socgen - us deleveraging - intermezzo. the plot thickens in next act

7/27/2019 SocGen - US deleveraging - Intermezzo. The plot thickens in next act.

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Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document

26 April 2010

EconomyBeyond the cycle

www.sgresearch.com

Stephen GallagherChief US Economist

(1) 212 278 [email protected]

Aneta MarkowskaSenior US Economist

(1) 212 278 [email protected]

Martin RoseResearch Associate(1) 212 278 [email protected]

The US private sector has undergone significant de-leveraging in the past two years.Households and businesses have succeeded in cutting their debt burdens. The US government,as an offset, has added on a substantial debt position. Further deleveraging is expected, butnow the private sector paydowns should slow. In phase two, greater deleveraging is likely tooccur as incomes and profits grow faster than the private sector credit. We do not anticipate atragedy as deleveraging plays out. But in Act II, the plot thickens in two ways. First, does theresumption of private sector credit growth imply crowding out? Government debt growthremains substantial. Second, will foreign investors continue to finance large US deficits? Thedeficit is now being financed almost entirely via foreign purchases of Treasury debt.

Q Households half way there Debt burden has declined to 2000 levels on the back of lowerinterest rates, spending cuts and debt write-offs. At current consumption levels, debt loads

are set to decline further. Timing is uncertain, but policy is targeting a gradual rise in savings.

Q Corporate sector gone too far This was one sector of the US economy that didnt reallyneed to de-lever, but companies responded to the crisis by bullet proofing their balance

sheets. Corporations have been replacing hard assets with cash which is very abnormal.

Q Small business more work ahead Unlike the corporate sector, small businesses enteredthe crisis with much more leverage and much higher concentration in real estate assets. The

contraction in asset prices was therefore far more damaging for the small business sector

which will likely continue to face de-leveraging pressures.

Q Government piling on debt The government has picked up where the private sector leftoff and is now largely responsible for the US external savings deficit. Public spending was

needed to prevent an economic downward spiral, but it came at a substantial cost that further

burdens fiscal finances. Unfortunately, the longer term fiscal outlook is a train-wreck waiting to

happen.

American ThemesUS deleveraging Intermezzo. The plot thickens in next act.

Leverage migration where is the end game?From corporates To households and small businesses To public sector

0

10

20

30

40

50

60

55 60 65 70 75 80 85 90 95 00 05 10

%of GDP

Corporate business

0

10

20

30

40

50

60

70

80

90

100

55 60 65 70 75 80 85 90 95 00 05 10

%of GDP

Household sector

Noncorporate business

0

10

20

30

40

50

60

70

80

90

100

55 60 65 70 75 80 85 90 95 00 05 10

%of GDP

Government

Source: Federal Reserve, SG Cross Asset Research

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


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American Themes

21 April 2010

US households deleveraging via savings, lowerinterest, and to some extent via debt forgivenessHouseholds appear to be doing all the right things in terms of repairing their balance

sheets. The savings rate has increased notably from secular lows and debt levels are

declining. However, more work needs to be done based on the savings rate which is still

below the long-term target. Timing is uncertain, but policy is fully calibrated in support

of a gradual rise (offset by income growth) in savings.

Over the past 2 years, households have made some notable progress toward repairing their

balance sheets. There are many different metrics that measure the extent of leverage, but our

preferred measure for households is the debt service ratio which compares debt payments

(interest + principal) to disposable income. As of Q4, the ratio stood at 12.6%, the lowest

since 2000, and importantly pre-dating the housing bubble.

How did households achieve such a quick reduction in debt burden? It took a lot of sweat

and tears (i.e. savings), some debt forgiveness, and some help from policy. All three have

contributed to a notable reduction in debt levels. Additionally, policy helped by serving up

ultra-low interest rates which presented many households with refinancing opportunities.

Household debt burden lowest in 10 years!

50

60

70

80

90

100

110

120

130

140

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

10.0

10.5

11.0

11.5

12.0

12.5

13.0

13.5

14.0

Household Debt, % of Disp. Income (LHS)

Debt Servi ce, % of Disp. Pers. Income (RHS)

Decline in debt

burden due to debt

reduction

Decline in debt

burden due to lower

interest rates


In fact, lower interest rates explain about two-thirds of the reduction in debt burden. This ishelpful today, but the benefit to households will be partially reversed out as interest rates

begin to rise. Another temporary boost has come from tax cuts which have lifted disposable

income, boosted the savings rate and reduced the debt service ratio. As these cyclical and

one-off factors begin to fade, debt levels will have to decline further to maintain/reduce debt

service ratios.

The speed of debt reduction depends on two factors: the level of savings and charge-off

rates. While higher savings/lower spending has contributed to debt reduction, our estimates

suggest that debt forgiveness has played a significant role. Indeed, looking the Feds data on



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American Themes

26 April 2010 3

charge-off rates at commercial banks, we calculate that principal write-downs explain almost

all of the reduction in mortgage debt and about half of the reduction in consumer credit

outstanding.

How much de-leveraging through defaults and debt forgiveness?

