30 September 2011

Cross Asset Research

Weekly
www.sgresearch.com

Focus US
Bernanke faces the Inquisition
Fed Focus
[email protected]

Current performance does not guarantee future results

p.3

Incoming activity data continue to hold up well despite the nosedive in sentiment. Q3 GDP is now tracking slightly above 2%. The problem is that solid growth today does not guarantee solid results in the future. Indeed, financial conditions continue to point to further downside risks. In recent weeks, financial contagion appears to have spread to US banks and the risk is that non-financials may be next. This is precisely what the Fed tried to hedge against with Operation Twist. The question is what else can the Fed do if the situation deteriorates further? Bernankes testimony before the Joint Economic Committee next week will hopefully offer some guidance. However, we do not expect the Chairman to offer strong new policy signals at this stage. Bernanke has to walk a fine line between showing readiness to act and not stirring up further controversy on the Feds aggressive actions.

Eco Focus
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The usual suspects

p.5

The statistical calendar for the first week of October will be bracketed by the Institute for Supply Managments (ISM) survey of manufacturing conditions and the Bureau of Labor Statistics update on the employment situation in September. We expect both reports to surprise to the upside compared to current Street projections. Between Monday and Friday, figures on private job growth from ADP employer services, non-manufacturing activity from the ISM and jobless claims from the Department of Labor may also thinking heading into the all-important nonfarm payroll report.

Rates Focus
[email protected]

Quo vadis?

p.7

Financial markets continue to sail into unchartered territory. Apart from the stress coming from the European front, the Fed is about to further dislocate the US Treasury curve with Operation Twist. We discuss the impact of this on long-dated rates and suggest a trade that benefits from a normalization going forward.

Fiscal Focus
[email protected]

How to balance a budget in a few steps

p.9

Over the next two months news flow and speculation will steadily increase with regards to the US debt super committees ability to crank out a bipartisan deficit reduction proposal by November 23. Given the highly partisan nature in Washington, it is unlikely that we will see a grand deal that includes tax increases and entitlement reform that is more than a token gesture. Our baseline scenario is for stabilization of the debt, but at a higher level than the Presidents plan or the CBOs baseline forecast. In this article, we go through a few steps that could balance the budget while addressing entitlement reform and including revenue into the equation.

Credit Focus
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Five Trade Ideas in the U.S. Financials Space

p.12

After a week of significant spread widening and downgrades by Moodys of Citigroup, Bank of America, and Wells Fargo, the last week of 3Q11 is starting off on a relatively quiet note. And while we expect this quiet tone to continue for most of the week, quiet should not be mistaken for stable, as volatility continues to be the theme in the US financials space. Indeed, after last weeks 26-118 bps widening in 5 year CDS for the major banks, most names are now at their widest point in the last 12 months. Unfortunately, there seems to be little to arrest this volatility in the short-term, making it extremely difficult for longer-term oriented investors to put money to work. However, this volatility does continue to create interesting relative value opportunities in both the cash and CDS space for investors who are looking to take advantage of certain situations where specific relationships have become dislocated. Therefore, we provide five trade ideas that have popped up on our screens this afternoon.

Calendar/Forecasts

p.14

PLEASE SEE IMPORTANT DISCLAIMER AND DISCLOSURES AT THE END OF THE DOCUMENT`
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ECONOMIC DATA PREVIEW

Release date Construction spending (%mom) ISM manufacturing/ISM-price paid Total vehicle sales (mln saar) Factory orders (%mom) ADP employment (thous. sa) ISM Non-Manf. Composite Initial jobless claims/continuing (thou. sa) ICSC Chain Store Sales (%yoy) Nonfarm payrolls (thous. Sa)
Nonfarm /priv. payrolls Ex strikers (thous. Sa)

Reference Period August September September August September September 30 Sep / 24 Sep September September September September September August August

SG Forecast 0.0 52.0/57.0 13.0 -0.5 45 54.2 395/3745 5.0 115 70/110 9.0 0.5 1.0 8.84

Consensus -0.2 50.5/53.8 12.6 0.1 75 52.8 410/3725 na 58 na 9.1 0.2 0.6 7.50

Previous -1.3 50.6/55.5 12.1 2.4 91 53.3 410/3765 4.6 0 46/63 9.1 -0.1 0.8 11.97

10/03 10:00 10/03 10:00 10/03 17:00 10/04 10:00 10/05 08:15 10/05 10:00 10/06 08:30 10/06 10/07 08:30 10/07 08:30 10/07 08:30 10/07 08:30 10/07 10:00 10/07 15:00

Unemployment rate (%) Avg hourly earnings (%mom) Wholesale Inventories (%mom) Consumer Credit (USD bn)

Source: SG Cross Asset Research, Bloomberg. For more forecasts, see the Calendar at the end of the publication.

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Fed Focus
Current performance does not guarantee future results
Incoming activity data continue to hold up well despite the nosedive in sentiment. Q3 GDP is now tracking slightly above 2%. The problem is that solid growth today does not guarantee solid results in the future. Indeed, financial conditions continue to point to further downside risks. In recent weeks, financial contagion appears to have spread to US banks and the risk is that non-financials may be next. This is precisely what the Fed tried to hedge against with Operation Twist. The question is what else can the Fed do if the situation deteriorates further? Bernankes testimony before the Joint Economic Committee next week will hopefully offer some guidance. However, we do not expect the Chairman to offer strong new policy signals at this stage. Bernanke has to walk a fine line between showing readiness to act and not stirring up further controversy on the Feds aggressive actions. So far, so good but downside risks mount Hard

alarm at the Fed. One consolation may be the fact that the non-financial sector so far has only seen modest contagion. However, it is hard to believe that the gap between financials and non-financials (see Chart 1.2) can remain this wide for a sustained period of time. It is true that corporate America has substantial amounts of cash and is less dependent on banks and capital markets than it was back in 2008. However, the financial sector is still the life blood of the economy. Small businesses, in particular, are highly dependent on financial institutions.
Chart 1.1: Financial contagion spreads to US banks
600 bps 5yr CDS spreads 500 US Banks European Banks

400

activity data continue to hold up well despite the nosedive in confidence. Business investment in particular remains resilient and appears on track for a significant gain in Q3. This puts our Q3 GDP tracking estimate at 2.2%. This is still too close to trend for the Feds comfort, but certainly better than the average growth of 0.8% in the first half of the year. The problem is that solid growth today is no guarantee that it will hold up in the coming months. Financial conditions continue to pose a significant risk to the outlook. We have already shaved more than a percentage point off of our 2012 forecast on the back of tighter credit, but the lack of improvement in conditions poses further downside risk. Indeed, in the past week, our financial conditions index has deteriorated further and now exceeds two standard deviations (see chart 1.3). The hit may start adversely impacting the economy as early as Q4.
Financial contagion spreads to US banks Until

300

200

100

0 07 08 09 10 11

Source: Bloomberg, SG Cross Asset Research/Economics

Chart 1.2: Corporates still fine, but for how long?

