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Macro Commodities Forex Rates Equity Credit Derivatives
Please see important disclaimer and disclosures at the end of the document
19 July 2010
EconomicsBeyond the Cycle
www.sgresearch.com
American ThemesFrom muni crisis to US sovereign debt crisis?Stephen GallagherChief Americas Economist
(1) 212 278 [email protected]
Aneta MarkowskaUS Senior Economist
(1) 212 278 [email protected]
Martin RoseResearch Associate(1) 212 278 [email protected]
The 2008-2009 recession has produced a significant crunch in state finances. Last year, budgetgaps were plugged with federal stimulus money, but now that the funds are running out, statesface renewed pressures. Here, we evaluate the risks for the US economy and financial markets.Q Municipal defaults likely to rise We anticipate a rise in municipal defaults in the comingquarters, which is normal following deep recessions. A state default would be far more
serious, but remains unlikely in our view. There has only been one state default in the past 110years. Arkansas defaulted in 1933 and functioned on federal money for two years.
Q EMU members vs. US statesThe key similarity is the need for austerity, which is the onlysustainable solution to the current budget woes. The main difference is the financial linkages,
which are much weaker in the case of municipal debt. Only 10% of the $2.8 trillion municipal
debt market is held by banking institutions, with the vast majority owned by wealthy
households. This suggests much smaller risks of financial contagion.
Q What could go wrong risk scenarios A rise in municipal defaults could spook investorsand trigger a funding crisis for state and local governments. While the Fed can purchase
short-term municipal paper as part of open market operations, we believe that the first round
of help would come from the federal government. How much help might be needed? We
estimate the projected budget gaps plus refinancing needs add up to about $300-$350 bn, or
about 2% of GDP. In the event of a federal bailout, we must also consider the risk of second-
round contagion effects into the Treasury market. If this risk were to materialize, we believe
that the Fed would likely restart quantitative easing. Fed purchases would cap Treasury yields,
but the dollar would suffer in this monetization end-game.
How are states closing their budget gaps? FY2010 cuts by program:
-
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
K-12 Education Higher Education Public
Assistance
Medicaid Corrections Transporation Other
USD bln
FY'2010 spending cuts by program
Source: National Governors Association
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Recent tremors in the municipal debt marketThe 2008-2009 recession has produced a significant crunch in state finances. Last year,
budget gaps were plugged with federal stimulus money, but now that the funds are running
out, states face renewed pressures. In recent months, several small municipalities have
warned against potential default.
A rise in municipal defaults is not unusual following recessions, and particularly following the
last recession which was very severe both in its depth and its duration. However, these
warnings have spooked municipal bond investors. The average municipal CDS spread as
measured by the MCDX index have widened out from 120 bps in late April to 250 bps in late
June (although spreads are still below the peak levels of 2008 when the auction rate market
shut down, triggering funding problems for many issuers). Spread movement in the cash
market has been less pronounced. In price terms, most securities have not moved much and
state and local governments have not seen much change in their borrowing costs, albeit
municipal yields failed to follow Treasury yields down over the past month.
The sharp widening in the CDS market has triggered a lot of concern among investors. In
particular, there have been a lot of questions about potential contagion to the broader
financial markets, similar to the way the seemingly small Greek problems spilt over to other
peripheral sovereigns and ultimately to the banking sector.
Municipal spreads show some pressures though yields have remained stable
-100
-50
0
50
100
150
200
250
300
350
400
02 03 04 05 06 07 08 09 10
bps
-200
-150
-100
-50
0
50
100
150
200
250
300
Markit CDS Index 5Y (LHS)
Muni AAA/A- vs. Treasury (RHS)
2.0
3.0
4.0
5.0
6.0
7.0
8.0
00 01 02 03 04 05 06 07 08 09 10
bpsMuni AAA/A-
Muni Insured
Muni BBB+/BBB-
Source: Bloomberg, SG Cross Asset Research
Whats in the $2.8 trillion municipal debt market?The municipal debt market is very fragmented and represents many different types of issuers
including, states, counties, cities, towns, school districts, special districts, utilities,
transportation systems, universities and hospitals, often with multiple securities. The bonds
can be backed by revenue streams tied to specific projects (65% of the market), or, in the
case of general obligation bonds, by the full faith and credit of the issuing governmental body
(35% of the market).
The average size of a municipal issue is much smaller than in the corporate markets. While the
overall size of the corporate market is much larger, at $11 trillion in total vs. $2.8 trillion in
Troubled States5Y CDS S&P
Rating
Illinois 315.0 A+
California 281.9 A-
New York 248.6 AA
Michigan 245.8 AA-
New J ersey 240.0 AA
Nevada 210.0 AA+
Florida 153.8 AAA
Troubled EMU Members5Y CDS
S&P
Rating
Greece 802.2 BB+
Portugal 289.3 A-
Ireland 250.9 AA
Spain 220.5 AA
Italy 176.2 A+ Source: Bloomberg; data as of Friday July 16
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19 July 2010 3
outstanding municipal securities, the municipal market has about 50,000 issuers vs. 3,000
corporate issuers.
Defaults tend to be much lower in the municipal market, for the simple reason that the issuers
operate as monopolies in their respective markets and have greater flexibility raising revenue
than corporations, either by raising taxes, increasing fees or implementing new user charges.
However, municipalities are much more constrained in managing their expenses as they are
often burdened by unfunded mandates passed down from the federal and state governments
(healthcare, social services).
Why are states in trouble?States in fiscal perilMany comparisons have been made between US states and the weaker EMU members with
unsustainable debt dynamics. From the debt load perspective, the states are in much better
shape. Overall state and local government debt is at just 20% of GDP. Adding it to the federal
debt pushes the overall general government debt to roughly 75% of GDP, which is more
problematic. However, the bigger of the two problems is federal government which is in much
worse shape than the states given its large debt loads and an unsustainable fiscal outlook.
Standalone state debt In the context of federal debt
0
5
10
15
20
25
30
35
40
52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09
% of GDP State & Local Gov't Debt
0
10
20
30
40
50
60
70
80
90
52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09
% of GDP Treasury Debt
State & Local Gov't Debt
Source: Global Insight, SG Cross Asset Research
For the states, the key problem is not debt levels, but the recent budget gaps. The lastrecession was the costliest post-war downturn for the states, both because of its severity and
its duration. In the previous recessions, states fiscal problems lasted for several years after the
economic trough; this time, problems could persist even longer, for several reasons. First,
consumption is likely to remain below pre-recession levels for some time, implying a lasting
drag on sales tax revenues. Persistently high unemployment also means that income tax
receipts are unlikely to return to pre-recession levels for several years. At the same time, the
persistently high levels of unemployment are also putting upward pressure on social benefit
spending, particularly unemployment insurance, Medicaid (health insurance for the poor) and
welfare.
