Jefferies & Company, Inc. Member SIPC
U.S. Economy, Inflation & Policy Sustainable economic expansion, low but rising inflation, unique monetary policy
challenges & profligate fiscal policy
Spring 2011
Ward McCarthy, Ph. D. Managing Director
Chief Financial Economist 212-323-7576
CONFIDENTIAL
U.S. Economy, Inflation & Policy: Sustainable economic expansion, low but rising inflation, unique monetary policy challenges & profligate fiscal policy
Page 3 Key Themes & Risks:
Page 4 Economic Expansion: Sustainable, GDP remains below potential
Page 5 Economic Expansion: The composition of the economy, implications for growth
Page 6 State & Local Finances: Time to pay the piper with job losses
PPage 77 St t & L l Fi C lif i S h tState & Local Finances: California Snapshot
Page 8 Anatomy of the economy: Consumer and investment are vital
Page 9 Labor Market: Private sector payrolls up, unemployment down
Page 10 Labor Market: This is not a jobless recovery
Page 11 Labor Market: Tea leaves point to improvement & compositional change
Page 12 Labor Market: Invisible hand at work, small & medium sized firms kick into gear
Page 13 Consumer: Making ends meet, setting an example for government
Page 14 Housing: Bouncing along the bottom, regional imbalances
Page 15 Manufacturing: Whirring, whittling away at excess capacity
Page 16 Inflation: Low, but headed higher gradually
Page 17 Inflation: Commodity surge, know when to hold ‘em
Page 18 Inflation: Ripple effects of housing
Page 19 Inflation: Expectations, anchors and public relations
Page 20 Monetary Policy: Volcker to Bernanke, ending a 30‐year disinflationary trend
Page 21 Monetary Policy: Taylor Made balance sheet & fed funds rate Page 22 Monetary Policy: Bank loans, transmission breakdown or cyclical lag?
Page 23 Fiscal Policy: Political irresponsibility in the age of entitlement
Pagge 24 Fiscal Policyy: No BS,, Bowles‐Simppson Commission Recommendations
Page 25 Treasury: MBS “wind down” reduces borrowing needs, debt ceiling hike still needed
Page 26 Treasury: Still reliant on overseas investors
Page 27 Treasury: Steep curve engenders stripping
Page 28 Appendix: Rates & Curve Perspective
Page 29 Disclaimer
2
se c econom
Key Themes & Risks
1. The U.S. economic fundamentals and growth prospects continue to improve. Growth is sustainable.
2. State and local finances, possible consequences of the catastrophe in Japan, lingering mortgage and housing imbalances, as well as rising food and energy prices are speed bumps that will limit the upside growth potential but not derail the U.S. economy.
33. 2011 growth will be driven by increased investment spending and a moderate increase in consumer spending 2011 growth will be driven by increased investment spending and a moderate increase in consumer spending.
4. Manufacturing activity is whirring and will continue to do so.
5. With income growth remaining moderate, consumers will continue to spend, but the increase in food and energy prices will cause reductions in discretionary spending.
b head higher Because of the composition of the U.S. economy, the effect of rising66. Inflation is lo Inflation is low butt willill grad graduallally head higher. Beca of the omposition of the U S the effect of rising commodity prices will be more limited than is the case in commodity-based economies.
7. Improved growth prospects and rising inflation will continue to increase friction on the FOMC as policymakers debate the timing of the eventual exit strategy.
8. The size and compposition of the Fed’s balance sheet will be the pprimaryy battle gground for ppolicyy debate ,, es ppeciallyy over the second half of the year.
9. The Fed’s ongoing efforts to prevent deflation, including QE2, is reviving inflation and bringing an end to a 30-year secular disinflationary trend.
10. The Treasury MBS wind down will reduce the need to increase auction sizes over the second half of the year, but th d bt ili ill till d t b i d b l t Q2the debt ceiling will still need to be increased by late-Q2.
11. Congress must bring an end to the age of entitlement to reduce the U.S. budget deficit or the U.S. will lose the AAA credit rating.
3
4
6
8
10
Real GDP, QoQ vs YoY (% Change)
-6
-4
-2
0
2
QoQ YoY
Output Gap: Deviation of GDP from Potential
-8
9/28/19909/30/19919/30/19929/30/19939/30/19949/29/19959/30/19969/30/19979/30/19989/30/19999/29/20009/28/20019/30/20029/30/20039/30/20049/30/20059/29/20069/28/20079/30/20089/30/20099/30/2010
$200
$0
$200
$400
($ blns)
$1,200
$1,000
$800
$600
$400
3/1/80
3/1/82
3/1/84
3/1/86
3/1/88
3/1/90
3/1/92
3/1/94
3/1/96
3/1/98
3/1/00
3/1/02
3/1/04
3/1/06
3/1/08
3/1/10
Economic Expansion: Sustainable, GDP remains below potential � U.S. economy entered the expansion phase of the cycle in Q4 2010
� U.S. economic growth will accelerate from the 2.3% quarterly average of the final three quarters of 2010
�� Jefferies projects 2011 GDP growth between 3% and 3 5% Jefferies projects 2011 GDP growth between 3% and 3.5%
� Nonetheless, GDP will remain well below potential for several more quarters because of the severity of the output gap from the recession
Source: Commerce DepartmentSource: Commerce Department
‐
‐
‐
‐
‐
‐
Source: Congressional Budget Office & Jefferies
$ ,
4
C itio of U S Lab For
50%60%70%80%90%
100%
Composition of U.S. Labor Force
Goods Producing
0%10%20%30%40%
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/19
1/1/20
1/1/20
1/1/20
1/1/20
1/1/20
1/1/20
Service Providing
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
2001 8 months 0.0% 2.6% -1.1% 1.4% 3.5% 2.1% 2.0% 1.8% 2007/2009 16 months -3.7% 1.6% 5.0% 3.7% 1.7% 2.6% 3.1% 3.0%
Economic Expansion: The composition of the economy, implications for growth Recessions & Recoveries, 1973 - 2010
---------Quarterly GDP Growth Following the Recession---------Length Of Decline In Recession Real GDP Trough +1 Trough +2 Trough +3 Trough +4 Trough +5 Trough +6 Average
