Danske FMOC

Investment Research General Market Conditions
22 June 2010
Flash Comment
FOMC: Preview
The Fed is expected to keep policy measures unchanged and we expect very few
changes to the statement. The European debt crisis and resulting deterioration in
financial market conditions is likely to delay the normalisation of monetary policy.
If anything, the section on growth could be downgraded a little on the recent
deterioration in financial conditions and the weak housing data. The forward looking
part of the statement will be held unchanged.
The market is currently pricing the first Fed funds rate hike in May 2011 and we do
not expect the statement to rock current market pricing much.
Activity
The recovery is looking increasingly robust. Domestic and foreign demand for consumer
and capital goods are back to pre-recession growth rates. The recovery is broadening from
the manufacturing to the non-manufacturing industries and the labour market has turned
the corner. Housing remains a weak spot but the data is currently difficult to interpret due
to tax credit distortions. The statement is likely to reflect a slightly less upbeat growth
picture given the recent deterioration in financial conditions and the weak housing data.
Even though near-term growth is likely to be viewed as solid, the outlook will remain for
moderate expansion.
Inflation
Core inflation has fallen below the Feds comfort zone and remains on a downward trend,
reinforced by the huge slack in the economy. 5y/5y B/E inflation has declined recently
but the deflationary element is countered somewhat by PPI data, which suggest that
deflationary pressure is easing in the production pipeline. The risk for a change in the
inflation language is very low. The FOMC is likely to reiterate its expectation that
inflation will remain subdued for some time.
Bias and policy outlook

There has not been much new information revealed from the FOMC members in the
inter-meeting period. It remains clear that hawks and doves still disagree significantly on
the language and on the desirable duration of the extended period. However, the doves
continue to hold a solid majority. Given the recent tightening of financial conditions and
renewed market fragility the extended period language is likely to be retained at this
meeting. We expect Hoenig to again be a lonely dissenter.
Fed funds rate and expectations

4.5 %
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
%
Fed funds
Futures market
Danske
08
09
10
11
Source: Bloomberg and Danske Markets
Probabilities for June 23 meeting
Unchanged
Hike to 0.50%
DB
100%
0%
Market*
100%
0%
* B ased o n o ptio nsprices as o f settlement June 21
Fed funds expectations

Date
22/06/10
+ 3m
+ 6m
+ 12m
DB
0-0.25%
0-0.25%
0-0.25%
0.75%
Market
0.19%
0.23%
0.28%
0.53%
Consensus
0-0.25%
0-0.25%
0-0.25%
1.00%
Market pricing
The market is currently pricing an initial 25 basis points hike in May 2011 and a close to
30% chance of a hike in January 2011. We do not expect the language in the statement to
rock these relatively dovish expectations much and hence recommend a neutral position
going into the meeting. DO NOT REMOVE THIS BREAK NOR LET IT MOVE ON TO
THE
FOLLOWING
PAGE
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Senior Analyst
Signe Roed-Frederiksen
+45 45 12 82 29
sroe@danskebank.dk
Senior Analyst
Peter Possing Andersen
+45 45 13 70 19
pa@danskebank.dk
www.danskeresearch.com
Flash Comment
FOMC chart book

Fed to keep ZIRP in place
2.50
and only gradually reduce balance sheet

Thousand bl
2.25
Size of Fed balance sheet >>
2.00
2.50
2.25
<< Fed funds rate
1.75
1.50
1.25
1.00
0.75
0.50
0.25
90
92
94
96
98
00
02
04
06
08
Thousand bl
<< Fed funds rate
2.00
1.75
1.50
1.25
Size of Fed balance sheet >>
1.00
0.75
0.50
-1
03
10
Source: EcoWin and Danske Bank
04
05
06
07
08
09
10
Source: EcoWin
Note: Dark (light) shading indicates periods of tightening (easing)
Core PCE inflation is heading south

6.0
breaking through the low end of the Feds comfort zone

%
5.0
6.0
3.00
5.0
2.50
Core PCE
4.0
4.0
3.0
3.0
"Comfort zone"
1.50
1.50
1.00
1.00
1.0
1.0
0.50
0.0
94
96
98
00
02
04
06
08
2.00
"Comfort zone"
2.0
92
0.00
0.00
07
Long-term inflation expectations have held stable...