500 bps 450 US Financials 400 350 300 250 200 150 100 50 0 06 07 08 09 10 11 US Industrials 5yr CDS spreads

recently, funding problems were seen as largely concentrated in the European banking sector. However, over the past two weeks, US financials have seen their CDS spreads widen considerably even as European bank spreads narrowed modestly (see Chart 1.1). This is in part driven by concern about US exposure to European institutions. As a result, CDS spreads for US financials are now at levels last seen in early 2009.
Corporates fine so far, but how long? The contagion

Source: Bloomberg, SG Cross Asset Research/Economics

The gap between financials and nonfinancials was similarly wide in mid-2008, but eventually non-financial spreads widened sharply as the crisis became systemic

to the US financial sector will no doubt be seen with

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and spread to the broader economy. Could the gap close via contraction in financial spreads? It is certainly possible, but the longer the European sovereign crisis goes unresolved, the greater the risk that contagion will eventually spread to the broader US economy.
Ongoing debate on what the Fed can and should do

Recent Fedspeak Highlights

Bernanke Recent weakness only in part due to temporary factors. However, believes that recent spike in inflation is transitory and should dissipate. Labor market is still key. Dudley Long way to go for Fed to meet dual mandate. In recent speeches, he stuck with the official FOMC statement, though highlighted that the Fed considered further easing options. He is satisfied with the drop in rates post-FOMC announcement, but still concerned about the fragile equity markets. Clearly biased toward further easing. In the past, Dudley also expressed support for price level targeting. Fisher Voted against the commitment to keep rates low through 2013. Believes that the Fed should not respond to swings in equity markets. Also suggested that the commitment to low rates removes the incentive for businesses to invest in the short-rum. Kocherlakota Also voted against the latest Fed decision. Believes that unemployment will be close to 8.5% at end of year. Given his forecasts he views that the Fed funds rate target should be raised by 50bps before the end of the year. Plosser The third dissenter. Believed that the decision was premature and would like to have seen more data (though after seeing the Philly Fed survey for August, he may have changed his mind). Anyway, Plosser is comfortable with the deeply negative real interest rates and favors faster normalization of monetary policy. Evans Very dovish. Believes the US is in a balance sheet recession. Believes that high unemployment is not structural, but rather an outcome of weak demand. Like Dudley, Evans also endorsed price level targeting as a policy option. Lockhart Economy is halting and showing lack of conviction. Wary of tightening policy unless absolutely necessary. Would like an explicit inflation target of 2%.

With this backdrop in mind, Bernanke heads to Congress next week to testify on the US economy before the Joint Economic Committee. The FOMC statement sounded decidedly downbeat on the outlook, with significant downside risks emanating from tighter financial conditions. Bernanke is likely to reiterate this position, with heavy discussion of financial sector developments. Doubtless, Bernanke also will be grilled on the twist, particularly by those in Congress who are opposed to any further Fed stimulus. By taking the recent unprecedented steps, the Fed has put itself at the cross hairs of an unpleasant political debate. Leaving politics aside, the more pressing question is what else the Fed can do? We look forward to Bernankes guidance on that. We see QE3 as the most likely next step, but our central scenario is that it will not happen until 2012 when inflation moderates. As far as nuclear options, several Fed officials have mentioned price level targeting as an option, but Bernanke has been cautious not to endorse it publicly. We do not expect a change in his stance for now.
[email protected]

Chart 1.3 SG weekly financial conditions index

Chart 1.3 Doves still in the voting majority

2 1 0 -1 -2 -3 -4

Index
*Bernanke *Yellen * Tarullo * Duke *Raskin * Dudley **Fisher **Kocherlakota **Evans **Plosser ***Pianalto ***Lacker ***Lockhart ***Williams Bullard Hoenig Rosengren

DO VI SH
-1 -3 0 -1 0 -3

HAW KIS H

2011 voters

3 3 -4 4 -4 2 -1 -1 2 5 -4
* permanent voters; ** 2011 voters; *** 2012 voters

-5 -6 -7 -8 -9
00 01 02 03 04 05 06 07 08 09 10 11
Source: Global Insight, SG Cross Asset Research/Economics
SG Financial Conditions Index

Source: Global Insight, SG Cross Asset Research/Economics

4 30 September 2011
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Eco Focus
The usual suspects
The statistical calendar for the first week of October will be bracketed by the Institute for Supply Managments (ISM) survey of manufacturing conditions and the Bureau of Labor Statistics (BLS) update on the employment situation in September. We expect both reports to surprise to the upside compared to current Street projections. Between Monday and Friday, figures on private job growth from ADP employer services, non-manufacturing activity from the ISM and jobless claims from the Department of Labor (DoL) may also color thinking heading into the allimportant nonfarm payroll report. National purchasers gauge rose in September

by 115,000 in September the largest job gain since April. Net of the boost related to the resolution of the aforementioned labor dispute, private entities likely added 110,000 positions, a touch above the 98,000 average posted over the June-August span. Reflecting continued pink-slipping by cash-strapped states and municipalities, government payrolls probably contracted by 40,000 last month, boosting cumulative public job losses over the past three years to an eye-popping 654,000. The remaining portions of the BLS September survey are expected to be comparatively positive as well. Echoing the observed downtick in our augmented insured unemployment rate between establishment surveys, the civilian jobless percentage likely dipped to a five-month low of 9.0%. Meanwhile, the average workweek of all employees probably expanded by six minutes to 34.3 hours, erasing the reported August decline. If our forecasts are on the mark, the index of aggregate hours worked climbed by 0.4% during the reference period. Barring any prior-month revisions, our estimate would place hours worked over the July-September span level with the second-quarter average, hinting at a summer rebound in nonfarm business productivity. Reflecting quirks associated with the timing of the September establishment survey, average hourly earnings likely jumped by 0.5%, pushing the year-to-year growth of this closely followed nominal compensation gauge three ticks higher to 2.2%.
Chart 2.2: Drop in continuing claims hints at pickup in private jobs
thousands
400

