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Macro Commodities Forex Rates Equity Credit Derivatives
Please see important disclaimer and disclosures at the end of the document
1 June 2010
EconomyBeyond the cycle
www.sgresearch.com
Stephen GallagherChief US Economist
(1) 212 278 [email protected]
Aneta MarkowskaSenior US Economist
(1) 212 278 [email protected]
Martin RoseResearch Associate(1) 212 278 [email protected]
Fed officials are being pulled in opposite directions. The US recovery is growing deeper rootsand may require scaling back exceptional policy measures. However, the European debt crisishas forced the Fed to take a small step back by reopening FX swap lines. It has also pushedback market expectations for rate hikes. But how much is Europe really worth to the Fed?
Q Europe unlikely to derail US recovery So far, economic evidence shows no signs ofspillover 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, butfinancial 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.
American ThemesWill Europe delay the Fed?
Financial conditions in the Taylor rule
-10%
* Alternative Scenario #1: Financial conditions do not imp rove
* Alternative Scenario #2: Financial conditions deter iorate fur ther
The augmented Taylor Rule includes starndard economic variables plus the SG Financial Conditions Index. Coefficients are fitted on post-1989 Fed decisions
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, 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
Taylor Rule ScenariosSG Financial Conditions Index
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
87 89 91 93 95 97 99 01 03 05 07 09 11 13
%
Fed Funds Rate
Baseline Scenario
Al te rnat ive Scen ari o #1 *
Al te rnat ive Scen ari o #2 *
-8.0
-7.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
87 89 91 93 95 97 99 01 03 05 07 09 11 13
%
Baseline ScenarioAl te rnat ive Scen ari o #1 *
Al te rnat ive Scen ari o #2 *
Source: Global Insight, Bloomberg, SG Cross Asset Research
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Economic outlook and monetary policyDespite 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 gapTiming 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.
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
projections in February 2009, and since then
its long term unemployment forecast rangehas increased from 4.5%-5.5% to 4.9%-
6.3%.
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
Unemployment Rate Cyclical vs. Structural
0
2
4
6
8
10
12
65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10
%
UR
UR excluding LT unemployment
Linear (UR excluding LT unemployment)
Source: Global Insight, SG Cross Asset Research
The Bernanke sequence1. 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
Evolution of Feds NAIRU Estimates
4.0
4.5
5.0
5.5
6.0
6.5
J an-09 Apr-09 J ul-09 Oct-09 J an-10 Apr-10
%
Lines represent the Fed's range;
boxes represent central tendency
Source: Federal Reserve
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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
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 CBO s 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
-5.0
0.0
5.0
10.0
15.0
20.0
58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12
% Fed Funds Rate
TR (based on CBO NAIRU)
TR (based on SG NAIRU)
0.0
2.0
4.0
6.0
8.0
10.0
12.0
58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12
% UR
NAIRU (CBO)
NAIRU (SG - HP Filter)
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%.
Standard Taylor rule results undervarious NAIRU assumptionsNAIRU
Prescribed
Rate
First rate
hike
Fed's
low 5% -1.75% Q1'12
Fed's
high 6% -0.45% Q2'11
Source: SG Cross Asset Research
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Empirical Taylor Rules
-5.0
0.0
5.0
10.0
15.0
20.0
58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15
% Fed Funds Rate
TR (based on CBO NAIRU)
TR (based on SG NAIRU)
Source: Global Insight, SG Cross Asset Research
The importance of financial conditionsAnother 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.
Including financial conditions as a variable in the Taylor ruleproduces 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.
1SG 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.
SG Financial Conditions Index 1
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
89 91 93 95 97 99 01 03 05 07 09
Source: Bloomberg, SG Cross Asset Research
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Taylor rules with financial conditions
* Alternative Scenario #1: Financial conditions do no t im prove* Alternative Scenario #2: Financial conditions deter iorate fur ther
SG Financial Conditions Index
Taylor Rule Scenarios
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
87 89 91 93 95 97 99 01 03 05 07 09 11 13
%Fed Funds Rate
Baseline ScenarioAlt er nat ive Scen ari o #1 *
Alt er nat ive Scen ari o #2 *
-8.0
-7.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.01.0
2.0
87 89 91 93 95 97 99 01 03 05 07 09 11 13
%
Baseline Scenario
Alt er nat ive Scen ari o #1 *
Alt er nat ive Scen ari o #2 *
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 knock-
on 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.
