
2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600

USD bln

Fed Liabilities

Excess reserves peaked in late February. Since then, Treasury has issued $200 bln SFP bills. This is when the fed funds rate started moving up.

Emergency Liquidity Programs Long-term Assets

400 200 Jan-07

Treasury Supplemental Financing Program (SFP) Bank Reserves Other assets (primarily currency)

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Even without outright asset sales, the Fed has several ways to absorb excess liquidity from the system: Special Financing Program (SFP), reverse repos and term deposits. The latter two are still being tested, but the SFP is already being used on a small scale. In late February, the Fed together with Treasury committed to issuing $200 bln of SFP bills. Those purchases have drained some $150 bln of excess reserves and sterilized another $50 bln of balance sheet

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growth. The Fed has taken a pause, but could easily scale up SFP issuance in an effort to continue the liquidity drain. The Fed could also use the SFP to sterilize FX swap lines which are injecting fresh dollars into the global financial system. As noted earlier, FX swaps could potentially increase the Feds balance sheet at a time when the US economy is gaining momentum. This combination could trigger a break in inflation expectations. Sterilization is a potential solution, although the Fed has made no such commitment to date. Sterilization would simply mean speeding up liquidity draining operations. Box 1: Liquidity Draining Facilities - Definitions Reverse repos: In a reverse repo agreement, the Fed borrows funds from primary dealers in exchange for collateral. The funds are locked up at the Fed and cannot be used for new lending. The Fed could technically continue to roll the repos until the underlying assets mature. Since a sale never takes place, the risk of dislocating asset prices is overcome. In a tri-party repo, the collateral is held by a custodian bank which is responsible for the administration of the transaction. Reverse repose are part of standard open market operations, however the Fed wants to expand the number of counterparties beyond primary dealers to include large money market funds. The Fed is in a process of setting up these new counterparties. Supplemental Financing Program: Under this program, the Treasury issues bills in excess of its funding needs. The proceeds are then deposited at the Fed in an SFP account. This Treasury issuance, combined with leaving the proceeds at the Fed, effectively drains liquidity from the system. Term Deposit Facility (TDF): This is a brand new facility which will work similarly to a certificate of deposit (CD) offered by a commercial bank. By taking term deposits from depository institutions, the Fed will lock up the funds which would otherwise be available for lending. The Fed has not yet made its final determination on maturities or how the funds will be allocated, but based on tests which will be conducted in coming months, TDF will be an 84day fixed-rate instrument offered through competitive single-price auctions.

Rate outlook
In the next tightening cycle, the Fed will be operating in a completely new framework. In the past, the Fed would establish a fed funds target and would supply the necessary amount of reserves so that the effective fed funds rate traded at the target. Two things have changed in the post-crisis world. First, the Fed has flooded the banking system with reserves which sharply exceed demand for overnight funds, and secondly the Fed began to pay interest on bank reserves. The latter is supposed to set the floor under the fed funds rate because banks have no incentive to lend at a lower rate than they can earn risk free at the Fed. However, there are some players in the overnight market including the GSEs and Home Loan Banks that do not have access to the Feds deposit facility and are willing to lend below IOER (interest paid on excess reserves). This is why the effective fed funds rate has been trading

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below the 0.25% rate paid on reserves, and why the Fed will have a hard time realigning the effective rate with the fed funds target.
Overnight rates a new framework
7.0 %

Fed Funds Target Fed Funds Effective

What sequence of rate movements?


The discount rate still has 50 bps to go if the Fed wants to restore the pre-crisis penalty spread of 100bps. After that, the corridor system described above implies that the fed funds target rate could move up first, followed by IOER.
3.0 2.5 %

6.0

Discount Rate Interest paid On Excess Reserves (IOER)

5.0

4.0

3.0

Discount Rate - Fed Funds Target


The normal penalty spread is 100bps. The differences prior to 2008 account for timing lags between FOMC and Fed Board meetings

2.0

2.0 1.5

1.0 1.0 0.0 Oct-07 Oct-08 Oct-09 Apr-07 Apr-08 Apr-09 Jan-07 Jan-08 Jan-09 Jan-10 Apr-10 Jul-07 Jul-08 Jul-09 0.5 0.0 03
Source: Bloomberg, SG Cross Asset Research

