EFTA00617493.pdf

Eye on the Market I July 29, 2011 J.P.Morgan The Capitol Grill. We have arrived at the sad precipice of the Treasury's stated deadline of August 2i0 , when available sources of funding are reportedly exhausted, other than from raising the debt ceiling. Both parties continue to propose deficit reduction plans that are unlikely to be agreed to by the other (or even their own). The Treasury has —$1 trillion in assets that it could sell (including $420 bn in gold, $370 bn in student loans and $85 bn in mortgage backed securities) to delay a default. The Treasury could also prioritize payments to bondholders, social security recipients, etc. However, there are market-impact, liquidity and feasibility issues that have to be overcome first (see page 3 for details on payment prioritization and the Treasury's view of asset sale risks). More importantly, asset sales and prioritization are a temporary fix; some combination of markets, rating agencies and unpaid entitlement recipients/vendors will likely force both parties back to the Capitol Grill shown below, where some tough choices will have to be made. In the near term, a small, less ambitious deficit reduction / debt ceiling increase is all Congress may have time for (let's at least hope for that). But even if a smaller deal is passed, there will be a lot ■ Burr THE CAPITOL GRILL E. CAPITOL ST. NE AND 1ST ST WASHINGTON. DC 2OOO2 Tratnifion Prime Spending Cuts, baons of dollars over to years Preen discretionary spending at 2011 levers t395 Reduce growth in non-defense discretionary (discr.) spending by 1% a year 327 RevenueRalsers,61llions of dollars over 10 years Emu non-defense discr. spending at 2011 (eve& 642 Raise tax rates on ordinary income by 1% 480 Reduce non-defense discr. spending by 1% a year 932 Raise the top 2 ordinary tat rates by 1% (jointfifers Erene non-defense discr. spending until-2o15 406 starting at $21.20 115 Reduce growth in defense spending 6y 1% a year 286 Raise tax rates on capitalgains 6y 2% 49 Treeze definse spending at 2011 level 611 Raise dividend tax rates on gfliWtaxpayers* to 20% 24 Rake defense spending by 1% a year 862 9ncrease cmyorate income tax rates by 1% sot Change inflation indexation for Social Security 112 Allow MIBusfi tax cuts to sunset asplanned 2,502 Change 'Medicare el@ibility age to 67 125 Allow Bush tax cuts on ITTIWtaxpayers to sunset 709 Alkw14edicare doctor reimbursement cuts 249 Estate/gift tax rates/exemptions to '09 levels 98 Change Medicaidgrants to states 287 'fax carried interest as ordinary income 21 Change Medicaidformulasfor reimbursements 18i Impose a financial crisis resporuibifityfee 3o Eliminate extension of unemployment benefits 57 Phase out mortgage interest &di/alai; 215 Endieefunion for state andfocaltaxes 862 Spending cuts already assumed to takepace 6y CRO Curtaildeductionfor charita6k giving 219 Reduce troops in 'Iraq/18h by 45i by 2015 1,134 limit tax benefit of itemized deductions to 28% 293 Eliminate oil andegaspr#rences 44 EmILTFO accounting 98 Tr° credit cards accrdwithout dsftcit reduction plan Reduce write-off benefits of corporate jets 3 sufficient to stabilize debt ratios at —70% of GDP by Extenddepreciation timefor certain equipment 241 2021 (see nextyage). The CPO Baseline stabilizes the End-9MT' indexation, mid& class tax cuts remain debt ratio, but requires 8 trillion less in deficits over 10 (asper OMB) 1,550 years con paredto the CRO !(tentative Case, which End9IStr indexation, mid& class tax cuts sunset assumes a continuation of most currentpolicies. (asper CBO) 661 Change tax bracket inflation indexation 87 Congress must %stash hands before returning to work 5x> Value added tax(fow estimate) 1,390 Sources: Office of Tianagement ant Budget, Congressional s Mph net worth taxpayers defined as those with Pudget Office, Committee for a Resyons161efecferaf Stscifet, adjustedgross income per year more than $25ok. Joint Committee on l'axation,11 Morgan Private Bank. EFTA00617493  Eye on the Market IP Morgan more work to do. As proposed by both Boehner and Reid plans, after agreement on $1-$I.5 trillion in spending cuts, 12- member bipartisan committees would be formed to make additional deficit reduction recommendations (joint committee reports due by Thanksgiving, with deliberations under special expedited rules by Christmas). To get a sense for why both revenue raisers and spending cuts are needed, we created two deficit reduction plans' representing ideological extremes. The first is a Huey Long "Share the Wealth" (STW) program relying exclusively on the wealthy and the corporate sector to close the deficit, without any spending cuts. Here's the STW program: US long-term debt scenarios • Raise top two ordinary income tax brackets (>$212.3 k Net debt to GDP, percent in annual adjusted gross income) by 5%; limit benefit of 105 itemized deductions to 28% on top 2 brackets; raise too • Italy capital gains tax rates on top 2 brackets back to 2001 95 (00 STW A levels; return estate & gift tax rates to 2009 levels; tax dividends for high income taxpayers at 20%; end oil 90 HHA •1c'e V"- and gas tax preferences; tax carried interest at ordinary 85 cep 3 President's Budget S rates; eliminate tax preferences for corporate jets 80 • Total deficit reduction of $1.4 trillion, including interest • France CBO June 2011 Baseline • 75 The other case is the Herbert Hoover Austerity plan (HHA), 70 which achieves deficit reduction solely through discretionary 65 • spending and entitlement cuts, with no revenues raised: 2010 2012 2013 2015 2016 2018 2019 2021 • Freeze non-defense discretionary spending at 2011 Sou ce: CBO, IMF, OMB,.. Morgan Private Bank. levels; reduce defense spending by 1% a year; change inflation indexation for social security (lowering payments); change Medicare eligibility age to 67; allow Medicare doctor reimbursement cuts to proceed as previously agreed • Total deficit reduction of $2.4 trillion, including interest We plot the STW and HHA plans on our CBO wedge, in between the CBO Baseline (all tax cuts return to 2001 levels and other contractionary measures), and the Alternative case (continuation of most current tax policies). As shown, neither plan arrests the rise in Federal debt; nor does the President's budget, nor the initial phases of the Reid or Boehner plans. You can use the Capitol Grill menu to construct deficit reductions of your own. Even if a smaller deal is all that is agreed to, perhaps S&P2 will wait to see what happens with the bipartisan deficit reduction committees before deciding what to do about the rating. In case there is a downgrade, we do not foresee a meaningful selloff in the Treasury markets; it could be a bigger problem for equity markets, at least in the short term: • Most collateral agreements appears to have leeway to avoid immediate liquidation of the collateral in case of a downgrade • Money market funds that are subject to 2a7 legislation even have the ability to hold defaulted collateral if selling would be disruptive and not in the fund's shareholder interest, so a downgrade should not force any specific action • There is nothing in ERISA language governing pension funds that would trigger a sale in case of a downgrade; it would be up to individual account guidelines as to whether there was flexibility on collateral rules. • We do not foresee any changes to bank or insurance company regulations regarding the zero risk-weighting applied to Treasuries, nor its eli ibility as general collateral in repo transactions3. • A downgrade by would probably trigger a matching downgrade of Agency paper (Fannie Mae and Freddie Mac), GNMA, municipal bonds backed by Treasury bonds, the Federal Home Loan Bank and the Federal Farm Credit Bank. There could be eventual down rades of insurance companies, bank subsidiaries and bank holding companies due to "sovereign ceiling" issues, but softened their language on this topic on this week's conference call. Other potential downgrade candidates: states with high levels of government dependency (e.g., South Carolina, Tennessee, Maryland, Virginia, New Mexico), defined by their exposure to Federal employment, procurement contracts and Medicaid transfers. • Finally, we do not expect material change in demand for Treasuries and quasi-sovereign paper by central banks reinvesting their current account or petrodollar surpluses. Well more than half of all AAA securities in the world are US Treasuries, Agencies and Agency-backed securities, leaving few and highly fragmented immediate options for central banks, insurance companies and other AAA buyers (soon to be AA buyers?). An end to central bank reserve accumulation (perhaps out of concerns for inflation) appears a bigger risk for Treasuries than central bank reserve diversification. I While we use OMB and CBO estimates of each budget item, there are cross•coefficients that take place when budget items are combined that we are not accounting for. There is no way to determine if they would have a systematically positive or negative bias. 2 At the current time, Moody's does not appear inclined to downgrade the US, as long as the debt ceiling is raised. 3 Haircuts applied to Treasury collateral are typically 2%; a downgrade could increase this by I% or so, but there is no reason to think this will happen automatically. It will depend on the volatility of the Treasury markets in the interim. 