Investment Research General Market Conditions

27 July 2011

Research
US debt default unlikely, downgrade likely

The timeline for meeting the 2 August deadline is very tight and the likelihood of getting a so-called grand bargain with substantial savings is now very low. Although we do not expect the stalemate to result in a temporary default, we now see a more than 50% chance that US sovereign debt will be downgraded by the rating agencies in the coming months. The deadline of 2 August may be postponed, as there seems to have been higher tax payments in July than expected. Hence, if no agreement is reached by 2 August we might see negotiations continue for a week or so. In our main scenario (no default but downgrade) we believe equities will correct by -5%, Bond yields would show a limited positive reaction and the US dollar would weaken slightly. This scenario is close to the market consensus.
However, there is a negative scenario (debt limit not raised in time) under which

stocks would correct -10% (S&P500), bond yields would rise 50bp (10 year T-note) and the US dollar would start to strengthen against cyclical currencies but still weaken against the Swiss franc, the Japanese yen and the euro.

The systemic risks connected with a downgrade of US government debt are very difficult to assess. While the conventional wisdom is currently that the impact will be moderate, there is no preceding experience with a downgrade of the numraire of the global financial system. The latter is a key point in our assessment of a nervous reaction in risk assets when a downgrade, as we expect, becomes reality.

Very tight timeline for negotiations

The timeline for reaching a deal to raise the debt limit is getting very tight. The deadline is less than one week from now and, in order to follow the legislative procedure, a deal has to be in place very soon. The deal has to be accepted in both the House where Republicans have a majority (240 vs Democrats 193) and the Senate where Democrats have a majority (59 vs 47 Republicans, two independent). If a deal in the House is approved, it would subsequently go to the Senate for approval and vice versa. However, the Senate may make amendments, which means it would have to be approved in the House again. Once the same bill is approved in both chambers, it goes to the president to be signed and put into law. Neither the Democrats nor the Republicans have full support from their respective parties on the individual plans, which is complicating a compromise even further. The House and the Senate previously stated a vote on competing proposals could occur as early as Wednesday. However, today it became clear that Republican speaker of the House John Boehner would have to delay a vote on the bill until Thursday due to doubts that it could come through in its current form as several Republicans had said the plan did not deliver the promised savings. Majority leader of the Senate Democrat Harry Reid is expected to await a vote in the House before putting his plan to the vote.
Chief Analyst Allan von Mehren +45 45 12 80 55 alvo@danskebank.dk Chief Strategist Morten Kongshaug +45 45 12 80 57 mokon@danskebank.dk Senior Analyst Peter Possing Andersen +45 45 13 70 19 pa@danskebank.dk Senior Analyst Kasper Kirkegaard +45 45 13 70 18 kaki@danskebank.dk

Important disclosures and certifications are contained from page 9 of this report. www.danskeresearch.com

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Real deadline for default may not be 2 August

In recent days, there has been some uncertainty over whether the deadline has changed as tax revenue for July has been higher than expected. Some calculations suggest the government may have another one to two weeks. So far, the US Treasury has not changed the date for when it expects to run out of money most likely because president Obama wants to keep maximum pressure on politicians in order to get a deal through. However, it may suggest that should a plan not be ready for the presidents signature before 2 August there could be scope for more time before the money runs out. Another issue is whether the US would actually default should the debt limit not be raised by 2 August. It seems likely that the government would decide to hold back payments to government employees and federal government contractors instead so it could still meet its debt obligations until a deal is in place. Hence, even if a deal is not in place before the government runs out of money, we do not believe a default would be the first outcome. However, it would be a terrible signal to financial markets to have to hold back government payments. Credibility in politicians ability to steer the US economy properly in the current troubled waters would deteriorate even further and it would be likely to send shock waves through the financial markets.

Obama able to raise debt limit if Congress fails

The US president will be able to lift the debt ceiling although no political agreement between Democrats and Republicans is found in time to avoid a debt default There are two suggestions currently up for discussion among lawmakers.
1. Former President Clinton has identified a constitutional escape hatch should Obama

and Congress fail to come to terms on a deficit reduction plan before the government hits its borrowing ceiling. A provision in the 14th Amendment gives, according to some legal experts, the president the powers to ignore the debt ceiling if any other means are exhausted.
2. Senate minority leader Mr McConnell has proposed to flip the current process upside

down by calling on Congress to disapprove rather than approve an administration request for a debt limit increase. It would then allow the president to veto the disapproval if it clears Congress, allowing the debt limit to be raised to avoid a default. Although president Obama has expressed doubts about both options, it is worth knowing that the president will still have options to avoid a default if the political negotiations on Capitol Hill is not finished before the deadline at the start of August.

