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Beyond August 2

Conference Call Presentation PackageJuly 21, 2011

Long-Term Interest Rates - 1900 to 2010

Bianco Research L.L.C.An Arbor Research & Trading Affiliated Company

Independent Objective Original

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Bianco Research, L.L.C July 21, 2011 2

Bianco Research, L.L.C 2

Summary/Conclusion

Debt Ceiling

We believe a debt deal will happen at the last minute, around or slightly after August 2. If not:

The risk of default in the days/weeks after August 2 is unlikely. Washington has enough money for debtservice and Social Security. It might have to make these payments priorities, opting instead to shut downmajor parts of the government. This could severely contract the economy and lead to a rally in Treasurybonds.

Washington does not get it. This is not about getting a deal and being done with it. Rather, the marketsare more concerned about the details. Moodys has again warned that this deal better be substantial orthe U.S. will lose its Aaa rating, even if the debt ceiling is raised.

Some in Washington are secretly hoping for market instability to help everyone focus on the debt ceiling.Those hoping for this need to be careful what they wish for. Once markets become unstable, reiningthem back in becomes difficult. See TARP. See Greece circa May 2010.

The Economy

We like to categorize economic statistics into leading, coincident, and lagging camps. Currently theleading indicators are struggling, suggesting the economy is going to disappoint for a while longer. Theeconomy has stopped disappointing, but this appears to be more about economists downgrading theiroutlook in line with reality than the economy actually getting better.

Federal Reserve Policy When Does The Fed Do QE3

The economy, inflation, and the stock market will ultimately drive Federal Reserve policy. Thesemeasures are not bad enough now for QE3, but if they get worse, dont be shocked if the FederalReserve moves in this direction. This possibility will act as a floor for risk-on markets.

European Prices

European yields suggest the situation in the EU is getting worse. Contagion is a very serious fear as themarkets in Spain and Italy continue to deteriorate.

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Bianco Research, L.L.C July 21, 2011 4Bianco Research, L.L.C 4

Government Spending As A Percentage of GDP

Total Outlays (Spending) To GNP/GDP

1953

20.75%

1813, 3.86%

1942

21.74%

2011est.

25.36%

1946, 23.73%

1943, 39.61%

1944, 41.56%

1865, 14.46%

1919, 23.44%

1945, 41.54%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1791

1801

1811

1821

1831

1841

1851

1861

1871

1881

1891

1901

1911

1921

1931

1941

1951

1961

1971

1981

1991

2001

2011

2021

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Civil War

WW1

WW21791 to 1928 = GNP

1929 to 2010 = GDP

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http://moneyland.time.com/2011/07/19/our-real-debt-problem/http://curiouscapitalist.blogs.time.com/2011/07/12/what-to-do-with-the-debt-ceiling-get-rid-of-it/http://www.reuters.com/article/2011/07/19/us-usa-debt-moodys-idUSTRE76I52X20110719

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Bianco Research, L.L.C July 21, 2011 6Bianco Research, L.L.C 6

Was Tuesdays Record One-Day Advance Meaningful?

The S&P 500

1,240

1,260

1,280

1,300

1,320

1,340

1,360

1,380

12/31/2010

1/14/2011

1/31/2011

2/14/2011

3/1/2011

3/15/2011

3/29/2011

4/12/2011

4/27/2011

5/11/2011

5/25/2011

6/9/2011

6/23/2011

7/8/2011

7/22/2011

1,240

1,260

1,280

1,300

1,320

1,340

1,360

1,380

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Bianco Research, L.L.C July 21, 2011 7Bianco Research, L.L.C 7

The Economy Points To More Subpar Growth

Comparing The Chicago Fed National Activity Index (CFNAI)

To The Economic Cycle Research Institute (ECRI) Growth Rate

Oct-09, 26.70

Nov-08

-29.00

Jul-10

-10.50

Apr-11

6.70

Jun-11

1.80

May-11

-0.19

May-10

0.31

Jan-09

-3.66-40

-30

-20

-10

0

10

20

30

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

ECRIGrowt

hRate(RedLine

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

CFNAI3-Month

Average(BlueLine

Red = ECRI Growth Rate (Right Scale)

Blue = CFNAI 3-Month Average (Blue Line)

The red line shows the growth rate of the ECRIs leadingindicator. It is constructed using seven indicators that

are understood to lead the economy (detailed here). Theblue line shows the Chicago Fed National Activity Index,a coincident indicator of 85 economic series (explainedhere).

Long-time readers know we are fans of labelingeconomic indicators as leading, coincident and lagging.Critics of this approach are correct in noting that allexpansions and contractions are different, so thisapproach can lead one astray. See the summer of 2010when the growth rate of the ECRIs leading indicatorcollapsed to recessionary territory of -10 but norecession followed. Was QE2 implemented in partbecause of this indicator?

