socgen - recovery now - fiscal consolidation later if there is still time

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Macro Commodities Forex Rates Equity Credit Derivatives

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

22 March 2010

EconomyBeyond the cycle

www.sgresearch.com

American ThemesRecovery now Fiscal consolidation later if there is still timeStephen 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]

The US fiscal debt outlook is a train-wreck waiting to happen if consolidation programs are notadopted in the next few years. Unfortunately for now, the economy remains dependent ongovernment stimulus policies. Moreover, even in recovery, the US economy may be vulnerable iffiscal policy is tightened too quickly. Congress may respond only to prevent a crisis. The crisisof course would be a loss of confidence by foreign investors.Q Fiscal policy - still generous in 2010 The American Recovery and Reinvestment Plan addedabout 2.5% to growth in 2009 and will add slightly more in 2010 as infrastructure spending

picks up. The scheduled expiration of temporary tax cuts could lead to some tightening next

year, but most cuts are likely to be extended.

Q Widening Atlantic gap diverging fiscal orthodoxies With fiscal policy remaining verygenerous in 2010 and no structural consolidation planned for 2011, removing accommodation

in the US will rest primarily with the Fed. We see Europe leading the way on fiscal

consolidation, which argues for a slower ECB tightening cycle. All else being equal, the

divergence is dollar-supportive.

Q Will foreign investors cooperate? The US may not be ready for fiscal consolidation, butpolicymakers are not the only ones calling the shots. The key structural vulnerability of the US

economy is its reliance on foreign capital, now flowing largely to the Treasury market. In mid-2007, foreign purchases of US private credit assets came to an abrupt stop, triggering a

disorderly de-leveraging of the private sector. A forced de-leveraging of the US public sector

would be even more devastating for the US economy and is a risk that cannot be ignored.

Treasury debt held by public, % of GDP

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Civil War

Debts incurr ed

during

Revoluti onary War

WWI

WWII

Depression

spending

War of 1812

SG Projections

Our projections assume most tax cuts will be extended (except for high-income families).

Source: US Treasury, SG Cross Asset Research

This document is being provided for the exclusive use of MARTIN ROSE (SGCIB)


2/24


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American Themes

22 March 2010 3

The legacy of crisis sharply higher government debt loads

General Governmen t Debt/GDP as of 2009

0

20

40

60

80

100

120

140

160

180

200

Japan

Italy

Ic

eland

G

reece

Belgium

TotalO

ECD

Hu

ngary

F

rance

UnitedS

tates

Po

rtugal

Canada

Euroarea

Germany

A

ustria

Netherlands

UnitedKin

gdom

Ireland

No

rway

Spain

P

oland

Sw

eden

CzechRe

public

Den

mark

Switze

rland

F

inland

SlovakRe

public

Korea

NewZe

aland

Luxem

bourg

Aus

tralia

%Larges t incr eases , 2007-2011:

Iceland 93%

Ireland 64%

UK 47%

US 38%

Japan 37%

Spain 32%

Total OECD 30%

General government debt includes state and local governments and certain pension liabilities.

Source:OECD

The US has some advantages, among them the worlds reserve currency and a safe haven

status for its government debt. Yet, the US is also facing some unique risks notably, it

continues to rely on foreign investors to finance a significant portion of its deficit spending.

This is an important difference between the US and Japan, which has accumulated even more

massive debt loads but has financed them entirely from domestic private savings. Low interest

rates in Japan are a market mechanism for correcting this savings imbalance. The same

market mechanisms imply higher rather than lower rates for the US.

How does the US compare?CDS 10Y Yield

Rating Outlook Rating Outlook 2009 2011 2009 2011

Austr ia AAA STABLE Aaa STABLE 52 66% 78% 1.9% 2.6% 3.50%

Belgium AA+ STABLE Aa1 STABLE 51 93% 105% -0.8% -0.5% 3.63%

Finland AAA STABLE Aaa STABLE 24 41% 52% 0.8% 0.9% 3.37%

France AAA STABLE Aaa STABLE 40 76% 92% -2.1% -2.1% 3.42%

Germany AAA STABLE Aaa STABLE 28 69% 82% 4.0% 5.4% 3.11%

Greece BBB+ NEG A2 NEG 310 103% 123% -11.1% -10.1% 6.36%

Ireland AA NEG Aa1 NEG 119 48% 81% -2.8% -0.6% 4.52%

Italy A+ STABLE Aa2 STABLE 96 114% 127% -2.7% -2.2% 3.95%

Netherlands AAA STABLE Aaa STABLE 32 66% 77% 6.3% 7.7% 3.38%

Portugal A+ NEG Aa2 NEG 121 75% 91% -9.7% -11.1% 4.31%

Slovakia A+ STABLE A1 STABLE 52 31% 43% -3.8% -2.8% 3.99%Spain AA+ NEG Aaa STABLE 94 47% 68% -5.3% -3.0% 3.88%

United Kingdom AAA NEG Aaa STABLE 77 57% 83% -2.6% -2.0% 3.95%

United States AAA STABLE Aaa STABLE 42 70% 92% -3.0% -3.7% 3.66%

Canada AAA STABLE Aaa STABLE - 70% 86% -2.9% -3.4% 3.45%

Japan AA NEG Aa2 STABLE 58 172% 197% 2.5% 2.8% 1.37%

Austr al ia AAA STABLE Aaa STABLE 36 14% 20% -4.2% -4.0% 5.67%

New Zealand AAA STABLE Aaa STABLE 45 25% 31% -2.7% -6.0% 5.89%

General Gov't

Debt/GDPDEBT RATING

as of

03/19/2010

as of

03/19/2010

S&P Moody's

Current Account

Balance/GDP

OECD Esti ma tes OECD Esti mate s

General government debt includes state and local governments and certain pension liabilities.

