US Fixed Income Outlook

March 24, 2011Ajay Rajadhyaksha Managing Director, Head of US Fixed Income and Securitized Products Research and StrategyUS Fixed Income Outlook 2Agenda• Macro Outlook• A steady recovery, and an easy Fed• Rates Outlook • Geopolitics: Japan, Euro tightening and the Middle East• Near-term risks: The debt ceiling, and life after QE2• Longer-term risks: The fiscal picture• Housing finance and the US mortgage markets• Beware of policy error: 5 years is not enough • Weak prepays / steady improvement in mortgage credit• Making Money: Stay in the carry trade Macro Outlook 4Detailed outlookNote: All numbers expressed in q/q saar % unless otherwise specified. The budget balance is fiscal year. Source: BEA, BLS, Federal Reserve, US Treasury, Barclays Capital% Change q/q saarQ1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4201020112012Real GDP3.71.72.62.83.53.03.53.53.53.54.04.02.83.03.6 Private consumption1.92.22.44.13.52.53.03.53.53.54.04.01.83.13.5 Public consump and invest.-1.63.93.9-1.50.0-0.5-1.0-1.0-1.0-1.0-0.5-0.51.00.1-0.9 Residential investment-12.325.7-27.32.820.015.015.010.010.010.012.012.0-3.07.811.3 Equip. & software investment20.424.815.45.513.016.016.017.015.013.012.012.015.113.714.6 Structures investment-17.8-0.5-3.54.55.08.010.010.011.011.011.011.0-13.84.910.5 Net exports ($bn, real)-338-449-505-395-442-473-488-508-521-536-547-560-422-478-541Final sales1.10.90.96.72.42.33.13.33.43.33.83.81.53.13.4Ch. inventories ($bn, real)44.168.8121.47.139.059.069.074.076.082.086.090.060.460.383.5GDP price index1.01.92.10.41.51.51.81.92.12.32.32.31.01.52.1Nominal GDP4.83.74.63.25.14.55.45.55.85.96.46.43.84.65.7Industrial output7.17.26.23.24.55.05.05.05.05.06.06.05.74.85.2Employment (avg mthly chg, K)39181-4613914520022023524525025025078200249Unemployment rate (%)9.79.69.69.68.98.88.68.48.27.97.67.39.68.77.7CPI inflation (%y/y)2.41.81.21.32.02.73.02.82.21.92.02.11.62.72.0Core CPI (%y/y)1.30.90.90.71.01.11.21.41.41.51.61.71.01.21.6Core PCE price index (%y/y)1.81.51.20.80.90.91.11.41.41.51.61.61.31.11.5Current account (%GDP)-3.0-3.4-3.5-3.0-3.5-3.8-3.9-4.0-4.2-4.3-4.4-4.5-3.2-3.8-4.3Federal budget bal. (%GDP)-8.9-7.9-6.2Federal funds rate (%)0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.250.751.25Calendar year average201120102012 5Note: Global series include: US, euro area, UK, Japan, Canada, China, India, Brazil, Turkey, South Korea, Russia, and Mexico. Source: CRB, Datastream, Haver Analytics, Barclays Capital.Global policy remains very accommodative...-4-2024681012141680859095000510Global nominal GDP, y/y % chgGlobal policy rate, %-6-4-2024680859095000510-40-30-20-10010203040Global nominal GDP - global policy rate,lhsCRB commodity price index, rhspp4q % chg 6Source: Statistical agencies, Haver Analytics....leading to rising energy and food prices-60-40-20020406005060708091011USEuro areaJapanChina% y/yConsumer fuel prices-5051015202505060708091011USEuro areaJapanChina% y/yConsumer food prices 7Meanwhile, core inflation is bottoming in the USSource: BLS, Haver Analytics, Barclays Capital-1012345000204060810Shelter CPICore CPI ex sheltery/y % chg-3-2-10123456030405060708091011Headline CPICore CPIforecasts% y/y 8But low unemployment needed for inflation – as in 70sNote: Shading indicates recession. Source: BLS, BEA, Haver Analytics-202468101214607080900010PCE price index, 4q chgUnemployment rate% 9Economic Outlook has Improved. But Hikes in 2011?Fed hike expectations have increased sharplyAs Economic Outlook has improved: But is that enough?Source: Federal Reserve, Bloomberg, Barclays Capital BBG Consensus ExpectationsReal GDP Growth, %Q1- 11Q2- 11Q3- 11Q4- 11Feb-113.50 %3.30 %3.50 %3.50 %Nov-102.20 %2.70 %2.90 %naUnemp. Rate, %Q1- 11Q2- 11Q3- 11Q4- 11Feb-119.20 %9.20 %9.00 %8.80 %Nov-109.50 %9.40 %9.30 %naQ1-Q2-Q3-Q4-0.00.20.40.60.81.01.21.41.61.8Mar-11Jul-11Nov-11 Mar-12 Jun-12Oct-12Jan-13FF Futures Implied Yield for a given month, Latest, %As of Oct-10, %% 10Need a much faster recovery to justify hikesExplaining Fed Funds Rate Using Unemployment Rate / Core Inflation RateMarket Implied Unemployment Rate Using Market Implied Hikes and Core Inflation RateSource: Federal Reserve, Bloomberg, Barclays Capital. Core inflation expectations have been estimated from 1y forward breakevens in the front end adjusted by the difference in our economist’s expectation of headline and core inflation8.9%5.9%6.4%7.8%6.9%5.9%1.9%2.1%1.0%2.6%1.5%1.6%5.25%5.75%6.25%6.75%7.25%7.75%8.25%8.75%9.25%Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-160.75%1.00%1.25%1.50%1.75%2.00%2.25%2.50%2.75%Implied Unemployment Rate (lhs)1y core i nfl a t i on endi ng the da te (rhs)Desired Fed Funds Ratey/y core CPI inflation, End of 20110.500.751.001.251.50Unemp. Rate,End of 201110.00-5.1-4.6-4.1-3.5-3.09.75-4.6-4.1-3.6-3.1-2.69.50-4.2-3.6-3.1-2.6-2.19.25-3.7-3.2-2.6-2.1-1.69.00-3.2-2.7-2.2-1.6-1.1 Rates Outlook 12Fears of Japanese repatriation are overstatedMOF intervention an offset to repatriationBond yields around Japan quakes, and