Several disagreements between Democrats and Republicans

Last week, markets became enthusiastic as the two parties were apparently getting closer to a grand bargain in which both parties agreed on a proposal to send to Congress. However, the Democrats left the deal, as they would not accept that tax increases were not part of a deficit reduction plan that made substantial savings on spending. Since then the parties have worked on separate proposals (see box below). The main points of disagreement are as follows.
1. Republicans propose a two-step plan for raising the debt limit. A first step would

postpone the deadline by six months, with another increase then in the limit tied to further savings coming from a bi-partisan Commission. President Barack Obama has strongly opposed this and his spokesman has said he would veto such a plan. The latest signs from Republicans are that it will be adjusted after the Congressional Budget Office (CBO) said the plan implied only USD850bn in savings. This would mean the rise in the debt limit would be even shorter than the six months, putting Republicans even closer to a collision course with the Democrats.
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2. Democrats are also opposed to the Republicans proposal of putting caps on spending.

President Obama says it would hurt investment in infrastructure, R&D investment and education, on which future growth in the economy should be based.
3. There is also disagreement on the balanced budget amendment proposed by

Republicans. This has actually previously been approved in the House but did not go through the Senate where Democrats have a majority. Overall, some clear obstacles still need to be removed. With both parties also struggling to keep their own party in support of their individual plans, there is still some work to be done.
Overview of separate fiscal plans Main elements in the Republican plan:
The debt limit of USD14.3trn to be raised in two steps. The first step would be an

increase of USD1trn in exchange for a USD1.2trn spending cut. A second increase of USD1.6bn early next year would be tied to a further savings plan being worked out by a new 12-member bipartisan Commission. Following calculations from the CBO, the rise in the debt limit in the first step might be changed to USD850bn, which would imply a period of less than six months before it would have to be raised again.
Bipartisan Commission to have special privileges. The Commission would be

assigned the job of finding USD1.8trn additional savings and have special privileges to bring legislation before the House and Senate. Its proposal would not be subject to amendment or Senate filibuster.
Cap on future spending. Legal limits on future spending in certain areas should raise

a further USD1.2trn over the next 10 years.

Balanced budget amendment to the Constitution. As part of the plan, the Senate and

House would be required to vote on a balanced-budget amendment to the Constitution after 1 October but before year-end.
Main elements in the Democrats plan
Increase in debt limit of USD2.4trn. This would enable the government to pay its

bills throughout the 2012 election year.

Spending cuts of USD2.7trn. It would cut USD1.2trn from federal agency budgets

and save on recurring programmes such as agriculture subsidies. It also counts about USD1trn in savings from winding down operations in Iraq and Afghanistan. The cuts would not touch any entitlement programmes.
Bipartisan commission to find further savings cuts. In line with the Republicans, the

plan from senator Harry Reid also includes a bipartisan commission that would work further on a plan to tackle the medium- and long-term challenges.
No increase in tax revenue. The democrats have removed an increase in tax revenue.

It is probably too late for a comprehensive package and it may be that President Obama will have to accept only a short-term increase in the debt limit to allow for more time to put a bigger plan in place. However, it is unlikely, in our view, that the debt limit will not be raised in time to avoid default.

US to lose its AAA rating in coming months

An increase in the debt limit in time will not be sufficient to avoid a downgrade. Politicians also need to come up with a credible plan for tackling the medium- and longterm US fiscal challenges in order to avoid a downgrade.
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On 18 April, Standard & Poors put the US AAA sovereign debt rating on negative outlook and on 14 July it went one step further and placed the AAA rating on CreditWatch with negative implications see note from Standard & Poors. According to the statement issued on 14 July Standard & Poors use[s] the CreditWatch to indicate a substantial likelihood of it taking a rating action within the next 90 days, or in response to events presenting significant uncertainty to the creditworthiness of an issuer (our italics). Standard & Poors may lower the long-term rating on the US by one or more notches into the AA category in the next three months, if we conclude that Congress and the Administration have not achieved a credible solution to the rising US government debt burden and are not likely to achieve one in the near future. Standard & Poors states that in its baseline scenario US net general government debt would reach 84% of GDP by 2013, which indicates a relatively weak trajectory compared with those of the USs closest AAA-rated peers (France, Germany, the UK and Canada). It also specifically highlights that the debt trajectory is expected to continue increasing in the medium term if a medium-term fiscal consolidation plan of USD4trn is not agreed upon. This probably means that US politicians have to come up with savings very close to the USD4trn mark in order to avoid a downgrade. So far, the two proposals from the Democrats and Republicans are at best close to or just below USD3bn and hence not close to what Standard & Poors seems to require to avoid a downgrade. Finally, Standard & Poors highlights that for a plan to be credible it has to be bipartisan. Moodys has also put the US under review for a possible downgrade, although this is mostly linked to the risk of a default in the short term should the debt limit not be raised. Moodys is less explicit about the exact terms of a downgrade should the debt limit be raised. However, we believe that it would very quickly follow with a downgrade should Standard & Poors announce a downgrade.