Source: OECD, Bloomberg, SG Cross Asset Research



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American Themes

22 March 2010

Size also matters, and this is another disadvantage for the US which has external borrowing

needs that dwarf those of any other country. The US government is expected to have a net

borrowing need of $1.3tn in fiscal year 2010 which could mean having to attract $400bn of

foreign capital to the US government bond market.

How much risk of a ratings downgrade?Eventually, if debt trends remain on their current course, the US faces the risk of a downgrade.

That could still be some time off. Traditional sovereign considerations suggest it will be several

years before the US Treasury risks losing its triple-A status. Hopefully, fixes can be

implemented before this threshold is reached. The concern might be that Congress does not

take action until a crisis is upon them.

Moodys warned in December that the US along with 16 other countries could lose their triple-

A credit rating if fiscal deficits and heavy debts are not effectively managed. The agency

implied that the US has until about 2013 to improve its fiscal position, so there is no

immediate threat of a downgrade. The most important factor preventing a downgrade will bethe ability to have sustained recovery coming out of recession while reducing fiscal deficits.

Therefore, those countries able to revive private sector demand will be best positioned to

maintain their AAA ratings. To this extent, the US government sees reviving the economy as

its primary near-term goal. The underlying structural deficit, and longer-term issues tied to

entitlement spending, will be tackled once the economy is on a more sound footing.

Wheres the downgrade threshold?

0

2

4

6

8

10

12

14

16

18

20

22

47 51 55 59 63 67 71 75 79 83 87 91 95 99 03 07

%

Interest expense, % of federal government bud get

includi ng state and local governments

According to Moody's, 18% is considered the threshold between Aaa and Aa.

This is consistent with a 10% level on general government finances (incl state and local) used in

international comparisons.

Source: BEA, SG Cross Asset Research

How much debt is too much? Logically, the answer depends on interest rates. Interest

payments by the federal government currently amount to just 8% of the total spending the

lowest levels since the 1970s despite a debt load that is almost three times the size. For credit

rating agencies, the demarcation zone between Aaa and Aa is a 10% debt affordability ratio

(interest/budget) for the general government which includes state and local finances. This

translates to a roughly 18% debt affordability ratio for US federal government excluding the

states (because states have relatively low debt levels and only 5% of their budgets goes

toward interest expense). If there is a point of no return for government finances, the US is

very far from reaching that stage.

A sovereign Aaa is not so

much characterized by

low debt () as by the

ability to raise a lot of

debt at a non-punitive

price in order to address a

shock, and the

subsequent ability to

reverse such a debt

increase.

Moodys Aaa

Sovereign Monitor,

December 2009



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American Themes

22 March 2010 5

The US will stay clear of the 18% threshold in the next three years in all but the most adverse

economic scenarios the adverse scenario involving much larger deficits than are currently

projected. Another risk is an interest rate shock, but it would have to be substantial. Based on

current debt projections, the effective interest rate paid by the government would have to rise

by about 250 bps (with 3m tbill near 3% and 10yr yld near 6%) in order to trigger the debt

affordability threshold.

Deficit spending impact on bond yieldsIntuitively, deficit spending implies higher real interest rates, but empirical evidence on the

causal link is very mixed. Thats because real interest rates are a function of total demand for

credit in the economy, including demand from the private sector. Inflows of foreign savings

can also offset the impact of savings shortages in the US which would otherwise tend to

boost real interest rates.

Real interest rates from TIPS market

-1

0

1

2

3

4

5

98 99 00 01 02 03 04 05 06 07 08 09

% 5yr

10yr

30yr

Source: Bloomberg

For now, both factors are working to maintain very low real interest rates in the US. Foreign

capital inflows have resumed and are now flowing largely into the US Treasury market.

Meanwhile, private demand for credit remains acutely weak, with both businesses and

households paying down debt (corporates swapping bank debt for corporate debt).

No crowding out for nowNet Lending (+) / Borrowing (-) in Credit Markets

Households

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

60 65 70 75 80 85 90 95 00 05 10

% of GDPHouseholds Non-fin Business

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

60 65 70 75 80 85 90 95 00 05 10

% of GDPNon-fin Business

Source: Federal Reserve, BEA, SG Cross Asset Research



6/24

American Themes

22 March 2010

The same two factors that have kept real rates at historically low levels in the past two years

pose some upside risk for Treasurys financing costs in the future. Private demand for credit

should start to recover as the economy improves. However, given the sub-par recovery

expected both in the US and in the developed world, we anticipate only a gradual pressure on

rates from crowding-out effects.

The bigger risk in our view comes from a potential reversal in foreign savings flows into the

US. In the past 10 years, emerging countries have been a big source of demand for US

Treasury debt, but the attempts to re-calibrate their own growth models away from exports

towards domestic spending implies they will have fewer dollars to recycle. This could prove to

be a key source of pressure on real interest rates in the coming years. Given the importance of

the issue, we will address it in greater depth in the following sections.