Now the leading indicators are weakening again. Butthis time the co-founder of the ECRI, LakshmanAchuthan, is worried that a protracted slowdown iscoming. Note that last summer when the ECRIs leadingindicator had a bigger dive into recessionary territory,Lakshman was counseling that a recession would notfollow. He was right.

The difference was last summers decline was driven bya number of market-based indicators like credit spreadsand the stock market. This years weakness is drivenmore by real economic indicators.

We have argued that if the economy turns far enoughsouth, QE3 will follow. The ECRI is a measure thatshould help us determine where the economy is

heading. Right now economic activity is not bad enoughto consider QE3 likely, but indicators continue to movein that direction.

http://www.arborresearch.com/bianco/?p=31761http://www.arborresearch.com/bianco/?p=33849http://www.arborresearch.com/bianco/?p=33849http://www.arborresearch.com/bianco/?p=33849http://www.arborresearch.com/bianco/?p=33849http://blogs.wsj.com/economics/2011/06/13/ecris-achuthan-prolonged-u-s-slowdown-underway/?KEYWORDS=Lakshmanhttp://blogs.wsj.com/economics/2011/06/13/ecris-achuthan-prolonged-u-s-slowdown-underway/?KEYWORDS=Lakshmanhttp://blogs.wsj.com/economics/2011/06/13/ecris-achuthan-prolonged-u-s-slowdown-underway/?KEYWORDS=Lakshmanhttp://blogs.wsj.com/economics/2011/06/13/ecris-achuthan-prolonged-u-s-slowdown-underway/?KEYWORDS=Lakshmanhttp://blogs.wsj.com/economics/2011/06/13/ecris-achuthan-prolonged-u-s-slowdown-underway/?KEYWORDS=Lakshmanhttp://blogs.wsj.com/economics/2011/06/13/ecris-achuthan-prolonged-u-s-slowdown-underway/?KEYWORDS=Lakshmanhttp://blogs.wsj.com/economics/2011/06/13/ecris-achuthan-prolonged-u-s-slowdown-underway/?KEYWORDS=Lakshmanhttp://www.arborresearch.com/bianco/?p=33849http://www.arborresearch.com/bianco/?p=33849http://www.arborresearch.com/bianco/?p=33849http://www.arborresearch.com/bianco/?p=31761

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Bianco Research, L.L.C July 21, 2011 8Bianco Research, L.L.C 8

The Economy Is No Longer Surprising

Citigroup Economic Surprise IndexUnited States

7/19/2011

6/3/2011

4/27/2011

2/28/200610/13/2006

5/12/2006

1/31/2007 8/15/2007

3/28/2008

12/5/2008

9/4/20085/28/2009 9/3/2009

8/25/2010

3/4/2011

-150

-125

-100

-75

-50

-25

0

25

50

75

100

12/23/2005

4/14/2006

8/4/2006

11/24/2006

3/16/2007

7/6/2007

10/26/2007

2/15/2008

6/6/2008

9/26/2008

1/16/2009

5/8/2009

8/28/2009

12/18/2009

4/9/2010

7/30/2010

11/19/2010

3/11/2011

7/1/2011

10/21/2011

-150

-125

-100

-75

-50

-25

0

25

50

75

100The Citigroup Economic SurpriseIndex (CESI) measures how theeconomy is performing relative

the Bloomberg median estimate.A falling line means the economyis underperforming estimates.Citigroup compiles this measurefor several countries andeconomic regions.

This measure has plunged from

March to early June, reflectinghow the recent soft patch hastaken economists by surprise.The bounce since early Junereflects economists downgradingtheir forecasts to meet a slowereconomy rather than an uptick inactivity.

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Bianco Research, L.L.C July 21, 2011 9

Bernanke Says QE3 Might Happen

From Bernankes Q&A The Before the Committee on Financial Services, U.S. House ofRepresentatives on July 13, 2011

REPRESENTATIVE SEAN DUFFY (R-WI): You -- in your testimony -- I only have 20 seconds left-- you talked about a potential additional stimulus. Can you assure us today that there is going tobe no QE3? Or is that something that you're considering?

MR. BERNANKE: I think we have to keep all the options on the table. We don't know where theeconomy's going to go, and if we get to a point where we're like -- you know, the economy --recovery is faltering and we're looking at inflation dropping down towards or something, you know,where inflation issues are not relevant, then, you know, we have to look at all the options.

REP. DUFFY: And QE3 is one of those?

MR. BERNANKE: Yes.REP. BACHUS: Thank you.REP. DUFFY: I yield back.

