Danske Markets - US Debt Default Unlikely 20110727

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Investment Research General Market Conditions

The timeline for meeting the 2 August deadline is very tight and the likelihood ofgetting a so-called grand bargain with substantial savings is now very low.

Although we do not expect the stalemate to result in a temporary default, we nowsee a more than 50% chance that US sovereign debt will be downgraded by the

rating agencies in the coming months.

The deadline of 2 August may be postponed, as there seems to have been highertax payments in July than expected. Hence, if no agreement is reached by 2

August we might see negotiations continue for a week or so.

In our main scenario (no default but downgrade) we believe equities will correctby -5%, Bond yields would show a limited positive reaction and the US dollar

would weaken slightly. This scenario is close to the market consensus.

However, there is a negative scenario (debt limit not raised in time) under whichstocks would correct -10% (S&P500), bond yields would rise 50bp (10 year

T-note) and the US dollar would start to strengthen against cyclical currencies

but still weaken against the Swiss franc, the Japanese yen and the euro.

The systemic risks connected with a downgrade of US government debt are verydifficult to assess. While the conventional wisdom is currently that the impact willbe moderate, there is no preceding experience with a downgrade of the numraire

of the global financial system. The latter is a key point in our assessment of a

nervous reaction in risk assets when a downgrade, as we expect, becomes reality.

Very tight timeline for negotiations

The timeline for reaching a deal to raise the debt limit is getting very tight. The deadline

is less than one week from now and, in order to follow the legislative procedure, a deal

has to be in place very soon.

The deal has to be accepted in both the House where Republicans have a majority (240 vs

Democrats 193) and the Senate where Democrats have a majority (59 vs 47 Republicans,

two independent). If a deal in the House is approved, it would subsequently go to the

Senate for approval and vice versa. However, the Senate may make amendments, which

means it would have to be approved in the House again. Once the same bill is approved in

both chambers, it goes to the president to be signed and put into law.

Neither the Democrats nor the Republicans have full support from their respective parties

on the individual plans, which is complicating a compromise even further. The House and

the Senate previously stated a vote on competing proposals could occur as early as

Wednesday. However, today it became clear that Republican speaker of the House John

Boehner would have to delay a vote on the bill until Thursday due to doubts that it could

come through in its current form as several Republicans had said the plan did not deliver

the promised savings. Majority leader of the Senate Democrat Harry Reid is expected toawait a vote in the House before putting his plan to the vote.

27 July 2011

Important disclosures and certifications are contained from page 9 of this report.

ResearchUS debt default unlikely, downgrade likely

Chief Analyst

Allan von Mehren

+45 45 12 80 55

[email protected]

Chief Strategist

Morten Kongshaug

+45 45 12 80 57

[email protected]

Senior Analyst

Peter Possing Andersen

+45 45 13 70 19

[email protected]

Senior Analyst

Kasper Kirkegaard

+45 45 13 70 18

[email protected]
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]


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Real deadline for default may not be 2 August

In recent days, there has been some uncertainty over whether the deadline has changed as

tax revenue for July has been higher than expected. Some calculations suggest the

government may have another one to two weeks. So far, the US Treasury has not changed

the date for when it expects to run out of money most likely because president Obama

wants to keep maximum pressure on politicians in order to get a deal through. However,

it may suggest that should a plan not be ready for the presidents signature before

2 August there could be scope for more time before the money runs out.

Another issue is whether the US would actually default should the debt limit not be raised

by 2 August. It seems likely that the government would decide to hold back payments to

government employees and federal government contractors instead so it could still meet

its debt obligations until a deal is in place. Hence, even if a deal is not in place before the

government runs out of money, we do not believe a default would be the first outcome.

However, it would be a terrible signal to financial markets to have to hold back

government payments. Credibility in politicians ability to steer the US economy properlyin the current troubled waters would deteriorate even further and it would be likely to

send shock waves through the financial markets.

Obama able to raise debt limit if Congress fails

The US president will be able to lift the debt ceiling although no political agreement

between Democrats and Republicans is found in time to avoid a debt default There are

two suggestions currently up for discussion among lawmakers.