Manufacturing reports from district Federal Reserve Banks, combined with auto-related pickups in a variety of midwestern ISM gauges, suggest that the national purchasing managers index climbed to a three-month high of 52.0 in September (see Chart 2.1). Wider reports of stepped-up hiring at factories probably will provide a lift to the headline measure in next weeks report. We would be very careful about projecting any change in the ISM employment gauge to movements in factory payrolls in the BLS report, however. Although the correlation between the ISM hiring barometer and the monthly change in manufacturing employment is high (0.89%), the former has accurately called the direction of the latter just half of the time since 1988. Consistent with the expected improvement in demand, the prices-paid diffusion index likely climbed by 1 percentage points to 57.0 the first rise since April.
Chart 2.1: Regional surveys point to rise in national factory index
70

350
65 60 55 50

300 250 200 150 100

Ests

45
40 35 30 2007 2008 2009 2010 2011

ISM National Mfg Index District Fed Bank Avg Regional ISM Avg Fed & ISM Avg

50 0

Jan Feb Mar Apr May Jun Jul Aug Sep Decline in Total Continuing Claims Private Payroll Change Ex Strikers
Source: SG Cross Asset Research

Source: SG Cross Asset Research

Another head-fake from ADP? Returning strikers boosted nonfarm job count

Buoyed by the return of 45,000 striking workers at Verizon Corporation, nonfarm payrolls probably climbed

The ADP National Employment Report may once again wrongly color expectations heading into the official BLS release. The 19,000 rebound in the average number of

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persons filing initial claims for unemployment insurance benefits between the August and September establishment surveys suggests that only 45,000 positions were added the weakest net job gain in four months. Perhaps more illuminating, the ADP survey will provide an update on the size of firms that are currently hiring, information that is unavailable in the official government release (see Chart 2.3). Since the end of the recession in June 2009, small employers have added 573,000 persons, while medium firms have created 505,000 net new jobs. In contrast, larger companies have shed 282,000 workers.
Chart 2.3: Little help wanted at large companies
Thousands 300 200 100 0

Initial jobless claims rose modestly in latest period

The upcoming jobless claims report is expected to test the veracity of the DoLs assertion that seasonal adjustment problems were behind the 37,000 drop in new filers to a 25-week low of 391,000 during the period ended September 24. We expect a comparatively modest uptick to 395,000 during the week ended October 1 that would pare the less volatile four-week moving average by 6,000 to 412,000. The total number of persons receiving regular state unemployment insurance probably climbed by 16,000 to 3.745 million during the period ended September 24. Two additional items should be pointed out concerning this report. First, pay close attention to the revised continuing claims tally for the week ended September 17. It was a sharp 112,000-upward adjustment to continuing claims for the period ended August 13 that prompted us to mark down our nonfarm payroll forecast last month. Second, continuing claims figures for a variety of other federal and state unemployment benefit programs during the September establishment survey period will become available with this release. Assuming no changes from the period ended September 10, the total number of persons receiving some form of unemployment insurance payment is roughly 125,000 below the level posted during the August canvass.
Auto purchases climbed to a five-month high

-100
-200 -300 -400 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Large (500 or more workers) Small (less than 50 workers) Medium (50 to 499 workers) Total

Source: SG Cross Asset Research

Non-manufacturing activity expected to quicken

Available regional canvasses conducted by the Federal Reserve Banks of Dallas and Richmond suggest that the ISM non-manufacturing activity gauge probably climbed by 0.9 point to 54.2 in September the highest reading since May (see Chart 2.4). Released on the heels of the ADP private jobs projection, the employment diffusion index likely will receive heightened scrutiny in this report. For reference, the 51.6 figure posted in August marked the weakest reading in 11 months.
Chart 2.4: Limited regional surveys point to a modest rise
Percent 15 10 5 Percent 65 60

Industry reports suggest that motor vehicle purchases gathered steam in September and may have reached a seasonally adjusted annual rate near 13 million for the first time since April (see Chart 2.5). After adjusting for anticipated price changes and seasonal differences between the unit volume and value series, auto dealers receipts likely climbed by 4%, or by $2.84 billion, and will add an estimated percentage point to headline retail sales for the month.
Chart 2.5: Motor vehicle sales trending higher
mln, saar 16
Total Vehicle Sales

mln, saar 16

55

14

12-Month Mavg

14

0
-5 -10 Dallas/Richmond Avg (lhs)

50
45 40

12

12

10
35
30

10

-15
-20 2008 2009

ISM Non-Manufacturing (rhs) 2010 2011

8 2008 2009 2010 2011

Source: SG Cross Asset Research

Source: SG Cross Asset Research

[email protected]
6

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Rates Focus
Quo vadis?
Financial markets continue to sail into unchartered territory. Apart from the stress coming from the European front, the Fed is about to further dislocate the US Treasury curve with Operation Twist. We discuss the impact of this on long-dated rates and suggest a trade that benefits from a normalization going forward. Heading into unchartered territory. The lack of

causing market prices to trade in a much wider range than usual. This is true not only for stocks (see Chart 3.1), but also for most fixed-income products.
Chart 3.1: Global uncertainty causes oscillating prices in all major markets, including the equity market