�GDP growth in the current recovery has been similar to the
prior two “jobless” recoveries and less robust than recoveries 1980 6 months -2.2% 7.6% 8.6% -3.2% 4.9% -4.9% -6.4% 1.1%
prior to 1990 1982 16 months 5 1% 9.3% 8.5% 8 0% 7.1% 7 7%
1973/1974 16 months -2.8% 3.1% 6.9% 5.3% 9.4% 3.0% 2.0% 5.0%
prior to 1990 19811981/1982 / 16 months -2 7% 2.7% 5.1% 9 3% 88 1% .1% 8 5% 8.0% 7 1% 7.7% Average 13 months -2.6% 5.3% 8.3% 3.4% 7.6% 2.0% 0.9% 4.6%
�U.S. activity & employment has become increasingly
concentrated in the service sector of the economy, which
helps to explain why growth has become less robust
1990/ 88 months 0 0% 22 7% .7% 1 7% 11 6% .6% 4 5% 4.3% 4 2% 3.2%1991 th 0.0% 1.7% 4.5% 4 3% 4.2% 3 2%
---------Quarterly GDP Growth Following the Recession---------Length Of Decline In Recession Real GDP Trough +1 Trough +2 Trough +3 Trough +4 Trough +5 Trough +6 Average
1990/1991 �This trend is also unsustainable if the U.S. economy is to
maintain a preeminent role in the global economy
There are speed bumps, but none of them will derail the U.S. economy:
� The rise in oil prices and ongoing distress in state and local finances pose headwinds that will limit the upside to growth
� Events in Japan create near-term downside risks and longer-term upside risks to the U.S. economy
Average 11 months -1.2% 2.3% 1.9% 2.2% 3.2% 3.0% 3.1% 2.6% Source: Commerce Dept
ompos n or ce
Source: Bureau of Laborstatistics & Jefferies
5
�
$50
$0
State Budget Deficits in Prior & Recent Recession (Actual & Projected)
-$200
-$150
-$100
State & Local Government Employment
-$2502002 2003 2004 2005
//2009 2010 2011 2012 2013
100
200
300
400
500(12-month cumulative change in thousands)
300
200
100
0
100
1 0 1 0 0 0 0 1 0 0 0 0 1 0 1 0 0 0 0 1 0 0 0 0 1
State Local
2/01/005/01/010/01/013/01/028/01/02
01/036/01/03
01/034/01/049/01/042/01/057/01/052/01/055/01/060/01/063/01/078/01/07
01/086/01/08
01/084/01/099/01/092/01/107/01/102/01/10
State & Local Finances: Time to pay the piper with job losses
� State & local government payrolls have declined by � State & local government payrolls have declined by 479k since August, 2008
� Local government payrolls have declined by 397k
State ggovernment empployyment has fallen byy a more moderate 82k, but more significant job losses are likely as state governments grapple with fiscal imbalances
�The ripple effect will reach federal government employment between 2012 and 2015
�California Snapshot:
California's February unemployment rate of 12.2% is the second highest in the nation and well above the 8.9% natiionall unemplloyment rate
St t B d t D fi it i P i & R t R i
-
California payrolls rose 218k over the past year
California industries with the fastest payrolls growth have been professional & business services (100k) trade 8 been professional & business services (100k) , trade 8 transportation (38k) and education & health services (49k)
-Government payrolls have declined by 62k -
-Source: Bureau of Labor Statstics
1/ 1/ 1/ 1/ 272946830527294683052
6
$1,500
$2,000
$2,500
GDP By State
$250
$300
$350
$400
State & Local Debt By State
$0
$500
$1,000
Ve NoMo
Wy
SouAlaRh MaIdaNe
De
We
Ha
Ne
Ne
Mi
ArkUta
Ne
KaIowKe OkSouOre
AlaLouCo MiTenWi
Co AriIndMi
Ma
Wa
Mi
Ma
Ge
No
VirOh
Ne Pe
IlliFloNe
TeCal
$0
$50
$100
$150
$200
Wy
No
Ve Id aSouMo
De M a
AlaWe
RhNe Ha
Ne
Ne
Mi
ArkIowUta
Ok
KaNe
AlaLouOre
TenSouCo M aMi
Ke MiWi
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Oh
Mi
Ne
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IlliFloPe Te NeCalrm
ontrth D
akotaontanayom
inguth D
akotaaskaode Islandaineahow Ham
pshirelaw
areest Virginiawaii
w Mexico
braskassissippikansasah vadansaswa ntuckylahom
auth Carolinaegonabam
auisianannecticutssourinnesseesconsinoradozonadiana sotaarylandashingtonchiganassachusettsorgiarth Carolinaginiaio w Jerseynnsylvanianoisridaw York
xasifornia
yoming
rth Dakota
rmont
ahouth D
akotaontanalaw
areaineaskaest Virginiaode Islandw Ham
pshirewaii
w Mexico
braskassissippikansaswa ah lahom
ansasvadaabam
auisianaegonnnesseeuth Carolinannecticutarylandssourintuckynnesotasconsinzonadianarth Carolinaoradoorgiaginiaashingtonio chiganw Jersey
assachusettsnoisrida ylvaniaxasw York
ifornia
California vs State Averages ($ blns)California vs State Averages: Spending & Debt Per Capita
$1,500
$2,000
$2,500
Av$8
$10
$12
(Thousands)
$500
$1,000
Average
California
$2
$4
$6 Average
California
$0
Spending Debt GDP
$
Spending Debt
State & Local Finances: California Snapshot
$
r o w w s n n l n l c w n x r o w w s l n n n l c w n x l nne
r o l r o nns
erage
7
‐
�A continued rise in consumer spending and increased investment outlays will carry the economy going forward
�The combination of high corporate cash positions
Real GDP 1.6% 5.0% 3.7% 1.7% 2.6% 3.1% 3.0% PCE 1.4% 0.7% 1.3% 1.5% 1.7% 2.8% 1.6% Durable goods 1.4% -0.1% 0.6% 0.5% 0.5% 1.5% 0.7% Nondurable goods 0.3% 0.5% 0.7% 0.3% 0.4% 0.7% 0.5% Services -0.2% 0.3% 0.0% 0.7% 0.8% 0.7% 0.4%
0.6% Nonresidential -0.1% -0.1% 0.7% 1.5% 0.9% 0.7% 0.6%
-0.3% Equip & Soft 0.3% 0.9% 1.2% 1.5% 1.0% 0.5% 0.9%
0.0% 0.0% Chg Inventories $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
-0.3% +Exports 1.3% 2.6% 1.3% 1.1% 0.8% 1.1% 1.4%
-1.6% Government 0.3% -0.3% -0.3% 0.8% 0.8% -0.3% 0.2%
0.3% State and local -0.1% -0.3% -0.5% 0.1% 0.1% -0.3% -0.2%
Anatomy of the economy: Consumer & investment are vital
Anatomy of the Recovery & Incipient Expansion Contributions to GDP Growth by Sector
Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Average
Source: Commerce Dept
��Consumer spending & inventory accumulation haveConsumer spending & inventory accumulation have been the backbone of growth to-date
�The boost to growth from inventory accumulation is dissipating
and investment tax stimulus will boost investment spending in 2011, but borrow from 2012
�Real estate activity and construction will not play a significant role in the growth trajectory in 2011