2 EFTA00617494  Eye on the Market I July 29, 2011 J.P.Morgan Of course, we can't account for the "unknown unknowns" we might be missing; it wouldn't be a surprise if some market participants reacted negatively or unpredictably if the debt ceiling is not raised. There are already some signs of funding tightness in short term credit markets; unwinding decades of market precedent is generally a bad thing. The US first received a AAA rating almost 100 years ago, when the US began to take over as the world's reserve currency from the United Kingdom. it would be a lamentable thing to lose. In not being able to agree on how to prevent escalation of the Federal debt, the country's elected representatives (and citizens they represent) may abrogate one of the most important parts of Washington's Farewell Address, which was to avoid "ungenerously throwing upon posterity the burden which we ourselves ought to bear". As time grows short, we are left hoping for divine inspiration to drive a sound compromise, perhaps driven by Senators Reid and McConnell; maybe we'll have one next week. Bottom line: don't sell your gold. Michael Cembalest Chief Investment Officer On asset sales to fund government operations If the debt ceiling is not raised, asset sales may be a better option in the short term than prioritization or default. However, asset sales would be a very tough pill for the Treasury to swallow. As recently as May 2011, Assistant Secretary of the Treasury for Financial Markets Mary Miller wrote a note entitled "Federal Asset Sales Cannot Avoid Needfor Increase in Debt Limit". Miller states that "afire sale offinancial assets would be damaging to the economy, taxpayers, andfinancial markets. It would harm the interests of taxpayers, and would undermine confidence in the United States. Nor would such sales postpone reaching the debt limitfor a meaningful amount of time. Congress would still need to raise the debt limit" Interestingly, Miller quotes Treasury Secretary James Baker as saying that the "gold reserve is thefoundation ofourfinancial system", a comment which was made after the move away from the gold standard in the early 1970's. Perhaps the Treasury would enter into a gold-for- cash swap with the Federal Reserve? Stranger things have happened. On our understanding of payment prioritization Summary of receipts and expenditures (August 3rd to 31st) Billions, USD 0 100 200 300 400 See chart for a theoretical modeling of what the Federal government might pay (and perhaps not pay) if it had to Interest on Treasury Securities r Total Federal live only on the $170 billion in government receipts +Social Security Benefits,, N' receipts +Medicare expected for August. The items above the dotted line +Defense VendorPayments are assumed to be paid. We have no idea if this can be +Unemployment Insurance Benefits done; it could be administratively impossible. +Military Active Duty Pay +Veterans Affairs Programs On the Manchurian Candidate proposal of the week +Federal Salaries+ Benefits in the Manchurian Candidate, the far right and far left +IRS Refunds of the political spectrum converge together for a brief +Foodnitrition Services+ TANF moment. This happened recently when Congressman +Education Department Ron Paul and Economist Dean Baker of the Center for 4-Housing and Urban., +Other Spendiig Economic Policy Research agreed (as per the July 26 WSJ) on how to give the Treasury room to issue more Source: Bipartisan Policy Center and BridgewaterAssociates Estimates. debt under the existing ceiling. Their idea: the Fed should rip up the $1.6 trillion of Treasuries it owns. Aside from its questionable legal issues and the hole it would blow in the Fed's balance sheet, it would compromise the Fed's ability to drain liquidity when the time comes (since it would do so by selling securities). It could also conjure up fears of debt monetization (and Zimbabwe). Consider this: people are worried about ECB holdings of Greek debt, which are much smaller. The material contained herein is intended as a generalmarket commentary. Opinions expressedherein are those ofMichael Cembalest and may differfrom those ofother. Morgan employees and affiliates. This information in no way constitutes.. Morgan research and shouldnot be treated as such. Further. the views expressed herein may differfrom that containedin. Morgan research reports. The above summary/prices/quotes/statistics have been obtainedfrom sources deemed to be reliable. but we do not guarantee their accuracy or completeness, any yield referenced is indicative and subject to change. 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