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Debt-to-GDP ratios by state
0
20
40
60
80
100
120
Delaware
Mon
tana
Oregon
Rho
de
Islan
d
Ca
liforn
ia
New
York
Missouri
M
assachuse
tts
New
Jersey
Neva
da
Pennsy
lvan
ia
Alaska
Illino
is
Sou
thCaro
lina
Texas
Co
lora
do
Flori
da
Wash
ing
ton
Hawa
ii
Ken
tucky
Indiana
Vermon
t
Arizona
Ida
ho
Michigan
Sou
thDa
kota
Ohio
New
Mexico
Connect
icu
t
Mississ
ipp
i
Ne
braska
Ma
ine
Utah
Ne
wHampsh
ire
Alabama
Minneso
ta
Georg
ia
Wisconsin
West
Virg
inia
Kansas
Tennessee
Mary
lan
d
Virg
inia
Iowa
Lou
isiana
N
ort
hCaro
lina
Arkansas
Okla
homa
Nort
hDa
kota
Wyom
ing
Districto
fCo
lum
bia
%o
fsta
teGDP
State and Loc al Government Debt
Federal debt portion
Total debt-to-GDP ratios shown above include both municipal and federal debt. We pro-rated Federal debt according to the states GDP. Total debtexpressed as % of states GDP.
Source: Global Insight, SIFMA, SG Cross Asset Research
Though revenues have begun to rise, helping to narrow overall budget shortfalls relative to last
year, this may not be enough to offset the coming declines in fiscal stimulus money. The
Center on Budget and Policy Priorities estimates that state budget gaps before the use of
federal stimulus funds amounted to $200 bn in FY 2010 and will be followed by $180 bn in
FY2011 and $120 bn in FY2012. However, after the use of stimulus funds, the projected
shortfall peaks in FY2011 (which for most states began on July 1, 2010). As such, the worst
may not be over yet for state and local governments.
Projected state budget gaps with and without fiscal stimulus funds
-$71
-$137 -$144-$119
-$39
-$63
-$36
-$1-$110
-$200
-$180
-$120
-220
-170
-120
-70
-20
FY 2009 FY 2010 FY 2011 FY 2012
USD bln -220
-170
-120
-70
-20
Budget gaps offs et by Recovery Act
Remaining bu dget g aps after Recovery Act
$260 bn over
the next two
years
The projected total budget shortfalls reflect state fiscal conditions at the start of the fiscal period, i.e. before deficit-closing actions are taken (i.e. before fiscal stimulus funds, budget cuts, tax increases and reserves).
FY2010 was the worst year in terms of overall budget gaps. However, after adjusting for fiscal stimulus funds, FY2011shortfalls are projected to be slightly larger.
Source: Center on Budget and Policy Priorities
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FY2010 budget shortfalls, % of state GDP
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Ca
liforn
ia
Alaska
Orego
n
New
Jersey
Illinois
Connecticu
t
Rho
de
Islan
d
Arizona
Was
hington
Hawa
ii
New
York
Main
e
Massac
huset
ts
Kansas
Wiscons
in
Minneso
ta
Nort
hCarolin
a
New
Mexico
Vermon
t
Nevad
a
Georg
ia
Oklahom
a
Pennsy
lvan
ia
Idah
o
Mary
lan
d
Miss
issipp
i
Iowa
Alabama
Uta
h
Virginia
De
laware
Lou
isiana
Districto
fCo
lumb
ia
Florid
a
Sou
thCarolin
a
Ken
tuck
y
Ohio
Michiga
n
New
Hampshir
e
Missou
ri
Co
lorad
o
Indian
a
Wes
tVirginia
Tennesse
e
Arkansas
Ne
brask
a
Texa
s
Sou
thDako
ta
Wyomin
g
Montan
a
Nort
hDako
ta
FY'2010 Budget Shortfalls, % of state GDP
FY'2010 total shor tfall = $200.1 bn
Source: Center on Budget and Policy Priorities, SG Cross Asset Research
Box 1: Balanced budget amendment what does it mean for the states?
In principle, a balance budget amendment which has been adopted in some form by 49 US states
(except Vermont) means that the state cannot spend more than its income. In practice, the implications
are not as straightforward. Thats because the balanced budget amendment applies to the state
governments general fund which receive all tax and fee collections and are subject to legislative
appropriations. The general fund excludes several important items:
Q Federal grants, which are typically committed for specific purposes
Q Transportation funds raised from gasoline taxes, which are earmarked for highways and other
transportation purposes
Q Tax collections apportioned to local governments
Q Capital expenditures, which are part of the states capital budget (separate from the operating
budget)
State general funds receive about 50%-60% of all revenue sources and only those funds are subject to
the balanced budget amendment. The balance budget amendment means that states generally cannot
finance operating shortages with long-term debt.
Unlike the US federal government or governments of troubled European countries which are
issuing large amounts of debt to finance current budget gaps, state and local governments
have less flexibility to do so. Most states have adopted balanced budget amendments which
prevent them from accumulating deficits over time. Some states have taken unconventional
measures to get around the requirement, such as delaying vendor payments, issuing IOUs or
delaying tax refunds; however this simply pushes the budget gap into the next fiscal period.
Given the size of projected budget gaps for the next few years, it is clear that states will have
to address them via tax increases and/or spending cuts.
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What are the problems in problem states?As mentioned earlier, the problem currently facing states and local government is not the
accumulation of earlier deficits, but rather the current and projected deficits that are a product
of an unusually severe recession. The states facing largest budget gaps tend to have theworst-performing economies with high unemployment rates and foreclosure rates above
national averages. As a result, these problem states have experienced the largest revenue
drops while their costs have ballooned.
What do problem states have in common?Budget gap - %
of General Fund
Budget
Budget gap
$ bln
Budget gap
% of state GDP
Debt / state
GDP
Change in
revenue
Unemployment
Rate
Prime
foreclosure
rate
Sub-prime
foreclosure
rate
Needs
supermajority?