�Trade is the direct link between Japan and the U.S. economy
�The indirect link with the financial markets and confidence has ggreater ppotential to adverselyy affect the U.S. in the short-term, but the markets are weathering the storm
�Reconstruction will boost U.S. exports to Japan & activity once it is underway
Fixed Investment
Structures
Residentiaesidential lR
Net Exports
-Imports
Federal
0.1%
-0.4%
0.3%0.3%
-1.4%
-2.7%
0.5%
-0.1%
-1.0%
0.0% 0.0%
1.9%
-0.7%
0.0%
0.4%
-0.5%
-0.3% 0.3%
-0.3%
-1.6%
0.2%
2.1%
0.0%
0.6%0.6%
-3.5%
-4.6%
0.7%
0.2% 0.8%
-0.1% 0.2%
-0.8% 0.8% 0.1%0.1%
-1.7% 3.3%
-2.5% 2.2%
0.7% 0.0%
8
Jobless Claims vs Unemployment Rate (%)
78
9101112
450
500
550
600
650
700
usands
Claims 4WKMA
UR
23
456
250
300
350
400
450
1/1/1
6/1/1
11/1
4/1/1
9/1/1
2/1/1
7/1/1
11/2
4/29
9/29
2/28
7/31
11/2
4/29
9/29
2/28
7/31
11/2
4/29
9/29
2/29
7/31
Thou
1980
1981
/1982
1984
1985
1987
1988
9/1989
/1991
/1992
/1994
/1995
9/1996
/1998
/1999
/2001
/2002
9/2003
/2005
/2006
/2008
/2009
Labor Market: Private sector payrolls up, unemployment down
�The labor market continues to pull itself out of a very deep hole
�Private sector payrolls increased by almost 1.3 million in 2010
�Jefferies projects that private sector payrolls will rise by roughly 2 million in 2011
�Recent unemployment claims are the lowest since July of 2008 and reflect improved market conditions
�Extended benefits caused the unemployment rate to remain stubbornly high and also contributed to large declines in the December and January unemployment rate
��The unemployment rate will dribble lower in the months and yearsThe unemployment rate will dribble lower in the months and years ahead
Source: Bureau of LaborStatistics
/////////////
9
State and local has
----- --------- - -
-
YoY Average Hourly Earnings vs Unemployment Rate
6
8
10
12
rcen
tAHE UR
0
2
4
1/1/4/1/7/1/10/11/1/4/1/7/1/10/11/1/4/1/7/1/10/11/1/4/1/7/1/10/11/1/4/1/7/1/10/11/1/4/1/7/1/10/11/1/
Pe
198019811982/1983198519861987/1988199019911992/1993199519961997/1998200020012002/2003200520062007/20082010
Labor Market: This is not a jobless recovery
�The recovery in the labor market has been slower since 1990 than was the case in the 1970 d 1980 1970s and 1980s
1980 -837,000 688,000 347,000 413,000 117,000 1981/1982 Recession 391,250
-----Quarterly Change in Private Sector Nonfarm Payrolls Peak to Trough Decline in Payrolls Trough +1 Trough +2 Trough +3 Trough +4 Trough +5 Trough +6 Trough +7 Average
The Labor Market In Recessions & R 1973 2011
1973/1975 -956,000 -160,000 673,000 663,000 991,000 351,000 508,000 452,000 496,857
�The good news is that private sector job growth 1981/1982 -2,710,000 296,000 916,000 1,202,000 1,013,000 1,179,000 953,000 736,000 899,286 has materialized earlier and been stronger in the Average -1,501,000 274,667 645,333 759,333 707,000 765,000 730,500 594,000 639,405 current cycle than in either of the prior “jobless” recoveries 1990/1991 -1,,280,,000 -325,,000 21,,000 -121,,000 -41,,000 297,,000 180,,000 479,,000 70,,000
2001 -1,630,000 -379,000 -165,000 -165,000 -64,000 -309,000 -53,000 188,000 -135,286
Trough +1 Trough +2 Trough +3 Trough +4 Trough +5 Trough +6 Trough +7 Average
�Conditions for faster private sector job growth 2007/2009 -7,311,060 -715,000 -386,000 81,000 342,000 312,000 438,000 564,000 90,857 are in place to offset losses in government Average -3,407,020 -473,000 -176,667 -68,333 79,000 100,000 188,333 410,333 -58,444
payrolls Source: Jefferies & Bureau of Labor Stat ist ics
�State and local government employment has government employment declined by a combined 459k, more losses are on the way as states grapple with bloated budget deficits
�There is a long way to go before the labor market is back to normal but the market is market is back to normal, but the market is headed in the right direction
�8.8 million private sector jobs were lost during the recession and the first two quarters of the recovery, and this reservoir of unemployed will lilimitit wage iincreases
Source: Bureau of LaborStatistics
r
2222222111111111111
10
‐
ISM Employment Indices
5055606570
ISM Employment Indices
202530354045
Manufacturing
Nonmanufacturing
Small Business: Optimism & Hiring Intentions
7/1/1997
2/1/1998
9/1/1998
4/1/1999
11/1/1999
6/1/2000
1/1/2001
8/1/2001
3/1/2002
10/1/2002
5/1/2003
12/1/2003
7/1/2004
2/1/2005
9/1/2005
4/1/2006
11/1/2006
6/1/2007
1/1/2008
8/1/2008
3/1/2009
10/1/2009
5/1/2010
12/1/2010
Composition of U.S. Labor Force: Private vs Government
5
0
5
10
15
20
25
95
100
105
110
17.0%
17.5%
18.0%
18.5%
19.0%
83%
83%
84%
84%
85%
30
25
20
15
10
5
75
80
85
90
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
Optimism Index Hiring Intentions
15.0%
15.5%
16.0%
16.5%
81%
82%
82%
1/1/19
5/1/19
9/1/19
1/1/19
5/1/19
9/1/19
1/1/19
5/1/19
9/1/19
1/1/19
5/1/19
9/1/19
1/1/19
5/1/19
9/1/19
1/1/20
5/1/20
9/1/20
1/1/20
5/1/20
9/1/20
1/1/20
5/1/20
9/1/20
Private Government
90
Jan90
Oct
91
Jul
92
Apr
93
Jan93
Oct
94
Jul
95
Apr
96
Jan96
Oct
97
Jul
98
Apr
99
Jan99
Oct
00
Jul
01
Apr
02
Jan02
Oct
03
Jul
04
Apr
05
Jan05
Oct
06
Jul
07
Apr
08
Jan08
Oct
09
Jul
10
Apr
11Jan
80
81
82
84
85
86
88
89
90
92
93
94
96
97
98
00
01
02
04
05
06
08
09
10
Labor Market: Tea leaves point to improvement & compositional change
�Indications from both the service and manufacturing ISM surveys point to continued hiring going forward
�There has also been an encouraging improvement in small business opptimism and hiringg intentions
�Small and medium-sized firms need to be the driving force job creation at this stage of the cycle
�The combination of private sector payroll growth and state & local ggovernment jjob losses have caused the ggovernment share of employment to decline
Source: Bureau of Laborstatistics & Jefferies
16 5%
Source: Institute os Supply Management
‐
‐
‐
‐
‐
‐
Source: National Federationof Independent Business
‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
11
Labor Market: Invisible hand at work, small & medium sized firms kick into gear Composition of AD Employment Data
�Job creation at small and medium sized firms
Level Changes Industry/ Size January F ebruary M arch January F ebruary M arch YT D 2010
Total private nonfarm 190 208 201 190 208 201 599 781
Small (1 - 49) 102 96 102 102 96 102 300 381 �Job creation at small and medium-sized firms is critical to job growth
�Hiring at small and medium-sized firms is off to an encouraging start in 2011
�The service sector continues to drive job
Small (1 49) 102 96 102 102 96 102 300 381 Medium (50-499) 82 101 82 82 101 82 265 441 Large (>499) 6 11 17 6 11 17 34 (41)
Goods-producing 30 21 37 30 21 37 88 (121)
S ll (1 49) 10 5 13 10 5 13 28 (115) �The service sector continues to drive job growth, but manufacturing employment has been on the rise
�Large firms continue to lag in job creation
�Construction remains mired in recession
Small (1 - 49) 10 5 13 10 5 13 28 (115) Medium (50-499) 17 19 21 17 19 21 57 41 Large (>499) 3 (3) 3 3 (3) 3 3 (47)
Service-providing 160 187 164 160 187 164 511 902
�Construction remains mired in recession Small (1 - 49) 92 91 89 92 91 89 272 496 Medium (50-499) 65 82 61 65 82 61 208 400 Large (>499) 3 14 14 3 14 14 31 6
Addendum: Manufacturing 26 20 37 26 20 37 83 78 g
Octo ber N o vember D ecember January F ebruary M arch YT D 2010
Total private nonfarm 79 122 246 190 208 201 599 781 Goods-producing (11) 21 26 30 21 37 88 (121) Service-providing 90 101 220 160 187 164 511 902 Manufacturing 2 19 29 26 20 37 83 78
12
Manufacturing 2 19 29 26 20 37 83 78 Construction & Mining (13) 2 (3) 4 1 0 5 (199) Source: ADP
$
8
10
12
$10.0
$20.0
$30.0
Consumer Credit vs Savings Rate (%)
Consumer CreditSavings Rate
0
2
4
6
$30.0
$20.0
$10.0
$0.0
1/1/1980
6/1/1981
11/1/1982
4/1/1984
9/1/1985
2/1/1987
7/1/1988
11/29/1989
4/29/1991
9/29/1992
2/28/1994
7/31/1995
11/29/1996
4/29/1998
9/29/1999
2/28/2001
7/31/2002
11/29/2003
4/29/2005
9/29/2006
2/29/2008
7/31/2009
Personal Income & Consumption
810121416
(YoY % Change)
Income Consumption
420246
1 4 7 1 1 4 7 1 1 4 7 1 1 4 7 1 1 4 7 1 1 4 7 1 1
/1/1980
/1/1981
/1/1982
0/1/1983
/1/1985
/1/1986
/1/1987
0/1/1988
/1/1990
/1/1991
/1/1992
0/1/1993
/1/1995
/1/1996
/1/1997
0/1/1998
/1/2000
/1/2001
/1/2002
0/1/2003
/1/2005
/1/2006
/1/2007
0/1/2008
/1/2010
Consumers: Making ends meet, setting an example for government �Consumers have restructured balance sheets by reducing debt and increasing savings
� The reduction in the payroll tax will expedite this restructuringg pprocess and also support sppendingpp g
� Job growth and the consequential increase in income will support somewhat faster spending going forward
�If sustained, the rise in gasoline prices will cause some reductions in discretionary spendingg
‐
‐
‐
Source: Jefferies & Bloomberg
y p
�The ongoing struggles in the housing market will limit the ability of consumers to increase leverage to accelerate spending
‐‐
Source: Jefferies & Bloomberg
/0///0///0///0///0///0///
13
�
1500
2000
2500
Housing Starts & Permits
0
500
1000
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
Starts Permits
1/1980
1/1981
1/1982
/1/1983
1/1985
1/1986
1/1987
/1/1988
1/1990
1/1991
1/1992
/1/1993
1/1995
1/1996
1/1997
/1/1998
1/2000
1/2001
1/2002
/1/2003
1/2005
1/2006
1/2007
/1/2008
1/2010
Home Prices: Median & Case Shiller(YoY % Ch )
05101520
(YoY % Change)
252015105
1/1
6/1
11
4/ 1
9/1
2/1
7/1
12
5/ 1
10
3/ 1
8/1
1/1
6/1
11
4/ 1
9/1
2/1
7/1
12
5/ 1
10
3/ 1
8/1
1/1
6/1
11
Median
Case Shiller
1/2000
1/2000
/1/2000
1/2001
1/2001
1/2002
1/2002
/1/2002
1/2003
/1/2003
1/2004
1/2004
1/2005
1/2005
/1/2005
1/2006
1/2006
1/2007
1/2007
/1/2007
1/2008
/1/2008
1/2009
1/2009
1/2010
1/2010
/1/2010
Housing: Bouncing along the bottom, regional imbalances
H i S & i �The 21.8% unemployment rate in the construction industry is the highest of any sector of the economy, and there is no significant relief in sight
�The good news in the housing sector is that the worst days are over, however
� Housing starts, building permits and new home sales are all hovering near historical low levels with no evidence of upward momentum upward momentum
� The housing sector will continue to bounce along the bottom in 2011, into 2012, and quite possibly beyond, but the housing data also reflects regional imbalances
Home pprices appear to have bottomed, althouggh thepp ,
Source: Jefferies & Bloomberg
ange
evidence is not yet totally compelling because of the high percentage of distressed sales
�Nevada, Arizona, Florida, Michigan and parts of California continue to have severely distressed housing & mortgage markets high Loan to Value ratios markets, high Loan-to-Value ratios
‐‐�These five states account for a disproportionate share of ‐problem mortgages and have housing markets that lag other ‐parts of the country ‐
di
Source: Jefferies & Bloomberg /// / // /
14
5
10
15
20
Inventories vs Production, YoY % Change
15
10
5
0
5
Inventories Production
20 1/1/1980
7/1/1981
1/1/1983
7/1/1984
1/1/1986
7/1/1987
1/1/1989
7/1/1990
1/1/1992
7/1/1993
1/1/1995
7/1/1996
1/1/1998
7/1/1999
1/1/2001
7/1/2002
1/1/2004
7/1/2005
1/1/2007
7/1/2008
1/1/2010
YoY Production vs Capacity
0
5
10
15
75
80
85
90
15
10
5
60
65
70
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
1/1/
Capacity
Industrial Production
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Manufacturing: Whirring, whittling away at excess capacity
�Inventory rebuilding and manufacturing activity have played a decisive leadership role in the recovery and the incipient expansion
��The recovery has reached the stage where inventories areThe recovery has reached the stage where inventories are likely to provide less of a lift, although the drag on Q4, 2010, GDP is not likely to be repeated