1. Former President Clinton has identified a constitutional escape hatch should Obamaand Congress fail to come to terms on a deficit reduction plan before the government

hits its borrowing ceiling. A provision in the 14th Amendment gives, according to

some legal experts, the president the powers to ignore the debt ceiling if any other

means are exhausted.

2. Senate minority leader Mr McConnell has proposed to flip the current process upsidedown by calling on Congress to disapprove rather than approve an administration

request for a debt limit increase. It would then allow the president to veto the

disapproval if it clears Congress, allowing the debt limit to be raised to avoid a default.

Although president Obama has expressed doubts about both options, it is worth knowing

that the president will still have options to avoid a default if the political negotiations on

Capitol Hill is not finished before the deadline at the start of August.

Several disagreements between Democrats and Republicans

Last week, markets became enthusiastic as the two parties were apparently getting closer

to a grand bargain in which both parties agreed on a proposal to send to Congress.

However, the Democrats left the deal, as they would not accept that tax increases were

not part of a deficit reduction plan that made substantial savings on spending.

Since then the parties have worked on separate proposals (see box below). The main

points of disagreement are as follows.

1. Republicans propose a two-step plan for raising the debt limit. A first step wouldpostpone the deadline by six months, with another increase then in the limit tied to

further savings coming from a bi-partisan Commission. President Barack Obama has

strongly opposed this and his spokesman has said he would veto such a plan. The

latest signs from Republicans are that it will be adjusted after the Congressional

Budget Office (CBO) said the plan implied only USD850bn in savings. This would

mean the rise in the debt limit would be even shorter than the six months, putting

Republicans even closer to a collision course with the Democrats.


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2. Democrats are also opposed to the Republicans proposal of putting caps on spending.President Obama says it would hurt investment in infrastructure, R&D investment and

education, on which future growth in the economy should be based.

3. There is also disagreement on the balanced budget amendment proposed byRepublicans. This has actually previously been approved in the House but did not gothrough the Senate where Democrats have a majority.

Overall, some clear obstacles still need to be removed. With both parties also

struggling to keep their own party in support of their individual plans, there is still

some work to be done.

Overview of separate fiscal plans

Main elements in the Republican plan:

The debt limit of USD14.3trn to be raised in two steps . The first step would be anincrease of USD1trn in exchange for a USD1.2trn spending cut. A second increase of

USD1.6bn early next year would be tied to a further savings plan being worked out

by a new 12-member bipartisan Commission. Following calculations from the CBO,

the rise in the debt limit in the first step might be changed to USD850bn, which

would imply a period of less than six months before it would have to be raised again.

Bipartisan Commission to have special privileges. The Commission would beassigned the job of finding USD1.8trn additional savings and have special privileges

to bring legislation before the House and Senate. Its proposal would not be subject to

amendment or Senate filibuster.

Cap on future spending. Legal limits on future spending in certain areas should raisea further USD1.2trn over the next 10 years.

Balanced budget amendment to the Constitution. As part of the plan, the Senate andHouse would be required to vote on a balanced-budget amendment to the

Constitution after 1 October but before year-end.

Main elements in the Democrats plan

Increase in debt limit of USD2.4trn. This would enable the government to pay itsbills throughout the 2012 election year.

Spending cuts of USD2.7trn. It would cut USD1.2trn from federal agency budgetsand save on recurring programmes such as agriculture subsidies. It also counts about

USD1trn in savings from winding down operations in Iraq and Afghanistan. The cutswould not touch any entitlement programmes.

Bipartisan commission to find further savings cuts. In line with the Republicans, theplan from senator Harry Reid also includes a bipartisan commission that would work

further on a plan to tackle the medium- and long-term challenges.

No increase in tax revenue. The democrats have removed an increase in tax revenue.

It is probably too late for a comprehensive package and it may be that President Obama

will have to accept only a short-term increase in the debt limit to allow for more time to

put a bigger plan in place. However, it is unlikely, in our view, that the debt limit will not

be raised in time to avoid default.

US to lose its AAA rating in coming months

An increase in the debt limit in time will not be sufficient to avoid a downgrade.

