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Euroland Contagion, Exposure and the Policy Response United States Recalibrating the Rate Outlook View GEF Archive

		The Global Economics Team

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Exposure to EMU peripheral bond markets can only be estimated - given the lack of full bank disclosure and the limits of the macro databases. In this report, we try to provide a ballpark estimate and also look at other potential channels of contagion, ranging from exports to sentiment and bank lending. We conclude that euro area banks' exposure to the EMU periphery could amount to about €140 billion. Germany's banking sector seems most exposed to Spain, France's to Greece and Spain's to Portugal.

What's more, German and, to a lesser degree, Italian exports are likely to be less affected by poor economic prospects at the periphery than France's and Spain's. And while depressed sentiment at the periphery poses short-term downside risks, the medium-term risks are more related to a potential credit crunch. We think that providing additional liquidity might help to buy time - though the fundamental problems are unlikely to go away very easily. But bank recapitalisation, further fiscal restraint and structural reforms might help to address the underlying issues.

Exposure to EMU Peripheral Bond Markets

Who Owns What?

Relatively long time series on the share of government debt held by foreigners don't exist for many euro area members. But there is some history, in some cases dating back to the beginning of the 1990s, for a subset of core and peripheral EMU countries - both large and small. In all of them, to various degrees, the share of government debt held by foreigners has increased over time.

For example, foreign holdings accounted for about one-third of government debt in Germany, Italy and Spain at the inception of the euro area. The equivalent figures for 2009 show that foreign holdings are more important across the board, with a share of the total ranging from 95% for Finland and three-quarters for Portugal to a little over half for Germany and Spain, and 45% for Italy.

Put differently, financial market integration - and possibly the birth of the euro - seems to have encouraged investors to diversify their portfolios, away from domestic bonds and into foreign bonds. This trend still seems well underway across the board, with the possible exception of Spain, where the share of government debt held by foreigners seems to have reached a plateau in 2005-06 and is now decreasing.

A snapshot of the four major euro area members reveals that residents hold between 55% (Italy) and 38% (France) of their respective country's government debt. The domestic market accounts for a less significant share of government debt in the smaller euro area members, ranging from around one-third for Belgium and Greece to one-quarter for the Netherlands and Portugal, and one-fifth or less for the remaining countries.

To various degrees, the so-called ‘home bias' effect seems to be a factor in all the major euro area members - more so in Italy than in France, with Germany and Spain in between. This effect refers to a typical pattern in financial markets: in case of adverse news - which could potentially push interest rates higher - foreign holders tend to hold on to the debt to a lesser degree than domestic holders. This means that while the former might liquidate the bonds more easily when prices fall, the latter might wait for longer (to the extent that they are not convinced that the country will default) - after all, higher interest rates would boost their incomes.

Timely information on the breakdown of government debt by type of holder is limited. But Eurostat's Debt Structure Questionnaire (December 2008) contains some useful clues. We analysed updated information on the breakdown of debt holders between residents and non-residents, and on the assumption that the debt held by residents is still divided between financial and non-financial holders in the same proportion as of late 2008. The upshot is that the large and medium-sized countries can count on their respective financial sectors - which can be seen as ‘natural buyers' - more than the small EMU peripherals (though this could also generate an artificial sense of security).

Spain - Evidence from the Macro Data

Among the EMU peripherals, Spain is the only country to publish a monthly breakdown of government debt held by non-residents. Central banks account for about one-third of the total, while the share of the financial sector - ranging from credit institutions to mutual and pension funds, and insurance companies - is approximately 40%. Households account for one-quarter of the total.

The breakdown by country or region shows that France accounts for about one-quarter of the total, followed by the residual categories of Asia, Africa and others (20%) and other EU countries (15%). Perhaps unsurprisingly, the share of the various European neighbours is quite high. For example, Germany, France, Italy and the Benelux countries make up over 50% of the total. Including the other EU countries, the percentage rises to about two-thirds.