� Investment tax incentives should help to boost investment spending, new orders and manufacturing activity in 2011
� However, some of the increased investment spending in 2011 will come at the expense of investment spending in 2012
� Despite the recovery in manufacturing activity, utilization rates are low and unemployment is high
� The unemployment rate in the manufacturing sector is 9.9%
�The capacity utilization rate of 76.3% compares with a 30-year average of 79.9%, peak of 85.2% and trough of 68.2%
‐
‐
‐
‐
p y
Source: Federal Reserve
‐
‐
‐
15
810121416
CPI & "Core CPI, YoY % Change
CPI Core CPI
4-20246
4 Jan80
Jan83
Jan86
Jan89
Jan92
Jan95
Jan98
Jan01
Jan04
Jan07
Jan10
Core CPI vs Smoothed Cleveland Fed Median CPI Core CPI vs Core Pce Deflator, YoY % Change
3 0%
4.0%
5.0%
6.0%
8
10
12
14
16
Core PCE Deflator
Core CPI
0.0%
1.0%
2.0%
3.0%
1 5 9 1 5 9 1 5 9 1 5 9 1 5 9 1 5 9 1 5 9
0
2
4
6
1/1
4/1
7/1
10
1/ 14/1
7/1
10
1/ 14/1
7/1
10
1/ 1
4/17/1
10
1/ 1
4/17/1
10
1/ 1
4/1
7/110
1/ 1
/1/1984
/1/1985
/1/1986
/1/1988
/1/1989
/1/1990
/1/1992
/1/1993
/1/1994
/1/1996
/1/1997
/1/1998
/1/2000
/1/2001
/1/2002
/1/2004
/1/2005
/1/2006
/1/2008
/1/2009
/1/2010
1/1980
1/1981
1/1982
/1/1983
1/19851/1986
1/1987
/1/1988
1/19901/1991
1/1992
/1/1993
1/1995
1/19961/1997
/1/1998
1/2000
1/20011/2002
/1/2003
1/2005
1/2006
1/2007/1/2008
1/2010
Inflation: Low, but headed higher gradually
CPI & "C " CPI Y Y % Ch
�Headline and core inflation remain low, but disinflation and the threat of deflation have abated
�Core prices have stabilized and will continue to creep higher as the year progresses
"
the year progresses
�The surge in commodity prices continues to cause a divergence between headline and core inflation readings
Source: Bureau of LaborStatistics
-
- - - - - - - - - - -
Source: Bureau of Labor Statistics & Federal Reserve Bank of Cleveland Source: Bureau of LaborStatistics & Jefferies
//////
16
1 9 1 9 1 9 1 9 1 9 1 9 1 9
20
30
40
50
9
11
13
15
CPI, Core CPI & Commodities( YoY % Change)
CPI Core CPI Commodities
30
20
10
0
10
1
1
3
5
7
403
1/1/1980
6/1/1981
11/1/1982
4/1/1984
9/1/1985
2/1/1987
7/1/1988
11/29/1989
4/29/1991
9/29/1992
2/28/1994
7/31/1995
11/29/1996
4/29/1998
9/29/1999
2/28/2001
7/31/2002
11/29/2003
4/29/2005
9/29/2006
2/29/2008
7/31/2009
Dollar Index vs Spot CRB
100
110
120
130
450
500
550
600
650
CRB Dollar
60
70
80
90
200
250
300
350
400
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
1/1
2/1990
2/1991
2/1992
2/1993
2/1994
2/1995
2/1996
2/1997
2/1998
2/1999
2/2000
2/2001
2/2002
2/2003
2/2004
2/2005
2/2006
2/2007
2/2008
2/2009
2/2010
2/2011Inflation: Commodity surge, know when to hold ‘em
�Commodity prices tend to be far more volatile than more general inflation readings
� This is why the FOMC described the rise in inflation from the run-up in commodity prices, including food and energy, as being “transitory”
�The FOMC is effectively taking a gamble that the upward pressure on commodity prices abates in the months ahead pressure on commodity prices abates in the months ahead
�Since the U.S. economy and inflation indices are dominated by the service sector, the rise in commodity prices has a more muted effect on the U.S. economy and inflation measures than countries that are more commodity-based
‐
‐
‐
20
‐
9
Source: Bureau of Labor Statistics & Bloomberg
‐‐
�Movement in commodity prices tends to be exacerbated by movement in the dollar
�A weaker dollar will support economic growth & boost both commodity inflation and import prices
Source: Bloomberg
17
8.0%
10.0%
12.0%
14.0%
16.0%
nt
CPI vs Housing (YoY% Change)
YoY CPI YoY Housing
4.0%
2.0%
0.0%
2.0%
4.0%
6.0%
Perc
en
Jan81
Jan83
Jan85
Jan87
Jan89
Jan91
Jan93
Jan95
Jan97
Jan99
Jan01
Jan03
Jan05
Jan07
Jan09
Jan11
Inflation: Ripple effects of housing
�Th The di disi fl ti inflationary i fl influence of the hhousing componentts of thef th i f th CPI has abated
�The effect of the housing components on the CPI varies by region, but is no longer disinflationary
��The convergence of regional inflation rates is primarily due toThe convergence of regional inflation rates is primarily due to the convergence of the housing components
‐
‐
Source: Bureau of LaborStatistics
‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
CPI: Component & Regional Breakdown Change in CPI: August, 2010, to February, 2011
(YoY Percent Change) Northeast Midw est South West National
CPI 0.6% 0.7% 1.1% 1.2% 1.0% Core CPI -0.2% 0.1% 0.1% 0.6% 0.2% Food 0.9% 1.0% 1.3% 1.4% 1.3% E 0% 4% 8 8% 9 2% 8 2%
Northeast Midw est South West National August F ebruary August F ebruary August F ebruary August F ebruary August F ebruary
CPI 1.4% 2.0% 1.5% 2.2% 1.1% 2.2% 0.7% 1.9% 1.1% 2.1% Core CPI 1.3% 1.1% 1.0% 1.1% 1.0% 1.1% 0.4% 1.0% 0.9% 1.1% Food 1.6% 2.5% 1.2% 2.2% 0.9% 2.2% 0.9% 2.3% 1.0% 2.3% E 2 8% 9 8% 3 9% 11 3% 2 4% 11 2% 2 1% 11 3% 2 8% 11 0% Energy 7.0% 7.4% 8.8% 9.2% 8.2%
Housing 0.7% 0.4% 1.5% 1.4% 1.1% OER -0.1% 0.7% 1.3% 1.4% 0.9% Rent 0.0% 0.3% 1.3% 2.1% 1.1%
0.0% 0.0% 0.0% 0.0% 0.0% Commodities 1.5% 1.6% 1.4% 1.3% 1.4% S i 0 2% 0 1% 1 0% 1 1% 0 6%
Energy 2.8% 9.8% 3.9% 11.3% 2.4% 11.2% 2.1% 11.3% 2.8% 11.0% Housing 0.1% 0.8% 0.1% 0.5% -0.5% 1.0% -1.1% 0.3% -0.4% 0.7% OER 0.5% 0.4% 0.2% 0.9% -0.1% 1.2% -1.4% 0.0% -0.3% 0.6% Rent 1.9% 1.9% 0.8% 1.1% -0.8% 0.5% -1.0% 1.1% 0.0% 1.1%
0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Commodities 2.2% 3.7% 1.6% 3.2% 1.5% 2.9% 1.6% 2.9% 1.7% 3.1% S i 0 9% 1 1% 1 4% 1 5% 0 8% 1 8% 0 2% 1 3% 0 8% 1 4%
18
Services 0.2% 0.1% 1.0% 1.1% 0.6% Source: Bureau of Labor Statistics & Jefferies
Services 0.9% 1.1% 1.4% 1.5% 0.8% 1.8% 0.2% 1.3% 0.8% 1.4% Source: Bureau of Labor Statistics & Jefferies
t t t
10 Y B k S d
2
2.5
3
3.510 Year Breakeven Spreads
0
0.5
1
1.5
1/8/ 3/ 10 4/ 116/ 127/ 2/8/ 3/ 10 4/ 116/ 127/ 2/8/ 3/ 10 4/ 116/ 12
/0/1900/22/1997/13/19980/2/1998/23/19991/12/1999/2/20002/22/2000/13/2001/1/2002/23/2002/14/20030/3/2003/23/20041/12/2004/3/20052/23/2005/14/2006/2/2007/24/2007/14/20080/3/2008/24/20091/13/2009/4/20102/24/2010