Politicians also need to come up with a credible plan for tackling the medium- and long-

term US fiscal challenges in order to avoid a downgrade.


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On 18 April, Standard & Poors put the US AAA sovereign debt rating on negative

outlook and on 14 July it went one step further and placed the AAA rating on

CreditWatch with negative implications seenote from Standard & Poors. According

to the statement issued on 14 July Standard & Poors use[s] the CreditWatch to indicate

a substantial likelihood of it taking a rating action within the next 90 days, or in response

to events presenting significant uncertainty to the creditworthiness of an issuer (our

italics).

Standard & Poors may lower the long-term rating on the US by one or more notches

into the AA category in the next three months, if we conclude that Congress and the

Administration have not achieved a credible solution to the rising US government debt

burden and are not likely to achieve one in the near future.

Standard & Poors states that in its baseline scenario US net general government debt

would reach 84% of GDP by 2013, which indicates a relatively weak trajectory

compared with those of the USs closest AAA-rated peers (France, Germany, the UK

and Canada).

It also specifically highlights that the debt trajectory is expected to continue increasing

in the medium term if a medium-term fiscal consolidation plan of USD4trn is not agreed

upon. This probably means that US politicians have to come up with savings very close

to the USD4trn mark in order to avoid a downgrade. So far, the two proposals from the

Democrats and Republicans are at best close to or just below USD3bn and hence not

close to what Standard & Poors seems to require to avoid a downgrade.

Finally, Standard & Poors highlights that for a plan to be credible it has to be bipartisan.

Moodys has also put the US under review for a possible downgrade, although this is

mostly linked to the risk of a default in the short term should the debt limit not be raised.

Moodys is less explicit about the exact terms of a downgrade should the debt limit beraised. However, we believe that it would very quickly follow with a downgrade should

Standard & Poors announce a downgrade.

Timing of a downgrade

The timing of any downgrade is a uncertain and depends on the exact outcome of the

deal. If we get a deal with limited savings but one that establishes a commission to come

up with more savings over the next six months, it is unclear how Standard & Poors

would react. Our best guess, though, is that after some time studying the deal closely

(about one month) Standard & Poors would downgrade the US sovereign debt rating

because the likelihood of getting a satisfactory savings plan in an election year (2012)

would be seen as limited. Standard & Poors could also choose to await the outcome ofthe commission, which might postpone a downgrade by six to eight months. However,

either way we believe it will ultimately come, as it is doubtful whether the two parties

will dare decide on sweeping reforms that will hurt many Americans during an election

year. =
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Systemic tail risks following a downgrade

In our view, the systemic risks in connection with a downgrade of US government debt

are very difficult to assess. While the conventional wisdom is currently that the impact

would be moderate, the AAA status for US government debt has been an anchor

condition for the global financial markets in modern times. There is no previousexperience of a downgrade of the numraire of the global financial system.

We have compiled a list of issues that may be of importance for the global financial

system if as it now appears likely the US loses its AAA long-term credit rating. We

think these issues should be considered as tail risk factors. They are most relevant in the

case where US Congress does not reach the deadline for increasing the debt limit and the

US enters a technical default, but there is also a risk that a one-notch downgrade would

imply some systemic risks.

Some money market funds, index funds, mutual funds and insurance companies arebound by covenant to invest only in AAA papers. This investor segment might be

forced to reduce or close down holdings of US Treasuries if the AAA rating is lost.

This could amplify the sell-off in Treasuries. In this case, some funds may choose to

change their covenants to be able to include non-AAA papers. However, this might

lead investors to move out of money market funds, which in time could lead to a

squeeze in the money market.

Treasuries are widely used as collateral in the repo, OTC derivates and futuresmarkets. A lower rating of US treasuries is likely to imply a larger haircut on treasuries

in these financial transactions. In turn, this could lead to margin calls on counter

parties implying a liquidity or funding squeeze in some markets.

A downgrade of the US government would have a knock-on effect and initiate a seriesof other downgrades.

First several government sponsored agencies including Fannie Mae, Freddie Mac,the Federal Home Loan Bank System and Farm Credit System Banks would be

likely to be downgraded in tandem with the US government.