Furthermore, the relative importance of the various countries and regions has changed over time. In 2000, for example, France was still top of the list in terms of Spain's government debt held by non-residents, but its relevance was less pronounced (20%). Conversely, Germany, the Benelux countries and the rest of Europe - apart from Italy - have all decreased their importance over time, while Asia has increased it. But the upshot is still that Europe is by far the most exposed region to Spain's government debt.

What about the Rest of the EMU Periphery?

Similar data don't exist for other EMU peripherals, i.e., the exposure to the government debt of these countries cannot be inferred precisely from the macro databases. However, the IMF's Coordinated Portfolio Investment Survey (CIPS) provides detailed - though not timely - information on total (not just government) debt securities held by non-residents for virtually all countries.

In the case of Greece, the CIPS data show that France accounts for about one-quarter of the total, followed by Germany (14%) and Italy (10%). Non-residents' holdings of Irish debt seem more diversified, with Germany accounting for 17% of the total, and France, Italy and the UK for 14% each. Conversely, non-residents' holdings of Portuguese debt seem rather concentrated, with France's share at around one-third.

Other Potential Risk Factors

So - apart from Spain - while it is perhaps fair to take the punctual estimates above with a pinch of salt, they provide a rough idea on the orders of magnitude involved, we think. The upshot is that the major euro area countries, in particular France and to a somewhat lesser degree Germany, are quite exposed to the EMU periphery.

For completeness, we also address two issues related to exposure to this region, which seem to have worried investors at times. The data, however, depict a fairly benign picture for the euro area as a whole and for most countries.

We focus on: 1. differences in the maturity structure of the debt; and 2. the share of non-central government debt on the total. In particular:

1.         Naturally, if a large proportion of the debt has a maturity shorter than, say, one year, refinancing risks would be more significant relative to a situation in which most of the debt is long term. Of course, the implications will be different depending on the average maturity of the long-term debt. Looking at the split between short-term (one year or less) and long-term (more than one year) government debt does not fully capture this dimension. Bearing this caveat in mind, Greece is the country with the highest share of long-term debt, while Portugal and Ireland exhibit the lowest share, among the EMU peripherals. Spain is in between.

2.         Markets seem concerned, on occasions, not only about central government debt, but also about the debt obligations of regions, local autonomies, etc. While these concerns are probably well founded in some instances, it is also worthwhile to note that in most EMU peripheral countries the bulk of the debt relates to the central government. Indeed, non-central government debt ranges from 1% of the total in Greece to 6% in Portugal. From this perspective, risks seem fairly contained, in our view. The only exception is Spain, where non-central government debt accounts for 22% of the total. In Italy, the equivalent figure is 7%.

What's the Exposure of the Banking Sector?

With the third leg of the market turmoil morphing once again into a banking crisis - after the global liquidity crunch in funding markets in 2008 and the European sovereign debt crisis more recently - it is natural to focus on the exposure of the banking sector to the EMU periphery. One option to gauge the potential repercussions is the BIS cross-border bank lending database. France, Germany and the UK have a combined exposure to Spain, Greece, Portugal and Ireland amounting to $1.2 trillion. Accounting for these countries' exposure to Italy too, the amount approaches $2 trillion.

Relative to the size of their respective economies, however, the most exposed country is a peripheral one, Ireland, where cross-border bank lending to Italy, Spain, Greece and Portugal exceeds 40% of GDP (though our equity analysts think that this can primarily be attributed to DEPFA - a member of German-based Hypo Real Estate, which is domiciled in Ireland). France and the Netherlands have a high exposure too, amounting to 33% and 31% of GDP, respectively. Portugal is highly exposed to Spain. This reflects foreign subsidiaries, but the bottom line is that - regardless of the fundamentals - a short-term funding problem in one of the EMU peripherals, at least theoretically, might result in more widespread funding problems. On the plus side, an eventual rescue package in one country would benefit all the others.