2010 estimate 2010 estimate 2010 estimate 2010 estimateQ1'2008 -
Q1'2009May-10 Apr-10 Apr-10
California 64.5% 54.6 3.0% 29.5% -16.2% 12.4% 2.6% 13.2% Yes
Arizona 57.9% 5.1 2.0% 22.8% -16.5% 9.6% 3.1% 11.9% Yes
Nevada 47.6% 1.5 1.1% 25.1% 1.5% 14.0% 6.3% 19.0% Yes
Illinois 40.9% 14.3 2.3% 24.5% -10.9% 10.8% 3.7% 16.8% No
New Jersey 38.4% 11.0 2.3% 26.0% -15.8% 9.7% 4.0% 24.8% No
New York 38.0% 21.0 1.8% 29.4% -17.0% 8.3% 2.6% 19.8% No
Rhode Island 33.0% 1.0 2.1% 30.2% -12.5% 12.3% 1.9% 10.7% Yes
Kansas 32.9% 1.8 1.5% 18.3% -11.1% 6.5% 1.3% 7.9% No
Alaska 30.7% 1.3 2.7% 25.0% -72.0% 8.3% 0.7% 7.3% No
Oregon 29.0% 4.2 2.6% 33.4% -19.0% 10.6% 1.8% 12.7% Yes
Florida 28.5% 6.0 0.8% 23.4% -11.5% 11.7% 9.8% 30.6% Yes
Vermont 28.1% 0.3 1.2% 22.8% -7.2% 6.2% 1.8% 15.9% No
Oklahoma 28.0% 1.6 1.1% 13.3% -12.6% 6.7% 1.8% 10.2% Yes
Washington 27.8% 6.2 1.9% 23.2% -9.0% 9.1% 1.3% 10.1% Yes
Maine 27.6% 0.8 1.7% 19.9% -11.0% 8.0% 2.6% 16.4% No
New Hampshire 27.5% 0.4 0.7% 19.3% -2.5% 6.4% 1.2% 8.8% No
Connecticut 27.0% 4.7 2.2% 20.8% -11.4% 8.9% 2.3% 15.6% No
Hawaii 26.4% 1.2 1.9% 23.2% -10.2% 6.6% 3.3% 15.8% No
North Carolina 26.2% 5.0 1.2% 14.5% -7.6% 10.3% 1.4% 6.6% No
Georgia 26.1% 4.5 1.1% 19.0% -19.1% 10.2% 2.1% 8.3% No
Wisconsin 23.8% 3.2 1.3% 18.8% -11.2% 8.2% 2.4% 15.8% No
Colorado 23.3% 1.6 0.6% 23.7% -10.1% 8.0% 1.4% 9.5% Yes
Pennsylvania 23.3% 5.9 1.1% 25.0% -5.5% 9.1% 1.6% 10.3% NoIowa 22.7% 1.3 1.0% 15.3% 3.6% 6.8% 2.0% 12.0% No
Alabama 22.5% 1.6 0.9% 19.2% 3.0% 10.8% 1.0% 5.4% No
Virginia 22.5% 3.6 0.9% 15.7% -19.9% 7.1% 1.1% 7.0% No
Idaho 22.4% 0.6 1.1% 22.2% -14.2% 9.0% 2.1% 11.2% No
Minnesota 22.3% 3.4 1.3% 19.2% -9.7% 7.0% 1.5% 10.8% No
Utah 22.2% 1.0 0.9% 19.9% -3.4% 7.3% 1.8% 12.4% No
Missouri 21.8% 1.7 0.7% 28.8% -1.3% 9.3% 1.1% 5.8% Yes
Louisiana 21.6% 1.9 0.9% 15.0% -8.8% 6.9% 1.9% 10.7% Yes
Maryland 21.1% 2.8 1.0% 17.1% -1.2% 7.2% 2.0% 11.5% No
South Carolina 20.0% 1.2 0.8% 24.2% -11.0% 11.0% 2.0% 10.9% No
Mississippi 18.7% 0.9 1.0% 20.6% -7.6% 11.4% 1.7% 6.5% Yes
New Mexico 18.0% 1.0 1.2% 21.2% -12.8% 8.4% 2.0% 10.3% No
Massachusetts 17.7% 5.6 1.5% 26.2% -16.8% 9.2% 1.7% 13.6% No
Delaware 17.2% 0.6 0.9% 45.6% -3.0% 8.8% 2.3% 16.2% Yes
Kentucky 14.5% 1.2 0.8% 23.0% -3.8% 10.4% 2.0% 11.6% Yes
Ohio 14.0% 3.6 0.8% 21.3% -9.0% 10.7% 3.1% 12.5% No
Michigan 12.4% 2.8 0.7% 22.1% -16.5% 13.6% 2.1% 7.8% Yes
Tennessee 11.1% 1.1 0.4% 18.2% -10.2% 10.4% 1.2% 5.5% NoIndiana 10.6% 1.4 0.5% 22.8% -3.5% 10.0% 2.9% 11.1% No
Texas 9.8% 3.5 0.3% 23.8% -8.8% 8.3% 0.9% 5.7% No
Nebraska 9.0% 0.3 0.4% 20.5% -5.5% 4.9% 0.9% 7.0% No
Arkansas 8.7% 0.4 0.4% 13.5% -4.2% 7.7% 1.1% 5.5% Yes
West Virginia 8.0% 0.3 0.5% 18.5% -9.4% 8.9% 1.3% 6.9% No
South Dakota 4.3% 0.0 0.1% 21.4% -6.2% 4.6% 0.8% 10.9% Yes
Wyoming 1.7% 0.0 0.1% 11.3% 19.7% 7.0% 0.8% 6.6% No
Montana 0.0% 0.0 0.0% 41.2% 3.2% 7.2% 1.2% 11.3% No
North Dakota 0.0% 0.0 0.0% 13.1% -12.1% 3.6% 0.5% 8.2% No
National Avg 15.2% 200.1 1.1% 22.2% -11.7% 9.7% 2.7% 13.6%
Source: Center on Budget and Policy Priorities, Global Insight, SG Cross Asset Research
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Based on 2010 budget gaps projected before any deficit-closing actions were taken, the
states facing the strongest budget pressures include some of the usual suspects, in the
following order: California, Arizona, Nevada, Illinois, New Jersey and New York.