Second, a variety of bonds or other liabilities that are directly or indirectlyguaranteed by the US could come under review or be downgraded. For instance,

Israeli and Egyptian bonds guaranteed by the US would be likely to be downgraded

if the US government loses its AAA rating.

Finally, several US financial institutions, among others large US insurers andsecurities clearing houses, seem likely to be downgraded along with the US as they

are constrained by the US sovereign credit rating.

The wave of subsequent downgrades could lead to a financing squeeze for financial

institutions and further deterioration in financial conditions.

As the No. 1 risk-free asset in the world, most risk assets would have to be reprised lower

if the downgrade turns out to be permanent, as the long-term global cost of capital would

also be affected negatively.


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Three scenarios and the impact for the markets

Main: debt limit raised but downgrade triggered on too-small budget cut

Our main scenario is that the debt limit will be raised by Congress in time to avoid a

default. However, we believe it is too late for a significant deal that will satisfy the rating

agencies and hence we see a downgrade of the US sovereign debt rating over the coming

months as the most likely scenario. Given recent developments, this is also becoming

market consensus.

The rating downgrade heralds a new situation for the No. 1 risk-free asset in the world.

We expect a one-notch downgrade of the USs long-term credit rating (Standard & Poors

from AAA to AA+). Unpredictable system financial risks are assumed to be under control

in this scenario. As this is mostly priced in by the markets already, it is unlikely to have a

severe impact on either the US economy or financial markets.

Bonds: This would imply only a moderate reaction in Treasury yields, as there isalready, say, a 50/50 probability of a one-notch downgrade priced in. We believe the 10-

year Treasury yield would increase by less than 10bp in this case. Maturities shorter thanfive years are likely to be less affected due to the offsetting expectations of a lower Fed

funds rate in a regime with more fiscal tightening. The yield curve would steepen a bit

further and asset swap spreads could decline a bit more, as government credit

deteriorates relative to bank credit. We see a limited reaction in Bunds and EUR swaps.

Equities: The stock market has already discounted a new regime for public debt,which means lower-than-usual valuation and higher-than-usual implied ERPs. Still

there would be room for a moderate negative reaction on Wall Street with the S&P500

down 5% as a reminder that economic policy will not stay as supportive for the profit

cycle in the future as experienced in the past amid fear of systemic financial risks.

FX: A higher US risk premium should see the US dollar depreciate against the otherreserve currencies the Swiss franc, the yen and most likely also the euro. A potential

sell-off in risky assets would, however, mitigate the negative effects on the dollar and

potentially even see the dollar gain against the cyclical currencies (e.g. the commodity

and EM currencies) if the shock to risk sentiment is large enough. Volatility should be

expected to rise but, as this scenario is increasingly priced in, the market impact could

prove limited. Our favoured positions would be modest short USD/CHF and USD/JPY.

Positive alternative: debt limit raised and large budget cut averts downgrade

In this scenario, we assume that the budget deal is USD3-4trn in budget savings over a

10-year period. These sizable savings would be likely to keep rating agencies from

downgrading US Treasuries, as it comes close to stabilising the debt to GDP ratio.

For investors to take risk, they need to know how much they would get to stay risk free,

and without a US Treasury downgrade, investors would remain comfortable about these

core investment conditions. The stronger economic headwinds coming from the tighter

fiscal policy in this scenario would be negative but this is outweighed by the certainty that

this scenario implies about: (a) Washingtons ability to address long-term economic

challenges and (b) the stability of the global financial system. The US economy in this

scenario would thus get a small lift as uncertainty lessens for corporates and consumers.

Bonds: The knee-jerk reaction is lower Treasury yields and a flattening of the curve,where the 30-year bond outperforms other segments. If a 50/50 probability of a

downgrade is currently priced in, we think the 10-year yield could decline by some10bp. Swap spreads would increase, with the 30-year Treasury asset swap spread

(swap rate less Treasury yield) increasing the most, i.e. a steeper swap spread curve.

We would expect a limited reaction in Bunds, with a risk ofr slightly higher Bund

yield, due to the unwinding of precautionary safe-haven flows.