6.0YoY CPI vs U of M Inflation Expectations5yr5yr forward
1.0
2.0
3.0
4.0
5.0
1 5
2
2.5
3
3.5
3.0
2.0
1.0
0.0
199
199
199
199
199
199
200
200
200
200
200
200
200
200
200
200
200
200
200
200
200
201
201
U of M Expectations CPI
0
0.5
1
1.5
04/06/08/10/12/02/04/06/08/10/12/02/04/06/08/10/12/02/04/06/08/10/12/02/ 6
0101
60901
70501
80101
80901
90501
00101
00901
10501
20101
20901
30501
40101
40901
50501
60101
60901
70501
80101
80901
90501
00101
00901
26/0726/0726/0726/0726/0726/0826/0826/0826/0826/0826/0826/0926/0926/0926/0926/0926/0926/1026/1026/1026/1026/1026/1026/11
Inflation: Expectations, anchors and public relations
�The TIPS market suggests that perceptions of deflation risks have abated, while longer-term inflation expectations remain anchored …for now
�The rise in commodity prices –especially gasoline and food priices– hhas caused consumer expectatiions of inflation tod f i fl ti spike well above actual inflation
�The rise in gasoline and food prices creates a significant public relations problem for the Fed which focuses on “core” price indices that exclude food and energy prices
�The rise in food and energy prices has also increased friction among policymakers at the Fed
‐
Source: Bloomberg
‐
‐
‐Source: Bloomberg
9 ‐‐
9 ‐‐
9 ‐‐
9 ‐‐
9 ‐‐
9 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
0 ‐‐
1 ‐‐
1 ‐‐
19
�
Historical Rate Movement
10
12
14
16
18
ent
Historical Rate Movement
2yr
5yr
10yr
0
2
4
6
8
1 4 7 10
1 4 7 10
1 4 7 10
1 4 7 10
1 4 7 10
1 4 7 10
1
Perc 30yr
20Volcker to Bernanke
/1/1980
/1/1981
/1/1982
0/1/1983
/1/1985
/1/1986
/1/1987
0/1/1988
/1/1990
/1/1991
/1/1992
0/1/1993
/1/1995
/1/1996
/1/1997
0/1/1998
/1/2000
/1/2001
/1/2002
0/1/2003
/1/2005
/1/2006
/1/2007
0/1/2008
/1/2010
5
10
15
Percen
t
Fed Funds 30 yr YoY CPI
5
0
Jan70
Oct
71Jul73Apr
75Jan
77Oct
78Jul80Apr
82Jan
84Oct
85Jul87Apr
89Jan
91Oct
92Jul94Apr
96Jan
98Oct
99Jul01Apr
03Jan
05Oct
06Jul08Apr
10Monetary Policy: Volcker to Bernanke, ending a 30 year disinflationary trend
�The bond market appears to be at the end of a 30-year secular declining rate trend
e
�Extraordinarily tight monetary policy during Paul Volcker’s regime caused two recessions in three years and also initiated a 30-year secular disinflationary trend that fostered lower rates
�This disinflationary trend had the potential to evolve into outright deflation if it persistedpersisted, which is why monetary policy has been anddeflation if it which is why monetary policy has been and remains extraordinarily accommodative
�Ben Bernanke is attempting to resuscitate the economy and preempt deflation so it does not evolve into outright deflation
Calibrating monetary policy to prevent deflation without generating Calibrating monetary policy to prevent deflation without generating inflation poses a unique policy challenge
�The FOMC focus on core inflation measures suggests that the Fed will move toward the exit strategy will be gradual
Source: Bloomberg & Jefferies
///////////////////
‐
‐
‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐
20
$2,000,000
$2,500,000
$3,000,000
Federal Reserve Balance Sheet
OtherEmergency LendingTargeted LendingS T Lending
$0
$500,000
$1,000,000
$1,500,000
1 4 7 1 1 4 7 1 1 4 7 1 1 4 7 1 1
Securities Portfolio
/23/2007
/23/2007
/23/2007
0/23/20 …
/23/2008
/23/2008
/23/2008
0/23/20…
/23/2009
/23/2009
/23/2009
0/23/20 …
/23/2010
/23/2010
/23/2010
0/23/20 …
/23/2011
Fed Securities Portfolio12
JEF Taylor Rule vs Alternative
$600 000
$800,000
$1,000,000
$1,200,000
$1,400,000
Treasuries Agencies
MBS
024681012
Percen
t
Fed Funds
Jefferies Taylor Rule
$0
$200,000
$400,000
$600,000
1/17/
3/17/
5/17/
7/17/
9/17/
11/17
1/17/
3/17/
5/17/
7/17/
9/17/
11/17
1/17/
3/17/
5/17/
7/17/
9/17/
11/17
1/17/
3/17/
5/17/
7/17/
9/17/
11/17
1/17/
108642
1/31/1
1/31/1
1/31/1
1/31/1
1/31/1
1/31/1
1/31/1
1/31/2
1/31/2
1/31/2
1/31/2
1/31/2
1/31/2
1/31/2
P y
Alternative Taylor Rule
2007
2007
2007
2007
2007
/2007
2008
2008
2008
2008
2008
/2008
2009
2009
2009
2009
2009
/2009
2010
2010
2010
2010
2010
/2010
2011
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
Monetary Policy: Taylor Made…balance sheet & fed funds rate
�The Fed balance sheet is aggain in the pprocess of exppandingg and will exceed $2.75 trillion due to the ongoing $600 billion LSAP
� Once the ongoing $600 billion LSAP has been completed, bank excess reserves will exceed $1.5 trillion
�The fed funds rate target has been in a 0% to 25 bps range for more than two years as part of the Fed’s anti-deflation defense
�The Fed will debate shrinking the balance sheet over the course of 2011
�The first steps will be to allow MBS and Treasury proceeds to roll-off
�2012 will be when the Fed enters the exit in earnest
‐
Source: Jefferies & Federal Reserve
Jefferies Ta lor Rule
Source: Federal Reserve & Jefferies
Source: Jefferies & Federal Reserve
222222222222222222222 7 7 7 7
21
‐‐‐‐‐
$1,400.00
$1,600.00
$1,800.00
Snapshot of Selected Commercial Bank Assets
C&I Loans Consumer Loans
Gov t Securities
$400.00
$600.00
$800.00
$1,000.00
$1,200.00
1/17/2007
4/17/2007
7/17/2007
10/17/2007
1/17/2008
4/17/2008
7/17/2008
10/17/2008
1/17/2009
4/17/2009
7/17/2009
10/17/2009
1/17/2010
4/17/2010
7/17/2010
10/17/2010
1/17/2011
Bank Excess Reserves25%6000
YoY C&I Loans (%) vs Payrolls (12 mo Change in thousands)
$800,000
$1,000,000
$1,200,000
$1,400,000
5%
0%
5%
10%
15%
20%
25%
2000
0
2000
4000
6000
$0
$200,000
$400,000
$600,000
1/3/2007 1/3/2008 1/3/2009 1/3/2010 1/3/2011
25%
20%
15%
10%
8000
6000
4000
1/1/1981
5/1/1982
9/1/1983
1/1/1985
5/1/1986
9/1/1987
1/1/1989
5/1/1990
9/1/1991
1/1/1993
5/1/1994
9/1/1995
1/1/1997
5/1/1998
9/1/1999
1/1/2001
5/1/2002
9/1/2003
1/1/2005
5/1/2006
9/1/2007
1/1/2009
5/1/2010
Payrolls C&I Loans
1 2 3 5 6 7 9 0 1 3 4 5 7 8 9 1 2 3 5 6 7 9 0
Monetary Policy: Bank loans, transmission breakdown or cyclical lag?