1350 1300
S&P Index

progress in defusing the European sovereign debt crisis, the ongoing banking financing troubles and the continuing concerns regarding the US recovery have already caused a significant deterioration in liquidity. Now, the approaching quarter-end has even led to a worsening of the situation. Quarter-end window dressing is plaguing the market even more than usual, as a large number of financial institutions want to present investors with a lean and clean balance sheet. This involves moving risky assets off the books, as much as this is possible. There used to be a number of brokerdealers with fiscal years different from the rest of the Street. Those institutions provided liquidity by taking some of the unfavourable assets on their balance sheet during periods of balance sheet window dressing. However, those broker-dealers either went out of business (Bear Stearns) or transformed themselves into bank holding companies in 2008 (Goldman Sachs, Morgan Stanley). This means that pretty much everyone is trading in the same direction, which hurts liquidity in the market and causes risky assets to trade at a larger-thanusual discount. As we noted in Wednesdays Daily, one noticeable victim in this respect has been GSE paper which, on an asset swap spread basis, cheapened some 10bp from a week ago.1 With GSEs essentially being less-liquid Treasuries, in our view, this creates an opportunity for investors to position for a renewed GSE spread tightening past quarter-end. We discuss this theme in more detail in the Agency section of our latest Rates Weekly. The corporate new issuance market is yet another example of the peculiar market situation: While high quality issuers (single-A or better) enjoy strong funding opportunities, lower-ranked ones (triple-B or lower) either cant issue at all (as happened in the previous week) or only at a sizeable concession (as in this past week). Global uncertainty, lack of market participation and balance sheet restrictions of liquidity providers are
1 Curve flattening and the poor performance of many duration hedges may have contributed to this move.

1250 1200 1150 1100

Jan Apr Jul Oct

Source: SG Cross Asset Research, Bloomberg

30-year TSY - Mind the gap! Operation Twist has changed the dynamics of the 10- to 30-year sector of the Treasury curve, forcing market participants to re-calibrate their models and to adjust their thinking about the back end of the yield curve. Until recently, the very long end of the Treasury curve was widely considered to be orphaned as few investors dared to express a view on this relatively illiquid and difficult-to-hedge part of the curve. With the Fed stepping in as a potent incremental buyer, a number of things have happened. First, the market instantaneously reduced the term-risk premium, causing 30-year yields to gap lower (see Chart 3.2). Second, 10s30s slope flattened significantly, as the Feds buying program is focused on the 20- to 30-year part of the curve. This reverses the previous steepening trend caused primarily by market participants lack of balance sheet and their ability to invest in long-dated Treasuries (see Chart 3.3). Third, implied volatility on 30-year tails has shot higher and now trades at a significant premium over volatility on shorter tails (see Chart 3.4). While both the anticipation and the announcement of Operation Twist had a pronounced bull-flattening effect on the back end of the yield curve, it now remains to be seen whether the execution of the program will cause a continuation of the trend, or (as happened during QE1) a reversal of the initial market reaction will take place.
7

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Chart 3.2: Frequency distribution of weekly changes in 30-year Treasury yields in 2011: Anything but normal
18 16
Frequency (%)

Chart 3.5: Daily change in 30-year TSY yield minus daily change in 5-year TSY yield

15
10 5

14 12

bp

10 8 6 4
2 0 -45 -30 -15 0 15 30 Weekly changes (bp)

0
-5 -10

-15 2010
Source: SG Cross Asset Research, Bloomberg

2011

Source: SG Cross Asset Research, Bloomberg

Chart 3.3: Secular changes in TSY 10s30s curve slope

La ck of ba lance s heet Fe d buying

100

10s30s slope [bp]

I nflation rising

V olatility de c lining
V ol up

Trade idea: Investors who expect a normalization of the behaviour of the UST yield curve can take advantage of currently elevated levels of 3m-30y swaption volatility. We recommend selling 3m-30y and to buy 3m-5y straddles, weighted to be vega-neutral. The combination is long gamma and has an initial premium take-out (see Table 3.1).
Table 3.1: Trade construction

75
50

25
0

Amt Straddle ATMF Vega Gamma Sell $100m 3m30y 2.97% -$127k -$2.7k Buy $411m 3m5y 1.39% $127k $4.5k $0 $1.8k

Premium $11m -$6m $5m

Source: SG Cross Asset Research; mid-market indications as of 29 September noon.

-25

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Fed selling creates RV opportunities. As market

Source: SG Cross Asset Research, Bloomberg

Chart 3.4: Divergence between implied volatility on 30-year tails and volatility on shorter-dated tails
250

Implied volatility [bp/year]

200

3m30y vol 3m5y vol

participants keep digesting the details known about Operation Twist so far, investors are fine-tuning their relative value (RV) models ahead of the Feds first market operation. We present a simple RV framework in a special publication. There are currently some dislocations in the 2- to 3-year sector worth exploring in our view (see Graph 6).
Chart 3.6: Relative value against the spline vs current Fed holdings as a percentage of outstanding notional
3

150

Fed owns little

Fed owns a lot

T SY 1% 5/14

Rich/Cheap vs. spline [bp]

100

2 1 0

Bond cheap

50 2008

2009

2010

2011

0
-1

10

20

30

40
T SY 0.5% 1 1 /13 T SY 0.5% 1 0 /13

50

60

Source: SG Cross Asset Research, Bloomberg

-2
-3

Historically, 30-year yields do not move more than 5-year yields. Between 2010 and July of this year, average daily yield movements have been virtually identical. It is only since the beginning of August that daily changes in 30year yields exceeded those on 5-year yields by 4bp on average (see Chart 3.5). Short-dated implied volatility indicates this excess volatility in 30-year tails will continue until year-end.

Bond rich

-4
-5 Fed holding of a particular issue [% of outstanding]

Source: SG Cross Asset Research, Bloomberg

Recommendation Sell 3m-30y straddles and buy 3m-5y straddles, weighted to be vega-neutral.

[email protected]

30 September 2011

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Fiscal Focus
How to balance a budget in a few steps
Over the next two months news flow and speculation will steadily increase with regards to the US debt super committees ability to crank out a bipartisan deficit reduction proposal by November 23. Given the highly partisan nature in Washington, it is unlikely that we will see a grand deal that includes tax increases and entitlement reform that is more than a token gesture. Our baseline scenario is for stabilization of the debt, but at a higher level than the Presidents plan or the CBOs baseline forecast. In this article, we go through a few steps that could balance the budget while addressing entitlement reform and including revenue into the equation.

