socgen - the post-election landscape – a fiscal deadlock

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Macro Commodities Forex Rates Equity Credit Derivatives

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18 October 2010

Economics/Strategy SpecialBeyond the Cycle

www.sgresearch.com

American ThemesThe post-election landscape A fiscal deadlock

US Economic Team

Aneta Markowska(1) 212 278 [email protected]

Rudy Narvas(1) 212 278 76 [email protected]

Brian Jones(1) 212 278 69 [email protected]

Martin Rose(1) 212 278 [email protected]

Rates Strategy

Fidelio Tata(1) 212 278 [email protected]

Macro View

Do politics matter? Historically, there is limited correlation between political and economiccycles in the US. This time, however, the stakes are high because of the weak economic

backdrop. With the private sector deleveraging and the external sector not yet ready to pick

up the baton, fiscal policy becomes an important driver of the US economic cycle.

Central scenario a political deadlock. This seems the most likely outcome based on thelatest polls. With Democrats expected to lose at least one house of Congress, it will be

difficult to pass any significant legislation. New fiscal stimulus is therefore unlikely, particularly

as conservatives gain power in Congress. Even with a full extension of the Bush tax cuts, the

fiscal stance for 2011 is likely to be slightly contractionary. This puts added pressure on the

Fed, even though monetary policy cannot fully address current economic problems.

Market Impact

The next FOMC meeting is just a day after the election and is likely to be a bigger marketmover. All else being equal, a reduction of uncertainty and the extension of current tax ratesshould be a positive for risky assets. However, the upside is limited since these are expected

outcomes. The downside would be maintaining current power structure in Congress, or

allowing tax rates to expire. Longer-term, new fiscal stimulus (more likely if Democrats win)

would be positive for equities, negative for the dollar and risky for Treasuries. Conversely,

premature fiscal austerity (more likely if Republicans win) could threaten the recovery and

pose a downside risk for equities, and an upside risk for Treasuries and the dollar.

Mid-term election: The outcomes and implications

Outcome Fiscal/Economic Impact Market Impact

Central scenario: Democratslose the House of

Representatives, maintain

weak advantage in the Senate

Bush tax cuts extended to low- and middle-income families (in lame duck session). No

new fiscal stimulus in 2011. Net effect: fiscal

stance to shave 0.9% from 2011 GDP

All e lse bei ng equal, a reduction of uncertainty and theextension of current tax rates should be a positive f or

risky assets. However, the upside is limited since these

are expected outcomes.

Risk Scenario 1: Democrats

hold on to power in both

houses

Bush tax cuts extended to low- and middle-

income families, but not the wealthy. Better

chance of new fiscal stimulus in 2011, but

status quo could hurt confidence, particularly

on the business side.

Status quo immediately negative for risky assets.

However, new fiscal stimulus, more likely in this

scenario, could prove potent, particularly when

combined with further monetary easing. Dollar negative

on greater monetization fears. A risk for Treasuries.

Risk Scenario 2: Republicans

regain both the House and the

Senate

Greater chance that Bush tax cuts would be

extended for all (even in lame duck session).

An extension of Bush tax cuts for the wealthy would be a

near-term positive for equities. However, the i ncreased

presence of conservatives could lead to premature fiscal

tightening which would be a negative for the economyand risky assets. Bullish Treasuries, bullish dollar.

Source: SG Cross Asset Research/Economics

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


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American Themes

18 October 2010

Do politics matter? The 2011 landscapeHow important is the political backdrop in driving the economic outlook? As much as we want

to think that politics matter, the reality is that there has been very limited correlation between

economic and political cycles in the US. If anything, causality seems to go from the economic

cycle to the political cycle, with most recessions triggering major shifts in the balance of

power. Indeed, it is quite likely that the very high unemployment will create a disgruntled

electorate in coming years, which could lead to a volatile political cycle with high turnover in

every election.

Consumer confidence and political cycles CEO Confidence and political cycles

0

20

40

60

80

100

120

140

160

1967 1972 1977 1982 1987 1992 1997 2002 2007

Conference Board Consumer Confidence Survey

Dem. Control

Rep. Control

Dem. President, Rep. Congress

Rep. President, Dem. Congress

0

10

20

30

40

50

60

70

80

90

1967 1972 1977 1982 1987 1992 1997 2002 2007

CEO Optimism

Dem. ControlRep. ControlDem. President, Rep. CongressRep. President, Dem. Congress

Source: Global Insight, SG Cross Asset Research/Economics

Despite the obvious differences in fiscal positioning between Democrats and Republicans, in

reality there is no obvious relationship between the balance of power and the fiscal stance.