Timing of a downgrade
The timing of any downgrade is a uncertain and depends on the exact outcome of the deal. If we get a deal with limited savings but one that establishes a commission to come up with more savings over the next six months, it is unclear how Standard & Poors would react. Our best guess, though, is that after some time studying the deal closely (about one month) Standard & Poors would downgrade the US sovereign debt rating because the likelihood of getting a satisfactory savings plan in an election year (2012) would be seen as limited. Standard & Poors could also choose to await the outcome of the commission, which might postpone a downgrade by six to eight months. However, either way we believe it will ultimately come, as it is doubtful whether the two parties will dare decide on sweeping reforms that will hurt many Americans during an election year. =

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Systemic tail risks following a downgrade

In our view, the systemic risks in connection with a downgrade of US government debt are very difficult to assess. While the conventional wisdom is currently that the impact would be moderate, the AAA status for US government debt has been an anchor condition for the global financial markets in modern times. There is no previous experience of a downgrade of the numraire of the global financial system. We have compiled a list of issues that may be of importance for the global financial system if as it now appears likely the US loses its AAA long-term credit rating. We think these issues should be considered as tail risk factors. They are most relevant in the case where US Congress does not reach the deadline for increasing the debt limit and the US enters a technical default, but there is also a risk that a one-notch downgrade would imply some systemic risks.
Some money market funds, index funds, mutual funds and insurance companies are

bound by covenant to invest only in AAA papers. This investor segment might be forced to reduce or close down holdings of US Treasuries if the AAA rating is lost. This could amplify the sell-off in Treasuries. In this case, some funds may choose to change their covenants to be able to include non-AAA papers. However, this might lead investors to move out of money market funds, which in time could lead to a squeeze in the money market.
Treasuries are widely used as collateral in the repo, OTC derivates and futures

markets. A lower rating of US treasuries is likely to imply a larger haircut on treasuries in these financial transactions. In turn, this could lead to margin calls on counter parties implying a liquidity or funding squeeze in some markets.
A downgrade of the US government would have a knock-on effect and initiate a series

of other downgrades.
First several government sponsored agencies including Fannie Mae, Freddie Mac,

the Federal Home Loan Bank System and Farm Credit System Banks would be likely to be downgraded in tandem with the US government.
Second, a variety of bonds or other liabilities that are directly or indirectly

guaranteed by the US could come under review or be downgraded. For instance, Israeli and Egyptian bonds guaranteed by the US would be likely to be downgraded if the US government loses its AAA rating.
Finally, several US financial institutions, among others large US insurers and

securities clearing houses, seem likely to be downgraded along with the US as they are constrained by the US sovereign credit rating. The wave of subsequent downgrades could lead to a financing squeeze for financial institutions and further deterioration in financial conditions. As the No. 1 risk-free asset in the world, most risk assets would have to be reprised lower if the downgrade turns out to be permanent, as the long-term global cost of capital would also be affected negatively.