-150

-100

-50

0

50

100

150

200

250

300

350

99 01 03 05 07 09

USD bln

Mtg Charge-offs (above norm)

Change in Mtg Debt Outstanding

Charge-offs explain almost all of the reductionin mo rtgage debt outstanding

-60

-40

-20

0

20

40

60

80

99 01 03 05 07 09

USD bln

Cons Credit Charge-offs (above norm)

Change in Consumer Debt Outstanding

Charge-offs explain about 50% of reduction

in consumer debt outstanding

2000

3000

4000

5000

6000

7000

8000

9000

10000

11000

99 01 03 05 07 09

USD bln

Mortgage Debt Outstandin gPro-forma without charge-offs

1000

1200

1400

1600

1800

2000

2200

2400

2600

2800

99 01 03 05 07 09

USD bln

Consumer Credit Outstandin gPro-forma without charge-offs

Charge-off estimates are based on bank charge-off rates from the Federal Reserve. We assume that the performance of bank assets is a

good proxy for the entire universe of mortgage and consumer debt (including debt that has been securitized).Source: Federal Reserve, SG Cross Asset Research

To be sure, organic debt reduction is also taking place and is set to continue. That s because

gross borrowing, determined by current levels of spending, is running below scheduled

principal repayments which are determined by past spending. In other words, the substantial

contraction in spending that occurred over the past 2 years will ensure that household debt

levels continue to shrink for the next several quarters. This is true even while allowing for some

nominal growth in spending.



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American Themes

21 April 2010

Lower spending also contributing to debt decline more to come

0

100

200

300

400

500

600

700

800

900

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

USD bln

Residential Investment (proxy for gros s borr owing)

7yr mov avg (proxy for pr incipal repayments)

-600

-400

-2000

200

400

600

800

1000

1200

1400

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

USD blnChange in Mtg Debt Outs tanding

0

200

400

600

800

1000

1200

1400

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

USD bln

Durable Good Spending (proxy for gross borrow ing)

5yr mov avg (proxy for pr incipal repayments)

-200

-150

-100-50

0

50

100

150

200

250

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

USD blnChange in Consumer Debt Outstanding

Source: Federal Reserve, BEA, SG Cross Asset Research

Will more spending cuts be required to complete the de-leveraging process of households?

This is the million dollar question, but without an obvious answer. While the savings rate is still

below long-term equilibrium and will eventually have to rise toward 7%, there are many ways

of getting there: lower consumption, higher income, lower effective tax rates or lower interest

payments. In a best-case scenario, we will get there via income growth, which would allow

consumption to grow modestly at the same time (with income being subsidized by exports).

This scenario is implicitly embedded in the current consensus thinking, and fully supported bycurrent policy efforts. Of course the risk is that policy efforts are derailed (or withdrawn

prematurely), triggering another wave of disorderly de-leveraging. In addition, we must

consider the long-term outlook for taxes and interest rates, both of which are likely to move

higher in the 3-5yr time frame. All else being equal, this will require further spending cuts

relative to income.

More work to be done

-1.0

1.0

3.0

5.0

7.0

9.0

11.0

13.0

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

multiple3.5

4.0

4.5

5.0

5.5

6.0

6.5

Savings Rate (LHS)

Household Wealth/Disposable Income - Inverted (RHS)

Policy has stabilized the savings rate by:

1. Reflating asset prices2. Boosting disposable income (tax cuts)3. Restoring credit flows




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American Themes

26 April 2010 5

Corporate sector saving too much and replacinghard assets with cashThis was one sector of the US real economy that didnt really need to de-lever, yet

corporate America too has been busy bullet proofing its balance sheets. In addition to

hoarding cash, businesses are allowing their tangible assets to shrink for the first time

in history. Putting the two facts together suggests that businesses are replacing

physical capital with cash. For an economy with positive potential growth, this situation

is abnormal. Normalization supports more capital spending in the coming quarters.

The US corporate sector as a whole did not have a serious leverage problem going into the

crisis. Yes, corporate debt levels have risen relative to GDP or revenues, but unlike in the

household sector, corporate sector debt growth can be fully explained by declining interest

rates. Interest payments on debt have in fact shrunk as a percentage of revenues since

peaking in the early 1990s. Debt affordability does not seem to be a problem for the corporate

sector, at least not at current levels of interest rates.

Corporate leverage: debt vs. interest payments

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

55 60 65 70 75 80 85 90 95 00 05 10

0

20

40

60

80

100

120

Interest/GVA (LHS)

Debt/GVA (RHS)


Yet, despite relatively healthy corporate finances going into the crisis, businesses have spent

the last 5 quarters bullet proofing their balance sheets.

Corporate cash positions are abnormally high. In Q4, the non-financial corporate sector held

5.9% of its assets in cash-like instruments. This is up from 4.4% in late 2008 and the highest

share of cash assets on record. In the immediate aftermath of the credit crunch, it is notsurprising that corporates are hoarding cash. Typically businesses use bank credit lines to

fund their inventory positions and many found their credit lines cut off or reduced following the

financial crisis. They simply do not want to find themselves in the same position again.