Both parties have been guilty of running up large deficits, regardless of the health of the

underlying economy.

Fiscal budget and political cycles

-11

-9

-7

-5

-3

-1

1

3

1967 1972 1977 1982 1987 1992 1997 2002 2007

Dem. Control Rep. Control

Dem. President, Rep. Congress Rep. President, Dem. Congress

Source: Global Insight, SG Cross Assets Research/Economics



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American Themes

18 October 2010 3

Will the upcoming election matter more than others? The stakes are certainly high this time

around given the economic backdrop. We believe that the US economy is in the midst of a

balance sheet recession, the prescription for which is loose fiscal policy. With the private

sector de-leveraging and unresponsive to monetary stimulus, the economy can only grow in

one of two ways: public sector expansion or net exports. As discussed in our September 23

Global Themes Japan is not the end game, we see external rebalancing as the ultimate end-

game in the US de-leveraging story, but unfortunately US policy does not control the speed of

that adjustment. In the meantime, fiscal policy becomes an important driver of US growth.

Savings-investment imbalances by sector

-12

-10

-8

-6

-4

-2

0

2

4

6

8

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

% of GDP

Savings-Investment Imbalance in the Private Sector

Savings-Investment Imbalance in the Public Sector

Source: Global Insight, SG Cross Assets Research/Economics

To be fair, not all agree with the above argument. Another school invokes Ricardian

equivalence and argues that businesses and consumers are saving in anticipation of future tax

increases. This view argues for fiscal consolidation as a way to unlock private sector demand.

We tend to lean towards the first explanation and see a greater threat in premature fiscal

consolidation.

Regardless of what should be done, the political reality is such that another round of fiscal

stimulus is unlikely, at least not on the scale seen in 2009. The support for fiscal expansion

has been eroding steadily since the spring. This was driven in part by the European sovereigndebt crisis and in part by US public perception that last years stimulus has not done much to

help the economy. The political support for fiscal expansion is likely to erode further after the

November 3 election as fiscal conservatives are likely to increase their presence in Congress.

Mid-term elections polls point to a Republican winBased on the latest polls, there is a very good chance that the mid-term election will result in

Republicans regaining control of the House of Representatives and also picking up a few

more seats in the Senate. Intrade.com, an online prediction market, puts an 87% chance on

Republicans regaining control of the House and a 62% chance that Democrats will lose

control of the Senate. This type of outcome points to a legislative deadlock which makes the

odds of meaningful fiscal stimulus even less likely.

http://www.sgresearch.com/p/en/2/12062/0/B109CD1535EB035CC12577A700506B58.html?sid=ef140e66ae986819dcf34cbf45e10cebhttp://www.sgresearch.com/p/en/2/12062/0/B109CD1535EB035CC12577A700506B58.html?sid=ef140e66ae986819dcf34cbf45e10cebhttp://www.sgresearch.com/p/en/2/12062/0/B109CD1535EB035CC12577A700506B58.html?sid=ef140e66ae986819dcf34cbf45e10cebhttp://www.sgresearch.com/p/en/2/12062/0/B109CD1535EB035CC12577A700506B58.html?sid=ef140e66ae986819dcf34cbf45e10ceb


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Mid-term election polls - Republicans likely to regain the House, Senate a toss up

48

6

46

Senate Polls

Democrats

Toss Ups

Republicans

184

40

211

House Polls

Democrats

Toss Ups

Republicans

Source: realclearpoli tics.com (as of 14 Oct 2010), SG Cross Asset Research/Economics

Though the newly elected Congress does not take over until January 1, the outcome of the

election may matter more in the more immediate future. Three states Illinois, Delaware and

West Virginia are running special elections to replace the interim Senators that replaced

Obama, Biden and the late Senator Robert C. Byrd. Barring unforeseen disputes, winners of

special elections are expected to take their seats - and their first votes - within days of the

Nov. 2 election. Since all three states are contested, there is a chance that Democrats may

lose three Senate seats as of November 3.