So, the exposure of the European banking sector to the EMU periphery is quite large - at least looking at cross-border bank lending. But what's the exposure to the government debt of the EMU peripherals? To provide a ballpark estimate, we triangulate various sources and apply a good dose of our own judgment, as follows:

•           What is known: The BIS estimates foreign banks' lending to EMU peripherals - not just governments, but also banks as well as households and non-financial corporations.

•           What is partially known: How much of this is government debt is unclear in most cases, with the exception of Spain - which discloses the breakdown of government debt held by non-residents.

•           What is not known: The missing link is whether each country's banks own those bonds in proportion to their total holdings of peripherals' assets - which we assume to be the case. It is increasingly likely that this might be disclosed in the upcoming bank stress-tests, our equity analysts think.

The upshot is that, in the case of Spain, non-residents hold slightly more that half of this country's government debt, based on central bank and IMF data. The BIS estimates that foreign banks' lending to Spain's government, banks, households and non-financial corporations was €801 billion at the end of last year. So, if 18% of the foreign holdings of government bonds are held by banks, and if each country's banks own those bonds in proportion to their total holdings of Spanish assets, then foreign banks might hold something like €42 billion of Spain's government debt. And (non-Spanish) euro area banks might hold about €25 billion. We calculate the foreign holdings of Spain's government bonds held by the various countries' banks by using the weight of each country's total exposure to Spain in the BIS figures.

Of course, not all the above-mentioned assumptions are needed for Spain, which discloses more information than the other peripherals. Crucially, the percentage of foreign holdings of government bonds held by banks is unknown for Greece, Portugal and Ireland. But the size of the countries and bond markets - together with their high share of government debt held by non-residents - suggests that foreign banks might hold a larger proportion of these countries' total government bonds outstanding. For example, French banks account for one-third of all foreign bank loans to Greece. If we assume that half of Greek government bonds owned outside Greece are held by banks (equivalent to approximately €102 billion), and that French banks hold one-third of that, then their share is €33 billion. The bottom line is that euro area banks' exposure to the EMU periphery could amount to about €140 billion.

Moreover, these numbers - taken at face value - suggest that exposure to Spain might be less of a concern for banks than exposure to Greece. What's more, Germany's banking sector seems most exposed to Spain and Spain's to Portugal. UK banks seem most exposed to Ireland, though the exposure does not seem to be particularly large - looking at the magnitudes involved.

Another implication is that, given the consequences of a Greek default on the euro area banks, it is perhaps easy to justify the loan that the euro area governments extended to Greece. Let's assume, just hypothetically, a default that would reduce Greece's debt burden to, say, 60% of GDP (not our central scenario). This would cut the value of its bonds by about half.

In this hypothetical scenario, the euro area governments might need to cover the losses, at a cost of €36 billion, i.e., half of our estimated foreign bank holdings of Greek government bonds. Put differently, a €30 billion loan that gives Greece a chance to address its fiscal imbalances seems a good alternative compared with a €36 billion loss for bailing out banks, should Greece fail (even abstracting from any multiplier effect). And the losses could even be twice as large, assuming a bigger haircut of, say, 70% (within the range of the rating agencies' assumptions), and that most of foreign bank lending to Greece has to do with the government.

Greece - Evidence from the Micro Data

Naturally, the estimates above should be intended as a guide to understand the orders of magnitude involved, rather than as an exact calculation - given that some key parameters are unknown. Full disclosure at the bank level is not available. But our bank equity analysts have collected information on the large European banks' exposure to Greece (see Elevated Bank Funding Risks and Policy Response, June 9, 2010).

While the majority of European banks have an immaterial exposure to Greece as a percentage of their equity, some banks exhibit a material exposure. Aside, obviously, from the Greek banks themselves, those most exposed include Commerzbank, Dexia and Deutsche Postbank. To a much lower extent, Erste, KBC, SocGen and BNP Paribas are also exposed.

Exposure to EMU Peripheral Economies

The Export Channel

The peripheral countries have tightened their belts to a greater extent than their neighbours in core EMU (see The Mediterranean Diet: Too Harsh for EMU Health? June 7, 2010). Clearly, fiscal austerity will affect the economy more negatively in the former group of countries than in the latter. This means that - all else being equal - exports from the rest of the euro area to, say, Spain, Greece, Portugal and Ireland are unlikely to fare very well.