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American Themes

21 April 2010

Corporate cash holdings at record high Debt swapping away from short-term

1.0

2.0

3.0

4.0

5.0

6.0

7.0

54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08

% of Assets ST FINANCIAL

ASSETS

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08

% of Assets

CORPORATE BONDS

BANK LOANS + CP

Source: Federal Reserve, SG Cross Asset Research Source: Federal Reserve, SG Cross Asset Research

Significant changes have also been made on the liability side of corporate balance sheets.

Between Q308 and Q409, nonfinancial businesses reduced their bank loans and commercial

paper outstanding by about $200 bln while increasing corporate debt by $430 bln. This has

reduced their reliance on short-term debt and the vulnerability associated with debt rolls.

While this bullet proofing of corporate

balance sheets is understandable in

the wake of the crisis, we believe that

businesses are now overdoing it. They

are saving too much, and not investing

enough. We draw this conclusion from

the fact that tangible corporate assets

measured at historical costs have

contracted for the first time on record.

This is a result of allowing capex to fall

below depreciation. This means that

corporate America is currently

replacing physical assets with cash.

Putting the pieces of the puzzle

together, we come to the conclusion

that businesses are replacing physical capital with cash. From a micro-standpoint, this is a

potentially self-destructing behavior because it reduces a companys long term earnings

growth potential which is not the best way to maximize shareholder value. For an economy

with positive trend growth (which we still deem to be a very safe assumption for the US), thissituation is abnormal. As businesses gain confidence about the recovery and about their

access to funds, they will be pressured to deploy the abnormally high cash cushions.

Another differentiating factor between households and businesses is income generation which

can go a long way in aiding the de-leveraging process. Whereas personal income growth is

still tentative, the corporate sector has already seen four quarters of very strong cash flow

generation which should continue in 2010. This is adding to the already large pile of corporate

cash which is screaming to be deployed. We see the corporate sector as being in the best

position to resume spending and contribute positively to US domestic demand.

Tangible assets at historical cost

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

USD trillion

TANGIBLE ASSETS AT COST

The first decline on record




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American Themes

26 April 2010 7

Small businesses still too much debtSmall business balance sheets look more like those of households, less like corporate

business. The slow recovery in small business activity is being blamed on poor access to

credit, but perhaps there is a reason. Small businesses have entered the crisis with

much more leverage than corporate America. Additionally, their asset base was much

more concentrated in real estate, most of it in residential real estate. The contraction in

asset prices was therefore far more damaging for the small business sector which is in

a much worse position to resume borrowing and spending.

The US small business sector has been a laggard in the recovery cycle. In fact, judging from

the NFIB confidence survey, it has not participated at all in the pickup in economic activity.

This underperformance is generally being attributed to lack of credit. Unlike corporate

America, which was able to turn to the credit markets to contend with tighter bank lending

standards, small businesses did not have that option. Additionally, small regional banks which

are the bloodline of small business loans remain heavily burdened by their commercial real

estate holdings and are not in a position to resume lending. While this is certainly an important

part of the story, we think that there is a more fundamental reason for small business

underperformance.

Unlike corporate America, small businesses entered the crisis in a much more leveraged

position. More importantly, their assets were much more heavily concentrated in real estate

(much of it residential), which made them more vulnerable to the historic price declines in

home prices. As prices declined, the already high leverage positions increased further.

Small business has more leverage and higher asset concentrations in real estate

Debt/Asset Ratio

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

55 60 65 70 75 80 85 90 95 00 05

Non-financial corporates

Non-corporate Business

% of Assets in Real Estate

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

55 60 65 70 75 80 85 90 95 00 05

Non-financial corporates

Non-corporate Business


In an effort to reduce leverage, small businesses have been shedding debt, but until recently

their efforts were being undermined by further price declines. Debt/asset ratios appear to have

stabilized in Q4, but further debt reduction will likely be needed to restore them to normal

levels.

Another difference between small and large businesses is cash positions. Whereas corporate

America has been generating a lot of cash, and hoarding most of it, small businesses have

sharply reduced their cash positions in recent quarters. This cash-bleed is unprecedented,



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American Themes

21 April 2010

and likely reflects a combination of poor profit performance but also the inability to access

credit which has forced small businesses to dip into their cash cushions for inventory

financing and other working capital needs.

Net changes in cash assetsSmall business sector (non-fin non-corporate)

-100

-80

-60

-40

-20

0

20

40

60

80

100

120

90 92 94 96 98 00 02 04 06 08

USD bln

Net change in cash positions (2 qtr moving average)

Corporate business sector (non-fin)

-200

-100

0

100

200

300

400

90 92 94 96 98 00 02 04 06 08 10

USD bln

Net change in cash positions (2 qtr moving avg)


Despite the high debt levels in the small business sector, interest payments on debt have

declined substantially in recent quarters. As a share of revenues, interest expense has

dropped from 12.3% in 2007 to 6.2% currently. Though debt reduction and interest rate

declines may explain the increase in debt affordability, the magnitude of the improvement

appears to be disproportionate. One explanation is that small businesses have shifted their

debt to shorter maturities (as their variable rate mortgages reset to Libor). If so, they will be

vulnerable to a reversal of the Feds easing cycle.