Fiscal consolidation - eventually - but recovery firstUnlike in Europe, where the Growth and Stability Pact is pressuring countries to address their

structural deficits as soon as 2011, the US is likely to be slower to consolidate its fiscal

finances. The Obama administration has made it clear that its immediate focus is on creating

jobs and ensuring a sustained recovery. If that requires more stimulus, so be it. To keep bond

vigilantes at bay in the meantime, President Obama has created a bipartisan commission for

fiscal responsibility and reform which is responsible for producing recommendations on how

best to close the budget gap by 2015 and to improve the long-term fiscal picture. It s a start,

although the political reality is that any recommendations made by the commission are

unlikely to be considered until the new Congress takes over in 2011, which delays

implementation to 2012 at the earliest. In the meantime, the balance of risks on fiscal policy is

tilted toward more spending rather than less.

ARRA still supportive in 2010, starting to fade in 2011ARRA how much has been spent?

$143.7

$109.0

$76.9

$144.3

$115.0

$198.1

0 50 100 150 200 250 300 350

Tax Relief

Entitlements

Contracts,

Grants, Loans

USD bln

Paid out

Remaining

Infra spending

projections:

20% in 2009 (on track)

40% in 2010 (on track)

25% in 2011

10% in 2012

5% thereafter

Source: recovery.gov, SG Cross Asset Research



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American Themes

22 March 2010

Effective Income Tax Rate

8

9

10

11

12

13

14

15

16

69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

%Effective Income Tax Rate

Capital gains taxes distort these calculations -

Included in taxes but not in income calculations.

Bush

tax cuts

Obama

tax

holiday


The mix of policies proposed by Obama is consistent with minimizing the hit to consumption

while maximizing government revenues. Thats because the tax hike will impact less than

5% of the population but the same 5% is responsible for about half of federal income taxes.

It is clearly a political issue, but given the small portion of the population impacted by the tax

hike, the proposal should find support in the general population, especially given the

extremely skewed income distribution and a historically low tax rate on the highest earners.

In all, there is little appetite in Washington for belt-tightening in the next year, particularly in

light of the upcoming mid-term elections. We estimate that the American Recovery and

Reinvestment Plan added about 2.3% to growth in 2009 and will add slightly more in 2010 as

infrastructure spending picks up. Marginal support from fiscal policy will begin to fade in 2011,

but only gradually. The negative impact should be largely offset by a pickup in private sector

demand.

Effective Income Tax RateIncome Distributio nTax Rate Distributi on

0

10

20

30

40

50

60

70

80

90

100

1913

1923

1933

1943

1953

1963

1973

1983

1993

2003

%

Highest tax bracket

Lowest tax bracket

Scheduled

expiration of

Bush tax

cuts

0

5

10

15

20

25

30

35

40

45

50

1917

1927

1937

1947

1957

1967

1977

1987

1997

2007

Shareofincomeaccruingtoeachgroup

Top 10% (incomes above $109,630)

Top 1% (incomes above $398,909)

Source: IRS, Prof. Emmanuel Saez University of California



9/24

American Themes

22 March 2010 9

Outlook for government financesThe fiscal outlook we outlined above is a double-edge sword. Maintaining fiscal

accommodation reduces downside risks to growth, but it also boosts deficits and debt levels,

which pose a risk for the long-term economic outlook. Yet, the big problem in the fiscal

outlook is not the current deficit or the next few years. Much of the current budget gap is

cyclical and will shrink as the economy recovers. The real problem comes after 2020 when the

impact of aging population will start putting substantial pressure on government finances.

Near-term impact of recessionFor FY2010 the CBO has projected a $1.3tn deficit and Obamas budget projects an even

larger $1.6tn gap. We believe that the final figure will be smaller than these projections which

use very conservative assumptions on the economy.

While the deficit is likely to be below projections this year, it is likely to exceed forecasts for

the outer years given the high likelihood that temporary tax cuts will be extended. Whereas

federal debt/GDP ratio is projected to stabilize at 65% under the baseline scenario (i.e. tax

cuts expire), extending the tax cuts for middle and low-income families would push it towards

73% by 2020.

Deficit and debt whats next?

Debt, % of GDP

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

SG forecast - most tax cuts extended

CBO basline - tax cuts expire

Deficit, % of GDP

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

SG forecast - most tax cuts extended

CBO baseline - tax cuts expire

Source: BEA, US Treasury, SG Cross Asset Research

As the projections demonstrate, much of the current deficit is cyclical. Under both scenarios,

it is expected to shrink to less than 4% of GDP by 2014 or perhaps even to 3% if temporary

tax cuts are phased out over the next three years. The projected timing on stabilizing the debt

coincides with the closing of the output gap which under the current forecasts is expected to

occur around 2014. The key takeaway is that returning the deficit to the 3% debt-stabilizing

threshold should not require a lot of deliberate tightening of fiscal policy.

How much deficit is too

much?

Achieving a sustainable fiscal

situation is generally equated to

stabilizing debt-to-GDP ratios.

Mathematically, that implies a

limit on the deficit equal to

nominal GDP growth times the

prevailing debt/GDP ratio.

In the US, we assume potential

growth of 4.5% (2.5% real +

2% inflation). The current

debt/GDP ratio is about 53%,

giving us a 2.4% sustainability

The speed limit on fiscal

deficits increases with the debt.