Obama economic team - old faces, same flavorThe key members of the administrations economic team did not wait for the two year

anniversary party to hand in their resignations. While there may be a new set of brains, thepolicy recommendation may be similar to the previous one. Aside from the yet to be

announced replacement of Larry Summers, the new blood is mostly old blood already well

established within Obamas inner economic policy circle.

Council of Economic Advisers

Since September, Austan Goolsbee has headed the Council of Economic Advisors, having

replaced Christina Romer. The appointment of Goolsbee is one reason why the status quo

may be the mantra within the inner circle, as he has been part of the Obamas team since the

2008 presidential campaign and was most recently a Senior Economic Advisor to the Office of

the President. Goolsbee is a University of Chicago Economics Professor who is known as acentrist with an interest in the new economy, government policy and taxes.

Office of Management and Budget

Nominated to replace Peter Orszag as Director of the Office of Management and Budget is

Jacob Lew. There have been reports in the press that key members of the inner circle did not

like Orszag, as he was seen as disloyal, hence change was needed. Jacob Lew is no stranger

to the OMB, as he held the same position during the Clinton Administration. He is currently a

Deputy Secretary in the State Department.

National Economic Council

Press reports suggest there is a general set of criteria that the White House is following in the

search for Summers replacement as Director of the National Economic Council. The



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American Themes

18 October 2010 5

preference is for a woman from the private sector, maybe at the CEO level. Even before the

exit of Romer, there had been criticism that there were not enough women within the inner

circle. Furthermore, having an ex-CEO may add credibility to the administration. The potential

candidates include:

Anne Mulcahy - Former Chairman and CEO of Xerox Corporation. Currently sits on Boardsof the Washington Post and Johnson & Johnson. Was member of Obamas Economic

Advisory team during 08 campaign.

Laura DAndrea Tyson - Former Chair of the Council of Economic Advisors in the Clintonadministration. Currently an outside advisor to Obama. Sits on boards of AT&T, Morgan

Stanley, Kodak, CB Richard Ellis.

Ann Fudge - Former CEO of Young & Rubicam, former President of Maxwell House CoffeeCo. Sits on boards of GE, Unilever and Novartis. Appointed by Obama to the NationalCommission on Fiscal Responsibility and Reform.

Diana Farrell - Deputy Director National Economic Council. Former Partner at McKinsey &Co.

Richard Parsons - Chairman Citigroup, Former Chairman/CEO of Time Warner.The front runner for Summers replacement, Anne Mulcahy, has already suggested that she

does not want the job and there are other more qualified people. Tyson, the other leading

candidate, has recently been asked by Obama to get the pulse of business executives on

what can be done to aid the recovery. At the same time, many people may shy away from

Summers position given the economic situation, and with an expected Republican win in

Congress little new may be done on the fiscal policy side to aid the economy.

2010 is not 1994Comparisons to 1994 have been common in recent months. Politically, the current

environment certainly resembles the 1994 backdrop. The period from 1992-1994 saw

Democrats in control of both Congress and the White House. However, only two years into

Clintons presidency, the party suffered a severe setback in the 1994 mid-term election by

losing control of both the House and the Senate for the first time in 40 years. Following the

1994 election, the US economy experienced one of the most prosperous times in its history.

The 1994 scenario is likely to see a replay in 2010, but can it be followed by an economicreplay?

We doubt it very much. In 1994, the US economy was still in the early stages of the leverage

cycle. With strong private sector demand for credit, the fiscal prescription was to cut public

spending to avoid crowding out private sector investment. Today, we are facing quite a

different problem and applying the 1994 analogy may in fact prove hazardous. The private

sector is suffering from an acute demand shortage. If the government cuts spending and

consolidates its finances prematurely, aggregate demand would likely contract.

Legislative AgendaHaving delayed several key votes until after the mid-term election, the lame duck Congress is

facing a heavy legislative agenda. Democrats are considering cramming as many as 20 pieces



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American Themes

18 October 2010

Lame duck session agenda key issuesBush tax cut

extension

Would maintain current tax rates into

2011; otherwise all marginal tax ratesare scheduled to rise between 3% and

5%

Most Democrats want to extend the tax

cuts only for individuals earning less than$200k (and famil ies earning less than

$250). Republ icans want to extend the

cuts for everyone.