04

05

06

07

08

09

10

Box 2: Interest Rate Definitions Fed funds rate: The rate at which banks lend to one another in the overnight funds market. Traditionally, the Fed used to control the fed funds rate by manipulating the supply of reserves in the system. As a result, the effective fed funds has historically traded within a few basis points from the Feds target. In the presence of large excess reserves, the Feds control of the fed funds rate has weakened considerably. To regain control of short term rates, the Fed in late 2008 began to pay interest on reserves which theoretically should set the floor under the fed funds rate. Discount rate: The rate at which the Fed lends to banks at the discount window on secured basis. Prior to 2003, the discount rate was typically set below the fed funds target, though there were high hurdles in obtaining the funds from the Fed. In 2003, the Federal Reserve overhauled its discount lending programs and established a positive spread over the fed funds target in order to discourage banks from arbitraging the Fed and to reduce the administrative hurdle. Since 2003, the discount rate has averaged at about 100 bps above the fed funds target (with difference accounting largely for timings lags between FOMC and Board of Governors meetings. The Board is responsible for setting the discount rate at the request of regional Federal Reserve branches. Interest on reserves: The rate which the Fed pays on excess reserves to depository institutions. This concept was introduced in late 2008 to restore the Feds control of overnight rates in the face of large excess reserves. The rate, which does not follow a strict formula, is determined by the Board of Governors (not the FOMC). Currently, the interest rates paid on excess and required reserves (IOER & IORR) are both set at 0.25%.

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The only bullet proof way to regain control of the fed funds rate is to drain the $1 trillion of excess liquidity from the system. That, however, is unlikely to happen quickly. To avoid losing credibility on its rate management, the Fed could simply switch from targeting the fed funds rate to targeting the interest paid on excess reserves (IOER). Of course, the big question is timing. As we noted earlier, our expanded Taylor rule (with financial conditions) suggests that the neutral rate will turn positive in the first half of 2011. In a perfect world, the Fed would use the time between now and then to fully drain excess liquidity, and follow up with rate hikes. However, the liquidity drain is likely to be slower and the Fed will have to worry about the impact of its bloated balance sheet on inflation expectations, particularly if the economy continues to improve. Rather than attempting to drain all the liquidity at once, the Fed has said that is could simply raise the interest paid on reserves. We believe that the first such increase could come as soon as December 2010. Back in February, Bernanke described a corridor system where the Fed would bracket the fed funds rate with the discount rate from above and the interest rate on excess reserves from below. The discount rate, at which the Fed lends to banks, is currently set at 50bps above the target. Prior to the crisis, the so-called penalty spread was set at 100bps. The Fed has already hiked the discount rate once in February and could do so again before the official tightening cycle begins. After that, the corridor system described by Bernanke implies that the fed funds target rate could move up first, followed by the IOER. The key risk factor for our Fed call is the state of financial markets. As demonstrated by our analysis, ongoing turmoil in the financial markets would likely delay the Fed by one to two quarters, assuming no knock-on effects on the real economy.

10

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SG Forecasts
Economic forecasts
The composition of US growth is currently undergoing a transition from inventories to final demand. Inventory contributions peaked in Q4, but were still substantial in Q1. At the start of Q2, we see supply roughly realigned with final demand, and we project only a
Net Trade, % contribut to GDP Exports Imports Government Spending Federal Govt State & Local PCE Deflator PCE Core CPI CPI Core Unemployment Rate Personal Income Disposable Personal Income Real Disposable Pers. Income Savings Rate Corp Profits
2.6 1.7 -29.9 -4.1 -36.4 -14.7 -2.6 -4.3 -1.6 -1.5 1.1 -2.2 1.6 8.2 -8.9 -1.2 0.2 3.7 22.8 6.7 11.4 3.9 1.4 2.0 1.9 2.3 9.3 3.3 7.7 6.2 5.4 15.7 -0.8 17.8 21.3 2.7 8.0 -0.6 2.6 1.2 3.7 1.5 9.6 -1.4 -1.2 -3.6 3.9 50.7 0.3 22.8 15.8 -1.3 0.0 -2.2 2.5 1.8 2.6 1.5 10.0 2.2 2.5 0.0 3.7 36.0 -0.6 7.2 10.4 -1.9 1.2 -3.9 1.5 0.6 1.5 0.0 9.7 3.7 3.4 1.9 3.4 9.3 -0.3 10.0 10.0 1.9 3.3 1.0 0.3 0.7 0.0 0.6 9.7 4.0 4.1 3.8 3.3 13.5 -0.1 10.0 9.0 1.6 2.5 1.0 2.4 1.0 3.0 1.0 9.3 4.9 4.4 2.0 3.2 13.2 -0.5 6.0 8.0 1.5 2.2 1.0 1.7 1.1 2.0 1.1 8.9 5.2 4.4 2.7 3.2 15.3 0.7 0.9 5.4 -9.6 -3.2 -13.9 3.1 7.7 0.5 3.3 2.4 3.8 2.3 5.2 2.9 3.9 0.5 2.7 -11.8 1.8 5.2 -0.2 0.2 1.5 -0.3 1.7 9.3 -1.8 1.0 0.8 4.2 -3.8 -0.4 11.3 10.5 0.6 3.0 -0.9 1.7 1.1 1.9 0.9 9.4 3.0 3.2 1.5 3.3 20.4 -0.5 6.4 8.2 1.6 2.0 1.3 1.8 1.2 2.1 1.2 8.2 4.8 4.4 2.6 3.2 12.6