So, it is natural to look at the major euro area members' export specialisation by destination. We focus on Germany, France, Italy and Spain because they represent about three-quarters of euro area GDP. The EMU periphery is not a huge market, i.e., it is somewhat obvious that German exports to that region, for example, do not represent a large share of the pie. Still, there are visible differences among the major euro area members: Germany is more focused on extra-EMU trade and its exposure to the EMU periphery is small, at around 6% of its total exports; France is more focused on intra-EMU trade and its exposure to the EMU periphery is about twice that of Germany, adjusting for to the relative size of their exports; Italy is in between - with an exposure to the periphery equal to 9% - while Spain's exports are as focused to the rest of the EMU as France's, with an exposure to the other peripheral countries (mainly Portugal, but also Greece and Ireland) equal to 11% of its total exports.

We think that the EMU periphery will expand far slower than the core and quasi-core countries this year and the next. For example, we expect Germany (core) to grow by 1.9% this year and 1.3% in 2011, Italy (quasi-core) to grow by 0.9% this year and 1.1% in 2011, and Greece (periphery) to shrink by 5% this year and 3.5% in 2011 (our full economic forecasts are published in our European Eco Weekly).

Given the relatively limited exposure for the euro area as a whole - and the small size of most peripheral countries apart from Spain - this means that the consequences of a worse-than-expected economic outlook in the EMU periphery are unlikely to significantly dent growth prospects for the EMU as a whole. However, euro area countries with a high exposure to the EMU periphery will fare worse than average from an export standpoint - all else being equal. In particular, this means that:

•           German and, to a lesser degree, Italian exports are likely to be less affected by poor economic prospects at the periphery.

•           French exports might be negatively affected to a somewhat greater extent, but the impact is likely to be limited for this country too.

•           The various peripheral countries are intertwined. For example, Spain's high exposure to Portugal (and Portugal's high exposure to Spain) is a risk at this juncture, especially because the only factor that we expect to add to GDP growth next year in Spain - which accounts for almost 12% of the euro area economy - is exports.

More broadly, a 10% depreciation in the trade-weighted exchange rate boosts GDP by approximately 0.7% over one year relative to the baseline, we think. This means that, for the euro area as a whole, the depreciation of 10% or so over the past 12 months would boost euro area GDP by 0.7% over the next 12 months, thus offsetting the overall fiscal tightening announced so far. We expect the trade-weighted exchange rate to reach a cyclical low next May - corresponding to a depreciation of 20% from the peak in 3Q 2009. Should this happen, euro area exports would benefit in 2012 too.

Although the effects of fiscal austerity and a weaker euro may offset each other for the euro area as a whole, this does not mean that all EMU countries will equally benefit or be penalised. Export-oriented economies should experience a greater boost to GDP growth from the euro depreciation (e.g., Ireland, Benelux, Germany and Austria), in our view. Conversely, the ‘fiscal sinners' will likely have to tighten their belts more aggressively than average, thus experiencing a greater drag on GDP growth (e.g., Greece, Ireland, Portugal and Spain).

The Sentiment Channel

Sentiment is a major driver in virtually all economic decisions and can affect the real economy even abstracting from the fundamentals. Investor concerns over the EMU periphery, from short-term liquidity risks to long-term solvency risks - along with a low conviction on the medium-term economic outlook - generated a pattern in several peripheral bond markets that resembled that of emerging markets prior to a crisis, as our credit strategists noted recently (see Financial System Letter: Sketches of Spain, May 26, 2010). In turn, this exerted negative feedback effects that increased liquidity, solvency and economic risks.

Similarly, the European Commission's gauge of economic sentiment - which combines confidence surveys across the manufacturing, construction, services, retail trade and consumer sectors - shows that the mood in the countries that the market has generally perceived to belong to core EMU over the past 25 years or so is more upbeat than in the periphery, where it has not yet reached its long-term average.