%
4.5
09
10
but this is key to watch

5.0
4.5
SPF 10-year
inflation forecast
4.0
08
5.0
0.50
3mth AR
10
3.00
2.50
2.00
2.0
0.0
90
Core PCE
4.0
4.0
Michigan 5-year
SPF 10-year
inflation expectations
inflation forecast
3.5
4.0
3.5
3.5
3.5
3.0
3.0
3.0
3.0
2.5
2.5
2.5
2.5
2.0 Michigan 5-year

inflation expectations
1.5
2.0
1.0
1.0
0.5
1.5
Implied B/E inflation

5y/5y forward TIPS
0.0
90 92
94
96
98
0.5
0.0
00
02
04
06
08

2|
22 June 2010
10
2.0
2.0
Implied B/E inflation

5y/5y forward TIPS
1.5
1.5
1.0
1.0
0.5
0.5
05
06
07
08
09
10
Flash Comment
Business confidence has recovered sharply

65
Index
and is close to peak levels

65
Index
ISM non-manufacturing
65
Index
Index
ISM non-manufacturing
65
60
60
60
60
55
55
55
55
50
50
50
50
45
45
40
40
35
35
30
30
45
Neutral zone
40
35
ISM manufacturing
30
90
92
94
96
98
00
02
04
06
08
40
ISM manufacturing
04
Job gains have been accelerated by census hiring

1000 persons, m/m
1000 persons, m/m
750
400
500
250
250
-250
-250
Non-farm payrolls
-750
-1000
90
92
94
96
98
00
02
04
06
08
7.5
-1000
-800
% y/y
10.0
15
7.5
10
-2.5
-2.5
-5.0
Real personal spending
22 June 2010
-15
-25
3|
10
Real personal spending
-10
-12.5
10
15
-10
-20
08
3 mth chg, % AR
3 mth chg, % AR
-5
-10.0
10
-5
-10.0
09
-15
06
08
-7.5
04
-800
-7.5
02
-600
and the pace of growth is likely to slow in H2
0.0
00
-400
Non-farm payrolls
0.0
98
400
200
07
2.5
96
1000 persons, m/m
-200
10
2.5
94
1000 persons, m/m
-200
-600
5.0
-12.5
92
10
-750
5.0
-5.0
09
Consumer spending has improved fast

Retail sales, CPI deflated
08
3 mth. avg.
-400
% y/y
07
200
-500
10.0
06
but underlying labour indicators are improving
500
-500
05
Source: EcoWin and Danske Bank)
750
35
30
10
45
Neutral zone
-20
Retail sales (CPI deflated)
-25
07
08
09
10
Flash Comment
House prices and home sales

2.5
Millions
in a boom-bust due to first time home buyer tax credit

% y/y
2.0
Real house prices (FHFA) >>
12.5
900
10.0
850
1.5
7.5
1.0
5.0
0.5
0.0
1.0
2.5
650
0.9
0.0
600
0.8
-5.0
80
85
90
95
00
05
550
0.5
400
0.4
-10.0
350
0.3
10
03
12
98
22 June 2010
07
08
09
90-day non-financial corporate

paper, A2/P2 rated
10
00
02
04
0
06
08
10
4
Fed funds
2
2
10-year Treasuries
96
06
Fed funds
94
10
8
92
05
...and money market spreads have widened slightly
0
90
4|
FRM 30-year mortgage lending rate
04
Moody's Baa corporate yield
10
0.6
-7.5
Financial conditions have been hit by European debt crisis...

%
0.7
<< Existing home sales
500
450
12
1.2
1.1
-1.0
-2.0
75
1.3
700
-2.5
<< Total home sales,

deviation from exponential trend
New Home sales>>
800
1.4
750
-0.5
-1.5
thousands
mln
3 mth LIBOR
0
0
03
04
05
06
07
08
09
10
Flash Comment
FOMC key statements

Hoenig (hawk, voter), June 3: The first step toward a more normal policy is to move
policy rates off zero, back toward neutral. With the improvements in market conditions
and liquidity, and with an improving outlook, the FOMC would be prepared to raise the
funds rate target to 1% by the end of summer.
Bernanke (neutral voter), June 9: If markets continue to stabilise, then the effects of
the crisis on economic growth in the United States seem likely to be modest. Although the
recent fall in equity prices and weaker economic prospects in Europe will leave some
imprint on the US economy, offsetting factors include declines in interest rates on
Treasury bonds and home mortgages as well as lower prices for oil and some other
globally traded commodities. The Federal Reserve will remain highly attentive to
developments abroad and to their potential effects on the U.S. economy.
Tarullo (neutral voter), May 21: A deeper contraction in Europe associated with sharp
financial dislocations would have the potential to stall the recovery of the entire global
economy and this scenario would have far more serious consequences for US trade and
economic growth.
Bullard (neutral voter), June 14: Unless events in Europe turn out to be much worse, I
think that in the near term, the US is probably a beneficiary of the crisis in Europe. I dont
think it should push back the date for the Fed to begin tightening.
Ive been an advocate of taking back some of the quantitative easing first and then
thinking about raising interest rates later.
Evans (neutral non-voter), May 31: I wouldnt be surprised if the Feds policy of
keeping rates low gets extended just a little bit. How the crisis in Europe ends up
affecting the economy will dictate how we will respond.
Lacker (hawk non-voter), May 26: The most likely outcome is that Europes sovereign
debt crisis shaves off a tenth or two of my growth forecast this year. It also raises the
profile of some downside risks.
Extracts from FOMC minutes, April 28 meeting