Unemployment in these states averaged at 11.3% in May vs. the national average of 9.7%. As
of April, the problem states recorded a prime foreclosure rate of 3.9% vs. 2.7% nationally and
a sub-prime foreclosure rate of 17.1% vs. 13.6% nationally.
Another problem facing some states is the requirement for a supermajority vote (2/3 or in
some cases or 3/5) for the approval of budgets and tax increases, which can make it very
difficult to make the necessary cuts. This has been a chronic problem in California which is
currently functioning without a budget.
Whats the damage?States in austerityDuring fiscal year 2010, state government resorted to a variety of methods to close their
budget gaps. Significant cuts were made in education, transportation, Medicaid and in the
corrections department. States instituted layoffs and furloughs, reduced salaries, cut
employee benefits, raised tuition, boosted transportation fees and reorganized agencies.
States also enacted over $20 bn in tax and fee increases which included sales tax hikes,
higher gasoline and tobacco prices and in some cases higher personal income taxes. These
austerity measures have been a drag on growth, both directly via lower government spending,
and indirectly via higher taxes.
State austerity already hurting growth more to come
-6
-4
-2
0
2
4
6
8
10
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
3m ann %
-40
-20
0
20
40
60
80
monthly change
State and Local Government Spendin g (LHS)
State Employment (RHS)
2 qtr moving averages
Source: Global Insight, SG Cross Asset Research
If no more federal stimulus funds are made available which is most likely going to be the
case states will need to take further steps to close the projected $144 bn FY2011 shortfall.
In direct terms, this translates to roughly 1% of GDP; however the impact on the economy will
depend on the types of measures taken. Spending cuts would likely translate to a more direct
hit to demand. Tax increases, particularly those on the wealthy, are likely to have lower
multiplier effects, producing a more modest hit to growth.
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How states solved their 2010 budget gaps
0
5
10
15
20
25
30
35
40
User
fees
Higher
educationfees
Courtrela
tedfees
Transpo
rationrelat
edfees
Busine
ssrelat
edfees
Layoffs
Furloughs
Early
retirem
ent
Salar
yreductions
Cutstoe
mplo
yeebe
nefits
Across
-the-bo
ard%
cuts
Targeted
cuts
Reduce
aid
tolocalg
ovt's
Reo
rganize
agencies
Priva
tization
Rainy
day
fund
Lottery
expansio
n
Gaming
/gambli
ngexpansio
nOthe
r
# of states taking action
Source: National Governors Association
Financial contagion risks lower than sub-prime or GreeceWhile the economy can probably survive state austerity, its chances for sustaining the
recovery would become much slimmer in the event of financial contagion. The sharp widening
in CDS spreads certainly raises concern, particularly in light of recent European experience.
However, the key to the contagion issue lies in who owns the debt.
Ownership of municipal debt limited exposure of the banking sector
Households
Funds (mmkt,
mutual, closed
end)
Banks
Brokers and
dealers
Insurance
Companies
Rest of the
world
Other
$2.8 trln outstanding
Source: Global Insight, SG Cross Asset Research
The European sovereign crisis became contagious because banks were significantly exposed
to the troubled governments. In the case of state and municipal debt, the situation is very
different. The ownership of municipal debt is dominated by US households which own about
70% of the $2.8 trillion outstanding, either via direct holdings or via money market and mutual
funds. Banking institutions hold just 10%, or $270 bn. For US commercial banks, municipal
holdings make up just 1.5% of their assets (vs. 1.7% of assets in Treasury debt).
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US states vs. EMU membersWe can draw many parallels between US state governments and those of individual EMU
members. In both cases, the governments in question have no independent monetary policy
that can be tailored to the specific regional economy and its problems. They also have noindependent currency that can be used as a macroeconomic tool.
EMU states vs. US statesEMU Countries 50 States
Independent currency/monetary policy No NoMacroeconomic policy function (fiscal) Yes No
Budget rules Imposed from above, thoughdiscipline has been uneven
Most states have adopted balancedbudget amendments; room formaneuver varies across states
Parental support? Recently made explicit with EFSF(though with strings attached andcapped).
No expectation of direct bailout, butfiscal support common (e.g. stimulusfunds, Buy America Bonds)
Central bank intervention? Ongoing Possible within normal open marketoperations (but limited to 6m
maturities)
Default mechanism? No Yes for municipal debt, no for state
Financial contagion risks? Higher large debt ownership bybanking institutions
Lower bulk of municipal debt ownedby households
Source: SG Cross Asset Research
However, we see several important differences that suggest lower risk of contagion frompotential defaults in the municipal debt market. In addition to the weaker financial linkages
discussed earlier, there are also important institutional differences. When the European debt
crisis first broke out, there was no institutional framework in place to support states facing
funding problems. Some of those shortcomings have been addressed, but only after the initial
damage to the financial markets. In the US, the institutional framework is not perfect, but it is
much better defined than it was in Europe six months ago. First, the Fed has the ability to
purchase municipal debt under normal open market operations (albeit limited to 6m
maturities). Another big shortcoming for Europe has been the lack of shared fiscal
responsibility. In the US, fiscal help for states is subject to political winds, but the risk is
nonetheless much smaller when only one fiscal authority is involved. There is a strong
precedent for fiscal support of the states. Lastly, the US also has institutional support for
banks in the form of FDIC insurance. The absence of deposit insurance in the Europeanbanking system contributed to financial contagion risks during the recent sovereign crisis
Another difference between US states and EMU members is that state governments share
responsibility for many services with the federal government. In the unlikely event of a state
default, the federal government would continue to pay social security, Medicare and other
programs funded at the federal level.
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Box 2: Federal vs. state government - who pays for what?
Services paid for by the federal government:
Q Social Security
Q Defense
Q Welfare (including food stamp programs)
Q Medicare (healthcare for the elderly)
Q Medicaid (healthcare for the poor shared with states)
Q Education (basic costs covered by the states, but the federal government funds various specializedprograms)
Q Employment/job training (incl. long-term unemployment benefits)
Q Public housing assistance
Q Transportation
Q Postal service
Q Hospitals
Services provided by state and local governments:
Q Education (elementary, secondary and higher)
Q Medicaid (healthcare for the poor shared with the federal government)
Q Unemployment benefits (extended benefits shared with federal government)
Q Transportation
Q State police, fire protection
Q Hospitals
Q Parks and recreation
Defaults in the municipal debt marketState defaults are extremely rare. There has only been one state default in the past 110 years.