Given that the US debt/GDP

ratio is expected to settle close

to 65%-70%, maintaining this

level puts the deficit speed limit

at 2.9%-3.1%.



10/24

American Themes

22 March 20100

The real problems come after 2020The real problem for fiscal finances is the impact of an aging population on entitlement

spending which is projected to accelerate sharply around 2020. The changing ratio of

taxpayers and those collecting benefits is simply moving in a direction that is unsustainable.The CBO projects that under the current law, the debt/GDP ratio will increase by another 20%

between 2025 and 2035, and even faster after that. If the temporary tax cuts are made

permanent, the situation is even more alarming, with debt/GDP ratio growing to 180% by

2035 up 110% from the levels expected around 2012.

The biggest portion of these increases comes from healthcare costs (Medicare and Medicaid)

which are expected to grow from 5% of GDP to 10% over the next 20 years, contributing 80%

of the growth in government expenditure. This is driven partly by demographics, but also by

per capita costs of healthcare which are rising much faster than inflation. Spending on Social

Security is also projected to rise over the same period, albeit much less, from 5% to 6% of

GDP.

US government budget what can be cut?Federal Outlays, % of GDP Federal Receipts, % of GDP

0

2

4

6

8

10

12

85 87 89 91 93 95 97 99 01 03 05 07 09

%MANDATORY SPENDING (ENTITLEMENTS)

NET INTEREST

DEFENSE

OTHER DISCRETIONARY SPENDING

0

2

4

6

8

10

12

85 87 89 91 93 95 97 99 01 03 05 07 09

%INCOME TAXES

CORP TAXES

SOC SECURITY

OTHER


Not doing anything to alter this projected path would be catastrophic for the economy.

Government borrowing to fund entitlement programs would crowd out private investment,

which by itself could push real interest rates substantially higher. Reducing the supply of

capital to the private sector would also slow potential growth of the economy, further

increasing the burden of entitlement programs. All else being equal, slower productivity

growth makes for a more inflation-prone environment, which would exacerbate the supply-

demand imbalances already created by an aging population.

Looking at the government

budget, it is virtually

impossible to find any other

solution than reforming the

entitlement system. The

increases in mandatory

spending (Social Security,

Medicare and Medicaid)

Federal outlays no offset to rising entitlement costs1986 2007 change chg 2007-2035

% of GDP

Social Security, Medicare, Medicaid 7.0 8.8 1.8 +6.0

Net Interest 3.0 1.8 -2.1 r ising

Defense 6.1 4.1 -1.3 f lat/up

Non-defense Discretionary Spending 6.1 5.2 -0.9 ?

Total Outlays 22.3 19.8 -2.4 UP




11/24

American Themes

22 March 2010 11

Box 1 IIMMPPAACCTTOOFFDDEEMMOOGGRRAAPPHHIICCSS OONNGGOOVVTTBBUUDDGGEETT

TT

hh

ee

rree

aa

ll

pp

rroo

bb

llee

mm

iiss

hh

ee

aa

lltthh

cc

aa

rree

In its Long-Term Budget Outlook, the Congressional

Budget Office gives its long-term views on the evolution of

the federal debt over the next decades, under two main

sets of assumptions: the extended-baseline scenario,

which extends the CBOs 10-year baseline budget

projections, and the more accommodative alternative

fiscal scenario, which extrapolates todays underlying

fiscal policy by including some widely expected policy

changes.

Both predict that government finances will remain on an

unsustainable fiscal path over the long run, which means

that the federal debt resulting from the accumulating

deficits will keep growing at a higher pace than the total

economy, unless the government addresses the issue.

According to the set of hypotheses chosen, the level of the

marketable debt may range from 79% to 181% of the GDP

in 2035, which would have severe effects on the economy.

The major contributors to this increase are the two main

health care programs, Medicare and Medicaid, which

together accounted for 20% of the federal outlays in 2009.

CBO projects that they will grow from 5% to about 10% of

the GDP, contributing to 80% of the growth in government

expenditures by 2035. Spending on Social Security is also

projected to rise over the same period, albeit much less,

from 5% to 6% of the GDP.

The reason for this increase is twofold: the aging of the

population and the rapid growth of per capita health care

costs. The retirement of the baby-boom generation

associated with an increasing life expectancy will

significantly reshape the worker-to-retiree demographics.

The share of people age 65 or older is projected to rise

from 13% to 20% while the share of people aged 20 to 64

should fall from 60% to 55% by 2035. As for the health

care costs, they will durably burden the Medicaid accounts

if no reform is initiated.

The accumulation of debt would seriously harm the

economy. As a way to tackle the issue, the fiscal policy mix

should ideally combine lower spending and higher

revenues.

Treasury debt, % of GDP

-20%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 2030

Path 1: Based on current law (i.e. temporary tax cuts expire)

Path 2: Alternative scenario (tax cuts extended)2

1

Source: Federal Reserve, CBO



12/24

American Themes

22 March 20102

during the last 20 years were offset largely by declines in defense spending, which came

down substantially after the end of Cold War. Interest spending has also shrunk thanks to the

secular declines in interest rates. Given the geopolitical backdrop and the fact that interest

rates are already at abnormally low levels, the odds are that spending on these categories

cannot shrink any further and is likely to expand in coming years. That leaves us with

discretionary spending, which is simply not big enough to offset the projected growth in

entitlement spending (even if it is cut to zero!).