Summary of Taylor Rule Estimates as of Q1Q1' 2010 YE 2010 YE 2011 YE 2012
Standard Rules
CBO NA IRU -1.75 -1.90 -0.46 1.90
SG NAIRU -0.44 -0.58 0.79 3.00
Emp irical Rules
CBO NA IRU -2.04 -2.10 -0.63 1.97
SG NAIRU -1.10 -1.10 0.25 2.69
Emp irical w ith FCI
CBO NA IRU -1.52 -1.71 -0.19 2.37
SG NAIRU -0.63 -0.82 0.67 3.16
Underlying Economic Assumptions
UR 9.70 9.40 8.70 6.80
Core PCE 1.30 1.00 1.49 1.80
Source: SG Cross Asset Research
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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 sidePrior 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 Fed s 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.
Fed balance sheetFed Assets
-
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
2,200
2,400
J an-07 J ul-07 J an-08 J ul-08 J an-09 J ul-09 J an-10
USD bln
Emergency Liqui dity Programs
Long-term Assets
Fed Liabilities
-
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
2,200
2,400
J an-07 J ul-07 J an-08 J ul-08 J an-09 J ul-09 J an-10
USD bln
Treasury Supplemental Financing Program (SFP)
Bank Reserves
Other assets (primarily currency)
Excess reserves peaked inlate February. Since then,
Treasury has issued $200
bln SFP bills. This is whenthe fed funds rate started
moving up.
Source: Global Insight, SG Cross Asset Research
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
Nearly all balance sheet expansionprograms have endedProgram Expiration Date
TAF March 8, 2010 (last 28-day auction)
TSLF February 01, 2010
PDCF February 01, 2010
AMLF February 01, 2010
CPFF February 01, 2010
MMIFF October 30, 2009
TALF J une 30, 2010 for CMBScollateral, March 31 for
all other collateral
FX swaps closed February 1,2010, reopened May 10
Treasury
purchases
February 01, 2010
MBS
purchases
February 01, 2010
Source: SG Cross Asset Research
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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 Fed s
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 theadministration 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 84-
day fixed-rate instrument offered through competitive single-price auctions.
Rate outlookIn 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 ofreserves 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
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
% Fed Funds Target
Fed Funds Effective
Discount Rate
Interest paid On Excess Reserves (IOER)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
03 04 05 06 07 08 09 10
% Discount Rate - Fed Funds Target
The normal penalty spread is 100bps. The
differences prior to 2008 account for timinglags between FOMC and Fed Board
meetings
What sequence of rate movements?
The discount rate still has 50 bps to go if the Fed
wants to restore the pre-crisis penalty sp read of
100bps.
After that, the corri dor system descr ibed above
implies that the fed funds target rate could move
up first, followed by IOER.
Source: Bloomberg, SG Cross Asset Research
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 Fed s 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.
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SG Forecasts
Economic forecastsAnnual year/year
2008 2009 2010 2011
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 A A E E
Real GDP -6.4 -0.7 2.2 5.6 3.0 4.5 4.8 3.4 0.4 -2.4 3.7 3.1
Real Final Sales -4.1 0.7 1.5 1.7 1.4 4.3 4.5 3.3 0.8 -1.7 2.5 3.1
Consumption 0.6 -0.9 2.8 1.6 3.5 3.9 3.6 3.2 -0.2 -0.6 2.8 3.0
Non-Resid Fixed Investment -39.2 -9.6 -5.9 5.3 3.1 8.5 11.7 7.7 1.6 -17.8 3.8 7.5
Business Structures -43.6 -17.3 -18.4 -18.1 -15.3 -10.0 -10.0 -5.0 10.3 -19.8 -14.2 -2.3
Equipment and Software -36.4 -4.9 1.5 19.0 12.7 16.0 20.0 12.0 -2.6 -16.6 12.7 10.7
Residential -38.2 -23.2 18.9 3.7 -10.7 25.0 25.0 15.0 -22.9 -20.5 6.5 12.5
Inventorie s Chg, % contibu t to GDP -2.3 -1.4 0.7 3.7 1.6 0.2 0.3 0.1 -0.3 -0.6 1.2 0.0
Net Trade, % contribut to GDP 2.6 1.7 -0.8 0.3 -0.6 -0.3 -0.1 -0.5 0.7 0.9 -0.4 -0.5
Exports -29.9 -4.1 17.8 22.8 7.2 10.0 10.0 6.0 5.4 -9.6 11.3 6.4Imports -36.4 -14.7 21.3 15.8 10.4 10.0 9.0 8.0 -3.2 -13.9 10.5 8.2