Arkansas defaulted during the Great Depression and functioned on federal money for two
years. Prior to that, several states also defaulted in the 1840s following a banking panic and a
five-year recession.
Chapter 9 bankruptcy filings by municipalities
0
2
4
6
8
10
12
14
16
18
20
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
# of filings per year
Source: United States Courts
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Municipal defaults are more common although less frequent than corporate defaults. Most
municipalities that miss a payment generally make up for it within a few months. For those
defaults that do end up restructuring their debt, this is done via Chapter 9 proceedings. Since
1937, there were only 616 Chapter 9 filings. Since 1980, 245 cases were filed, and about 1/3
of those were dismissed by court without any debt adjustment.
Box 3: Debt restructuring mechanism for state and local governments
A state is a sovereign and as a sovereign it cannot file for bankruptcy. There is no legal process for
restructuring state debt.
Municipalities file for bankruptcy protection under Chapter 9 proceedings. This is different than
businesses which file under Chapter 7 (liquidation) or Chapter 11 (reorganization). Key features of Chapter
9 protection include:
Q Only the debtor can initiate Chapter 9 proceedings involuntary bankruptcies are not permitted in
the municipal world
Q Chapter 9 allows for adjustment of debts, not for liquidation
Q Bottom line: municipality continues its existence in bankruptcy, and often continues to pay its debt.
The court cannot decide what services will be provided by the governmental body.
Some states have statutory provisions to authorize (or block) municipal bankruptcy filings. The
state can:
Q Offer bridge financing or refinancing of the trouble debt
Q Offer grants to the municipality to bridge financing crisis
Q Transfer services to other governmental agencies to reduce expenditures
Q Use intercept of state tax payable to the municipality to ensure essential services
Default statsMunicipal defaults are not uncommon. However, municipal bonds have historically exhibited
much lower default rates and higher recovery rates than corporate bonds. In a recent study
based on the 1990-2007 period, Fitch found that the cumulative five-year default rate on
investment-grade municipal debt averaged at 0.1% compared with 1.2% for corporates.
These results are broadly in line with a recent Moodys study, the results of which are shown
in the table below. Average recovery rates are also significantly higher on municipal debt. The
ultimate recovery rate has averaged at 67% on municipal issues vs. 38% on senior unsecured
corporate bonds.
Municipal default rates typically lag the economic cycle, given the delayed impact of
recessions on state budgets. Most municipal defaults are concentrated among weaker creditsand weaker purposes, such as hospitals and housing bonds. Stronger purposes, such as
utilities, universities, or even general obligation bonds tend to default less frequently given a
greater ability to collect on their receivables.
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Default Rates: municipal vs. corporate debt Recovery Rates: municipal vs. corporate debtMunicipal Bonds
Senior Unsecured
Corporate Bonds
30-day post-default price 59.9% 37.5%
Ultimate recovery rate (avg) 67.0% 38%*
Ultimate recovery rate (median) 85.0% 30%*
* based on data from 1987 to 2007
The data above covers the period from 1970-2009. Based on a study that
covers only Moodys rated bonds. There were 18,400 bonds in the sample asof 2009.
Source: Moodys
It is important to keep in mind that in the case of general obligation bonds which are backed
by the full faith and credit of the local governments, a decision to default is largely political.
While it is politically difficult to raise taxes of lay off public sector workers, the implications of
defaulting and being shut out of the debt markets are far more severe. This is why local
governments generally tend to side with bondholders rather than the constituents.
Bailout optionsOur central scenario is that states will close their projected gaps by spending cuts and/or tax
increases. Municipal default rates will likely rise, but that is normal following recessions and is
expected by the market. Bailouts for states and/or municipalities are not very likely at this
stage. Indeed, the heads of President Obamas debt commission recently told governors not
to count on the federal government for more budget bailouts. The only scenario in which we
envision more aid for state and local governments is one in which a rise in defaults spooks
investors and triggers widespread funding problems in the municipal market.
Central bank able, but not willingThe Feds ability to purchase state and local government debt is clearly spelled out in section
14 of the Federal Reserve Act. This ability is part of normal market operations, not emergency
powers.
The Fed can buy securities issued in anticipation of the collection of taxes or in anticipation of
the receipt of assured revenues by any State, county, district, political subdivision, ormunicipality in the continental United States, including irrigation, drainage and reclamation
districts. However, there is an important restriction built into the stature which limits the Feds
buying to municipal securities maturing within six months of the purchase. Since municipal
debt tends to be long-dated, we estimate that this limits the Feds buying ability to only about
$100 bln.
Despite its ability to purchase municipal debt, historically, the Fed has been reluctant to do so.
Municipal debt purchases were considered in the late 1990s when the Treasury was running
fiscal surpluses and reducing the amount of debt outstanding. The Fed needed alternative
10-year cumulative
Default Rates
Municipal
Bonds
Corporate
Bonds
Aaa 0.00% 0.50%Aa 0.03% 0.54%
A 0.03% 2.05%
Baa 0.16% 4.85%
Ba 2.80% 19.96%
B 12.40% 44.38%
Caa to C 11.60% 71.38%
Investment Grade 0.06% 2.50%
Speculative Grade 4.55% 34.01%
All Rated 0.09% 11.06%10-year cumulative default rate is the percentage of bonds that ended up in default 10
years after issuance
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asset classes to conduct open market operations. After considering municipal debt, the Fed
decided against it. The Fed also did not intervene in the municipal market in late 2008 and
2009 despite significant dislocations and some political pressure.
We conclude that the Fed intervention in the market is unlikely and, in the event of disruptions
in the municipal debt market, the first round of aid would come from the federal government.
Federal government strong precedent of bailoutsThere is no explicit mechanism for Federal bailouts of failing states or municipalities. However,
there is a strong precedent. Following the default of Arkansas in 1933, the state functioned on
federal money for two years (until it passed a sales tax). There are also more recent examples
of federal aid for cash-strapped state and local governments.
Q Last years stimulus funds. As part of the American Recovery and Reinvestment Act
(ARRA) of 2009, the federal government earmarked about $140 bn (1% of GDP) in direct relief
to state and local governments to be distributed over a roughly 2 year period. The funds,which cover about 30% of projected state shortfalls, largely took the form of increased
Medicaid funding and a State Fiscal Stabilization Fund. Stimulus money has reduced the
extent of state spending cuts and state tax increases.