Reforming the entitlement spending requires some difficult and politically undesirable choices.

The most robust solution for the problem of an aging population is to raise the retirement age.

But even this by itself may not be sufficient. Reducing the projected path of per capita costs is

crucial and requires policies that will stimulate a productivity revolution in the healthcare

sector (which has been abysmal). The solution may be in new healthcare delivery systems that

utilize todays technology to eliminate waste, but so far there is no consensus on precisely

what those policies should be.

Box 2 CCOONNTTIINNGGEENNTTLLIIAABBIILLIITTIIEESSSShhoouulldd wwee ccoonnssiiddeerr FFaannnniiee//FFrreeddddiiee ddeebbtt??

Some analysts claim that the analysis of government debt

should include off-balance sheet liabilities, particularly

since the government has extended an explicit backing to

Fannie Mae and Freddie Mac. Together, the liabilities of the

two mortgage giants amount to more than $8tn ($5.3tn in

MBS securities and $2.8tn in straight debt). Treating these

as a government liability

would more than double

federal debt held by the

public, pushing the

debt/GDP ratio well

above 100%. But, is this

a correct methodology?

Absolutely not.

Unlike Treasury debt,

which is backed by

nothing more than the

full faith and credit of theUnited States

government, agency

liabilities are backed by

hard assets. These assets have certainly declined in value,

leaving the government on the hook for any losses, but the

net liability to the government is just a fraction of gross

agency debt.

The CBO estimates that the total cost to the government

from Fannie and Freddieoperations will amount to

$390 bln over the next

10 years. That includes a

$291 bln loss on

transactions originated

before the

conservatorship and an

additional subsidy for

new mortgage

commitments expected

during 2010-2019. These

estimates lift thegovernments NET

liabilities by about 3%.

GSE debt, % of GDP

0

20

40

60

80

100

120

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

%

Agen cy Debt

Agen cy MBS

Treaasury Debt

Source: Federal Reserve, SG Cross Asset Research



13/24

American Themes

22 March 2010 13

Box 3 SSTTAATTEEFFIINNAANNCCEESSUUSS ssttaatteess iinn ddiirree ffiissccaall ssttrraaiigghhttss

The recession of 2008-2009 has produced the worst crunch in state finances since the Great

Depression. And, the worst is yet to come. History shows that the worst budget crunch for

states occurs between 1-2 years after a recession ends and that full recovery can take years.

Add to this the fact that federal stimulus dollar used to plug state budget holes will begin to dry

up at the end of 2010, and the inevitable conclusion is that state leaders will have to consider

significant spending cuts and/or tax increases in order to erase budget shortfalls in the coming

years.

Though California is in a league of its own for fiscal dysfunction, it is not the only US state in

fiscal peril. In a recent study, PEW Center on the States found at least nine states with similar

characteristics to California where fiscal finances are in dire straights (they include Arizona,

Rhode Island, Michigan, Nevada, Oregon, Florida and New Jersey). Illinois and New York did not

make the list despite very wide budget gaps because of less severe statistics on unemployment

and foreclosure rates. However, these states are also considered as high-risk markets by bond

investors.

There are several legal/constitutional obstacles to a comprehensive fix to state fiscal problems.

First, almost all states have adopted a balanced budget amendment which keeps undue focus

on plugging short-term fiscal holes and prevents state leaders from focusing on long-term

solutions. Another problem facing some states is the requirement for a supermajority vote (2/3 or

in some cases 3/4 or 3/5) to approve state budgets, which often leads to gridlock. This problem

has been especially acute in California where lawmakers have been unable to agree on the

much-needed spending cuts and/or tax increases.

Because of its chronic budget woes and inability to tackle its finances, California has been

frequently compared to Greece. For the most part, we see these comparisons as misleading.

Relative to GDP, California is facing a roughly 2% deficit in 2010 and a debt ratio of just 6.5%

(2008 data). More importantly, however, the US has a federal government which would ensure a

number of basic services even in the event of debt default by the state. Lastly, a default by

California vs Greece would

have vastly different

implications for the

financial system. In the US,

banks are regulated by

both state and federal

governments, but the FDIC

is ensuring deposits at the

national level and

institutions hold mostly US

Treasuries (rather then

muni debt) as their risk-free

assets.

Projected 2010 StateBudget Gaps0% 20% 40%

California

Illinois

Arizona

Nevada

New York

Alaska

New Jersey

Vermont

Georgia

Washington

Wisconsin

Connecticut

Florida

Kansas

North Carolina

Louisiana

Maine

Minnesota

Utah

Rhode Island

Hawaii

Maryland

Colorado

Pennsylvania

Massachusetts

Delaware

Alabama

Idaho

New

Hampshire

Oregon

Oklahoma

Iowa

South Carolina

Ohio

Michigan

Kentucky

Virginia

Missouri

Tennessee

Mississippi

Texas

Indiana

New Mexico

West Virginia

Nebraska

Arkansas

South Dakota

Wyoming

Montana

North Dakota

Deficit, % of Budget

Source: PEW Center on the States

State government debt, % of GDP

0

10

20

30

40

50

60

70

80

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

% State & Local Gov't Debt

Treasury Debt




14/24


15/24


16/24

American Themes

22 March 20106

The concern over Chinas shrinking trade surplus would be null and void if it led to an equal

narrowing of the US trade deficit. But the growing Chinese demand is unlikely to benefit the

US. Instead, we expect Chinas trade surplus to be transferred to Australia, Brazil, Taiwan,

South Korea and Japan (or what we call the China 5). It is not clear that these countries will

show the same appetite for recycling their trade surpluses into US Treasury debt. If they dont,

the US government may have a harder time attracting foreign lenders.