Small business leverage: debt vs. Interest payments

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

65 70 75 80 85 90 95 00 05 10

Interest /GVA (LHS)

Debt/GVA (RHS)


Though asset prices have likely stabilized, we believe that debt levels in the small business

sector remain too high and will continue to restrain demand for credit from the sector. Supply

remains an issue as well, although the Small Business Administration (SBA) can use stimulus

dollars to support certain small businesses which are in a position to borrow, but cannot get

access to credit. The bottom line, however, is that small businesses remain too leveraged and

too cash strapped to be in a position to resume spending and support economic activity.



9/19

American Themes

26 April 2010 9

Government picking up where the private sectorleft off While the private sector has been working hard to reduce its debt burden, the US

government has done the opposite. Unfortunately for now, the economy remains

dependent on government stimulus policies and even in recovery it may be vulnerable if

fiscal policy is tightened too quickly. However, the longer term fiscal outlook is a train-

wreck waiting to happen if consolidation programs are not adopted in the next few

years. The risk is that investors move ahead of Congress, forcing another leg of dis-

orderly deleveraging.

Fiscal expansion is always a double-edge sword, particularly the historically large fiscal

stimulus that was put in place following the financial and economic meltdown of 2008. Public

spending was needed to prevent an economic downward spiral, but it came at a big cost.

Currently, the government is financing record debt levels at a very low cost, but the interest

burden is likely to increase substantially as the economy recovers. In addition to cyclical

pressures on interest rates and debt affordability there is the additional risk associated

with a potential demand-supply imbalance in the Treasury market. Issuance will remain

substantial in the coming years, but foreign demand for Treasury debt is in question,

particularly if the government fails to undertake structural fiscal reform in the next few years.

The problem is not current debt but future growth

0

2

4

6

8

10

12

14

16

18

20

22

50 55 60 65 70 75 80 85 90 95 00 05 10

%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Interest/Gov't Budget

Interest/GDP

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Civil

War

Debts

incurred

during

Revolutio

nary War

WWI

WWII

Depression

spending

War of

1812

SG

Projections

Source: Federal Reserve, BEA, Cross Asset Research

To be sure, debt affordability is not a problem today. The US government is currently financing

its debt at an effective rate of 2.3%, the lowest since the 1950s. This explains why interestexpense as percent of budget or GDP has not changed at all in the past 3 years despite a

sharp increase in debt levels. However, that doesnt mean that it wont change in the future.

First, interest rates are likely to rise from these historically low levels, which alone could

substantially reduce debt affordability. Secondly, the debt level (as percent of GDP) is also

likely to rise in the next few years, particularly if temporary tax cuts are extended beyond their

planned expiration at the end of 2010. As a result, interest expense is almost certain to rise

substantially in the next few years, which raises some concern about downgrade risk.

For ratings agencies, the key metric in evaluating downgrade risk is the share of government

budget that goes toward interest expense. For the US, the Aaa demarcation zone is seen at



10/19

American Themes

21 April 20100

18%, more than double the current level. The US is expected to stay clear of that threshold in

the next three years in all but the most adverse economic scenarios the adverse scenario

involving much larger deficits than are currently projected. Another risk is an interest rate

shock, but it would have to be substantial. Based on current debt projections, the effective

interest rate paid by the government would have to rise by about 250 bps (with 3m Tbills near

3% and a 10yr yield near 6%) in order to trigger the debt affordability threshold.

While we see limited risk of a US sovereign debt downgrade in the next 2-3 years, beyond that

we cannot be so certain. For now, the economy needs public support, but at some point the

government will have to consolidate its finances which may require spending cuts and/or tax

increases. Additionally, the longer term fiscal outlook is a train-wreck waiting to happen if

serious consolidation efforts are not adopted by Congress. Under current law, i.e. without

serious reform of the entitlement program, fiscal finances are set to explode around 2020-

2030. For now, Treasury investors have given the government the benefit of doubt, but it is not

clear how much more time the government can buy. The risk is that investors move ahead of

Congress, forcing another leg of dis-orderly deleveraging.

The impact of entitlements on government debt

-20%

30%

80%

130%

180%

230%

280%

330%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 2030 2050

Path 1: Based on current law (i.e. temporary tax cuts expire)

Path 2: Alternative scenario (tax cuts extended)

2

1

Source: US Treasury, CBO

For a more detailed discussion of the US fiscal outlook, supply and demand, see March 22,

2010 American Themes, US recovery now fiscal consolidation later if there is still time.

Putting it all together Have we really made anyprogress?Though the private sector has done a significant amount of de-leveraging in the past 2

years, the economy as a whole has not made much progress at all. Indeed, it continues

to run a significant savings deficit which is adding further to its national debt.

Depending on what data we use, the US savings imbalance is anywhere between 3% of

GDP (current account) and 6% of GDP (savings-investment approach). As a whole, the

US economy has made little progress toward de-leveraging and re-balancing.