Obamas plan called for one dollar of tax increases for every two dollars in spending cuts. The Debt Commission looked for one dollar in tax increases for every three dollars in spending reductions. As we said in our initial analysis of the Obama deficit plan, we were disappointed by the heavy reliance on Tax cuts, as well as little on the side of entitlement reform. Looking over the instruction manual. Over the coming weeks we will likely see more plans on how to reduce the deficit to add to our collection. Not to miss out on all the fun we will briefly illustrate what type of measures could be taken to bring the budget close to balance over the next 10-years. The CBO provides a comprehensive analysis of various budget options that could reduce the deficit and we use this as the framework in which we will slice up the deficit. We will look first at the CBOs baseline assumption, a worst case scenario, and our current fiscal baseline before examining a hypothetical scenario that balances the budget.

Closing in on November 23 With the Presidents deficit reduction plan now out in the open, it is now up to the debt super committee to agree on a proposal by November 23. While it is highly unlikely that the committee will adopt Obamas plan, the proposal does act as one flag post to help navigate to an agreement.

In terms of deficit reduction, Obamas plan is somewhere between his Deficit Commissions proposal which assumes a return to a balanced budget; and the S&P baseline that assumes a high level of deficits over the next 10-years. From a policy perspective, Obamas heavy reliance on tax increases puts it to the left of the Debt Commission and even further left from House Budget Chairman Paul Ryans plan which reduced the deficit with no tax increases.
Chart 4.1: Extension of expiring policies will move debt-to-GDP to dangerous levels

CBOs errs on the side of current law. The CBOs baseline scenario is on the optimistic side, as it assumes that the Bush tax cuts are left to expire, no AMT relief and a doctor payment rates reduction. It does include $2.1bn in austerity measures outlined in the Budget Control Act of 2011, the debt ceiling deal. The result is a ten-year cumulative deficit of $3.1tn with a deficit-to-GDP of a manageable 1.2% versus 8.5% today. Debt-to-GDP under these assumptions

Chart 4.2: Hypothetical deficit reduction scenario moves towards balancing the budget.

90%

85%
80% 75%

9% 7% 5%

All tax cuts extended SG Baseline Obama def icit reduction SG hy pothetical scenario CBO baseline

70%
65%
All tax cuts extended SG Baseline Obama def icit reduction SG hy pothetical scenario CBO baseline

3% 1% -1%
2019 2021 2009 2011 2013 2015 2017 2019 2021

60% 55%
50% 2009 2011
Source: SG Cross Asset Research

2013

2015

2017

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should fall to 61% of GDP from a peak of 73% in 2013. The main issue with the CBO baseline is that it assumes that there is no reform to entitlement spending. This suggests that beyond 2021 the deficit could revert back to an adverse path. Bad habits are hard to break. Under the worst case, we assume that the Bush tax cuts will be made permanent, AMT is indexed to inflation, other expiring tax measures are made permanent, and doctor-payment rates are maintained. We also assume that there is $2.1tn in spending cuts from the Budget Control Act of 2011 (the debt ceiling agreement). This would result in a cumulative ten-year deficit of $8.2tn. By 2021 debt-to-GDP should rise to 83% from 68% today with the deficit checking in at 4.4% in 2021 and rising.

next ten years. As well, raising the limit of taxable earnings for Social Security reduces the deficit by about $460bn. Increasing eligibility and full retirement ages saves about $260bn. These and other small fixes could shave off about $1.1tn off the deficit between 2012 and 2021. With respect to health care spending there a combination of four policies could shave off about $600bn. The biggest is to change Medicaid payments to block grants. Switching the payment method would deter gaming of the Medicaid funding formula by states and the result would be about $300bn in savings over ten-years. House Budget Committee Chairman Paul Ryan included this idea in his deficit plan earlier this year. Raising the Medicare eligibility age to 67 would save $125bn. The one caveat to our choice of cuts is that there is some risk that it will do enough to restrain long term growth in healthcare costs. On the tax side, our scenario would raise revenue by almost $1.1tn. Although we would prefer to see comprehensive tax reform, we have excluded them to keep the illustration simple. The partial extension of the Bush tax cuts for those making under $250k should increase revenues by $500bn. Limiting itemized deductions to 15% of income should raise $1.2tn in new revenue. We also include the repeal of LIFO and treat carried interest as ordinary income, both combined they reduce the deficit by $100bn. Elimination of the AMT should give ease some of the increased tax burden, but increases the deficit by $800bn.
Chart 4.3: Under the hypothetical scenario US should have no problem meeting obligations

We sit somewhere in the middle. Our baseline assumes that the Bush Tax cuts are only extended for those making under $250k, $180bn in fiscal stimulus in 2011, and $2.4tn in deficit reduction over the next 10 years. Under our scenario, we should see the debt-toGDP rise to 77.1% by the end of 2021. The SG baseline follows a similar path to the deficit reduction plan outlined by President Obama. Neither of the scenarios assumes significant enough entitlement reform to stem costs related to demographics after 2021.

One for every three. We have always maintained that the framework to follow for deficit reduction should be the Presidents Deficit Commissions proposal. But even the President has not followed his own Commissions advice. But we will in this exercise on how a few steps can bring the budget closer to balance.

Using a framework that relies on $1 of revenue for every $3 of spending reduction, our scenario suggests that a $4.2tn deficit reduction plan could bring the budget almost to balance by 2021. Discretionary spending cuts account for about 40% of the total deficit reduction with most of the gains made through the $900bn first stage of cuts outlined in the BCA and ending of overseas wars ($1.3tn). We also assume that the full amount of the Obamas Jobs Act, $447, is implemented. The lack of progress on mandatory spending reform has been disappointing, particularly given that there are several straightforward fixes available. With respect to Social Security, the current inflation assumption overstates actual inflation. A shift from CPI-W (wage earners and clerical workers) to CPI-U (all urban consumers), which captures a greater portion of the population, could save the tax payer $110bn over the

30 26 22

%, interest payment to revenue Unch. Fwd Fwd + 100bp Fwd + 200bp

Fwd + 50bp Fwd + 150bp

Aa space

Debt reversibility band

18 14 10

Aaa
6
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Source: Bloomberg, CBO, Global Insight, SG Cross Asset Research/Economics

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Out of the oven and into our plates. Putting all this together we would get a cumulative deficit of $3tn between 2012 and 2021. The deficit-to-GDP ratio would fall from 8.5% this year to 0.2% in 2021. The other key metric, debt-to-GDP declines to 61% by 2021 after peaking at 73% in 2013. The net-interest-to-revenue ratio, a key metric used by ratings agencies, suggests the ability of the US to meet its interest obligations would be in line with what would be expected of an AAA credit. This would still be the case even if the yield curve is shocked by +200bps (see chart 4.3).