Most participants expressed a preference for strategies that would eventually entail sales
of agency debt and MBS in order to return the size and composition of the Federal
Reserves balance sheet to a more normal configuration more quickly than would be
accomplished by simply letting MBS and agency securities run off. They agreed that sales
of agency debt and MBS should be implemented in accordance with a framework
communicated in advance and be conducted at a gradual pace that potentially could be
adjusted in response to changes in economic and financial conditions. Participants
expressed a range of views on some of the details of a strategy for asset sales. Most
participants favoured deferring asset sales for some time. A majority preferred beginning
asset sales some time after the first increase in the Federal Open Market Committees
(FOMC) target for short-term interest rates.
In light of stable longer-term inflation expectations and the likely continuation of
substantial resource slack, policymakers anticipated that both overall and core inflation
would remain subdued through 2012, with measured inflation somewhat below rates that
policymakers considered to be consistent over the longer run with the Federal Reserves
dual mandate.
Participants saw the escalation of fiscal strains in Greece and spreading concerns about
other peripheral European countries as weighing on financial conditions and confidence
in the euro area. If other European countries responded by intensifying their fiscal
5|
22 June 2010
Flash Comment
consolidation efforts, the result would likely be slower growth in Europe and potentially a
weaker global economic recovery. Some participants expressed concern that a crisis in
Greece or in some other peripheral European countries could have an adverse effect on
US financial markets, which could also slow the recovery in this country.
Nearly all members judged that it was appropriate to reiterate the expectation that
economic conditions including low levels of resource utilisation, subdued inflation
trends, and stable inflation expectations were likely to warrant exceptionally low levels
of the federal funds rate for an extended period.
See Flash comment: FOMC minutes: exit in slow motion
Statement from April 28 meeting