Quarterly Annualized Growth Rates 2009 A/ E 2010 E Q1 Q2 Q3 Q4 Q1 Q2 Q3


Real GDP Real Final Sales Consumption Non-Resid Fixed Investment Business Structures Equipment and Software Residential Inventories Chg, % contibut to GDP
-6.4 -4.1 0.6 -0.7 0.7 -0.9 2.2 1.5 2.8 5.6 1.7 1.6 3.0 1.4 3.5 4.5 4.3 3.9 4.8 4.5 3.6

Annual year/year 2008 2009 2010 2011 Q4


3.4 3.3 3.2 7.7 -5.0 12.0 15.0 0.1

A
0.4 0.8 -0.2

A
-2.4 -1.7 -0.6

E
3.7 2.5 2.8

E
3.1 3.1 3.0 7.5 -2.3 10.7 12.5 0.0

-39.2 -9.6 -5.9 5.3 3.1 8.5 11.7 -43.6 -17.3 -18.4 -18.1 -15.3 -10.0 -10.0 -36.4 -4.9 1.5 19.0 12.7 16.0 20.0 -38.2 -23.2 -2.3 -1.4 18.9 0.7 3.7 -10.7 3.7 1.6 25.0 0.2 25.0 0.3

1.6 -17.8 3.8 10.3 -19.8 -14.2 -2.6 -16.6 12.7 -22.9 -20.5 -0.3 -0.6 6.5 1.2

marginal contribution inventories.

from

The good news is that both consumers and businesses appear to be accelerating their spending growth. On the basis of monthly evidence, we currently peg Q2 consumption growth at 3.9% while business spending on equipment and software is running near 16% pace. The pickup in final demand should ensure a continuation of the recovery cycle even as inventory contributions fade.

Source: BEA, SG Cross Asset Research

Rates and FX forecasts

The

European

debt

crisis
Central Bank Rate Forecasts
US Canada
current 0.25 0.25 current 10.62 3.25 3 mths 0.25 0.50 6 mths 0.25 0.75 6 mths 4.15 4.25 9 mths 0.50 1.00 1 yr 1.25 1.50 1 yr 4.75 5.00

poses a risk for the US recovery. The stronger dollar and weaker equity markets could shave off a few tenths from our GDP forecasts, although these negatives could be offset by lower gasoline prices and lower mortgage rates. On the basis of our economic outlook, we maintain our baseline view that the Feds tightening cycle will commence in December.

10 year bond yields


US Canada

FX rates
USD per EUR USD per GBP CAD per USD JPY per USD
Source: SG Cross Asset Research

current 1.22 1.44 1.07 90

6 mths 1.20 1.46 0.96 98

1 yr 1.10 1.41 0.95 118

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SG Proprietary Indicators
SG Business Cycle Index
6 5 5 4 0 3 2 -5 1 0 -1 -1 0 SG US B usiness Cycle Index (LHS) GDP , y/y (RHS) -1 5 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 1 0 -2 -3 -4

The US economy is clearly out of a recession regime, but growth is slowing from the breakneck pace registered at the turn of the year. Financial conditions are the key downside risk in our economic scenario. Our business cycle index has slowed notably in recent weeks. The slowdown reflects primarily tighter financial market conditions and is not yet evident in the economic data. In part, the deceleration is also consistent with the transition to demand-led growth which is slowing GDP growth from the 5.6% peak in Q3 towards a 3%4% range. For now, we do not think that the recent market turmoil will derail the US recovery, but financial conditions do pose a risk and need to be monitored closely.