Q The Build America Bonds program. The program was introduced on February 17, 2009,
as part of the ARRA. These are taxable municipal bonds that carry special tax credits or direct
federal subsidies. All issuance to date has been in the direct-pay BABs, where the Treasury
Department provides borrowers with cash subsidy payments equal to 35% of their interest
costs. With tax-credit BABs, investors receive the right to a federal income tax credit equal to
35% of their BAB interest income. The tax credit can be carried forward to future years if the
bondholders tax liability is insufficient in a given year. The net effect in either case is
substantially reduced interest expense to state and local governments. Unlike tax-exemptdebt, normally issued by state and local government, BAB bonds are attractive to taxpayers in
lower tax brackets or to those that do not pay income taxes (e.g. pension funds, endowments
or foreign investors). Since the launch of the program, $180 bln in Buy America Bonds have
been issued, or about 20% of total municipal issuance. Under current law, the program is
open to bonds used to finance capital expenditure projects and issued before January 1,
2011.
How much aid may be needed?The total projected budget shortfall for FY2011 is about $145 bn. While this gap will be closed
at least partially via austerity measures, in the worst case scenario we can assume that the
burden will fall back on the federal government. This amount is roughly equal to the relief fund
for states included in the 2009 fiscal stimulus package.
Refinancing needs for states are relatively low given the long-term nature of most municipal
debt. We estimate that about $200 bn in municipal debt is maturing over the next 12 months,
or 7% of all issues outstanding.
In the worst case scenario, whereby the municipal debt market shuts down completely, the
federal government may have to provide $350 bn in aid. This is equivalent to 2.4% of US
GDP. This would roughly offset the expected improvement in the federal deficit over the next
year.
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How vulnerable is the Treasury market?Unlike Japan, which is facing a chronic savings surplus, the US is facing a chronic savings
deficit. Market mechanisms to resolve this problem are higher bond yields and/or weak
currency. For now, massive portfolio flows into the US are delaying these adjustments andkeeping Treasury yields artificially low. However, the heavy reliance on ongoing purchases is
precisely the reason for our upside bias on Treasury yields.
In our baseline scenario we assume a gradual adjustment toward higher yields and higher
savings rates, offset by a shrinking trade deficit. However, the 2007 episode taught us an
important lesson that we should not become too complacent on the ability of the US economy
to finance its external deficit. In 2007, the main source of financing was the sale of structured
credit assets which came to an abrupt stop. The savings deficit is now being financed via
sales of US Treasury debt which has its own fundamental issues. Indeed, federal government
is facing greater fundamental challenges than state and local governments.
Foreign Private Purchases of US Assets Foreign Official Purchases of US Assets
-20
-10
0
10
20
30
40
50
60
70
95 97 99 01 03 05 07 09
Treasury
Agency
Corp Bonds
Equity
-15
-10
-5
0
5
10
15
20
25
95 97 99 01 03 05 07 09
Treasury
Agency
Corp Bond
Source: Global Insight, SG Cross Asset Research
Given the ongoing reliance on external financing, we cannot ignore the possibility that foreign
investors might lose confidence in the US government and significantly reduce their
purchases of Treasury debt. It is not clear what might cause such a scenario, but another
bailout for state and local governments could be a potential trigger.
In the event of a municipal debt problem and contagion to the Treasury market, we believe
that the Fed would step in and become a buyer of government paper. To the extent that the
Feds purchases are successful in capping bond yields, the dollar would become the main
adjustment variable.
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ConclusionsState austerity is the only sustainable solution to the current budget woes. In this regard, state
and local governments are similar to the troubled EMU members. We see the risk of financial
contagion as less pronounced than in the case of sub-prime mortgages or Greece.
We see a state default as highly unlikely. A rise in municipal defaults is likely and normal
following a deep recession. Higher municipal defaults are expected by the market.
The main risk would be above-normal defaults rates, or defaults occurring in unusual
segments of the municipal market such as general obligation bonds and/or revenue bonds
backed by stronger purposes (utilities, education). This could spook investors and trigger
funding problems for state and local governments. If this occurs, we see the following as the
most likely sequence of responses:
Q The first round of help would likely come from the Federal government rather than theFed.
Another stimulus package with relief funds for local governments.
More direct intervention is less likely, but could occur in the event of a state funding
crisis.
Market impact: There is some risk that Federal support for states might spook foreign
buyers of Treasury debt. This would also weigh on the dollar.
Q In the event of contagion, the Fed would likely step in to support the Treasury market.
Monetization is the end game in this scenario.
Market impact: Fed purchases could cap bond yields, but the dollar would suffer.