•Fed balance sheet expansion and the consequential increase in bank excess reserves have yet to foster significant bank lending
•Bank C&I lending tends to lag the business cycle, so the slow recovery in lending is not atypical recovery in lending is not atypical
•C& I lending has begun to creep higher, but consumer lending continues to contract
�Once banks feel more confident about taking on more credit risk they will have an enormous reservoir of reserves to fuel risk, they will have an enormous reservoir of reserves to fuel increased lending
' Source: Jefferies & Federal Reserve
‐‐
Source: Jefferies & Federal Reserve
‐
‐
‐
‐
‐
‐
‐
Source: Jefferies & Federal Reserve
22
-
e o es S Co ss o o des a a e o o
4000
5000
6000
U.S. Budget: History & CBO Projections ($millions)
Re i t
0
1000
2000
3000
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2
Receipts
Outlays
950953956959962965968971974977980983986989992995998001004007010013016019
29
Receipts & Outlays vs GDP (%) Actual vs Projected
21
23
25
27
29
Outlays/GDP Receipts/GDP
15
17
19
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
2016
2020Fiscal Policy: Political irresponsibility in the age of entitlement
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2
�The current schism in FY11 appropriations negotiations is over scraps from outlays of more than $3.4 trln
�The December 2010 decision to extend tax cuts & unempp yloyment ce p s
benefits, cut payroll and business investment taxes will increase the size of the FY11 budget deficit to roughly $1.45 trillion from $1.342 trillion in FY10
�Without significant remedial action, the budget deficit will remain massive and threaten long-term prosperity massive and threaten long term prosperity
� As a share of GDP, outlays remain well above the historical norm of about 21% of GDP
� As a share of GDP, revenues remain well below the historical norm of 18% of GDP 18% of GDP Congress has taken no steps to address these Congress has taken no steps to address theseof . imbalances
� The U.S. risks losing its AAA credit rating as early as 2015 unless dramatic steps are taken to both increase revenue and cut spending
� The Bowles-Simpson Commission provides a good framework forpso p good deficit reduction negotiations over the next two years
23
�
Fiscal Policy: No BS, Bowles-Simpson Commission Recommendations The Bowles-Simpson Commission provides a realistic and workable framework for deficit reduction negotiations.
It is a program of shared pain, but it is not clear if there is the political will adopt the B-S recommendations without the threat of losing the AAA credit rating.
Recommendations include:
� Capping both government expenditures and revenue at 21% of GDP, which would result in reduced spending and higher taxes to balance the budget
Forcingg Con ggress to undertake compprehensive tax reform byy 2012 byy raisin gg taxes for each yyear Conggress fails to act
� Simplifying the tax code by reducing the tax brackets to three personal brackets and one corporate rate, and eliminating all credits and deductions
� Increasingg the Social Securityy contribution ceilingg, indexingg the retirement agge to longgevityy and basingg benefits on means testing
� Limiting tax collections to income earned within the United States
� Increasing Medicaid co-pays
� Capping for Medicaid/Medicare growth & forcing Congress and the President to increase premiums or co pays� Capping for Medicaid/Medicare growth & forcing Congress and the President to increase premiums or co-pays and/or raise the Medicare eligibility age in the event of cost overruns
� Eliminating all earmarks
� Freezing federal worker wage increases through 2014, eliminating 200,000 federal jobs and 250,000 federal non defense contractor jobs non-defense contractor jobs
� Reducing military forces in Europe and Asia by one-third
24
Treasury: MBS “wind down” reduces borrowing needs, debt ceiling hike still needed
P ro jected 2s 3s 5s 7s 10s 30s T IP S5 T IP S10 T IP S30 T o tal M aturing N et C o upo n
P ro jected 2011 T reasury C o upo n C ash F lo ws
�Treasury MBS sales will reduce borrowing needs by more than $140 bln over the next year Nov $35.0 $32.0 $35.0 $29.0 $24.0 $16.0 $10.0 $181.0 $48.4 $132.6 $25.0
Oct $35.0 $32.0 $35.0 $29.0 $21.0 $13.0 $10.0 $175.0 $45.9 $129.1 $7.0
�This reduces the need to increase the size of Dec $35.0 $32.0 $35.0 $29.0 $21.0 $13.0 $165.0 $47.9 $117.1 $5.0
Jan $35.0 $32.0 $35.0 $29.0 $21.0 $13.0 $13.0 $178.0 $64.8 $113.2 $10.0 auction sizes later this year Feb $35.0 $32.0 $35.0 $29.0 $24.0 $16.0 $10.0 $181.0 $75.5 $105.5 $32.0
�Congress will need to raise the $14.294 trillion M ar $35.0 $32.0 $35.0 $29.0 $21.0 $13.0 $11.0 $176.0 $54.5 $121.5 $5.0 debt ceiling by mid-Q2 Apr $35.0 $32.0 $35.0 $29.0 $21.0 $13.0 $12.0 $177.0 $71.6 $105.4 $6.0
M ay $35.0 $32.0 $35.0 $29.0 $24.0 $16.0 $11.0 $182.0 $49.2 $132.8 $26.0 �Treasury may revert to “extraordinary measures” Jun $35.0 $32.0 $35.0 $29.0 $21.0 $13.0 $9.0 $174.0 $55.2 $118.8 $6.0 to avoid a debt ceiling violation if necessary July $36.0 $33.0 $36.0 $29.0 $21.0 $13.0 $13.0 $181.0 $56.9 $124.1 $26.0
�These sales are independent of monetary policy August $36.0 $33.0 $36.0 $29.0 $24.0 $16.0 $11.0 $185.0 $81.8 $103.2 $6.0 and future Fed asset sales
September $37.0 $34.0 $37.0 $29.0 $21.0 $13.0 $11.0 $182.0 $57.8 $124.2 $26.0
FY'11 Total $424.0 $388.0 $424.0 $348.0 $264.0 $168.0 $33.0 $69.0 $19.0 $2,137.0 $709.5 $1,427.5