It should also be noted that the biggest drag to GDP in the hypothetical scenario is in 2013 and 2014, with deficits falling by $518bn and $438bn, respectively. Our baseline is for close to stall speed growth in 2013, 1.8%, but this already incorporates a $454bn decline in the deficit. The bigger hit to GDP could be in 2014 where we have the deficit declining by only $178bn. Our baseline forecast for GDP in 2014 is 2.5%.
[email protected]

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Credit Focus
Five Trade Ideas in the U.S. Financials Space
After a week of significant spread widening and downgrades by Moodys of Citigroup, Bank of America, and Wells Fargo, the last week of 3Q11 is starting off on a relatively quiet note. And while we expect this quiet tone to continue for most of the week, quiet should not be mistaken for stable, as volatility continues to be the theme in the US financials space. Indeed, after last weeks 26-118 bps widening in 5 year CDS for the major banks, most names are now at their widest point in the last 12 months. Unfortunately, there seems to be little to arrest this volatility in the short-term, making it extremely difficult for longer-term oriented investors to put money to work. However, this volatility does continue to create interesting relative value opportunities in both the cash and CDS space for investors who are looking to take advantage of certain situations where specific relationships have become dislocated. Therefore, we provide five trade ideas that have popped up on our screens this afternoon.
Trade Idea #1 Buy Bank of America 5 yr CDS

MS continues to look in a better light, with the equity analyst community at least forecasting a positive quarter for MS, while some estimates for Goldman have forecasted a 3Q loss. Furthermore, concerns that emerged last week about MS sovereign exposure have largely been put to rest, with management aggressively quashing speculation about potential losses. What is important to remember is that these two names always trade in reference to one another. Therefore, notwithstanding the existing technical pressure that has pushed the CDS differential to the current 148 bps, we believe that if MS posts a good trading quarter relative to GS, that the spread differential will compress further on fundamentals alone. In this trade, as a point of reference, we look to the GS 5.25% 2021s and the MS 5.50% 2021s which are currently quoted only 81 bps apart. Trade Idea #3 Buy JPM 4.35% 2021s (+230/220 bps), Sell JPM 5.60% 2041 (+230/220 bps). In line with what we have seen for other names in our sector, the JPMorgan credit curve has flattened in recent weeks due to a combination of broader market credit concerns and the Federal Reserves recent Operation Twist announcement. As such, the JPM 10s/30s curve is now flat, meaning investors are not getting rewarded for extending out the credit curve. In this proposed swap, investors can take out roughly 2.5 points and shorten 20 years in maturity, while decreasing 120 bps in yield, which is close in line to the yield differential of the 10s/30s treasury curve.

(+385/395 bps), Sell Morgan Stanley 5 yr CDS (+435/450 bps). Last week represented the first time since mid-July that MS CDS has traded wide relative to Bank of America. And while we thought that MS was likely to underperform relative to BAC, we never thought we would see the CDS underperform to this extent. In point, with a current 50 bps bid-side differential, the last time we saw MS trade at such a discount to BAC was in July 2010. Therefore, we think the recent widening in MS CDS has been overdone and believe that the gap will compress in the coming weeks. As a point of reference, we look to the cash market where the BAC 3.75% 2016s (+485/475 bps) are quoted 39 bps, inexpensive on a z-spread basis to the MS 3.80% 2016s (+440/430 bps). Furthermore, the BAC 5.00% 2021s (+440/420 bps) are quoted essentially flat to the MS 5.50% 2021s (440/420 bps).

Trade Idea #2 Buy Morgan Stanley 3.80% 2016s (+440/430 bps), Sell Goldman Sachs 3.625% 2016s (+325/315 bps). Or Buy Goldman Sachs 5 yr CDS (+287/297 bps), Sell Morgan Stanley 5 yr CDS (+435/450 bps). In addition to our comments above about the extent of the widening last week in Morgan Stanley, we also look forward in the context of the companies upcoming 3Q11earnings. Judging from the current trends in the capital markets, both names will likely demonstrate 3 Q results that are reflective of the difficult environment. Yet based on what weve seen from equity analysts revised 3Q estimates for both companies,

30 September 2011

Trade Idea #4 Flatteners in Goldman Sachs and GECC. As part of the recent market volatility, financial credit curves in both the cash and CDS markets have flattened or in some cases inverted. In point, the current 5/10s CDS curves in the higher beta names in our space (i.e., MS and BAC) are roughly 25 bps inverted. We believe that sector spreads will continue to be under pressure in the coming weeks and that there will be further pressure on the credit curves for GS and GECC. While their 5/10s CDS curves are trading flat, GS and GECC stand out for their relative steepness of their cash curves. Specifically, the z-spread differential between the GS 3.625% 2016s and the GS 5.25% 2021s currently stands at +38 bps while the differential between the GECC 2.95% 2016s (+215/205 bps) and the GECC 4.625% 2021s (+228/218 bps) is +27 bps. This compares to 5/10s z-spread differentials of -29 bps for Bank of

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America, - 3 bps for Citigroup, +6 bps for JPMorgan, and -1 bps for Morgan Stanley. Trade Idea #5 Buy GECC 5 yr CDS (+295/302 bps), Sell Sallie Mae 5 yr CDS (+565/590 bps). Despite the 8-notch ratings differential at Moodys, we believe Sallie Mae is fundamentally better positioned than GECC in the current market. Over the past several years, Sallie Mae has done much to improve its fundamental profile including reducing its reliance on the unsecured debt markets and an overall deleveraging, improving its underwriting standards within its private loan portfolio,

and transforming its business model from low margin FFELP originations to more of a servicing-oriented business model. And while GECC has also made meaningful progress in improving its credit profile since the depths of the credit crisis, GECC is still very reliant on the wholesale funding markets. Therefore, in this period of market stress, we believe the current 270 bps bid-side spread differential is too much and should compress in the current volatile market.
[email protected]