And the results don't change allowing for an intermediate group of quasi-core (or perhaps semi-peripheral) countries including, say, Italy and Belgium. So, from this perspective too, the chances are that - with confidence more depressed in some parts of the southern fringes of the euro area - negative feedback effects, admittedly unquantifiable, are more likely in the EMU periphery than in the core countries.

The Bank Lending Channel

Bank lending matters a great deal for the euro area economy. Indeed, its firms rely on bank financing far more than market-based financing. As of 1Q10, for example, the outstanding amount of securities other than shares issued by euro area non-financial corporations stood at €850 billion, while the outstanding amount of bank loans to this sector was €4,680 billion. In other words, of the entire financing of the non-financial corporate sector in the euro area - defined as the sum of bank loans, debt securities issued and quoted shares - just 9% comes from credit markets, while bank loans represent 52% of the total and equity the remaining 39%.

So, can we have a revival in economic activity ahead of a revival in bank lending? History suggests that we can answer this question affirmatively, i.e., credit crunches tend to precede economic recessions by about three quarters. And this is the case for other financial downturns too, such as equity (five quarters) or house price busts (three quarters). More importantly, an economic recovery is possible even before credit growth returns to positive territory. Indeed, this is already happening. Economic recessions typically end two quarters before credit crunches end and nine quarters before house prices bottom out, while equity prices tend to bottom out just as economic recessions end.

Put differently, episodes of credit crunches generally last twice as long as recessions. What's more, during these episodes the real economy typically starts recovering while credit is still contracting. While this may sound encouraging at first sight, the bad news is that these creditless recoveries tend to be much weaker than recoveries in which no credit crunch has taken place. During these creditless recoveries, it generally takes much longer for GDP to return to its pre-recession level.

Our econometric framework takes into account the feedback and lagged effects among GDP, loans to the non-financial private sector, inflation and the lending rate (see Credit Crunch versus Creditless Recovery - The Risks, January 11, 2010). Under our base case of a sub-par recovery this year and next, credit growth is likely to turn positive no earlier than mid-2011. In turn, the robust credit expansion witnessed over the past decade will not be there to support the euro area economy as and when growth strengthens more visibly.

The Policy Response

What Buys Time ...

It is becoming increasingly evident that the crisis of confidence will not be assuaged by more regulatory forbearance or further short-term measures. Still, buying time is a critical element of any policy response, especially while one figures out the longer-term response. So what buys time? The answer is extra liquidity support:

•           Term-funding schemes: The ECB has recently announced that it will provide additional three-month loans to banks at full allotment, i.e., unlimited liquidity. These refinancing operations - which could eventually be further extended into the latter part of this year and perhaps even beyond on an as-needed basis - could help to signal that the ECB is prepared to help banks secure term funding, especially in case non-euro area money managers no longer have the confidence to extend short-term money to some euro area banks.

•           Buying government bonds: The ECB looks set to continue to purchase government bonds, and perhaps even other instruments, in ‘dysfunctional' markets for as long as needed. If this helps to tighten prices, it might contribute to lowering the funding strains for the euro area banks, because government bond repos are done on a mark-to-market basis.

•           Lending to governments in need: The newly established European Financial Stability Facility (EFSF) will raise funds and provide loans of up to €440 billion to euro area members, subject to strict conditionality. The euro area members will back the EFSF's bond issuance based on their respective share of the ECB's paid-up capital.

... and What Is Needed

Additional liquidity won't break the circle, we think. At best, it will buy time to address the underlying problems. However, as the experience of the last two years suggests, papering over the cracks with liquidity may even reduce the chances of a quick resolution of what we see as the underlying issue: the solvency of both banks and governments (see EuroTower Insights: The Lure of Liquidity, June 17, 2010).