Source: Jefferies
25
C J 11 D 10 N 10 O 10 S 10 A 10- - -
40%
50%
60%
% Of Treasuries Owned by Foreign Investors
$2,500,000
$2,600,000
$2,700,000
Fed Custody Holdings of Treasuries for Central Banks (Thousands)
0%
10%
20%
30%
Ma
Au JanJunN
oA
p Se FeJulD
eM
aO
cM
aAu JanJunN
oA
p Se FeJulD
eM
aO
cM
aAu
$2,000,000
$2,100,000
$2,200,000
$2,300,000
$2,400,000
25 25 25 25 25 25 25 25 25 25
25 25 25 25 25 25 25 25 25
ar-00g-00n
-01n
-01v-01r-02p-02b-03-03c-03
ay-04t-04
ar-05g-05n
-06n
-06v-06r-07p-07b-08-08c-08
ay-09t-09
ar-10g-10
5Aug
09
5Sep
09
5Oct
09
5Nov
09
5Dec
09
5Jan
10
5Feb
10
5Mar
10
5Apr
10
5May
10
5Jun
10
5Jul10
5Aug
10
5Sep
10
5Oct
10
5Nov
10
5Dec
10
5Jan
11
5Feb
11Treasury: Still reliant on overseas investors
M ajo r F o reign H o ldings o f T reasury Securit ies
C o untry Jan 11 D ec-10 N o v 10 Oct-10 Sep 10 A ug-10
China, M ainland $1,154.7 $ 1,160.1 $ 1,164.1 $1,175.3 $1,151.9 $1,136.8
�The U.S. is still heavily reliant on overseas investors, especially central banks, to fund the budget deficits
�Overseas investors hold roughly 50% of U.S. Treasuries t t di outstanding
�China is still the largest holder of Treasury debt, but has been shortening the maturity structure of holdings
�Estimates of China’s holdings were revised higher by $351 bln as of June 2010
Japan $885.9 $882.3 $875.9 $873.6 $860.8 $832.5
United Kingdom $278.4 $272.1 $242.5 $209.2 $190.5 $181.0
Oil Exporters $215.5 $211.9 $204.3 $207.8 $215.4 $211.7
Brazil $197.6 $186.1 $189.8 $183.0 $181.0 $170.5
Carib Bnkng Ctrs 4g $166.5 $168.1 $158.8 $146.3 $157.7 $172.6
Taiwain $157.2 $155.1 $154.4 $154.5 $153.3 $153.4
Russia $139.3 $151.0 $167.3 $176.3 $173.3 $173.7
Hong Kong $128.1 $134.2 $134.9 $135.2 $131.9 $ 133.9
Switzerland $ 107.6 $ 107.0 $ 107.0 $ 107.7 $ 110.0 $ 113.0
Canada $86.6 $76.8 $76.9 $66.2 $56.5 $44.9
Other $1,022.6 $1,010.4 $1,013.5 $ 1,004.2 $998.3 $992.7
$351 bln as of June, 2010
�Global central banks tempered purchases of Treasury securities after QE2, but have been more active recently
Grand Total $4,453.4 $4,438.3 $4,412.5 $4,373.1 $4,324.1 $4,271.8
Private $1,303.7 $1,282.2 $1,231.4 $1,171.0 $1,156.9 $1,152.6
For. Official $3,149.7 $3,156.1 $3,181.1 $3,202.1 $3,167.2 $3,119.2
Treasury B ills $438.9 $462.3 $499.2 $531.3 $495.4 $486.9
T-Bonds & Notes $2,710.8 $2,693.8 $2,681.9 $2,670.8 $2,671.8 $2,632.4
30% $
g p g p g
Source: Jefferies & Federal Reserve
c c ‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
‐‐
26
t t
$
Bond Stripping (%) vs Curve
1 50
2.00
2.50
3.00
3.50
4.00
75%
80%
85%
90%
95%
pp g (%)
Bonds Share of Total
2s vs 30s
1.00
0.50
0.00
0.50
1.00
1.50
50%
55%
60%
65%
70%
JanMa
Ma
JulSe No
JanMa
Ma
JulSe No
JanMa
Ma
JulSe No
JanMa
Man87
ar88
ay89
90p91
v92
n94
ar95
ay96
97p98
v99
n01
ar02
ay03
04p05
v06
n08
ar09
ay10
$190,000
Stripped Bonds Outstanding
$160,000
$170,000
$180,000
$120,000
$130,000
$140,000
$150,000
Jan 93 Jan 95 Jan 97 Jan 99 Jan 01 Jan 03 Jan 05 Jan 07 Jan 09
Treasury: Steep curve engenders stripping
Bond Stri in vs Curve
‐
‐
p p p ‐ ‐ ‐‐ ‐
o ‐ ‐ ‐ ‐‐ ‐
o ‐ ‐ ‐ ‐‐ ‐
o ‐ ‐ ‐ ‐
�The steep slope of the curve has fostered record t i i istripping actiivity
�Pension funds and insurance companies, both domestic and overseas, have been actively purchasing long -term Treasury zero coupons to extend duration exposure
‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
27
�
Historical Rate Movement
10
12
14
16
18
ent
Historical Rate Movement
2yr
5yr
10yr
0
2
4
6
8
1 4 7 10 1 4 7 10 1 4 7 10 1 4 7 10 1 4 7 10 1 4 7 10 1
Perc 30yr
4 5
Current Cycle Coupon Spreads vs 2 year (%) Historical Cyclical Coupon Curve Movement/1/1980
/1/1981
/1/1982
0/1/1983
/1/1985
/1/1986
/1/1987
0/1/1988
/1/1990
/1/1991
/1/1992
0/1/1993
/1/1995
/1/1996
/1/1997
0/1/1998
/1/2000
/1/2001
/1/2002
0/1/2003
/1/2005
/1/2006
/1/2007
0/1/2008
/1/2010
1.52
2.53
3.54
4.5
2s v 3s
2s v 5s
2s v 7s
2s v 10s0 5
1.0
1.5
2.0
2.5
3.0
ercent
-1-0.5
00.5
1
01 04 07 10 01 04 07 10 01 04 07 10 01 04 07 10 01 04 07 10 012s vs 30s
1.5
1.0
0.5
0.0
0.5
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
4/1
7/1
10/
1/1
P
2s v 5s 5s v 10s 10sa v 30s 2s v 30s
/02/06/02/06/02/06/02/06/02/07/02/07/02/07/02/07/02/08/02/08/02/08/02/08/02/09/02/09/02/09/02/09/02/10/02/10/02/10/02/10/02/11
1/1980
1/1981
1/1982
/1/1983
1/1985
1/1986
1/1987
/1/1988
1/1990
1/1991
1/1992
/1/1993
1/1995
1/1996
1/1997
/1/1998
1/2000
1/2001
1/2002
/1/2003
1/2005
1/2006
1/2007
/1/2008
1/2010
Appendix: Rates & Curve Perspective
� The Fed’s QE2 is intended to reflate the economy and will � The Fed s QE2 is intended to reflate the economy and will cause both inflation and inflation expectations to rise
�QE2 marks the end of a 30-year secular disinflationary trend that was initiated during the Volcker years
The slope of the curve will remain steep due to rising inflationThe slope of the curve will remain steep due to rising inflation, rising inflation expectations, the end of QE2, expectations of stronger growth, the threat to the U.S. AAA credit rating and the eventual need for the Fed to sell assets prior to raising the fed funds rate.
P
e
Source: Bloomberg &Jefferies
///////////////////-
1.5
/ / / / / / / / / / / / / / / / / / / / /
Source: Bloomberg & Jefferies
‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐‐
‐
‐
28
e e t o o d a ust a a a c a se ces ce se u de t e ct e o t e o s o o ce ta a c a se ces to o esa e c e ts
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