SG Real-Time Recession Probability Model


1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10
Real-time recessio n pro babities are derived fro m a regime switching mo del using the same fo ur co incident inditaro rs used by NB ER cycle dating co mmittee. These include: emplo yment, real inco me, real sales (retail + business) and industrial pro ductio n

NBER recessions Modeled Rec. Prob

SG Fed Model
Rate Cut Probability
Latest Probabilities
100% 80% 60% 40% 20% 0% 92% 96% 100% 80% 60% 40% 20% 0% 3M 6M 9M Probability of at least one rate hike w ithin the next 3, 6, 9 and 12 months 12M 0% 0% 0% 0%

Rate Hike Probability

67% 18% 3M 6M 9M 12M probability of at least one rate cut w ithin the next 3, 6, 9 and 12 months

Historical Perspective - 6 month ahead probability


100% 80% 60% 40% 20% 0% 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 rate cuts Probability of at least one rate cut w ithin next 6 months 100% 80% 60% 40% 20% 0% 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 rate hikes Probability of at least one rate hike w ithin next 6 months

Probability derived from a probit model based on employment, core inflation, ISM index and a liquidity index
Source: SG Economic Research

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Rates and Short-term Funding


Rates
Fed Funds Expectations
European sovereign debt issues have induced significant corrections across the financial market over the past month. 1. Libor rates both spot and implied forwards have risen substantially. The rise is driven primarily by European banks whose access to wholesale dollar funding was impaired following sovereign downgrades of several European countries. 2. Liquidity pressures and in some cases forced deleveraging have triggered sharp corrections in equity, commodity and credit markets, and in highgrowth currencies. 3. Financial turmoil has pushed back expectations for the Feds tightening cycle. Markets are now pricing the first rate hike around Q1-Q2 2011. 4. Soft inflation data, weaker commodity prices and concerns about the impact of austerity measures have pushed back inflation expectations implied by the TIPS market. The 10yr breakeven is now trading at lowest levels since late 2009.
4.0 3.5 3.0 2.5 2.0 1 .5 1 .0 0.5 0.0 Jan- A pr07 07 Jul07 Oct- Jan- A pr07 08 08 Jul08 Oct- Jan- A pr08 09 09 Jul09 Oct- Jan- A pr09 1 0 1 0 Jul1 0 Oct1 0 % 2.5 2.0 1 .5 1 .5 1 .0 0.5 0.0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 1 .0 0.5 0.0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 1 0yr breakeven 5yr 5yrs fo rward 0.00 6/1 0 8/1 0 1 0/1 0 1 2/1 0 2/1 1 0.75 1 .00 % Latest Week ago M o nth ago 0.50 2.0 0.25 1 .5 1 .0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 2.5 3.5 3.0

Treasury Yield Curve (10y - 2y)

Real Treasury Yields


5yr real 1 0yr real 3.0 2.5 2.0

Inflation Expectations

Short Term Funding


Libor vs. OIS (3m) - Historical and Implied

A1/P1 Nonfin CP vs. OIS (3m)


0.5 0.4 0.3 0.2 0.1 0.0 -0.1 -0.2 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 3.5 3.0 2.5 2.0 1 .5 1 .0 0.5 0.0 -0.5 1 /09

ABCP vs. OIS (3m)

4/09

7/09

1 0/09

1 /1 0

4/1 0

Source: Bloomberg, SG Economic Research

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Credit Availability
Mortgages & Consumer Credit
Conforming Mortgage Rate
6.0 5.5 30yr Fannie M B S 30yr Co nfo rming M o rtgage Rate 1 .20

Fannie/Freddie MBS Spreads


1 .60 Fannie/Freddie M B S vs. swap

European sovereign concerns have led to some re-widening in corporate credit spreads, particularly in the financial sector. Notably, the impact on US financials has not been as pronounced as that seen in Europe given limited exposure of US banks to European assets. It has been mixed news for the residential mortgage market. Sub-prime values declines with all risky assets, but MBS yields fell with Treasury yields that were pulled down by safe haven flows. As a result, the 30yr conforming mortgage rate fell below 5% to match lowest levels of this cycle. Jumbo mortgage rates have fallen even more impressively to lowest levels in 5 years.