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SG Forecasts
Economic forecastsQuar ter ly Annual ized Growth Rates Annual year /year
2008 2009 2010 2011
Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 A A E E
Real GDP 2.2 5.6 2.7 3.2 3.1 2.9 2.6 2.3 0.4 -2.4 3.1 2.7
Real Final Sales 1.5 1.7 0.8 3.0 2.9 2.8 2.6 2.5 0.8 -1.7 1.9 2.6
Consumption 2.8 1.6 3.0 3.3 3.3 3.0 2.6 2.7 -0.2 -0.6 2.6 2.9
Non-Resid Fixed Investment -5.9 5.3 2.2 8.5 8.1 7.6 7.6 5.3 1.6 -17.8 3.2 7.0
Business Structures -18.4 -18.1 -15.5 -10.0 -10.0 -5.0 0.0 0.0 10.3 -19.8 -14.3 -2.3
Equipment and Software 1.5 19.0 11.4 16.0 15.0 12.0 10.0 7.0 -2.6 -16.6 11.8 10.1
Residential 18.9 3.7 -10.3 3.0 5.0 10.0 10.0 10.0 -22.9 -20.5 0.2 8.0
Inventories Chg, % contibut to GDP 0.7 3.7 1.9 0.2 0.2 0.1 0.0 - 0.1 -0.3 -0.6 1.2 0.0
Net Trade, % contri but to GDP -0.8 0.3 -0.8 -0.3 -0.4 -0.5 -0.5 -0.5 0.7 0.9 -0.5 -0.5
Exports 17.8 22.8 11.3 10.0 8.0 6.0 5.5 5.5 5.4 -9.6 12.1 6.2Imports 21.3 15.8 14.8 10.0 9.0 8.0 8.0 8.0 -3.2 -13.9 11.6 8.2
Government Spending 2.7 -1.3 -1.9 0.1 0.1 0.3 1.7 1.6 3.1 1.8 0.1 1.1
Federal Govt 8.0 0.0 1.2 3.3 2.5 2.2 2.0 1.7 7.7 5.2 3.0 2.0
State & Local -0.6 -2.2 -3.8 -2.0 -1.5 -1.0 1.5 1.5 0.5 -0.2 -1.8 0.4
PCE Deflato r 2.6 2.5 1.5 -0.4 1.4 2.0 1.5 1.6 3.3 0.2 1.5 1.6
PCE Core 1.2 1.8 0.6 0.9 1.1 1.2 1.3 1.5 2.4 1.5 1.1 1.3
CPI 3.7 2.6 1.5 -0.8 1.6 2.2 1.7 1.8 3.8 -0.3 1.6 1.7
CPI Core 1.5 1.5 0.0 0.8 1.0 1.2 1.3 1.6 2.3 1.7 1.0 1.3
Unemployment Rate 9.6 10.0 9.7 9.7 9.6 9.5 9.4 9.2 5.2 9.3 9.6 9.1
Personal Income -1.4 2.2 3.9 5.0 4.3 4.4 4.7 4.7 2.9 -1.8 3.2 4.6
Disposable Personal Income -1.2 2.5 3.7 5.5 4.0 3.8 4.1 4.2 3.9 1.0 3.5 4.2
Real Disposable Pers. Income -3.6 0.0 2.1 5.9 2.6 1.8 2.6 2.6 0.5 0.8 2.0 2.6
Savings Rate 3.9 3.7 3.5 3.9 6.8 3.6 3.5 3.5 2.7 4.2 4.5 3.4
Corp Profits 50.7 36.0 35.9 8.6 12.4 15.0 10.8 8.1 -11.8 -3.8 25.9 10.9
2010 E 2011 E2009 A
Source: BEA, SG Cross Asset Research
Rates and FX forecastsCentral Bank Rate Forecasts current 3 mths 6 mths 9 mths 1 yr
US 0.25 0.25 0.25 0.25 0.50
Canada 0.50 0.50 0.75 1.25 1.75
10 year bond yields current 3 mths 6 mths 9 mths 1 yr
US 2.95 3.00 3.25 3.50 4.00
Canada 3.17 3.25 3.50 4.00 4.50
FX rates current 3 mths 6 mths 9 mths 1 yr
USD per EUR 1.30 1.20 1.20 1.15 1.10
USD per GBP 1.53 1.50 1.52 1.50 1.50
CAD per USD 1.05 1.00 0.98 0.96 0.95
J PY per USD 87.0 90.0 92.0 94.0 96.0 Source: SG Cross Asset Research
The US economy lost some
momentum since late springand we have recently
downgraded our 2010
forecast form 3.8% to 3.1%.
The reasons for the
slowdown are totally clear,
but may reflect a combination
of expiring stimulus programs
and some spillover effects
from the European debt
crisis. We still see the odds
tiled towards sustaining the
recovery, albeit at a slowerpace than previously thought.
The consumer is still
supported by decent income
gains and the capex cycle
remains underpinned by
strong profit growth.
However, confidence remains
shaky. The inventory cycle is
coming to an end and adds
to the overall economic
slowdown. Lastly, fiscal
stimulus is peaking andthough the fiscal drag should
be gradual, it is nonetheless
no longer adding to growth.
The upcoming tax increases
at the local and federal level
are the key reason for our
below-consensus 2011
forecast.
The downside risks on
growth and inflation suggest
that the Fed should remainon hold through mid-2011. In
the context of steady Fed
policy, we see limited upward
pressure on bond yields over
the next 6 months. Longer,
term, a sustained recovery
should start to push bond
yields higher, particularly as
the Fed signals tightening.
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SG Proprietary IndicatorsSG Business Cycle Index
-15
-10
-5
0
5
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
-6
-4
-2
0
2
4
6
SG US B usiness Cycle Index (LHS)
GDP , 2 qtr moving average (RHS)
SG Real-Time Recession Probabil ity Model
Real-time recession pro babilities are derived from a regime switching model using the same fo ur coincident indicators used by NBER cycle
dating co mmittee. These include: employment, real income, real sales (retail + business) and industrial productio n
-
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10
NBER recessions
Modeled Rec. Prob
Probability derived from a probit model based on employment, core inflation, ISM index and a liquidity index
Historical Perspective - 6 month ahead probability
SG Fed Mod el
Rate Cut Probability Rate Hike ProbabilityLatest Probabilities
15%
40%
63%72%
0%
20%
40%
60%
80%
100%
3M 6M 9M 12M
probability of at least one rate cut w ithin the next 3,6, 9 and 12 months
0% 0% 1%5%
0%
20%
40%
60%
80%
100%
3M 6M 9M 12M
Probability of at least one rate hike
within the next 3, 6, 9 and 12 months
0%
20%
40%
60%
80%
100%
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
rate cuts
Probability of at least one rate cut within next 6 months
0%
20%
40%
60%
80%
100%
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
rate hikes
Probability of at least one rate hike within next 6 months
Source: SG Economic Research
Our Business Cycle index
suggests that the economy
is slowing from 4% pace in
Q4-Q1 towards 2% pace.
This is above our current
GDP forecasts and
suggests further downside
risks. However, some of
the recent weakness
reflects movements in
financial variables which
could bounce back. High-frequency economic
indicators have stalled, but
are not showing renewed
deterioration. Overall, the
BCI is consistent with a
loss of momentum, but
argues against a double-
dip scenario.
Our real-time recession
tracking model now
updated through May
shows very slim chances
that the economy is
entering recession.
Our fundamentally-derived
Fed probability models
show slim chances that the
Fed will be hiking rates in
the next 12 months,
although the chances of
additional rate cuts (read:
additional easing) have
been fading. the Fed has
opened the door for a
possible resumption of
quantitative easing, but the
economy would have to
deteriorate much further
before the Fed takes such
a step.
