jefferies & company, inc. · 2011. 4. 21. · economic expansion: sustainable, gdp remains...

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

[email protected]

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

0 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

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$50

$100

$150

$200

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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


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

‐‐


/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 ,


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 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

‐

‐


‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

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


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


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

‐‐


‐

‐

‐

‐

‐

‐

‐


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


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

�


10

12

14

16

18

ent


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

Important Disclosures

This commentary has been produced by a Jefferies & Company, Inc. trading desk and is not a fixed income research report prepared by a research analyst. The views of the trading desk may differ from those of the Research Department. The trading desk trades or may trade as principal in the securities that are the subject of this trading commentary. The trading desk has or may have proprietary positions in the securities that are the subject of this trading commentary. This is a marketing communication and is not and should not be construed as investment researchis a marketing communication and is not and should not be construed as investment research.

This material has been prepared by Jefferies & Company, Inc. ("Jefferies") a U.S.-registered broker-dealer, employing appropriate expertise, and in the belief that it is fair and not misleading. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Additional and supporting information is available upon request. This is not an offer or solicitation of an offer to buy or sell any security or investment. Any opinion or estimate constitute our best judgment as of this date, and are subject to change without notice. Jefferies and its affiliates and its and their respective directors, officers and employees may buy or sell securities mentioned herein as agent or principal for their own account. In the United Kingdom this material is issued and approved by Jefferies International Limited and is intended for use only by persons who have professional experience in matters relating to material is issued and approved by Jefferies International Limited and is intended for use only by persons who have professional experience in matters relating to investments falling within Articles 19(5) and 49(2)(a) to (d) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (as amended), or by persons to whom it can otherwise be lawfully distributed. In the member states of the European Economic Area this document is for distribution only to persons who are "qualified investors" within the meaning of article 2(1)(e) of The Prospectus Directive. For Canadian investors, this document is intended for use only by professional or institutional investors. None of the investments or investment services mentioned or described herein is available to other persons or to anyone in Canada who is not a "Designated Institution" as defined by the Securities Act (Ontario). For investors in the Republic of Singapore, this material is intended for use only by accredited, expert or institutional investors as defined by the Securities and Futures Act and is distributed by Jefferies Singapore Limited which is regulated by the Monetary Authority of Singapore Any matters arising from or in connection with this material should be brought to the attention of Jefferies regulated by the Monetary Authority of Singapore. Any matters arising from, or in connection with, this material should be brought to the attention of Jefferies Singapore Limited at 80 Raffles Place #15-20, UOB Plaza 2, Singapore 048624, telephone: +65 6551 3950. In Australia this information is issued solely by Jefferies & Company, Inc. and is directed solely at wholesale clients within the meaning of the Corporations Act 2001 of Australia (the "Act") in connection with their consideration of any investment or investment service that is the subject of this document. Any offer or issue that is the subject of this document does not require, and this document is not, a disclosure document or product disclosure statement within the meaning of the Act. Jefferies & Company, Inc. is regulated by the Securities and Exchange Commission and the Financial Industry Regulatory Authority, under the laws of the United States of America, which differ from Australian laws. Jefferies & Company, Inc. has obtained relief under Australian Securities and Investments Commission Class Order 03/1100, which conditionally exemptspts it from holdingg an Australian financial services license under the Act in respect of the provision of certain financial services to wholesale clients.spect p Recipients of this commentary in any other jurisdiction should inform themselves about and observe any applicable legal requirements in relation to the receipt of this material. Jefferies International Limited is authorized and regulated in the United Kingdom by the Financial Services Authority. Its registered office is at Vintners Place, 68 Upper Thames Street, London EC4V 3BJ; telephone +44 20 7029 8000; facsimile +44 20 7029 8010.

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29

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