Repeal of "Don't ask

don't tell"

Would repeal the current ban on gays

serving openly in the mili tary

Less likely to pass if Republicans control

the House

DREAM Act Part of immigration reform. The bill

would give the children of illegal

immigrants a chance to earn legal

residence


the House

Extension of

unemployment

benefits

Without an extension, about 5 million

workers will lose unemployment

benefits between December and April


the House (Republicans will only approve

it if paid for by other spending cuts)

Medicare doctor

reimbursement

Without action, physicians will face a

Medicare reimbursement cut of 23

percent on December 1, followed by

another 6.5 percent at the beginning

on 2011. This could restrict access to

medical care by senior citizens.


the House. Vote may be delayed until

2011 which would reduce the odds of a

"fix"

China penalty bill Would impose tariffs on Chinese goods

that offset the perceived impact of

currency manipulation

Already passed in the house. Initially had

no support in the Senate, but momentum

has been growing. Senate supporters said

they would push for it to be taken up

during a lame-duck session. The bill has

no White House support.Renewable

electricity standard

The bill would require utilities to

source 15 percent of their electricity

from renewable sources by 2021.

Four Republicans have signed onto the

bill, but Democrats do not have the full

support of their own caucus.

Child nutrition

reauthorization

Most school nutrition programs must

be reauthorized every five years.

Several key programs expired on

September 30, 2010.

Already passed the House and the Senate

Agriculture Committee but stalled in the

House over funding issues.

Ratification of START

II treaty

The treaty was signed by the U.S. and

Russian presidents on April 8 in Prague

as a replacement for the START I

nuclear arms reduction treaty that

expired in December 2009.

67 votes are needed to ratify the

agreement; Democrats currently control

just 59 seats in the Senate

Confirmations of key

economic posts

Jacob Lew is awaiting confirmation as

head of the Office of Management and

Budget and Peter Diamond, a recent

Nobel Prize winner is awaiting

confirmation as a Fed Governor

Lew's confirmation was held up as a

bargaining chip to pressure Obama to

relax the deep water drilling moratorium.

Peter Diamond's nomination was blocked

by certain Republicans who claimed he

did not have the necessary macro policy

background

Source: SG Cross Asset Research/Economics

of legislation into the lame-duck session, before losing Congress to Republicans on January 1.

However, realistically speaking, they will be hard pressed to pass only a small portion of their

planned agenda. The biggest item by far is the Bush tax cuts which are schedule to expire onDecember 31. Democrats also want to tackle Dont ask, dont tell, the DREAM Act, the

extension of emergency unemployment benefits, defense authorization, renewable electricity

standards, Medicare doc reimbursements, cyber security, an arms treaty with Russia, mine



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American Themes

18 October 2010 7

safety, EPA suspension, currency manipulation, food safety and child nutrition. Congress also

has to consider confirming Jacob Lew as head of the Office of Management and Budget and

Peter Diamond, a recent Nobel Prize winner, as a Fed Governor.

Bush tax cutsThe Bush tax cuts will be the top issue on the Congressional agenda following the November

election. Without any action, the cuts will expire automatically at the end of the year, shaving

about 2% from 2011 GDP growth. We assume that they will be extended for low- and middle-

income families, which is the current consensus view. Raising the marginal tax rate on the

wealthy would shave about 0.5% from growth next year, which is implicitly incorporated into

the current forecasts.

Effective Personal Income Tax Rate Legislated Tax Rates by Income Level

8

9

10

11

12

13

14

15

16

69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

% Effective Income Tax Rate

Capital gains taxes di stort thesecalculations - Included in taxes butnot in income calculations.

Bushtaxcuts

Obamatax

holiday

0

10

20

30

40

50

60

70

80

90

100

19

13

19

23

19

33

19

43

19

53

19

63

19

73

19

83

19

93

20

03

%

Highest tax bracket

Low est tax bracket

Scheduledexpiration ofBush tax cuts


We see the chances skewed slightly towards a full extension, including the highest income

earners. Republicans are certainly on board, and there are a number of centrist Democrats

who also support an across-the-board extension of the Bush tax cuts on the premise that the

economy is too weak to withstand any tax increases. The administration is still opposed to a

tax cut for the wealthy, but it is doubtful that President Obama would veto a tax extension bill

simply to impose higher taxes on the rich.