According to official data, Chinas Treasury portfolio is already shrinking, but the data may be

somewhat misleading as it identifies the immediate source of funds as opposed to end

buyers. China may have been redirecting its purchases via London or other banking centers.

Indeed, the $16.4bn shrinkage in Chinas Treasury portfolio in the past three months has been

more than offset by a $33.4bn growth in UK holdings which often capture transactions done

on behalf of other countries (e.g. OPEC). The risks therefore still lie ahead.

Monetization the option of last resortWhile it is certainly not our central scenario, we must consider what would happen if foreigninvestors suddenly lost appetite for US Treasury debt. In all likelihood, the curve would

steepen sharply and higher bond yields would induce a spike in private savings and a collapse

in private demand. In the face of financing difficulties, expansionary fiscal policy would be out

of the question. The consequences for the US economy would be devastating, with the only

saving grace being cheaper dollar and positive contributions to growth from net exports.

Of course, there would be a lot of pressure on policymakers to do something. With fiscal

hands tied by financing difficulties, the pressure would be squarely on monetary policy. The

easiest way out: use the Fed to buy excess Treasury supply and prevent curve steepening.

The Fed would probably try to dress it up as quantitative easing. There is a fine line between

QE and monetization, but in a fiscal crisis scenario, central bank purchases of Treasury debt

would be a de facto monetization. The long term consequences of such actions would behighly inflationary.

Leverage migration Is the Fed next?From corporates in the 1980s/1990s To households in the 2000s To publ ic sector in the 2010s

0

10

20

30

40

50

60

70

80

90

52 57 62 67 72 77 82 87 92 97 02 07

%

Total business (corporate

and noncorporate)

0

20

40

60

80

100

120

52 57 62 67 72 77 82 87 92 97 02 07

%

Household sector

0

10

20

30

40

50

60

70

80

90

100

52 57 62 67 72 77 82 87 92 97 02 07

%

Total government (federal,

state and local)

Is the

Fed

next?




17/24

American Themes

22 March 2010 17

ConclusionsCrowding out is an important problem, but it is a problem for the future. Until private demand

for credit comes back, we need the federal government to continue playing a Keynesian role.

Richard Koo, who coined the phrase balance sheet recession, describes it as a period when

the private sector switches from maximizing profit growth to minimizing debt. During such

periods, classically prescribed policy responses dont work because the de-leveraging

impulse renders monetary policy ineffective. Instead, the prescribed policy mix should target

the public sector which is able to take on more debt.

While the mix seems to make sense today, it has unproven long-term effects. US

policymakers have responded to the bursting tech bubble of the late 1990s by creating a

mortgage and housing bubble. Now to correct it, they may be creating a government debt

bubble. Having moved from too much leverage in the corporate sector (late 1990s) to toomuch leverage in the household sector (2000s) to too much leverage in the public sector

(2010s), the menu of choices is getting smaller. Ultimately the only balance sheet left able to

take on more leverage is that of the Fed. However, in the case of the Fed, more leverage does

not mean more debt, it means more money. Ultimately, monetization may be the only way out.

Historically, monetization has almost always led to hyperinflation.



18/24

American Themes

22 March 20108

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 5.9 3.8 3.5 2.9 3.1 0.4 -2.4 3.5 2.9

Real Final Sales -4.1 0.7 1.5 1.9 3.0 3.2 2.9 3.0 0.8 -1.7 2.5 2.9

Consumption 0.6 -0.9 2.8 1.7 2.5 2.9 2.9 3.0 -0.2 -0.6 2.3 2.9

Non-Resid Fixed Investment -39.2 -9.6 -5.9 6.5 6.7 7.7 4.5 6.1 1.6 -17.7 3.8 6.2

Business Structures -43.6 -17.3 -18.4 -13.9 -12.0 -10.0 -10.0 -5.0 10.3 -19.6 -12.6 -2.3

Equipment and Software -36.4 -4.9 1.5 18.2 15.0 15.0 10.0 10.0 -2.6 -16.7 11.6 9.1

Residential -38.2 -23.2 18.9 5.0 10.0 15.0 15.0 15.0 -22.9 -20.4 9.5 11.4

Inventories Chg, % contibut to GDP -2.3 -1.4 0.7 3.8 0.8 0.3 0.0 0.1 -0.3 -0.6 1.0 0.1

Net Trade, % contr ibu t to GDP 2.6 1.7 -0.8 0.3 -0.1 -0.3 -0.3 -0.4 0.7 0.9 -0.3 -0.5

Exports -29.9 -4.1 17.8 22.4 16.0 7.0 7.0 6.5 5.4 -9.6 12.5 6.3Imports -36.4 -14.7 21.3 15.3 14.0 8.0 8.0 8.0 -3.2 -13.9 10.8 8.0