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Calendar
October Monday 3
Jul Construction spending (%m) -1.3 Aug 0.0
e

Economic data, Fed speakers, Feds Treasury purchases and Treasury auctions previews Tuesday 4
Jul
e

Wednesday 5
2.4 Aug -0.5 Jul ADP employment 91 Aug 45
e

Thursday 6
9/24
e e

Friday 7
9/30 Aug Nonfarm payrolls, (thous. sa) Nonfarm payrolls ex. strikers (thous. sa) Private payrolls ex. strikers (thous. sa) Unempl. rate Avg hourly earnings (%m) Avg weekly hours 0.0 Sepe 115

Factory orders

Initial jobless claims

410
9/17

395
9/24
e

Aug Aug ISM mfg. ISM-prices paid 50.6 55.5 Sep

e

Sepe 54.2

52.0 57.0

ISM Non-Manf. Composite

Contin. claims

3765 3745
Aug Sep 5.0
e

53.3

46

70

ICSC Chain Store Sales (%yoy)

4.6

63

110 9.0 0.5 34.3 Auge

8.84

Aug Total vehicle sales (mln saar) 12.1

Sepe 13.0

9.1 -0.1 34.2 Jul

Consumer credit ($bn)

11.965

Fed Beige Book

Kocherlakota, Kohn $2.75-$3.50bn; Apr14 - Sep15 FED MBS reinvestment begins $3.25-$4.00bn; Nov18 - Aug21 ann 3Y/10Y/30Y (32/21/13) Evans, Williams

10

11
NFIB Small Bus. Optimism IBD/TIPP Economic Optimism Monthly Budget Statement FOMC Minutes

12
JOLTs Job Openings

13
Trade Balance Jobless claims

14
Import Price Index Retail Sales Michigan Confidence Index Business Inventories

$3.25-$4.00bn; Apr17 - Sep18

Feds Treasury operation schedule TBA 2pm ann 30Y TIPS ($7bn)

17
Empire Manufacturing Index Industrial Production Capacity utilization

18
Producer Price Index TIC Flows NAHB Housing Index

19
FED Beige Book CPI Housing Starts Building permits

20
Jobless Claims Leading Indicators Philadelphia Fed. Existing Home Sales
ann 2Y/5Y/7Y (35/29/29) auc 30Y TIPS ($7bn)

21

24
Chicago Fed. Activity Index

25
S&P/CaseShiller Index Consumer Confidence House price Index Richmond Fed. Mfg Index

26
Durable Goods Orders New Home Sales

27
Jobless Claims GDP 3Q (A) Personal Consumption Core PCE Pending Home Sales Kansas City Fed Index

28
Personal Income/Spending Core PCE U. of Michigan Index

auc 2Y Note ($35bn) 30 September 2011

auc 5Y Note ($29bn)

auc 7Y Note ($29bn) 14

Source: SG Cross Asset Research, NY Federal Reserve, Bloomberg. Forecasts are subject to change according to incoming data Reopening.

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Forecast summary
Economics
Economic Forecasts: The US outlook at a glance
Nominal GDP 2010 $13 088bn GDP (% qoq ann) Consumer expenditure Government expenditure Investment Exports Imports Nominal GDP (% yoy) CPI headline (% yoy) CPI core (% yoy) Unemployment rate (%) Employment (%yoy) Average hourly earnings (% yoy) Savings rate (%) Fiscal stance* (% of GDP) Output gap (% of GDP) Corporate profits before tax (% yoy) Current account (% of GDP) Budget balance (% of GDP) Federal Debt (% of GDP) Public Debt (% of GDP) Fed Funds Target (%) 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 -6.4 27.4 -6.3 18.2 -6.7 8.8 -6.9 5.0 -7.0 3.2 -6.9 2.5 -7.0 2.8 -7.1 4.1 1.2 0.9 9.6 0.1 2.3 5.6 1.2 0.6 9.6 0.7 2.3 5.2 2.2 1.1 8.9 1.0 2.1 4.9 3.3 1.5 9.1 0.8 2.1 5.1 3.5 1.8 9.2 1.1 2.0 5.3 3.1 2.0 9.3 0.9 1.9 5.4 2.2 2.0 9.3 0.6 2.0 5.3 1.5 1.8 9.4 0.5 2.0 5.3 Q310f 2.5 2.6 1.0 2.3 10.0 12.3 Q410f 2.3 3.6 -2.8 7.5 7.8 -2.3 Q111f 0.4 2.1 -5.9 1.2 7.9 8.3 Q211f 1.3 0.1 -1.1 6.5 6.0 1.3 Q311f 1.6 1.4 -0.5 6.0 5.0 1.0 Q411f 2.2 2.0 -0.9 8.1 5.0 3.0 Q112f 1.4 2.1 -1.3 1.4 4.0 3.5 Q212f 1.7 2.0 -0.7 3.2 4.0 3.0 2009 -3.5 -1.9 1.7 -18.8 -9.4 -13.6 -2.5 -0.3 1.7 9.3 -4.4 3.0 5.2 -1.6 -7.8 9.1 -2.7 -3.3 54.3 75.3 0.25 2010f 3.0 2.0 0.7 2.6 11.3 12.5 4.2 1.6 1.0 9.6 -0.4 2.4 5.3 -0.2 -6.6 32.2 -3.2 -9.7 61.8 82.8 0.25 2011f 1.6 2.0 -2.0 5.5 7.3 4.8 3.8 3.0 1.6 9.1 1.0 2.0 5.2 1.2 -6.9 4.8 -2.7 -8.2 67.8 88.8 0.25 2012f 1.8 1.8 -0.9 4.5 4.6 2.6 3.8 1.6 1.7 9.4 0.5 2.0 5.2 0.5 -7.0 3.9 -2.8 -7.8 73.9 94.9 0.25