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Rates and Short-term FundingFed Funds Expectations
Real Treasury Yields
A1/P1 Nonfin CP vs. OIS (3m)
Inflation Expectations
Treasury Yiel d Curve (10y - 2y)
Short Term Funding
ABCP vs. OIS (3m)
Rates
Libor vs. OIS (3m) - Historical and Impl ied
0.00
0.25
0.50
0.75
1.00
7/10 9/10 11/10 1/11 3/11
%
Latest
Week ago
Month ago
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1/09 4/09 7/09 10/09 1/10 4/10 7/10
-0.2
-0.1
0.0
0.10.2
0.3
0.4
0.5
1/09 4/09 7/09 10/09 1/10 4/10 7/10
0.0
0.5
1.0
1.5
2.0
2.5
1/09 4/09 7/09 10/09 1/10 4/10 7/10
5yr real
10yr real
1.0
1.5
2.0
2.5
3.0
3.5
1/09 4/09 7/09 10/09 1/10 4/10 7/10
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1/09 4/09 7/09 10/09 1/10 4/10 7/10
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 for
rate hikes have been
pushed back notably over
the past two months.
Double-dip concerns and
renewed deflation fears
have triggered bullish
flattening of the Treasury
yield curve. Inflationbreakevens have declined
to lowest levels since
October 2009.
Funding pressures tied to
the European sovereign
crisis have eased
somewhat, but funding
spreads remain
significantly above April
levels.
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Credit AvailabilityMortgages & Consumer CreditConformi ng Mortgage Rate
ABX AAA Tranches
Corporate Credit
Swap Spread (10yr)
HY Spreads(Lehman HY - 10yr Swap)
Inv Grade Corp SpreadDJ Inv Grade CDX Index
Sector CDS Spreads
Fannie/Freddie MBS Spreads
Consumer ABS Spreads
0.40
0.80
1.20
1.60
1/09 4/09 7/09 10/09 1/10 4/10 7/10
Fannie/Freddie M BS vs. swap
20
30
40
50
60
70
80
90
100
1/08 7/08 1/09 7/09 1/10 7/10
index 2006-12006-2
2007-1
2007-2
3.0
3.5
4.0
4.5
5.0
5.5
6.0
1/09 4/09 7/09 10/09 1/10 4/10 7/10
30yr Fannie MB S
30yr Conforming Mortgage Rate
0
200
400
600
800
1000
1200
1/09 4/09 7/09 10/09 1/10 4/10 7/10
bpcredit cards
autos
0
50
100
150
200
250
300
1/09 4/09 7/09 10/09 1/10 4/10 7/10
-20
-10
0
10
20
30
40
50
1/09 4/09 7/09 10/09 1/10 4/10 7/10
600
800
1000
1200
1400
1600
18002000
2200
1/09 4/09 7/09 10/09 1/10 4/10 7/10
0
50
100
150
200
250
300
350
400
450
1/09 4/09 7/09 10/09 1/10 4/10 7/10
Financials
Industrials
Source: Bloomberg, SG Cross Asset Research
The European sovereign
crisis and US double-dip
concerns have triggered a
rotation to safe haven
assets and away from risk.
Among risky assets,
equities have been hurt the
most. Corporate credit has
been a bit more resilient, in
part helped by declines ingovernment bond yields.
Mortgages have benefited
the most. The 30yr fixed
conforming rate has
dropped to around 4.9%,
matching the lows
registered in 2003. This is a
silver lining that offers
some offset to the adverse
impact of tighter financial
conditions.
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FX MonitorDollar Major Dollar Inde x
USD/EUR
Carry Trade Index
FX Volatili ty (G10 avg)
JPY/USD
Carry-to-Risk Ratio
Yield Differential
Implied Vol
5
10
15
20
25
30
1/09 4/09 7/09 10/09 1/10 4/10 7/10
70
72
74
76
78
80
82
84
86
88
1/09 4/09 7/09 10/09 1/10 4/10 7/10
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
1.0
2.0
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 0 2 03 04 05 0 6 07 0 8 0 9 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 7/10
80
85
90
95
100
105
1/09 4/09 7/09 10/09 1/10 4/10 7/10
1.1
1.2
1.2
1.3
1.3
1.4
1.4
1.5
1.51.6
1/09 4/09 7/09 10/09 1/10 4/10 7/10
Source: Bloomberg, SG Cross Asset Research
The dollar has benefited
from the European
sovereign crisis, but
recently gave back some
of those gains. The
reversal reflects a rotation
of economic fears from
Europe to the US. The data
has been weak in the US
while large European
economies are benefiting
from the weak currency.
Additionally, there is a
sense that European
policymakers are finally
addressing some of the
institutional weaknesses
that have led to the crisis
(EFSF, ECB purchases of
sovereign debt, bank
stress tests).
Over the next 12 months,
we see the dollar gaining
further as the US avoids a
double-dip recession while
the European periphery
continues its struggle with
austerity.
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19 July 2010 21
Commodities and EquitiesCrude Oil (Nymex WTI)
Copper
Consumer Staples -0 .2%
Utilities -0 .7%
Telecom -2 .7%Health Care -3 .7%
IT -4 .3%
Materials -4 .6%
Financials -4 .9%
Industrials -6 .4%
Energy -6 .9%
Consumer Discretionary -8 .7%
VIX
GoldCommodities
Volatility Skew(25 delta put - 25 delta call, SPX Index)
Sector Performance - 4 wk chg
Equities
Baltic Dry Index
20
40
60
80
100
1/09 4/09 7/09 10/09 1/10 4/10 7/10
500
600
700
800
900
1000
1100
1200
1300
1/09 4/09 7/09 10/09 1/10 4/10 7/10
0
10
20
30
40
50
60
1/09 4/09 7/09 10/09 1/10 4/10 7/10
0
2
4
6
8
10
12
14
16
18
1/09 4/09 7/09 10/09 1/10 4/10 7/10
0
50
100
150
200
250
300
350
400
1/09 4/09 7/09 10/09 1/10 4/10 7/10
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
1/09 4/09 7/09 10/09 1/10 4/10 7/10
Source: Bloomberg, SG Cross Asset Research
European austerity,
double-dip fears in the US
and growing concerns on
China have created a
difficult backdrop for
commodities. Aside from
double-dip fears, the
global inventory cycle is
coming to an end now that
production has converged
to demand. This by itself
has reduced demand for
commodities.
While we may not see a
resolution to the above
concerns in the near-term,
we believe that the global
economy will ultimately
overcome the headwinds
and avoid a double-dip.
Sustaining the globalrecovery should underpin
commodity demand and
be supportive for risk
appetite.
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