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Equities: A relief reaction could push Wall Street up by +5% (S&P500) As both PEvaluation and implied ERPs suggest that that the stock market is already discounting a

difficult economic future position for the US and most of the OECD, we believe the

focus would return to the currently very supportive profit cycle.

US dollar: In this scenario, the US dollar would be caught between two counteractingforces: (a) the support from a reduced US risk premium and (b) the negative cyclical

effects of future tighter fiscal policy (this would not least work through the impact on

monetary policy with markets postponing expectations of a first Fed hike). We would

expect the first effect to dominate in the short term, however, and for the dollar to

temporarily rebound. Option market volatility should fall back. In our opinion, the

biggest rebound among the US dollar pairs should be expected in USD/JPY and

USD/CHF, whereas the reaction in EUR/USD should be more modest. Our favoured

positions would be long AUD/JPY and long USD/CHF.

Negative alternative: debt limit not raised US defaults temporarily

This would be a double negative as it shows that Washington is currently unable to

address the long-term challenges for the US economy and unwilling to at least

temporarily meet its obligations to bond holders. We assume that the market would asses

this as being equivalent to a three-notch downgrade by all rating agencies, which includes

a high probability that unpredictable systemic risks would emerge. Furthermore, we

assume that the default would only be short lived as the harsh financial markets reaction

has historically been among the best weapons against political gridlock in Washington.

The overall impact would be a sharp decline in risk aversion and clearly negative effects

for the US economy, which would be likely to be pushed into a low-growth scenario that

would prove very persistent. The global economy would be negatively affected by this

and it could add to European growth and debt problems as well.

Bonds: This would be equivalent to an estimated increase in the fair level of 10-yearTreasury yield by 40-50bp. Again safe-haven flows from risky asset markets and

expected lower future Fed rates might initially absorb some of the impact in particular

for short maturities. There will be a significant steepening of the 5-30 and 10-30

Treasury curve. The US swap spread curve would flatten. The money market basis

might widen because of stress in the money market, which in turn would push swap

spreads versus short maturity Treasuries wider. For longer maturities, this is likely to

be countered by rising credit premiums on Treasuries. Yields on Bunds would decline

on safe-haven flows and the spread versus 10-year and 30-year Treasuries would

widen (i.e. US minus German yield). In this scenario the 10-30 EUR swap could

flatten due to the risk of hedging flows in the European life and pensions sector.

Equities: In our view, a negative 10% reaction should be anticipated until thepolicymakers get their grip on the situation and come up with some short- and long-

term solutions on the debt issue. As in our main scenario, the matter of potential

systemic risks (see page 5) would spur uncertainty. Furthermore, the US debt jitters

would be likely to trigger European stock market outperformance of Wall Street as the

eurozone debt crisis has finally found its match. Global financial stocks would be

likely to continue to underperform other GICS sectors.


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US dollar: A bigger sell-off in risky assets coinciding with general deleveraging couldlead to an unwinding of short dollar positions (which according to, for example, IMM

data have been building further over the past month). This should mitigate the negative

dollar effects, at least against the cyclical currencies, and potentially even see the

dollar gain against the EM and commodity currencies. USD/JPY and USD/CHF

should be expected to test new lows and modest support would perhaps even form for

GBP/USD and EUR/USD in what would be likely to be high-volatility trading. Short

US dollar positions against the most liquid currencies should perform and, in general,

illiquid currencies (e.g. the Scandinavian currencies) and carry target currencies (e.g.

Australian dollar, New Zealand dollar and Mexican peso) are likely to come under

pressure. Our favoured positions would be long a basket of highly liquid currencies

against low liquidity and cyclical currencies (e.g. long Japanese yen, Swiss franc, euro

and British pound versus short Australian dollar, New Zealand dollar, Turkish lira and

Swedish krona).


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DisclosureThis research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank").

The authors of this research report are Allan von Mehren (Chief Analyst), Morten Kongshaug (Chief Strategist),

Peter Possing Andersen (Senior Analyst) and Kaspar Kirkegaard (Senior Analyst).

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in the research report.

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Danske Markets - US Debt Default Unlikely 20110727

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