De-leveraging and re-balancing by definition have to go hand in hand. De-leveraging implies

reducing the debt, which can only be done by eliminating the savings-investment deficit. The

other side of that deficit is the current account. Both imply that the US economy as a whole



11/19

American Themes

26 April 2010 11

remains highly dependent on foreign capital. Foreign willingness to finance this deficit is a key

source of vulnerability for the US economy.

US is still dis-saving!

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

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

% of GDP

Savings - Investment Imbal ance

Current Account Balance

The difference is a

statistical discrepancy

Source: OECD, Bloomberg, SG Cross Asset Research

So, how much progress have we made? Some, but there is more work to be done. The private

sector has done a lot of work toward reducing its savings-investment imbalance, but the

public sector has undone most of the work. As a result, gross national savings are still falling

short of domestic investment to the tune of 6% of

GDP. Theoretically, this figure should equal the

current account balance, since the savings deficit

has to be financed externally, but statistical

discrepancies can lead to large gaps in these two

measurements. According to the current account,

the US is running a savings deficit of 3% of GDP.

We tend to believe the current account numbers,

because they are reaffirmed by a similar pattern in

foreign capital flows. Even so, the US economy

still has a long way to go toward closing the

savings deficit and stabilizing US external debt.

Savings-investment imbalances by sector

-15

-10

-5

0

5

10

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

% of GDP

Savigns-Investment Imbalance in the Household Sector

Savigns-Investment Imbalance in the Business Sector

Savings-Investment Imbalance in the Public Sector

Source: OECD, Bloomberg, SG Cross Asset Research

Savings falls faster than investment

0

5

10

15

20

25

78 83 88 93 98 03 08

% of GDP

Gross Domestic InvestmentGross National Savings

Source: SG Cross Asset Research



12/19

American Themes

21 April 20102

In the meantime, the external deficit is the Achilles heel of the US economy because it makes

it vulnerable to disruptions in foreign financing. We learned this the hard way in mid-2007

when foreign purchases of US structured credit assets stopped abruptly and triggered dis-

orderly de-leveraging of the private sector. Prior to the crisis during 2006 and early 2007,

these purchases had financed more than half of the US external deficit. Today, Treasury debt

is playing a similar role, not only by attracting large amounts of foreign capital, but by doing so

despite the very unsustainable fiscal outlook. In 2009, foreigners purchased 36% of net new

supply, or $502 bln. This amounts to 120% of the US current account deficit, suggesting that

the US government is now solely responsible for the entire external deficit. If foreign demand

for Treasury debt were to stop abruptly, similarly to the sub-prime experience of 2007, the

implications for the US economy would be catastrophic.

US capital inflows external deficit now financed largely via Treasuries

6m averages

Forei gn Pri vate Purchases of US Assets Forei gn Offi ci al Purchases of US Assets

-20

-10

0

10

20

30

40

50

60

00 02 04 06 08 10

Treasury

Agency

Corp Bonds

Equity

-15

-10

-5

0

5

10

15

20

25

95 97 99 01 03 05 07 09

Treasury

Agency

Corp Bond


ConclusionsOur analysis of sector financials suggests that households and the government have further to

go in terms of boosting their savings and reducing debt levels. Among those two, the

government has a lot more heavy lifting to do. In contrast, the corporate sector appears to be

saving too much and not investing enough.

Financial markets can remain complacent for long periods of time, but sooner or later

investors have a way of forcing necessary adjustments. If there is a second chapter of the

disorderly deleveraging/rebalancing of the US economy, its beginning would likelyoriginate in the Treasury market. This is where investors should look for warning sings.

All sectors of the US economy even the healthy corporate sector have increased their

sensitivity to interest rate increases in the past decade. Any problems in the Treasury market

would substantially increase the debt burden for the entire economy.



13/19

American Themes

26 April 2010 13

SG Forecasts

Economic forecastsAnnual year/year

2008 2009 2010 2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 A A E E

Real GDP -6.4 -0.7 2.2 5.9 3.8 3.5 2.9 3.1 0.4 -2.4 3.5 2.9

Real Final Sales -4.1 0.7 1.5 1.9 3.0 3.2 2.9 3.0 0.8 -1.7 2.5 2.9

Consumption 0.6 -0.9 2.8 1.7 2.5 2.9 2.9 3.0 -0.2 -0.6 2.3 2.9

Non-Resid Fixed Investment -39.2 -9.6 -5.9 6.5 6.7 7.7 4.5 6.1 1.6 -17.7 3.8 6.2

Business Structures -43.6 -17.3 -18.4 -13.9 -12.0 -10.0 -10.0 -5.0 10.3 -19.6 -12.6 -2.3

Equipment and Software -36.4 -4.9 1.5 18.2 15.0 15.0 10.0 10.0 -2.6 -16.7 11.6 9.1

Residential -38.2 -23.2 18.9 5.0 10.0 15.0 15.0 15.0 -22.9 -20.4 9.5 11.4

Inventories Chg, % contibut to GDP -2.3 -1.4 0.7 3.8 0.8 0.3 0.0 0.1 -0.3 -0.6 1.0 0.1