Information received since the Federal Open Market Committee met in March suggests
that economic activity has continued to strengthen and that the labour market is beginning
to improve. Growth in household spending has picked up recently but remains
constrained by high unemployment, modest income growth, lower housing wealth, and
tight credit. Business spending on equipment and software has risen significantly.
However, investment in non-residential structures is declining and employers remain
reluctant to add to payrolls. Housing starts have edged up but remain at a depressed level.
While bank lending continues to contract, financial market conditions remain supportive
of economic growth. Although the pace of economic recovery is likely to be moderate for
a time, the Committee anticipates a gradual return to higher levels of resource utilisation
in a context of price stability.
With substantial resource slack continuing to restrain cost pressures and longer-term
inflation expectations stable, inflation is likely to be subdued for some time.
The Committee will maintain the target range for the federal funds rate at zero to 0.25%
and continue to anticipate that economic conditions, including low rates of resource
utilisation, subdued inflation trends and stable inflation expectations. These are likely to
warrant exceptionally low levels of the federal funds rate for an extended period. The
Committee will continue to monitor the economic outlook and financial developments
and will employ its policy tools as necessary to promote economic recovery and price
stability.
In light of improved functioning of financial markets, the Federal Reserve has closed all
but one of the special liquidity facilities that it created to support markets during the
crisis. The only remaining such programme, the Term Asset-Backed Securities Loan
Facility, is scheduled to close on June 30 for loans backed by new-issue commercial
mortgage-backed securities it closed on March 31 for loans backed by all other types of
collateral.
Voting for the FOMC monetary policy action was: Ben S. Bernanke, Chairman; William
C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra
Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the
policy action was Thomas M. Hoenig, who believed that continuing to express the
expectation of exceptionally low levels of the federal funds rate for an extended period
was no longer warranted because it could lead to a build-up of future imbalances and
increase risks to longer run macroeconomic and financial stability, while limiting the
Committees flexibility to begin raising rates modestly.
See Flash Comment - FOMC: Extending the 'extended period' language
6|
22 June 2010
Flash Comment
FOMC
HAWKISH
NEUTRAL
Lacker
Richmond
Non-voter
Plosser
Philadelphia
Non-voter
Hoenig
Kansas City
Voter
Fisher
Dallas
Non-voter
Kocherlakota Minneapolis
Non-voter
Duke
Board member
Voter
Pianalto
Cleveland
Voter
Evans
Chicago Fed
Non-voter
Warsh
Board member
Voter
Tarullo
Board member
Voter
Lockhart
Atlanta
Non-voter
Bernanke
Chairman
Voter
Bullard
St. Louis
Voter
Kohn
Board member
Voter
Dudley
New York
Voter
Yellen
San Francisco
Non-voter
Rosengren
Boston
Voter
DOVISH
7|
22 June 2010
Flash Comment
Disclosure
This research report has been prepared by Danske Research, which is part of Danske Markets, a division of
Danske Bank. Danske Bank is under supervision by the Danish Financial Supervisory Authority. The authors of
this report are Signe Roed-Frederiksen, Senior Analyst and Peter Possing Andersen, Senior Analyst.
Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high
quality research based on research objectivity and independence. These procedures are documented in the Danske
Bank Research Policy. Employees within the Danske Bank Research Departments have been instructed that any
request that might impair the objectivity and independence of research shall be referred to Research Management
and to the Compliance Officer. Danske Bank Research departments are organised independently from and do not
report to other Danske Bank business areas. Research analysts are remunerated in part based on the overall
profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other
remuneration linked to specific corporate finance or debt capital transactions.
Danske Bank research reports are prepared in accordance with the Danish Society of Investment Professionals
Ethical rules and the Recommendations of the Danish Securities Dealers Association.
Financial models and/or methodology used in this research report
Calculations and presentations in this research report are based on standard econometric tools and methodology
as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be
obtained from the authors upon request.
Risk warning
Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis
of relevant assumptions, are stated throughout the text.
First date of publication
Please see the front page of this research report for the first date of publication. Price-related data is calculated
using the closing price from the day before publication.
Disclaimer
This publication has been prepared by Danske Markets for information purposes only. It has been prepared
independently, solely from publicly available information and does not take into account the views of Danske
Banks internal credit department. It is not an offer or solicitation of any offer to purchase or sell any financial
instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no
representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from
reliance on it. Danske Bank, its affiliates or staff may perform services for, solicit business from, hold long or
short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned
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8|
22 June 2010

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Investment Research General Market Conditions

Bias and policy outlook

Fed funds rate and expectations

Source: Bloomberg and Danske Markets

Probabilities for June 23 meeting

* B ased o n o ptio nsprices as o f settlement June 21

Source: Bloomberg and Danske Markets

Fed funds expectations

Source: Bloomberg and Danske Markets

FOMC chart book

and only gradually reduce balance sheet

<< Fed funds rate

<< Fed funds rate

Size of Fed balance sheet >>

Source: EcoWin and Danske Bank

Note: Dark (light) shading indicates periods of tightening (easing)

Core PCE inflation is heading south

breaking through the low end of the Feds comfort zone

Long-term inflation expectations have held stable...

but this is key to watch

Source: EcoWin and Danske Bank

Note: Dark (light) shading indicates periods of tightening (easing)

Source: EcoWin and Danske Bank

2.0 Michigan 5-year

Implied B/E inflation

Source: EcoWin and Danske Bank

Implied B/E inflation

Source: EcoWin and Danske Bank

Business confidence has recovered sharply

and is close to peak levels

Job gains have been accelerated by census hiring

1000 persons, m/m

Real personal spending

Note: Dark (light) shading indicates periods of tightening (easing)

Source: EcoWin and Danske Bank

and the pace of growth is likely to slow in H2

Source: EcoWin and Danske Bank

1000 persons, m/m

1000 persons, m/m

Consumer spending has improved fast

Note: Dark (light) shading indicates periods of tightening (easing)

Source: EcoWin and Danske Bank

but underlying labour indicators are improving

Source: EcoWin and Danske Bank)

Note: Dark (light) shading indicates periods of tightening (easing)

Source: EcoWin and Danske Bank

Retail sales (CPI deflated)

Source: EcoWin and Danske Bank

House prices and home sales

in a boom-bust due to first time home buyer tax credit

Real house prices (FHFA) >>

Source: EcoWin and Danske Bank

90-day non-financial corporate

...and money market spreads have widened slightly

FRM 30-year mortgage lending rate

Source: EcoWin and Danske Bank

Moody's Baa corporate yield

Financial conditions have been hit by European debt crisis...

<< Existing home sales

Source: EcoWin and Danske Bank

<< Total home sales,

New Home sales>>

Source: EcoWin and Danske Bank

FOMC key statements