Government Spending -2.6 6.7 2.7 -1.2 2.1 1.7 1.6 1.5 3.1 1.9 1.7 1.6

Federal Govt -4.3 11.4 8.0 0.2 5.3 2.7 2.5 2.2 7.7 5.2 4.0 1.9

State & Local -1.6 3.9 -0.6 -2.0 0.0 1.0 1.0 1.0 0.5 -0.2 0.2 1.3

PCE Deflator -1.5 1.4 2.6 2.7 2.1 -0.7 2.2 2.1 3.3 0.2 1.7 1.5

PCE Core 1.1 2.0 1.2 1.4 0.9 0.9 0.9 1.1 2.4 1.5 1.1 1.1

CPI -2.2 1.9 3.7 2.6 1.6 -0.9 2.6 2.5 3.8 -0.3 1.8 1.8

CPI Core 1.6 2.3 1.5 1.5 0.8 0.9 0.9 1.0 2.3 1.7 1.2 1.1

Unemployment Rate 8.2 9.3 9.6 10.0 9.7 9.5 9.3 9.2 5.2 9.3 9.4 8.6

Personal Income -8.9 3.3 -1.4 3.7 4.5 4.5 4.9 5.1 2.9 -1.7 3.6 4.8

Disposable Personal Incom e -1.2 7.7 -1.2 4.3 4.5 4.5 4.4 4.6 3.9 1.1 3.9 4.3

Real Disposable Pers. Income 0.2 6.2 -3.6 1.9 2.4 5.2 2.2 2.5 0.5 0.9 2.3 2.7

Savings Rate 3.7 5.4 3.9 4.1 4.9 5.4 5.3 5.3 2.7 4.3 5.2 5.2

Corp Profits 22.8 15.7 50.7 18.8 13.3 13.1 11.4 15.3 -11.8 -4.7 18.2 10.9

Quarterly Annualized Growth Rates

2009 A/ E 2010 E


Rates and FX forecastsCentral 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 2.00

10 year bond yields current 6 mths 1 yr US 3.67 3.90 4.75

Canada 3.46 3.90 5.00

FX rates current 6 mths 1 yr

USD per EUR 1.35 1.32 1.25

USD per GBP 1.50 1.53 1.47

CAD per USD 1.02 0.98 1.02

JPY per USD 90.01 100 110

Source: SG Cross Asset Research

The US recovery is gainingspeed, but there are lingering

questions on sustainability. In

recent quarters, inventories

have contributed

substantially to growth. The

consumer has shown some

signs of life, but demand is

not yet strong enough to

ensure a sustained recovery.

Employment is the missing

link and we expect that

private payrolls will make amore decisive turn to the

upside in the coming months.

This should reinforce the

recovery forces and shore up

the outlook for consumption.

While growth should slow

from the breakneck pace of

Q4, we see a high chance

that the recovery will be

sustained.

The Fed is likely to remain onhold until Q4, when we

expect the first rate hike.

Limited inflation pressures

suggest no rush, although the

Fed will have to move at

some point to ensure that

inflation expectations remain

well anchored. The path of

Fed policy remains closely

tied to employment. We

anticipate a 200K job gain for

March which should give theFed enough confidence to

drop the extended

language from the FOMC

statement at the April 28

meeting. The anticipation of

rate hikes should push bond

yields and the dollar higher.



19/24

American Themes

22 March 2010 19

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)

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 income, real sales (retail + business) and industrial production

SG Real Time Recession Probability Model

-

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

59 61 62 64 66 68 70 72 74 76 78 80 82 84 85 87 89 91 93 95 97 99 01 03 05 07 08

NBER recessionsModeled Recession Prob

Probability derived from a probit model based on employment, core inflation, ISM index and a liquidity index

Histor ical Perspective - 6 month ahead probability

SG Fed ModelRate Cut Probability Rate Hike Probability

Latest Probabilities

86%

100% 100% 100%

0%

20%

40%

60%

80%

100%

3M 6M 9M 12M

probability of at least one rate cut within 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 cutsProbability 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 has

clearly moved out of a

recession regime, as

demonstrated by our real-

time probability model.

Our US business cycle

index reinforces the call for

a sustained recovery and

suggests limited risks of a

double dip. The index is

pointing to GDP growth

near 4.0%, not too far from

our Q1 forecast for 3.8%

annualized growth.

Our fundamental Fed

probability models have

been showing a somewhat

distorted picture since

policy hit the zero bound

on the overnight rate.

Taylor rule-type equations

currently prescribe a

negative policy target of

about 2%, which is why

our model points to

substantial odds of further

rate cuts and zero odds of

rate hikes. Importantly, the

model does not capture

the effects of quantitative

easing which have

compensated for the

inability to go below zero.

We believe that the Fed will

hike a bit faster than the

model implies in an effort

to keep inflation

expectations well anchored

in light of a ballooning

monetary base.



20/24

American Themes

22 March 20100

Rates and Short-term FundingFed Funds Expectations

Real Treasury Yields

A1/P1 Non fin CP vs. OIS (3m)

Inflation Expectations

Treasury Yield Curve (10y - 2y)

Short Term Funding

ABCP vs. OIS (3m)

Rates

Libo r vs. OIS (3m) - Historical and Imp lied

0.00

0.25

0.50

0.75

1.00

3/10 5/10 7/10 9/10 11/10

%

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

-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

0.0

0.5

1.0

1.5

2.0

2.5

1/09 4/09 7/09 10/09 1/10

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

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1/09 4/09 7/09 10/09 1/10

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

Market expectations forrate hikes are broadly in

line with our own. The

Treasury yield curve

remains very steep and

offers very attractive carry

to investors. This will

probably change when the

Fed starts signaling rate

hikes. We see bond yields

moving sideways in the

next few months on the

back of continued carrytrade activity. However,

yields should start moving

higher in the second half

as we get closer to the rate

hike cycle.