Government Spending -2.6 6.7 2.7 -1.3 -1.9 1.9 1.6 1.5 3.1 1.8 0.6 1.6
Federal Govt -4.3 11.4 8.0 0.0 1.2 3.3 2.5 2.2 7.7 5.2 3.0 2.0
State & Local -1.6 3.9 -0.6 -2.2 -3.9 1.0 1.0 1.0 0.5 -0.2 -0.9 1.3
PCE Deflator -1.5 1.4 2.6 2.5 1.5 0.3 2.4 1.7 3.3 0.2 1.7 1.8
PCE Core 1.1 2.0 1.2 1.8 0.6 0.7 1.0 1.1 2.4 1.5 1.1 1.2
CPI -2.2 1.9 3.7 2.6 1.5 0.0 3.0 2.0 3.8 -0.3 1.9 2.1
CPI Core 1.6 2.3 1.5 1.5 0.0 0.6 1.0 1.1 2.3 1.7 0.9 1.2
Unemployment Rate 8.2 9.3 9.6 10.0 9.7 9.7 9.3 8.9 5.2 9.3 9.4 8.2
Personal Income -8.9 3.3 -1.4 2.2 3.7 4.0 4.9 5.2 2.9 -1.8 3.0 4.8
Disposable Personal Income -1.2 7.7 -1.2 2.5 3.4 4.1 4.4 4.4 3.9 1.0 3.2 4.4
Real Disposable Pers. Income 0.2 6.2 -3.6 0.0 1.9 3.8 2.0 2.7 0.5 0.8 1.5 2.6
Savings Rate 3.7 5.4 3.9 3.7 3.4 3.3 3.2 3.2 2.7 4.2 3.3 3.2
Corp Profits 22.8 15.7 50.7 36.0 9.3 13.5 13.2 15.3 -11.8 -3.8 20.4 12.6
Quarterly Annualized Growth Rates
2009 A/ E 2010 E
Source: BEA, SG Cross Asset Research
Rates and FX forecasts
Central Bank Rate Forecasts current 3 mths 6 mths 9 mths 1 yr
US 0.25 0.25 0.25 0.50 1.25
Canada 0.25 0.50 0.75 1.00 1.50
10 year bond yields current 6 mths 1 yr
US 10.62 4.15 4.75
Canada 3.25 4.25 5.00
FX rates current 6 mths 1 yr
USD per EUR 1.22 1.20 1.10
USD per GBP 1.44 1.46 1.41
CAD per USD 1.07 0.96 0.95
JPY per USD 90 98 118 Source: SG Cross Asset Research
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
marginal contribution frominventories.
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.
The European debt crisis
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.
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SG Proprietary IndicatorsSG Business Cycle Index
-15
-10
-5
0
5
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
-4
-3
-2
-1
0
1
2
3
4
5
6
SG US Business Cycle Index (LHS)
GDP, y/y (RHS)
SG Real-Time Recession Probabi lity Model
Real-time recession probabities are derived from a regime switching model using the same four co incident inditarors used by NB ER cycle
dating com mittee. These include: employment, real incom e, real sales (retail + business) and industrial production
-
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10
NBER recessionsModeled Rec. Prob
Probabil ity derived from a probit model based on employment, core inflation, ISM index and a li quidity index
Historical Perspectiv e - 6 month ahead prob ability
SG Fed Mod elRate Cut Probability Rate Hike Probability
Latest Probabilities
18%67%
92% 96%
0%
20%
40%
60%
80%
100%
3M 6M 9M 12M
probability of at least one rate cut w ithin the next 3,
6, 9 and 12 months
0% 0% 0% 0%0%
20%
40%
60%
80%
100%
3M 6M 9M 12M
Probability of at least one rate hike
within the next 3, 6, 9 and 12 months
0%
20%
40%
60%
80%
100%
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 within next 6 months
0%
20%
40%
60%
80%
100%
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 within next 6 months
Source: SG Economic Research
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.
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1 June 2010 13
Rates and Short-term FundingFed Funds Expectati ons
Real Treasury Yie lds
A1/P1 Non fin CP vs. OIS (3m) ABCP vs. OIS (3m)
Rates
Libor vs. OIS (3m) - Historical and Implied
Treasury Yield Curve (10y - 2y)
Short Term Funding
Inflation Expectations
0.00
0.25
0.50
0.75
1.00
6/10 8/10 10/10 12/10 2/11
%
Latest
Week ago
Month ago
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1/09 4/09 7/09 10/09 1/10 4/10
-0.2
-0.1
0.0
0.1
0.20.3
0.4
0.5
1/09 4/09 7/09 10/09 1/10 4/10
0.0
0.5
1.0
1.5
2.0
2.5
1/09 4/09 7/09 10/09 1/10 4/10
5yr real
10yr real
1.0
1.5
2.0
2.5
3.0
3.5
1/09 4/09 7/09 10/09 1/10 4/10
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1/09 4/09 7/09 10/09 1/10 4/10
10yr breakeven
5yr 5yrs forward
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
J an-
07
Apr-
07
J ul-
07
Oct-
07
J an-
08
Apr-
08
J ul-
08
Oct-
08
J an-
09
Apr-
09
J ul-
09
Oct-
09
J an-
10
Apr-
10
J ul-
10
Oct-
10
%
Source: Bloomberg, SG Economic Research
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 whoseaccess to wholesale dollar
funding was impaired
following sovereign
downgrades of several
European countries.