Net Trade, % contri but to GDP 2.6 1.7 -0.8 0.3 -0.1 -0.3 -0.3 -0.4 0.7 0.9 -0.3 -0.5

Exports -29.9 -4.1 17.8 22.4 16.0 7.0 7.0 6.5 5.4 -9.6 12.5 6.3Imports -36.4 -14.7 21.3 15.3 14.0 8.0 8.0 8.0 -3.2 -13.9 10.8 8.0

Government Spending -2.6 6.7 2.7 -1.2 2.1 1.7 1.6 1.5 3.1 1.9 1.7 1.6

Federal Govt -4.3 11.4 8.0 0.2 5.3 2.7 2.5 2.2 7.7 5.2 4.0 1.9

State & Local -1.6 3.9 -0.6 -2.0 0.0 1.0 1.0 1.0 0.5 -0.2 0.2 1.3

PCE Deflator -1.5 1.4 2.6 2.7 2.1 -0.7 2.2 2.1 3.3 0.2 1.7 1.5

PCE Core 1.1 2.0 1.2 1.4 0.9 0.9 0.9 1.1 2.4 1.5 1.1 1.1

CPI -2.2 1.9 3.7 2.6 1.6 -0.9 2.6 2.5 3.8 -0.3 1.8 1.8

CPI Core 1.6 2.3 1.5 1.5 0.8 0.9 0.9 1.0 2.3 1.7 1.2 1.1

Unemployment Rate 8.2 9.3 9.6 10.0 9.7 9.5 9.3 9.2 5.2 9.3 9.4 8.6

Personal Income -8.9 3.3 -1.4 3.7 4.5 4.5 4.9 5.1 2.9 -1.7 3.6 4.8

Disposable Personal Income -1.2 7.7 -1.2 4.3 4.5 4.5 4.4 4.6 3.9 1.1 3.9 4.3

Real Disposable Pers. Income 0.2 6.2 -3.6 1.9 2.4 5.2 2.2 2.5 0.5 0.9 2.3 2.7

Savings Rate 3.7 5.4 3.9 4.1 4.9 5.4 5.3 5.3 2.7 4.3 5.2 5.2

Corp Profits 22.8 15.7 50.7 18.8 13.3 13.1 11.4 15.3 -11.8 -4.7 18.2 10.9

Quarterly Annualized Growth Rates

2009 A/ E 2010 E

Source: BEA, SG Cross Asset Research

Rates and FX forecastsCentral Bank Rate Forecasts current 3 mths 6 mths 9 mths 1 yr

US 0.25 0.25 0.25 0.50 1.25

Canada 0.25 0.50 0.75 1.00 2.00

10 year bond yields current 6 mths 1 yr US 3.74 4.25 4.75

Canada 3.72 4.25 5.00

FX rates current 6 mths 1 yr

USD per EUR 1.33 1.30 1.22

USD per GBP 1.54 1.49 1.44

CAD per USD 1.00 0.95 1.01

JPY per USD 93 100 110

Source: SG Cross Asset Research

The US economy is currently

in a key transition period frominventory led growth to

demand led growth.

Inventories have added

substantially to growth in the

past 3 quarters, but we

believe that production is

now roughly realigned with

demand. Questions on

sustainability linger, but so far

all the pieces are falling into

place for a successful

transition.

1. Employment is turning

positive. If continued, this will

support organic

consumption growth without

relying on credit creation

which is likely to be slow in

this cycle.

2. Consumption has gained

momentum since March and

could very well exceed 3% inQ1 and Q2 (upside risk to our

forecasts shown in the table).

Importantly, this acceleration

coincides with a turn in

employment, which supports

sustainability.

3. The capex cycle is also

gaining momentum. Business

have cut spending excessively

during the downturn and are

now in a catch-up mode.

The Fed has remained dovish

until now, but the data should

pressure the Fed to change

its tone. We look for the Fed

to drop the extended

language on April 28 and to

hike in December 2010. 10yr

Treasury yield to rise to

4.50% by year-end.



14/19

American Themes

21 April 20104

SG Proprietary IndicatorsSG Business Cycle Index

-15

-10

-5

0

5

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

-4

-3

-2

-1

0

1

2

3

4

5

6

SG US Business Cycle Index (LHS)

GDP , y/y (RHS)

SG Real-Time Recession Probability Model

Real-time recession pro babities are derived from a regime switching model using the same four co incident inditarors used by NBER cycle

dating co mmittee. These include: employment, real income, real sales (retail + business) and industrial productio n

-

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

NBER recessions

Modeled Rec. Prob

Probabili ty derived from a probit model b ased on employment, core inflation, ISM index and a li quidity index

Historical Perspective - 6 month ahead probability

SG Fed ModelRate Cut Probability Rate Hike Probability

Latest Probabilities

100%100%97%48%

0%

20%

40%

60%

80%

100%

3M 6M 9M 12M

probability of at least one rate cut within the next 3,

6, 9 and 12 months

0% 0% 0% 0%0%

20%

40%

60%

80%

100%

3M 6M 9M 12M

Probability of at least one rate hike

within the next 3, 6, 9 and 12 months

0%

20%

40%

60%

80%

100%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

rate cutsProbability of at least one rate cut w ithin next 6 months

0%

20%

40%

60%

80%

100%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

rate hikes

Probability of at least one rate hike within next 6 months

Source: SG Economic Research

The US economy has

clearly moved out of a

recession regime, as

demonstrated by our real-

time probability model.

