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What Budget Problems?

January 29, 2013

by Christian Thwaites

of Sentinel Investments

"Vickers falls on fear of peace." There's an apocryphal story of how on the day after D-Day, the stock of Vickers, a large defense contractor, abruptly fell. I can't find the source but it was a good story going around the City some, ahem, 30 years ago. Last week there was not a lot of price action in bonds until Friday when economic upticks replaced budgets as the main driver. We saw a one point correction in treasuries. The market is right to push budget concerns into the background for now. Between the American Taxpayer Relief Act (or ATRA, the one that raised regressive taxes but, hey, tough) and the Budget Control Act (BCA) of 2011, some $2.3 trillion of savings are programmed in for the next 10 years. Of that, two-thirds comes from spending cuts and one third from revenue increase. This is what it looks like:

$bn Program Cuts Revenue Increases and Interest Savings Total
BCA of 2011 $1,465 $236 $1,701
ATRA of 2013 $3 $644 $647
Total $1,468 $880 $2,348
Needed to stabilize deficit TBD TBD $1,368
Grand Total $3,716

Sources: Center on Budget and Policy Priorities

The Washington debate is entirely focused on the "Needed to stabilize…" line and the split between program cuts and revenues. It is not about whether the total makes any sense. The $1,368 is the magic number which stabilizes the deficit at around 2.5% of GDP and debt at around 72%. So that's $1,368tr over 10 years during which the US economy will probably grow at a nominal 4% from around $16,000bn to $24,000bn or a cumulative (which is the language of 10-year budget negotiations) of $224,000bn. That's a 0.6% of GDP problem. Greece in its worse days had a 10% problem, putting some of the hyperbole around the US's position into perspective.

US government spending has been falling for a while. Of the big five budget expenditures which account for 80% of the federal budget (so, defense, Social Security, Medicare, Medicaid and interest), two fell and overall spending grew 3.6% compared to receipts at 11%. Here's the YOY growth in government spending:

Source: Federal Reserve Bank of St. Louis, Economic Research

This is why GDP for 2013 will continued to show a net drag from the government sector, which is about 8% of GDP. Some commentators point to the non-sustainability of government debt. No. Net interest on debt is covered 10 times by receipts and 57 times by GDP. In Greece those numbers were closer to 5 and 15. This is not to promote non-cyclical deficit spending but to reason why bond markets are not spooked by the budget and why the postponement of the debt ceiling was a non-issue. There's plenty of domestic savings to fund budgets for, well, ever if deleveraging doesn't stop.

The fear of sequester (about $120bn on the line) and the continuing resolution, which would theoretically shut the government down, are likely flash points. All markets will recoil if there's a real impasse. So for now the bond market is about real economic data and political showdowns. Not about debt and budgets.

US Economy

It was a quiet week. This week hots up withISM, employment and GDP data. But what was reported last week was encouraging starting with claims at 330,000, the lowest since January 2008. The stock market generally likes employment gains and this week was no exception. Here the four week moving average against the S&P[1]:

Source: Federal Reserve Bank of St. Louis, Economic Research

The claims performance may not last. First, there's a very large seasonal adjustment. The reportedDOLunadjusted numbers were 436,766 compared to 416,880 this time last year. So this year's adjustment is down 106,766 and last year's was 44,880. There might well be a spring up in claims in coming weeks as adjustment factors come in to play.

In other areas, the Kansas City and Richmond Federal Reserve manufacturing surveys remained in very weak territory with order backlogs and number of employees down. One respondent summed it up in a neat reciprocity:

"Since Congress continued to delay making firm decisions…we are again delaying decisions [to expand]".

The Richmond service sectors were better with some revenues up (but not retail) and stable employment. Not surprisingly, given the opera of the first few weeks of the year, big ticket sales are off. Finally the Leading Economic Indicators was up but this likely overstates growth. The index has a 42% weighting to hours worked and consumer expectations (which are linked) and another 15% weight to the S&P and bond spreads, which may only have a weak wealth effect right now. None of these look robust enough to lead to the 4.5% increase in GDP, which is what the historical relationship would indicate. This week's GDP number will be a lot more sober.