2. Liquidity pressures and
in some cases forced de-
leveraging have triggered
sharp corrections in equity,
commodity and credit
markets, and in high-
growth 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.
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Credit AvailabilityMortgages & Consumer CreditConformi ng Mortgage Rate
ABX AAA Tranches
Corporate Credit
Swap Spread (10yr)
HY Spreads(Lehman HY - 10yr Swap)
Inv Grade Corp SpreadDJ Inv Grade CDX Index
Sector CDS Spreads
Fannie/Freddie MBS Spreads
Consumer ABS Spreads
0.40
0.80
1.20
1.60
1/09 4/09 7/09 10/09 1/10 4/10
Fannie/Freddie MBS vs . swap
20
30
40
50
60
70
80
90
100
1/08 4/087/0810/081/09 4/097/0910/091/10 4/10
index 2006-1
2006-2
2007-1
2007-2
3.5
4.0
4.5
5.0
5.5
6.0
1/09 4/09 7/09 10/09 1/10 4/10
30yr Fannie MBS
30yr Conforming Mortgage Rate
0
200
400
600
800
1000
1200
1/09 4/09 7/09 10/09 1/10 4/10
bpcredit cards
autos
0
50
100
150
200
250
300
1/09 4/09 7/09 10/09 1/10 4/10
-20
-10
0
10
20
30
40
50
1/09 4/09 7/09 10/09 1/10 4/10
600
800
1000
1200
1400
1600
1800
2000
2200
1/09 4/09 7/09 10/09 1/10 4/10
0
50
100
150
200
250
300
350400
450
1/09 4/09 7/09 10/09 1/10 4/10
Financials
Industrials
Source: Bloomberg, SG Economic Research
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 inEurope 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.
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FX MonitorDollarMajor Dollar Index
USD/EUR
Carry Trade Index
Carry-to-Risk Ratio
Yield Differ ential
Implied Vol
FX Volatility (G10 avg)
JPY/USD
5
10
15
20
25
30
1/09 4/09 7/09 10/09 1/10 4/10
70
72
74
76
78
80
82
84
86
88
1/09 4/09 7/09 10/09 1/10 4/10
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
99 00 01 02 03 04 05 06 07 08 09 10
%
+/- 1St Dev range
More
attractiv
Less
attractiv
1.02.0
3.0
4.0
5.0
6.0
00 01 02 03 04 05 06 07 08 09 10
5
15
25
35
00 01 02 03 04 05 06 07 08 09 10
100
110
120
130
140
150
160
170
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 1/10
80
85
90
95
100
105
1/09 4/09 7/09 10/09 1/10 4/10
1.1
1.2
1.2
1.3
1.3
1.4
1.4
1.5
1.5
1.6
1/09 4/09 7/09 10/09 1/10 4/10
Source: Bloomberg, SG Economic Research
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 toemerging 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 dollarindex 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 ofweaker euro and promote
rebalancing of trade
between the US and the
emerging world.
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Commodities and EquitiesCrude Oil (Nymex WTI)
Copper
Telecom -3.9%
Co nsumer Staples -4.8%Utilities -6.4%
Health Care -6.7%
Consumer Discretionary -7.0%
IT -8.1%
Financials -9.0%
Materials -9.2%
Industrials -9.6%
Energy -11.9%
VIXVolatility Skew
(25 delta put - 25 delta call, SPX Index)
Sector Perform ance - 4 wk chg
Equities
Baltic Dry Index
GoldCommodities
20
40
60
80
100
1/09 4/09 7/09 10/09 1/10 4/10
500
600
700
800
900
1000
1100
1200
1300
1/09 4/09 7/09 10/09 1/10 4/10
0
10
20
30
40
50
60
1/09 4/09 7/09 10/09 1/10 4/10
0
2
4
6
8
1012
14
16
18
1/09 4/09 7/09 10/09 1/10 4/10
0
50
100
150
200
250
300
350400
1/09 4/09 7/09 10/09 1/10 4/10
500
1000
1500
2000
2500
3000
3500
4000
45005000
1/09 4/09 7/09 10/09 1/10 4/10
Source: Bloomberg, SG Economic Research
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 estimatethat CPI headline will
contract by 0.2% m/m in
both May and June. This
will add a substantial boost
to consumer fire power.
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