Emergency unemployment benefitsFailure by the Congress to pass legislation extending the federally funded Emergency

Unemployment Compensation (EUC) program after the current November 30, 2010 expiration

date would have a material impact on personal income through April of next year. If the

reported reduction in government unemployment insurance benefits last July is a reliable

guide, roughly 1.075 million persons could fall off EUC rolls per month after the current

deadline passes. Assuming an average payment of $1,325 per person, the projected monthly

reduction to personal income would be about $17.1 billion annualized, or about 0.14%. New

legislation granting retroactive benefits if enacted, however, would prompt immediate catch-

up payments. Such was the case last August.



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18 October 2010

Workers on unemployment benefit rolls

0

1

2

3

4

5

6

7

8

9

10

11

00 01 02 03 04 05 06 07 08 09 10

w orkers, mln

EXTENDED BENEFITS

EMERGENCY UNEMPL COMP

CONTINUING CLAIMS

5mln

workers to

lose

benefits

without

another

extension


Tax breaks for businessesIn September, President Obama announced several new stimulus proposals primarily aimed at

businesses, which include a 100% bonus depreciation, making the R&D tax credit permanent,

and additional infrastructure investment in transportation. The proposals look to support

demand on the business side, putting into to play the mounds of cash corporations are sitting

on which would hopefully help stimulate the overall economy and jobs growth.

1. Infrastructure investment in transportation This would be done by the re-authorizingof the federal transportation act for 6 years. The administration has not given the total cost,

but pledged an immediate investment of $50bn. This would be funded by raising taxes on

oil and gas companies.

2. Making R&D tax credit permanent The credit expired in December. Making itpermanent would cost about $100bn over 10 years.

3. Bonus depreciation for capex investments made through 2011. Businesses were ableto write off 50% of their capex last year. The new proposal would increase it to 100% in

2011. This would allow businesses to keep an estimated $200 bln over the next two years.

Cost would be recovered in future years when no write-off is taken, therefore it would be

net neutral on the deficit over the long run.

There are no plans to address these measures during the lame duck session, so it will be up

to the new Congress to consider the Presidents proposals. Will they pass? For the most part,

Obama has clearly focused on business-friendly ideas that will be difficult for Republicans to

reject. Making R&D tax credit permanent has been something that the party touted in the past

and they should also welcome the bonus depreciation proposal. But, as we have seen in the

delays to the recent Small Business Jobs Act, even getting agreement on relief for businesses

is still not very easy.Republicans are less likely to approve of the infrastructure investment

program, particularly if it is funded by targeted tax hikes on businesses.

More importantly, would these new proposals be successful in stimulating business demand?

At face value, the latest proposals add up to about 2.5% of GDP, but the impact on the

economy is likely to be much less, particularly over the long-run. We suspect that fiscal

multipliers for tax breaks are quite small in the current environment given that businesses are

showing a strong impulse to preserve cash. The unwillingness to spend is driven by two key



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American Themes

18 October 2010 9

factors: uncertainty about future demand and uncertainty about the tax/healthcare/regulatory

environment. Given the lack of visibility on these issues, businesses are unlikely to boost

investment, even in light of substantial temporary tax savings.

Empirical evidence on past stimulus is generally consistent with our conclusions. The CBO

has studied the impact of similar legislation in the 2002 and 2003 stimulus acts and concluded

that it only had modest effects. One CBO study said that it increased output by only 0.1 to 0.2

percent and created only 100k to 200k jobs. The reasons for the rather mild effectiveness

included the expectations that provisions would be extended, the unique circumstances of the

2001 recession, and long planning lags for investment projects.

Direct government spending would be more helpful in our view, but the infrastructure proposal

is small in absolute terms and unlikely to offer a meaningful boost. There is growing opposition

to more Keynesian stimulus in Washington which makes a larger package unlikely in the near-

future.

On the whole, we see the proposals as marginally positive for the economy, but unlikely to

provide enough of a positive shock to change the direction of the expected recovery over the

next 12 months.

Financial Regulation/HealthcareThere has been some anecdotal evidence which suggests that some of the hesitance by

businesses to boost hiring is due to the uncertainty on the regulatory side which is casting a

shadow over the business climate.

Health care reform

The other large act which has left the bitter taste of uncertainty is the health care reform

passed earlier this year. The reform means that most Americans will be required to have health

insurance and most businesses will be required to offer it to their employees. To facilitate this,

the new law will create a new kind of insurance plan called a health insurance exchange. The

main point of contention is the cost, both to the government as well as the private sector.

Also, the long implementation period from 2010 until 2014 gives a lot of time for uncertainty to

fester.