Source: SG Cross Asset Research. * Fiscal stance is defined as the change in the cyclically adjusted budget balance

Rates
figures as of end of period Fed fund target FF effective - FF target spread 3mo OIS spread - FF effective 3mo LIBOR - 3m OIS spread 3mo LIBOR 2-year Treasury yield 5-year Treasury yield 10-year Treasury yield 30-year Treasury yield 2-year swap spread 5-year swap spread 10-year swap spread 2s10s slope 2s5s slope 5s10s slope 10s30s slope 3m-into-2y swaption vol (bp/year) 5y-into-5y swaption vol (bp/year) 30-Sep 0.25% -0.17% 0.01% 0.29% 0.37% 0.26% 0.97% 1.94% 2.97% 31.4bp 29.1bp 18.4bp 1.68% 0.71% 0.96% 1.03% 44.7 104.2 Q411 0.25% -0.17% 0.00% 0.25% 0.33% 0.10% 0.80% 2.00% 2.95% 30bp 28bp 11bp 1.90% 0.70% 1.20% 0.95% 43 105 Q112 0.25% -0.17% 0.00% 0.30% 0.38% 0.10% 0.70% 1.75% 2.58% 30bp 26bp 6bp 1.65% 0.60% 1.05% 0.83% 48 108 Q212 0.25% -0.17% 0.00% 0.30% 0.38% 0.10% 0.80% 2.00% 2.95% 30bp 28bp 11bp 1.90% 0.70% 1.20% 0.95% 53 105 Q312 0.25% -0.17% 0.05% 0.30% 0.43% 0.10% 0.90% 2.25% 3.33% 30bp 30bp 15bp 2.15% 0.80% 1.35% 1.08% 58 103 Q412 0.25% -0.17% 0.05% 0.30% 0.43% 0.10% 0.90% 2.25% 3.33% 30bp 30bp 15bp 2.15% 0.80% 1.35% 1.08% 63 100 2013 0.25% -0.17% 0.05% 0.30% 0.43% 0.10% 0.90% 2.25% 3.33% 35bp 33bp 15bp 2.15% 0.80% 1.35% 1.08% 68 100 2014 0.25% -0.05% 0.05% 0.20% 0.45% 0.25% 1.10% 2.50% 3.63% 35bp 34bp 20bp 2.25% 0.85% 1.40% 1.13% 73 100 2015 0.31% -0.05% 0.05% 0.10% 0.41% 0.50% 1.25% 2.50% 3.50% 35bp 34bp 20bp 2.00% 0.75% 1.25% 1.00% 78 100

Treasury auctions
Announcement date 6-Oct 6-Oct 6-Oct 13-Oct 20-Oct 20-Oct 20-Oct Security type 3-Year Note 10-Year Note (R) 30-Year Bond (R) 30-Year TIPS (R) 2-Year Note 5-Year Note 7-Year Note Auction date 11-Oct 12-Oct 13-Oct 20-Oct 25-Oct 26-Oct 27-Oct Settlement date 17-Oct 17-Oct 17-Oct 31-Oct 31-Oct 31-Oct 31-Oct Estimated amount $32bn $21bn $13bn $7bn $35bn $29bn $29bn Change in size from previous auction $0bn $0bn $0bn $0bn $0bn $0bn $0bn Maturing amount New Cash

$0bn $0bn

$66bn $7bn

$57bn

$42bn

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APPENDIX
ANALYST CERTIFICATION The following named research analyst(s) hereby certifies or certify that (i) the views expressed in the research report accurately reflect his or her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed in this report: John Guarnera EXPLANATION OF CREDIT RATINGS U.S. Credit Research does not currently maintain ratings or credit opinions on individual companies. Trade ideas may be short term in U.S. Credit Research does not currently maintain ratings or credit opinions on individual companies.

CONFLICTS OF INTEREST This research contains the views, opinions and recommendations of Socit Gnrale (SG) credit research analysts and/or strategists. To the extent that this research contains trade ideas based on macro views of economic market conditions or relative value, it may differ from the fundamental credit opinions and recommendations contained in credit sector or company research reports and from the views and opinions of other departments of SG and its affiliates. Credit research analysts and/or strategists routinely consult with SG trading desk personnel in formulating views, opinions and recommendations in preparing research. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and reports. Therefore, this research may not be independent from the proprietary interest of SG trading desks which may conflict with your interests. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, trading desk and firm revenues and competitive factors. As a general matter, SG and/or its affiliates normally make a market and trade as principal in fixed income securities discussed in research reports.

IMPORTANT DISCLOSURES
Bank of America Bank of America Citigroup Goldman Sachs Goldman Sachs Morgan Stanley SG acted as co-manager in Bank of America's bond issue. SG acted as co-manager in BAML's senior HG bond issue. SG acted as co-manager in Citigroup's senior bond issue SG acted as co-manager of Goldman Sachs' HG bond issue. SG acted as co manager in Goldman Sachs' senior high grade bond issue. SG acted as co-manager of Morgan Stanley's HG bond issue (4.5% 23/02/16 EUR). . SG or its affiliates act as market maker or liquidity provider in the equities securities of Mediaset. SG or its affiliates expect to receive or intend to seek compensation for investment banking services in the next 3 months from Mediaset. SG or its affiliates had an investment banking client relationship during the past 12 months with Bank of America, Citigroup, Goldman Sachs, Morgan Stanley. SG or its affiliates have received compensation for investment banking services in the past 12 months from Bank of America, Citigroup, Goldman Sachs, Morgan Stanley. SG or its affiliates managed or co-managed in the past 12 months a public offering of securities of Bank of America, Citigroup, Goldman Sachs, Morgan Stanley. SGAS had a non-investment banking non-securities services client relationship during the past 12 months with Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Wells Fargo. SGAS had a non-investment banking securities-related services client relationship during the past 12 months with Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Wells Fargo. SGAS received compensation for products and services other than investment banking services in the past 12 months from Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Wells Fargo. SGCIB received compensation for products and services other than investment banking services in the past 12 months from Bank of America, Citigroup, Goldman Sachs, Morgan Stanley.

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or call +1

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