What remains is still a very easy set of financial conditions. Here's the Chicago measure:

Source: Federal Reserve Bank of St. Louis, Economic Research

This is mostly based on Treasury,CP, debt and lending and, when showing negative values, indicates financial conditions looser than average. And that's where we are. This week saw the Fed's balance sheet breach $3tr for the first time. Exactly as theFOMCminutes indicated, we saw treasuries increase by $10.3bn over the week, in line with the $45bn monthly target andMBSby $33bn compared to a $40bn target. The MBS purchases are usually more sporadic because the Fed has to wait for origination issues. So here's MBS held by the Fed:

Source: Federal Reserve Bank of St. Louis, Economic Research

And here's MBS at the sellers, the commercial banks:

Source: Federal Reserve Bank of St. Louis, Economic Research

And finally here are the Fed's holdings of short paper:

Source: Federal Reserve Bank of St. Louis, Economic Research

This is making it difficult for us on the MBS side. Normally, we would get defensive by using higher coupon issues to bring in duration. But the Fed support program is distorting things right now. In the bigger picture, we continue to see enthusiasticTIPSbuying. This week's 10-Year auction came at (0.63%) compared to an average for the last six auctions (there are about six a year) of (0.43%). We'll probably look back in years to come as to how the government could borrow at negative rates for so long and why it didn't load up on cheap debt…but for now, let's assume that the upcoming FOMC meeting will have precious little to worry about on the inflation side.


We touched the 1,500 level on the intraday. The last time we were at that level was in December 2007 when earnings were $89 heading to $61 a year later. This time earnings are about $100 with a forward estimate of $112. So a rough P/E comparison of 16x compared to 13x. As with all big market rallies several things are letting loose at the same time. First, here's the VIX[2] to S&P ratio.

Source: Federal Reserve Bank of St. Louis, Economic Research

In the high "risk-off" days of recent years this dropped to numbers in the mid-30s. At the current low levels of the VIX, it's at levels seen in late 2007. It's a rapid embrace of risk. Second, the flows from retail clients are coming on strong. Some of this is beginning of year rebalancing and new 401(k) flows. Some may be trying to catch up to the returns of 2012. Third, there's some short covering with the 50 most shorted companies up 8% YTD compared to the S&P of 5.3%. Fourth, a narrower list of leaders. There were 454 stocks, or 24%, making their all time highs on the NYSE in early January. By last week that number dropped to 354 or 19%.

The valuations, however, on top companies remain in the 12x to 13x range and that's not expensive. Another thing we hear is that dealers are short index calls that expire this week and that ETF desks continue to see real dollar demand in equities…buying liquid, passive vehicles is usually the first way to get equity exposure. This rally may stay a while.


There was some concern that recent gains (for example, Spanish yields well under 5%, most European stock markets up 6% to 10% YTD) would come under stress as the first of theLTROs came up for voluntary repayment. This €489bn facility greatly helped bank funding a year ago but carried some stigma as peripheral banks off-loaded bad collateral. On Friday, theECBannounced that about half the banks would repay €137bn of that. All things being equal, this reduces the ECB balance sheet. But this should not be viewed as tightening (H/TLorcan Kelly at TrendMacro). The bank will keep open a 3-month option and maintain all its open refinancing operations. So there's no change to overall policy stance and certainly no change to rates. European banks have rallied 50% since May last year and while there are some loan quality issues for smaller banks, the ECB will keep them afloat. Initial market reactions were an uptick in the euro and bonds steady.

Bottom Line : We have been long equities and high yield and trading GTs for a while. We continue to use MBS for the income and some protection from duration volatility (hence the higher coupons). It's worked out well and the run up could continue. Equity investors are not about to play five years of catch up all at once but there's latent demand for equities out there for now.

Sources: "To Stabilize the Debt, Policymakers Should Seek Another $1.4 Trillion in Deficit Savings," Richard Kogan (1/9/2013), Center on Budget and Policy Priorities; TrendMacro; Federal Reserve Bank of Kansas; Federal Reserve Bank of Richmond; Federal Reserve Bank of St. Louis; Federal Reserve Bank of San Francisco; Capital Economics; Bureau of Labor Statistics; CRT Ader; J.P. Morgan Market Intelligence; Federal Reserve Board; ISI; Goldman Sachs; ConvergEx Group; Pantheon MacroEconomic Advisors; High Frequency Economics; Bloomberg; The Conference Board, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

[2] Chicago Board Options Exchange Market Volatility Index is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. An investment cannot be made directly in an index.

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