Several insurance companies have already begun to raise premiums, citing the additional

benefits they are forced to offer as a result of the reform bill. Though the most importantprovisions of the health care bill will not kick in until 2014, some have already become

effective. Among them: elimination of lifetime limits on coverage and a requirement that plans

cover dependent children up to the age of 26. By raising premiums, insurance companies are

passing the cost of added benefits to businesses. Large businesses (i.e. those with more than

50 employees) that do not provide health care will also face fines under the new legislation.

There is also a risk for a large number of companies that may fall under the Cadillac plan tax

which penalizes companies that offer high-cost insurance policies.

Adding to the uncertainty is the fact that Republicans have threatened to repeal the healthcare

legislation if they take over Congress in 2011 on the premise that the electorate never

supported the legislation. In a recent AP poll of 1,251 adults, about 40% of respondents wereopposed to the reform, 30% favored it and 30% said they were neutral. Of course, the

Republican threats are nothing more than political posturing as President Obama would never

sign a repeal of healthcare legislation into law. However, there is some chance that at some



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American Themes

18 October 20100

point between now and 2014 a Republican President and Republican Congress could

overturn the healthcare reform. Therefore the uncertainty is likely to fester for some time. To

the extent that this uncertainty is preventing businesses from making long-term investment,

prospects for clarity on the healthcare issue are slim at the moment.

Financial regulation

Though the financial reform bill passed over the summer was less contentious than the

healthcare reform, the issue here is that it leaves a lot of questions unanswered.

For example, the SEC and CFTC must now ensure that standardized derivatives are traded on

exchanges and cleared through central clearing houses, but the act leaves the definition of

what is a standardized derivative to be decided by the regulatory authorities. The Volker rule

limits banks activities in proprietary trading, but there is no clear definition of what proprietary

trading is. The new capital standards for institutions deemed too big to fail have yet to be

decided and are subject to a study. Indeed, the Dodd-Frank bill calls for nearly 70 studies, on

subjects as varied as implementing a fiduciary standard for brokers, analyzing reverse

mortgages, and regulating carbon markets. These studies are a result of proposals that were

watered down in the negotiating process.

That said, firms are already finding ways to circumvent some interpretations of the rule. One

big concern, as pointed out by the Brookings Institute (2010), is that given the complexity of

the act, global coordination may be necessary. Otherwise, we may see regulatory arbitrage

with a race to lower the standards.

Fiscal stance impact on US economyThe fiscal stance for next year is expected to be mildly contractionary, even with a full

extension of Bush tax cuts. The contraction comes from a reversal of the 2009 stimulus

package which has peaked in terms of flows of funds into the economy.

2009 Stimulus 70% spent

$243.0

$163.2

$147.8

$45.0

$60.8

$127.2

0 50 100 150 200 250 300 350

Tax Relief

Entitlements

Direct Spending

USD bln

Paid out Remaining

Infra spendingprojections:20% in 2009

40% in 2010

25% in 2011

10% in 2012

5% thereafter

Source: www.recovery.gov, SG Cross Asset Research/Economics



11/15

American Themes

18 October 2010 11

According to the latest estimates, about 70% of the $787bn American Recovery and

Reinvestment Program has been paid out, and 91% has been made available (i.e. contracts

signed). Though funds continue to be distributed, the impact on the economy occurs on the

margin and the flows are now shrinking. This is true in the case of infrastructure funds and the

grants to state and local government which helped to plug budget holes last year and delayed

the necessary spending cuts. With the amount of available funds now shrinking, local

government have been forced to adopt austerity measures. These cuts will continue into 2011.

Combining the effects of last years fiscal stimulus package wi th a tax hike on high-income

earners, we estimate that fiscal policy will shave 0.9% from growth next year. If the Bush tax

cuts are extended for all income levels, the fiscal drag would shrink to about 0.5% in 2001.

Is there room for more fiscal expansion?Though the economy could use another round of fiscal stimulus, the benefits of more deficit

spending have to be considered in the context of government finances. It is a well know fact

that US public finances are on an unsustainable long-term path which results from an aging

population and rising per-capita healthcare costs. These issues will become more acute

around 2020. Is there room for fiscal expansion in the near-term? Yes, but only with a built-in

exit strategy so that any fiscal expansion does not add to the long-term debt burden.

How far is the US government debt from a downgrade threshold?