So, what measures can break the circuit? There is no easy solution, we think. Given the weakness of governments in many EMU member states, and given the size of the fiscal and banking sector problems, these issues are unlikely to find a quick fix. In this context, three aspects are important:

•           Recapitalisation of the banking sector: This is an issue especially where the unlisted banks represent a fair share of total lending to the non-financial private sector. For example, based on a stress-test analysis of the loan portfolio of the Spanish savings banks, we estimate the recapitalisation needs at €43 billion (see Spain Economics: The Housing Market and the Savings Banks' Restructuring, April 12, 2010). TARP-like programmes exist in many EMU countries, but banks have preferred to borrow short term from the central bank at near-zero interest rates and buy longer-dated assets yielding a higher return, in the hope of restoring profitability and generating capital internally over time. The results of the stress tests at the end of July will be key, we think (see EuroTower Insights: Stress Testing Europe, June 30, 2010). The publication of detailed bank-by-bank results - at least for the major European banks - of a harmonised European-wide stress-test is an important step in the right direction. But swift policy action following the test is equally important. So far, Europe has seen a relatively slow take-up of the various bank rescue funds set up by the different governments.

•           Fiscal restraint: Much has been done in this area, with virtually all EMU countries having announced - to various degrees - their belt-tightening programmes. But more is probably needed. For example, the European Commission has asked Spain to clarify where some of the projected savings for next year will come from, and has already mentioned that more fiscal consolidation will be needed in both Spain and Portugal over and beyond 2011. The fiscal plans for both countries will be reviewed on July 13. The Benelux countries too, with their newly elected governments, will clarify their fiscal tightening programmes in due course. And beyond the announcement effect, which no doubt is important too, the focus is now shifting to the implementation phase of these plans.

•           Structural reforms: This is an issue in many peripheral and also some core countries in the EMU. For example, Spain has recently ratified its labour market reform. The main measures are: 1. greater flexibility for companies to opt out of agreed wage increases; 2. a state-owned fund to reduce the dismissal costs of workers; 3. restrictions on temporary contracts; 4. liberalisation of the job agency market; and 5. reduction of the dismissal costs from 45 to 33 days per year worked. While an important step in the right direction, the reform seems to fall short of the requests that the IMF reiterated, among others, in its latest country review. France too has recently announced its pension reform, which will raise the legal retirement age, but perhaps too gradually, to 62 in 2018. In both countries - and in several others - the chances are that more will be needed on these fronts.

Conclusions

The main takeaway for financial markets is that exposure to the EMU periphery is quite substantial for the core countries. We estimate that euro area banks hold about €140 billion of EMU peripheral bonds. The export, sentiment and bank lending channels pose additional risks. And while depressed sentiment at the periphery poses short-term downside risks, the medium-term risks are more related to a potential credit crunch. Indeed, wholesale funding as a transmission mechanism of elevated sovereign funding costs remains a key concern, given that European banks are more wholesale-funded than any other major banking system. According to our equity analysts, European banks have €3.3 trillion of senior wholesale funding - almost half due in 2010-12. We think that providing extra liquidity might help to buy time, though the fundamental problems are unlikely to go away very easily. Bank recapitalisation, further fiscal restraint and structural reforms might help to address the underlying issues.

United States
Recalibrating the Rate Outlook
July 05, 2010

By Richard Berner, James Caron & David Greenlaw | New York

Marking to market - again.  It's time to mark our US yield forecast to market for the second time in as many months, as our belief that real yields would rise this year has not worked.  Both real rates and inflation breakevens fell sharply as the European sovereign credit crisis triggered fears of contagion that might promote a US double-dip recession, slower global growth and deflation.  Real 10-year yields measured in the TIPS market have declined to just over 1% - close to record lows - while 10-year inflation breakevens are near 1.8%, back to October 2009 levels.

Contagion fears have not materialized, but there is clear evidence that growth is slowing from a strong second quarter.  Among the indicators: an expected ‘payback' in home sales, a June slide in one measure of consumer confidence, declines from high levels in business surveys, and hints of slower bookings at some companies.  To be clear, we expect the deceleration to be limited.  But with uncertainty high, risk appetite low and investors fearful of a double-dip, we concede that 10-year Treasury yields will probably decline further to 2.75%, before rising only moderately through year-end to 3.5%. 