Our US business cycle

index reinforces the call for

a sustained recovery and

suggests limited risks of a

double dip. The index is

pointing to GDP growth

near 4.0%, not too far from

our Q1 forecast for 3.8%

annualized growth.

Our fundamental Fed

probability models have

been showing a somewhat

distorted picture since

policy hit the zero bound

on the overnight rate.

Taylor rule-type equations

currently prescribe a

negative, which is why our

model points to substantial

odds of further rate cuts

and zero odds of rate

hikes. Importantly, the

model does not capture

the effects of quantitative

easing which have

compensated for the

inability to go below zero.

We believe that the Fed will

hike a bit faster than the

model implies in an effort

to keep inflation

expectations well anchored

in light of a ballooning

monetary base.



15/19

American Themes

26 April 2010 15

Rates and Short-term FundingFed Funds Expectations

Real Treasury Yields

A1/P1 Nonfin CP vs. OIS (3m)

Inflation Expectations

Treasury Yield Curve (10y - 2y)

Short Term Funding

ABCP vs. OIS (3m)

Rates

Libor vs. OIS (3m) - Historical and Implied

0.00

0.25

0.50

0.75

1.00

4/10 6/10 8/10 10/10 12/10

%

Latest

Week ago

Month ago

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1/09 4/09 7/09 10/09 1/10 4/10

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

1/09 4/09 7/09 10/09 1/10 4/10

0.0

0.5

1.0

1.5

2.0

2.5

1/09 4/09 7/09 10/09 1/10 4/10

5yr real

10yr real

1.0

1.5

2.0

2.5

3.0

3.5

1/09 4/09 7/09 10/09 1/10 4/10

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1/09 4/09 7/09 10/09 1/10 4/10

10yr breakeven

5yr 5yrs forward

0.0

0.5

1.0

1.5

2.0

2.5

3.03.5

4.0

J an-

07

Apr-

07

J ul-

07

Oct-

07

J an-

08

Apr-

08

J ul-

08

Oct-

08

J an-

09

Apr-

09

J ul-

09

Oct-

09

J an-

10

Apr-

10

J ul-

10

Oct-

10

%

Source: Bloomberg, SG Economic Research

Market expectations forrate hikes are broadly in

line with our own. We look

for the Fed to hike rates

just once this year, in

December. After that, our

own path is somewhat

faster than that implied by

the market. We think that

the Fed, after giving the

market plenty of warning,

will move relatively fast in

2011. We look for a 2.50%target by end of 2011, a

much faster pace of

tightening than in the

previous cycle. The

measured pace of

tightening in 2005-2006 is

though to have contributed

to complacency and the

property bubble.

The Treasury yield curve

remains very steep andoffers very attractive carry

to investors. This positive

carry is keeping a lid on

10yr yields for now, but it

will probably change when

the Fed starts signaling

rate hikes. We see bond

yields moving sideways in

the next few months on the

back of continued carry

trade activity. However,

yields should start movinghigher in the second half

as we get closer to the rate

hike cycle.

Inflation breakevens in the

Treasury market have

largely normalized,

consistent with well-

anchored expectations.



16/19

American Themes

21 April 20106

Credit AvailabilityMortgages & Consumer CreditConforming Mortgage Rate

ABX AAA Tranches

Corporate Credit

Swap Spread (10yr)

HY Spreads(Lehman HY - 10yr Swap)

Inv Grade Corp SpreadDJ Inv Grade CDX Index

Sector CDS Spreads

Fannie/Freddie MBS Spreads

Consumer ABS Spreads

0.40

0.80

1.20

1.60

1/09 4/09 7/09 10/09 1/10 4/10

Fannie/Freddie MBS vs. swap

20

30

40

50

60

70

80

90

100

1/08 4/08 7/08 10/081/09 4/09 7/09 10/09 1/10 4/10

index 2006-1

2006-2

2007-1

2007-2

3.5

4.0

4.5

5.0

5.5

6.0

1/09 4/09 7/09 10/09 1/10 4/10

30yr Fannie MBS

30yr Conforming Mortgage Rate

0

200

400

600

800

1000

1200

1/09 4/09 7/09 10/09 1/10 4/10

bpcredit cards

autos

0

50

100

150

200

250

300

1/09 4/09 7/09 10/09 1/10 4/10

-20

-10

0

10

20

30

40

50

1/09 4/09 7/09 10/09 1/10 4/10

600

800

1000

1200

1400

1600

1800

2000

2200

1/09 4/09 7/09 10/09 1/10 4/10

0

50

100

150

200

250

300

350

400

450

1/09 4/09 7/09 10/09 1/10

Financials

Industrials


Mortgage spreads have

not responded adversely to

the end of the Feds

purchases. This is very

good news, and a reason

why mortgage rates have

remained in the 5%-5.25%

range. These are near-

historic lows that should

support housing

affordability and sales

activity.