4

6

8

10

12

14

16

18

20

22

50 54 58 62 66 70 74 78 82 86 90 94 98 02 06 10 14%

Interest expense, % of federalgovernment budget

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

50% 60% 70% 80%

InterestPayment/Revenue(%)

Debt/GDP (%)

OMB CBO

Aaa Space

Aa Space

'09 '10

'11

'12

'13

'20

'09'10

'11'12

'13

'20

Source: CBO Budget Projections (Aug 2010), OMB Mid-Session Review (July 2010), SG Cross Asset Research/Economics

Can the US run into problems before demographic issues begin to weigh? When will public

debt become unaffordable? While analysts often focus on public debt as a percentage of

GDP, it is more appropriate to examine the debt issue from the angle of interest payments and

the constraints this burden can generate on the budget. Such an analysis introduces more

flexibility in that it allows for a better accounting of the impact of interest rate changes on debt

affordability. Moreover, it is a key metric used by rating agencies in determining the riskiness

of sovereign debt.

From this point of view, the rating of the US sovereign debt does not seem to be at risk, at

least in the near future. Interest payments by the federal government currently amount to just



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American Themes

18 October 20102

8% of the total spending the lowest levels since the mid-1970s despite a debt load that is

almost three times the size. For credit rating agencies, the demarcation zone or reversibility

band between AAA and AA is a 10% debt affordability ratio (interest/budget) for the general

government. In the case of the US, removing state and local governments from the equation

translates to about 18% as the threshold on federal debt interest. The ratio for 2010 -

projected at around 9% - is only half way to this threshold.

When will US public finances hit the point of no return? It depends on the assumptions about

the path of interest rates. According to Moodys, the US could come dangerously close to the

reversibility band as soon as 2013. Using OMB or the non-partisan CBO assumptions on

interest payments suggests that the US has until 2020 before it comes close to the

downgrade threshold. The OMB and CBO in their budget projections assume a slow and

gradual increase of the effective interest rate (net interest/debt) that would only double in 10

years. This corresponds to of the most favorable scenarios in Moodys projections. Their

baseline scenario assumes a sharper rate increase that would bring the 5y yields to 4% in

2012 from the current 1.2%. In the adverse scenario where yields would surge to 6%, the

reversibility band would be hit before 2013.

How does the US compare?CDS 10Y Yield

Rating Outlook Rating Outlook 2009 2011 2009 2011

Austria AAA STABLE Aaa STABLE 74 70% 77% 2.3% 3.4% 2.72%

Belgium AA+ STABLE Aa1 STABLE 122 101% 105% 0.5% 2.1% 3.16%

Finland AAA STABLE Aaa STABLE 28 53% 69% 1.3% 3.1% 2.51%

France AAA STABLE Aaa STABLE 69 86% 99% -2.2% -1.9% 2.70%

Germany AAA STABLE Aaa STABLE 33 76% 84% 5.0% 7.2% 2.29%

Greece BB+ NEG Ba1 STABLE 690 119% 139% -11.2% -6.7% 8.88%

Ireland AA- NEG Aa2 *- - 418 70% 92% -2.9% 1.4% 6.17%

Italy A+ STABLE Aa2 STABLE 173 129% 135% -3.1% -3.5% 3.74%

Netherlands AAA STABLE Aaa STABLE 42 69% 79% 5.4% 5.9% 2.50%

Portugal A- NEG A1 STABLE 380 87% 99% -10.3% -10.3% 6.08%

Slovakia A+ STABLE A1 STABLE 77 39% 49% -1.3% -3.0% 3.66%

Spain AA NEG Aa1 STABLE 203 63% 78% -5.4% -3.3% 3.99%

United Kingdom AAA NEG Aaa STABLE 57 72% 91% -1.3% -1.0% 2.87%

United States AAA STABLE Aaa STABLE 44 83% 95% -2.9% -4.0% 2.43%

Canada AAA STABLE Aaa STABLE - 82% 81% -2.7% -1.6% 2.76%

Japan AA NEG Aa2 STABLE 54 193% 205% 2.8% 3.5% 0.89%

Australia AAA STABLE Aaa STABLE 35 19% 26% -4.1% -2.8% 5.03%

New Zealand AAA STABLE Aaa STABLE 46 35% 44% -3.0% -6.0% 5.03%

General Gov't

Debt/GDPDEBT RATING

as of

10/14/2010

as of

10/14/2010

S&P Moody's

Current Account

Balance/GDP

OECD Esti mates OECD Estimates

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

Source: OECD Economic Outlook, Bloomberg, SG Cross Asset Research/Economics

While rates are likely to remain low for some time, the high reliance on foreigners to finance