Inflation expectations in

the Treasury market have

largely normalized. The low

nominal yields are driven

by real rates which remain

abnormally low. Privatesector demand for credit

remains very depressed

which explains low real

rates, but that should

begin to change as the

recovery in domestic

demand gains momentum.

The fiscal outlook also

poses a risk to real rates.

Short-term liquidity

remains abundant,although markets are

pricing some lift in Libor-

OIS spreads in the next

few months. Immediately,

this may be tied to quarter-

end pressures, but spreads

could also see some lift as

the Fed takes steps to

reduce excess reserves.



21/24

American Themes

22 March 2010 21

Credit AvailabilityMortgages & Consumer CreditConforming 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

Fannie/Freddie MBS vs. swap

20

30

40

50

60

70

80

90

100

1/08 4/08 7/08 10/08 1/09 4/09 7/09 10/09 1/10

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

30yr Fannie MBS

30yr Conforming Mortgage Rate

0

200

400

600

800

1000

1200

1/09 4/09 7/09 10/09 1/10

bp credit cards

autos

0

50

100

150

200

250

300

1/09 4/09 7/09 10/09 1/10

0

5

10

15

20

25

30

35

40

45

50

1/09 4/09 7/09 10/09 1/10

600

800

1000

1200

1400

1600

1800

2000

2200

1/09 4/09 7/09 10/09 1/10

0

50

100

150

200

250

300

350400

450

1/09 4/09 7/09 10/09 1/10

Financials

Industrials


One of the key near-term

risks for the economy is

what will happen to

mortgage rates once the

Fed stops purchasing MBS

assets. The good news is

that mortgage spreads

have remained near their

lows despite a substantial

reduction in the Feds

buying pace. The

conforming mortgage rateremains near the 5% level,

or close to an all-time low.

In addition, jumbo rates

have been coming down

steadily. The rate

environment should

support housing activity as

we move into the spring.

Corporate credit continues

to perform very well.

Although spread tighteninghas slowed in recent

months, spreads remain

near their lows. Corporate

default rates have peaked,

while profit generation has

been very strong and

should continue. Cost

cutting has been the key

driver of profits and

investors are increasingly

looking for revenue growth.

A turn in employment

which will sustain

consumption could be

the next trigger for further

spread narrowing.



22/24

American Themes

22 March 20102

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

65

70

75

80

85

90

1/09 4/09 7/09 10/09 1/10

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

attractive

Less

attractive

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

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


Since November, the dollar

has rallied substantially

against the Euro. The

Greek debt woes have

been a big driver, but more

fundamentally the US

economy is facing better

cyclical prospects than the

euro area due to pent-up

demand and much better

employment prospects.We see Europe leading the

way on fiscal consolidation

while the Fed moves ahead

of the ECB on monetary

tightening. All else being

equal, these trends should

support further dollar

strength.

The dollar should also

outperform the yen in the

next 12 months given thedivergent paths on growth

and monetary policy. We

see the yen as the next

carry trade funding

currency.

Carry trade activity has

been supported by

declining FX volatility. Rate

differentials have not been

very attractive, but that

should begin to change as

commodity economies

accelerate their tightening

cycles.



23/24

American Themes

22 March 2010 23

Commodities and EquitiesCrude Oil (Nymex WTI)

Copper

Co nsumer Discretionary 7.4%

Financials 7.2%Industrials 6.9%

IT 5.0%

Telecom 4.9%

Materials 4.4%

Health Care 3.3%

Co nsumer Staples 2.6%

Utilities 1.9%

Energy 1.9%

VIXVolatility Skew

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

Sector Performanc e - 4 wk chg

Equities

Baltic Dry Index

GoldCommodities

20

40

60

80

100

1/09 4/09 7/09 10/09 1/10

500

600

700

800

900

1000

1100

1200

1300

1/09 4/09 7/09 10/09 1/10

0

10

20

30

40

50

60

1/09 4/09 7/09 10/09 1/10

0

2

4

6

8

1012

14

16

18

1/09 4/09 7/09 10/09 1/10

0

50

100

150

200

250

300

350400

1/09 4/09 7/09 10/09 1/10

500

1000

1500

2000

2500

3000

3500

4000

45005000

1/09 4/09 7/09 10/09 1/10


Commodities continue to

be supported by the

cyclical outlook, although

the gains may slow in the

near-term as the

manufacturing cycle starts

to lose momentum. The

transition to demand-led

growth, however, should

sustain the upward trend.

Equity markets are moving

ahead of the economy.

Despite the uncertainty

surrounding jobs, VIX has

fallen to levels that are

normally reached after

employment turns positive.

We believe that this market

call will be reaffirmed by

the data.

We see equity gains

reinforced by the profits

cycle which should

maintain strong

momentum in the coming

quarters. While revenue

gains will be modest

relative to other recovery

cycles, we see room for

substantial margin

expansion even with

employment growth.



24/24

American Themes

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socgen - recovery now - fiscal consolidation later if there is still time

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