The values of sub-primemortgage CDOs have risen

notably in recent weeks.

The rise - to highest levels

since late 2008 - reflects

growing confidence that

the housing recovery will

be sustained beyond the

period of tax incentives.

Corporate credit continues

to perform well. Although

the pace of spreadtightening has slowed in

recent months, the

tightening has continued,

particularly in the high-

yield market. Corporate

default rates have peaked

and profit generation has

been very strong, both

factors supporting the

credit markets.

Importantly, profit growth

is increasingly being drivenby revenues, rather than

cost cutting, which is good

news for sustaining the

cycle. Sustained

employment gains which

would drive consumption

will be the key factor for

risky assets in the coming

months.



17/19

American Themes

26 April 2010 17

FX MonitorDollarMajor Dollar Index

USD/EUR

Carry Trade Index

FX Volatility (G10 avg)

JPY/USD

Carry-to-Risk Ratio

Yield Differ ential

Implied Vol

5

10

15

20

25

30

1/09 4/09 7/09 10/09 1/10 4/10

70

72

74

76

78

80

82

84

86

88

1/09 4/09 7/09 10/09 1/10 4/10

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

99 00 01 02 03 04 05 06 07 08 09 10

%

+/- 1St Dev range

More

attractiv

Less

attractiv

1.0

2.0

3.0

4.0

5.0

6.0

00 01 02 03 04 05 06 07 08 09 10

5

15

25

35

00 01 02 03 04 05 06 07 08 09 10

100

110

120

130

140

150

160

170

1/00 7/00 1/01 7/01 1/02 7/02 1/03 7/03 1/04 7/04 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10

80

85

90

95

100

105

1/09 4/09 7/09 10/09 1/10 4/10

1.1

1.2

1.2

1.3

1.3

1.4

1.4

1.5

1.5

1.6

1/09 4/09 7/09 10/09 1/10 4/10


Since November, the dollar

has rallied substantially

against the Euro. The

Greek debt woes have

been a big driver, but more

fundamentally the US

economy is facing better

cyclical prospects than the

euro area due to pent-up

demand and much better

employment prospects.We see Europe leading the

way on fiscal consolidation

while the Fed moves ahead

of the ECB on monetary

tightening. All else being

equal, these trends should

support further dollar

strength.

The dollar should also

outperform the yen in the

next 12 months given thedivergent paths on growth

and monetary policy. We

see the yen as the next

carry trade funding

currency.

Carry trade activity has

been supported by

declining FX volatility. Rate

differentials have not been

very attractive, but that

should begin to change as

commodity economies

accelerate their tightening

cycles.



18/19

American Themes

21 April 20108

Commodities and EquitiesCrude Oil (Nymex WTI)

Copper

Co nsumer Discretionary 6.7%

Industrials 5.2%

Energy 5.0%

Financials 4.8%

IT 3.6%

Materials 1.3%

Utilities 1.3%

Co nsumer Staples -0.3%

Telecom -2.3%

Health Care -4.2%

VIX

GoldCommodities

Volatili ty Skew(25 delta put - 25 delta call, SPX Index)

Sector Performance - 4 wk chg

Equities

Baltic Dry Index

20

40

60

80

100

1/09 4/09 7/09 10/09 1/10 4/10

500

600

700

800

900

1000

1100

1200

1300

1/09 4/09 7/09 10/09 1/10 4/10

0

10

20

30

40

50

60

1/09 4/09 7/09 10/09 1/10 4/10

0

2

4

6

8

10

12

14

16

18

1/09 4/09 7/09 10/09 1/10 4/10

0

50

100

150

200

250

300

350

400

1/09 4/09 7/09 10/09 1/10 4/10

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1/09 4/09 7/09 10/09 1/10 4/10


Commodities continue to

be supported by the

cyclical outlook, although

the gains may slow in the

near-term as the

manufacturing cycle starts

to lose momentum. The

transition to demand-led

growth, however, should

sustain the upward trend.

Equity markets are moving

ahead of the economy.

Employment gains

evident in the March

payroll report were an

important trigger for

extending the equity rally.

Employment turns have

historically triggered

significant declines in

market volatility (implied

and realized) and that is

precisely what has

occurred in the past

month.

We see equity gains

reinforced by the profits

cycle which should

maintain strong

momentum in the coming

quarters. While revenue

gains will be modest

relative to other recovery

cycles, we see room forsubstantial margin

expansion even with

employment growth.



19/19

American Themes

IMPORTANT DISCLAIMER: The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities andincluding any expression of opinion, has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to accuracy orcompleteness although Socit Gnrale (SG) believe it to be clear, fair and not misleading. SG, and their affiliated companies in the SG Group, may fromtime to time deal in, profit from the trading of, hold or act as market-makers or act as advisers, brokers or bankers in relation to the securities, or derivativesthereof, of persons, firms or entities mentioned in this document or be represented on the board of such persons, firms or entities. SG is acting as a principal

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