The lower yields fall, the more sharply they will rise in 2011.  This rally is more about fear and technical factors than about fundamentals.  Indeed, the more that Treasuries rally now, and the more investors become comfortably long carrying them, the greater is our conviction that yields will rise sharply as fundamentals resurface.  We continue to think that the fundamentals of moderate growth, a rebound in private credit demands, a bottoming in inflation and a Fed that begins to implement its exit strategy will push yields significantly higher in 2011.  Indeed, we see a 150bp rise in both 10-year yields (to 5%) and fed funds (to 1.75%) over the four quarters of next year.  The former is unchanged from our May/June forecasts, but the end-2011 funds rate is 50bp lower than before.

Libor spreads only one signpost of risk.  For now, risk-aversion dominates investor sentiment.  Far from abating slowly as we expected, contagion fears have intensified and seem likely to remain at a simmer; that's the key reason why our forecasts have missed the mark.  Starting in February, we focused on unsecured interbank lending spreads as the key signpost of and transmission channel for spillovers of financial stress from the European crisis to the rest of the world.  The backup in such spreads was moderate, and the aggressive package of financial support for the peripheral European countries in early May helped Libor-OIS spreads and risk-aversion stabilize late in the month. 

Risk-aversion manifest in equities, term premiums.  That was then.  The European support package provided liquidity, but because solvency remains the critical problem, the key signposts of risk turned out to be equity prices themselves and bond risk premiums.  Investors perceived increasing threats to the global expansion and a growing cloud of uncertainty around both the European banking system and US policies - including taxes, budget restraint and regulatory reform.  In response, they have been de-risking their portfolios and buying Treasuries.  With the Fed on hold and investors shunning risky assets, carrying Treasuries at low cost has become the favored means to hedge tail risks.  More ominously, some investors fret that policymakers are out of options to prevent a slowdown, while others worry that the authorities are implementing fiscal restraint and financial regulatory reform prematurely.  Those fears are evident in bond risk (term) premiums, which have declined by a whopping 60bp in the past two months.  

Three technical factors magnify the decline in Treasury yields.  First, investors who were short or underweight Treasuries through May are buying to rebalance portfolios.  Recently, fund managers have been getting back to neutral weightings, which implies that they will need to buy Treasuries in the process.  As the universe of Treasuries increases, managers who index to a benchmark need to buy more and more Treasuries to remain at the prescribed weighting of their index.  Second, the end of a tumultuous quarter prompted investors to window-dress portfolios.  Both of these two influences are evident in overseas buying by investors, who were slow in putting cash to work in 2Q.

Third, the dearth of mortgage supply has prompted the Fed to exchange positions in higher-coupon mortgages for those with lower coupons and longer duration, creating a bid for longer-dated securities.  The Fed expected that production of higher-coupon mortgages would catch up with its buying program, but the plunge in rates dried up supply of those issues.  Estimating duration in the MBS market is difficult today because negative equity and tighter credit conditions are causing historically based prepay models to malfunction.  But the Fed's planned portfolio adjustment should be a short-term positive for bonds.

Near-term risks have increased.  We do acknowledge that current market turmoil threatens the near-term outlook: Uncertainty is the enemy of growth and risky assets; with financial regulatory reform in the US and globally still far from settled, lenders remain cautious.  The decline in equity prices, now 17% from the April peak, and the chilling effect of volatility in capital markets have made financial conditions somewhat less supportive of growth.  And the weak performance of US private domestic final demand in the first three quarters of this recovery - up at a 2.4% annual rate - is cold comfort to those like ourselves who expect overall growth in the range of 3-3.5% over the coming year. 