US deficits is a source of concern. If inflows of foreign capital were to stop abruptly, the

impact on US finances could be very damaging. Yet, this risk is mitigated by the fact that

foreigners have to recycle their savings somewhere and there are limited destinations for

those savings. For now, the strong appetite from investors for Treasury debt can be read as a

green light for more fiscal stimulus. However, to ensure against potential tail risks, any new

fiscal expansion should be accompanied by a credible exit strategy that limits the impact on

the outlook for debt growth.



13/15

American Themes

18 October 2010 13

Market impactTo what extent do mid-term elections matter?There is only sparse statistical evidence that a particular outcome of U.S. mid-term elections

triggers a systematic reaction in the financial markets. Specifically, political gridlock (a

situation in which the White House, the U.S. Senate and the U.S. House of Representatives

are not controlled by the same party) cannot be easily identified as a useful factor in the asset

allocation process.1For example, 10-year Treasury rates have shown little, if any, directionality

that can be attributed solely to the presence of the four political gridlocks experienced in the

U.S. since 1970.

No systematic impact of political gridlock on 10-year Treasury yields

2

4

6

8

10

12

14

16

1962 1967 1972 1977 1982 1987 1992 1997 2002 2007

10-yearTreasury[%]

Democratic gridlock

Republican gridlock

No gridlock

Here, we define a Democratic gridlock as a period when Democrats control the White House but not Congress. Viceversa, a Republican gridlock covers periods with Republicans in the White House with Dems controlling Congress.

Source: SG Cross Assets Research/Rates Strategy, Bloomberg

A coincidental or a causal relationship?At the time of writing, the market predicts a roughly 87% chance of Republicans controlling

the House of Representatives after the 2010 Congressional elections according to Intrade2.

Since the beginning of this year, this probability has risen from around 40% while at the same

time the 2s10s yield curve slope has declined and implied volatility has fallen. Is this a

coincident? While the high R-square (coefficient of determination) of the regressions between

the expected election outcome and slope and vol, respectively, points to some sort of

relationship, we believe this is mostly coincidental. Yield curve flattening and the decline in

implied volatility is mostly the outcome of QE2, which in turn is the result of a weakening

1 For an analysis of political gridlock on the stock market see: Fidelity Investments

(2010) Do midterm elections impact stocks? as of 9/28/10.

2 Intrade is a prediction market where one can buy and sell "shares" in financial,

political, weather and other important subjects. See http://www.intrade.com

https://guidance.fidelity.com/viewpoints/midterm-electionshttps://guidance.fidelity.com/viewpoints/midterm-electionshttps://guidance.fidelity.com/viewpoints/midterm-electionshttps://guidance.fidelity.com/viewpoints/midterm-elections


14/15

American Themes

18 October 20104

economy. The weak economy, on the other hand, also causes voters dissatisfact ion with the

ruling party (Democrats), which results in political gains of the opposing party (Republicans).

Election outcome and 2s10s curve slope Election outcome and 5y5y swaption volatility

R = 0.8132

Data since 2010

190

215

240

265

290

30 40 50 60 70 80

2s10sTSY[bp]

Probability of Republicans to control theHouse of Representatives [%]

R = 0.8016

Data since 2010

90

100

110

120

130

30 40 50 60 70 80

5y5yVol[bp/year]

Probability of Republicans to control theHouse of Representatives [%]

Source: SG Cross Asset Research/Rates Strategy, Bloomberg, intrade Source: SG Cross Asset Research/Rates strategy, Bloomberg, Intrade

Eclipsed by the November 3 FOMC meetingWhile the November 2 mid-term elections will certainly have some (although a hard to predict)

impact on the financial markets, the FOMC meeting on the following day is the by far more

important event. As the market is waiting for clarity about the shape and form of QE2, implied

volatility is likely not to move significantly in either direction until after the November 3 FOMCmeeting. The same is true for outright interest rate levels, curve slope, swap spread and other

important product classes within fixed income.

For this reason we recommend that market participants do not alter their investment behavior

solely based on the mid-term elections, but rather stay focused on fundamental economic

data and news regarding QE2.



15/15

American Themes

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