Bernanke's comments about QE3 are consistent with our own. If the data turns bad enough, QE3will happen. Right now the economy is not bad enough. We also detailed this in our last

conference call. Bernanke appears to give a caveat above when he says, "and we're looking atinflation dropping down towards or something, you know, where inflation issues are not relevant."This is in reference to the Federal Reserve's belief that inflation and inflation expectations are themost important statistics in guiding monetary policy. So, what happens if the economy turns southand (not or) the stock market tanks with it? The next chart shows that the S&P 500 and 10-yearTIPS breakevens have been 94% correlated over the last year. If stocks tank, expect TIPSbreakevens to follow. Bernanke would view such a deflation risk as more than reason enough to

institute QE3.

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http://www.bloomberg.com/news/2011-07-15/bernanke-damps-additional-stimulus-prospects.html

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Bianco Research, L.L.C July 21, 2011 11Bianco Research, L.L.C 11

10-Year Tips Breakevens

10-Year TIPS Breakeven Inflation Rate

6/22/2011

2.231

4/11/2011, 2.66

4/29/2010

2.431

9/10/2007

2.189

12/31/2008, 0.12011/20/2008, 0.041

8/24/2010

1.512

1/11/2010, 2.465

6/10/2009

2.070

3/6/2009

0.846

7/4/2008

2.598

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

9/29/2006

1/7/2007

4/17/2007

7/26/2007

11/3/2007

2/11/2008

5/21/2008

8/29/2008

12/7/2008

3/17/2009

6/25/2009

10/3/2009

1/11/2010

4/21/2010

7/30/2010

11/7/2010

2/15/2011

5/26/2011

9/3/2011

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

TIPS Breakeven (Thick Line/Left Scale)

Yield of the 10-Year Treasury Note minus the

Yield of 10-Year TIPS Note

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Bianco Research, L.L.C July 21, 2011 12Bianco Research, L.L.C 12

TIPS Versus Stocks

The S&P 500 And 10-Year TIPS Breakevens

1.50%

1.60%

1.70%

1.80%

1.90%

2.00%

2.10%

2.20%

2.30%

2.40%

2.50%

2.60%

2.70%

7/30/2010

8/13/2010

8/27/2010

9/13/2010

9/27/2010

10/11/2010

10/25/2010

11/8/2010

11/22/2010

12/7/2010

12/21/2010

1/5/2011

1/20/2011

2/3/2011

2/17/2011

3/4/2011

3/18/2011

4/1/2011

4/15/2011

5/2/2011

5/16/2011

5/31/2011

6/14/2011

6/28/2011

7/13/2011

10-YearTips

Breakeven(redline

1,000

1,050

1,100

1,150

1,200

1,250

1,300

1,350

1,400

S&P5

00(bluebars)

10-Year TIPS Breakeven

(left scale)

S&P 500 (right scale)

Correlation = 94.2%

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Bianco Research, L.L.C July 21, 2011 13Bianco Research, L.L.C 13

European Yields

Ireland: 10-Year Yield and 5-Year CDS

7/18/2011, 14.08%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

15.00%

1/29/2009

3/20/2009

5/11/2009

6/30/2009

8/19/2009

10/8/2009

11/27/2009

1/18/2010

3/9/2010

4/28/2010

6/17/2010

8/6/2010

9/27/2010

11/16/2010

1/5/2011

2/24/2011

4/15/2011

6/6/2011

7/26/2011

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

15.00%

Irish 10-Year Yield

5-Year CDS

Portugal: 5-Year CDS vs. 5-Year Yields

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

15.00%

16.00%

17.00%

18.00%

09/17/09

11/06/09

12/28/09

02/16/10

04/07/10

05/27/10

07/16/10

09/06/10

10/26/10

12/15/10

02/03/11

03/25/11

05/16/11

07/05/11

08/24/11

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

15.00%

16.00%

17.00%

18.00%

5-Year Yields

5-Year CDS

Greece: 5-Year CDS vs. 5-Year Yields

0.00%

2.50%

5.00%

7.50%

10.00%

12.50%

15.00%

17.50%

20.00%

22.50%

25.00%

09/17/09

11/06/09

12/28/09

02/16/10

04/07/10

05/27/10

07/16/10

09/06/10

10/26/10

12/15/10

02/03/11

03/25/11

05/16/11

07/05/11

08/24/11

0.00%

2.50%

5.00%

7.50%

10.00%

12.50%

15.00%

17.50%

20.00%

22.50%

25.00%

5-Year Yields

5-Year CDS

Spain: 5-Year CDS vs. 5-Year Note

1/10/2011

4.936%

0%

1%

2%

3%

4%

5%

6%

1/29/2009

3/20/2009

5/11/2009

6/30/2009

8/19/2009

10/8/2009

11/27/2009

1/18/2010

3/9/2010

4/28/2010

6/17/2010

8/6/2010

9/27/2010

11/16/2010

1/5/2011

2/24/2011

4/15/2011

6/6/2011

7/26/2011

0%

1%

2%

3%

4%

5%

6%

5-Year CDS

Spanish 5-Year Yield

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