Five factors offer strong support for moderate growth.  The near-term risks do not significantly alter our view of moderate, sustainable growth in 2H10.  To begin with, the recent decline in energy prices and in mortgage rates is a significant offset to those financial headwinds.  And we continue to think that five other factors will support moderate growth: 1) despite the financial restraint noted above, overall financial conditions, especially the availability of credit, are still supportive; 2) ongoing strength in domestic demand in the rapidly growing economies of Asia and Latin America is boosting exports; 3) improvements in wage income will sustain consumer spending; 4) capital spending needs to catch up to corporate replacement needs, pent-up demand and the past acceleration in the economy; and 5) a substantial acceleration in infrastructure outlays from last year's ARRA stimulus legislation has begun to show up in highway and bridge construction. 

Three factors point to significantly higher real rates in 2011: 1) Treasury borrowing needs will remain high as there is scant sign of budget cutting on the immediate horizon;   2) sustainable growth will help to refuel private credit demands, first by businesses, and later by households; and 3) term premiums will rebound significantly as the Fed begins to implement its exit strategy.

Saving-investment balances start to turn; private credit demands should follow.  Retrenchment by both businesses and households in the recession involved significant cutbacks in spending and borrowing, and a pick-up in saving.  Corporate cash flow outstripped inventory change and capital spending, resulting in a record negative corporate ‘financing gap', or financial surplus, at -2.5% of corporate GDP in 3Q09.  For their part, consumers cut spending (including housing investment) beyond the loss of incomes, resulting in a massive swing to surplus.  As a result, net corporate and household demand for credit plunged.

In our view, both are starting to turn, and with them, credit demands.  Growth in corporate cash flow is still strong; we estimate that after-tax profits rose by about 29% over the past year and cash flow by about 8%.  But inventory accumulation is just beginning; capital spending on equipment is heading to the 7-8% growth we think is needed to replace worn-out equipment; and structures outlays should begin to turn by the end of this year.  As a result, the corporate financing gap is moving up sharply - it was zero in 1Q10 - and business credit demands, which turned significantly positive in 1Q, will likely follow.

Household debt is defined to be the sum of home mortgages and consumer credit, and excludes the liabilities of non-profit organizations and other entities classified under households in the flow of funds accounts.

Households are still deleveraging, so their credit demands will pick up more slowly than we expected earlier this year.  Accordingly, income growth is outstripping spending as consumers rebuild saving, and the still-positive household ‘financing gap' reflects the fact that net investment in housing will remain anemic.  Nonetheless, that gap is narrowing and we think the combination of corporate and household improvement will promote a moderate rebound in private credit demands later this year and into 2011.

Fed exit still likely next spring, but at a slightly slower pace.  Inflation expectations, slack in the economy and inflation trends will determine the timing and extent of the Fed's exit strategy.  Inflation expectations measured by forward breakevens have declined in the past two months, and those measured in consumer surveys remain stable.  We believe that the Fed has been successful in limiting downside risks to inflation expectations and that underlying inflation is in the process of bottoming, supported by narrowing slack in goods and services, housing and labor markets.  In particular, the most recent inflation data evince the emerging stabilization in rents in real estate markets.  Yet the more uncertain backdrop for future growth and inflation means that Fed officials probably will raise rates in 2011 a bit more cautiously than we expected in May/June, to 1.75% by the end of 2011, or 50bp lower than our earlier forecast. 

Term premiums: Nowhere to go but up.  Against that backdrop, we expect that 10-year, zero coupon term premiums, which today are hovering near 40bp (measured by a model developed at the Fed), will move higher again over the course of 2011.  At work will be three factors: First, following 27 months of a zero interest rate regime, the first Fed move, no matter how well telegraphed and made conditional on the outlook, will create uncertainty about the future path of monetary policy.  In addition, a rising rate environment will trigger a variety of portfolio reallocations that probably will raise interest rate volatility from today's rock-bottom levels.  Like short-term rates, volatility has nowhere to go but up.  And finally, the risk that no credible plan will emerge from the Administration or Congress to address our long-term fiscal challenges still runs high, despite the wake-up calls from the sovereign credit crisis and from another dismal report card on our long-term budget outlook from the CBO.  Indeed, today's low US rates in a perverse way may rekindle the hope that deficits and debt don't matter when you are still the largest sovereign - hardly a call to action.

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