5.0 4.5 4.0 3.5 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0

0.80

0.40 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0

ABX AAA Tranches


1 00 90 80 70 60 50 40 30 20 1 /08 4/08 7/08 1 0/08 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 200 0 1 /09 index
2006-1 2006-2 2007-1 2007-2

Consumer ABS Spreads


1 200 1 000 800 600 400 bp credit cards auto s

4/09

7/09

1 0/09

1 /1 0

4/1 0

Corporate Credit
Swap Spread (10yr)
50 40 30 20 1 0 0 -1 0 -20 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 1 00 50 0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 300 250 200 1 50

Inv Grade Corp Spread


DJ Inv Grade CDX Index

HY Spreads
(Lehman HY - 10yr Sw ap)
2200 2000 1 800 1 600 1 400 1 200 1 000 800 600 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 450 400 350 300 250 200 1 50 1 00 50 0 1 /09

Sector CDS Spreads


Financials Indust rials

4/09

7/09

1 0/09

1 /1 0

4/1 0

Source: Bloomberg, SG Economic Research

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FX Monitor
Dollar
Major Dollar Index
Since late November, the dollar has strengthened 20% against the euro and we expect the trend to continue toward 1.10. On the surface, this poses a potentially big hit to US exporters. However, the impact depends on what happens to other currencies, notably to emerging Asia. In our main scenario, EM and commodity currencies should continue to strengthen vis--vis the dollar, offsetting much of the euro weakness. Indeed, this pattern has been in place between November and April when the trade-weighted dollar index gained only 2%. Recently, deleveraging and risk aversion have led to some weakness in EM/commodity currencies, however we do not expect this to be sustained. Ultimately, we look for further strengthening of Asian and commodity currencies which would mitigate the impact of weaker euro and promote rebalancing of trade between the US and the emerging world.
0.4 0.3 0.2 0.1 0.0 99 00 01 02 03 04 05 06 07 08 09 1 0
35

FX Volatility (G10 avg)


30 25 20 1 5 1 0 5

88 86 84 82 80 78 76 74 72 70 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0

1 /09

4/09

7/09

1 0/09

1 /1 0

4/1 0

USD/EUR
1 .6 1 .5 1 .5 1 .4 1 .4 1 .3 1 .3 1 .2 1 .2 1 .1 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 1 05 1 00 95 90 85 80 1 /09 4/09

JPY/USD

7/09

1 0/09

1 /1 0

4/1 0

Carry Trade Index


1 70 1 60 1 50 1 40 1 30 1 20 1 1 0 1 00 1 /00 7/00 1 /01 7/01 1 /02 7/02 1 /03 7/03 1 /04 7/04 1 /05 7/05 1 /06 7/06 1 /07 7/07 1 /08 7/08 1 /09 7/09 1 /1 0

Carry-to-Risk Ratio
0.8 0.7 0.6 0.5 +/- 1St Dev range % M o re attractiv e

Yield Differential
6.0 5.0 4.0 3.0 2.0 1.0 00 01 02 03 04 05 06 07 08 09 10

Im plied Vol
Less attractiv
25 15 5 00 01 02 03 04 05 06 07 08 09 10

Source: Bloomberg, SG Economic Research

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Commodities and Equities


Commodities
Crude Oil (Nymex WTI)
Equity prices are a downside risk to the recovery, although we do not yet see the declines as deep enough to induce major behavioral changes by the consumers. The main transmission channel would be the savings rate which over long periods of time correlates well with household wealth positions. So far, equity price declines have not been deep enough to alter the wealth/income ratio substantially. Importantly, home prices are no longer declining and are even rising in some areas. This should also mitigate negative wealth effects coming from equity prices. So far, we see no spillover into consumer confidence which continues to improve gradually. Like lower mortgage rates, lower commodity prices offer an offset to some of the negative effects associated with the European sovereign crisis. On the basis of recent price declines, we estimate that CPI headline will contract by 0.2% m/m in both May and June. This will add a substantial boost to consumer fire power.
40 30 20 1 0 0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 60 50 400 350 300 250 200 1 50 1 00 50 0 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 60 1 00 1 300 1 200 80 1 1 00 1 000 900 800 40 700 600 20 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0 500 1 /09 4/09 7/09 1 0/09 1 /1 0 4/1 0

Gold

Copper
5000 4500 4000 3500 3000 2500 2000 1 500 1 000 500 1 /09

Baltic Dry Index

4/09

7/09

1 0/09

1 /1 0

4/1 0

Equities
Sector Performance - 4 wk chg
Teleco m Co nsumer Staples Utilities Health Care Co nsumer Discretio nary IT Financials M aterials Industrials Energy - 3 .9 % - 4 .8 % - 6 .4 % - 6 .7 % - 7 .0 % - 8 .1% - 9 .0 % - 9 .2 % - 9 .6 % - 11.9 %

VIX
1 8 1 6 1 4 1 2 1 0 8 6 4 2 0

Volatility Skew
(25 delta put - 25 delta call, SPX Index)

1 /09

4/09

7/09

1 0/09

1 /1 0

4/1 0

Source: Bloomberg, SG Economic Research

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