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Three scenarios and the impact for the markets

Main: debt limit raised but downgrade triggered on too-small budget cut Our main scenario is that the debt limit will be raised by Congress in time to avoid a default. However, we believe it is too late for a significant deal that will satisfy the rating agencies and hence we see a downgrade of the US sovereign debt rating over the coming months as the most likely scenario. Given recent developments, this is also becoming market consensus. The rating downgrade heralds a new situation for the No. 1 risk-free asset in the world. We expect a one-notch downgrade of the USs long-term credit rating (Standard & Poors from AAA to AA+). Unpredictable system financial risks are assumed to be under control in this scenario. As this is mostly priced in by the markets already, it is unlikely to have a severe impact on either the US economy or financial markets.
Bonds: This would imply only a moderate reaction in Treasury yields, as there is

already, say, a 50/50 probability of a one-notch downgrade priced in. We believe the 10year Treasury yield would increase by less than 10bp in this case. Maturities shorter than five years are likely to be less affected due to the offsetting expectations of a lower Fed funds rate in a regime with more fiscal tightening. The yield curve would steepen a bit further and asset swap spreads could decline a bit more, as government credit deteriorates relative to bank credit. We see a limited reaction in Bunds and EUR swaps.
Equities: The stock market has already discounted a new regime for public debt,

which means lower-than-usual valuation and higher-than-usual implied ERPs. Still there would be room for a moderate negative reaction on Wall Street with the S&P500 down 5% as a reminder that economic policy will not stay as supportive for the profit cycle in the future as experienced in the past amid fear of systemic financial risks.
FX: A higher US risk premium should see the US dollar depreciate against the other

reserve currencies the Swiss franc, the yen and most likely also the euro. A potential sell-off in risky assets would, however, mitigate the negative effects on the dollar and potentially even see the dollar gain against the cyclical currencies (e.g. the commodity and EM currencies) if the shock to risk sentiment is large enough. Volatility should be expected to rise but, as this scenario is increasingly priced in, the market impact could prove limited. Our favoured positions would be modest short USD/CHF and USD/JPY. Positive alternative: debt limit raised and large budget cut averts downgrade In this scenario, we assume that the budget deal is USD3-4trn in budget savings over a 10-year period. These sizable savings would be likely to keep rating agencies from downgrading US Treasuries, as it comes close to stabilising the debt to GDP ratio. For investors to take risk, they need to know how much they would get to stay risk free, and without a US Treasury downgrade, investors would remain comfortable about these core investment conditions. The stronger economic headwinds coming from the tighter fiscal policy in this scenario would be negative but this is outweighed by the certainty that this scenario implies about: (a) Washingtons ability to address long-term economic challenges and (b) the stability of the global financial system. The US economy in this scenario would thus get a small lift as uncertainty lessens for corporates and consumers.
Bonds: The knee-jerk reaction is lower Treasury yields and a flattening of the curve,

where the 30-year bond outperforms other segments. If a 50/50 probability of a downgrade is currently priced in, we think the 10-year yield could decline by some 10bp. Swap spreads would increase, with the 30-year Treasury asset swap spread (swap rate less Treasury yield) increasing the most, i.e. a steeper swap spread curve. We would expect a limited reaction in Bunds, with a risk ofr slightly higher Bund yield, due to the unwinding of precautionary safe-haven flows.
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Equities: A relief reaction could push Wall Street up by +5% (S&P500) As both PE

valuation and implied ERPs suggest that that the stock market is already discounting a difficult economic future position for the US and most of the OECD, we believe the focus would return to the currently very supportive profit cycle.
US dollar: In this scenario, the US dollar would be caught between two counteracting

forces: (a) the support from a reduced US risk premium and (b) the negative cyclical effects of future tighter fiscal policy (this would not least work through the impact on monetary policy with markets postponing expectations of a first Fed hike). We would expect the first effect to dominate in the short term, however, and for the dollar to temporarily rebound. Option market volatility should fall back. In our opinion, the biggest rebound among the US dollar pairs should be expected in USD/JPY and USD/CHF, whereas the reaction in EUR/USD should be more modest. Our favoured positions would be long AUD/JPY and long USD/CHF. Negative alternative: debt limit not raised US defaults temporarily This would be a double negative as it shows that Washington is currently unable to address the long-term challenges for the US economy and unwilling to at least temporarily meet its obligations to bond holders. We assume that the market would asses this as being equivalent to a three-notch downgrade by all rating agencies, which includes a high probability that unpredictable systemic risks would emerge. Furthermore, we assume that the default would only be short lived as the harsh financial markets reaction has historically been among the best weapons against political gridlock in Washington. The overall impact would be a sharp decline in risk aversion and clearly negative effects for the US economy, which would be likely to be pushed into a low-growth scenario that would prove very persistent. The global economy would be negatively affected by this and it could add to European growth and debt problems as well.
Bonds: This would be equivalent to an estimated increase in the fair level of 10-year

Treasury yield by 40-50bp. Again safe-haven flows from risky asset markets and expected lower future Fed rates might initially absorb some of the impact in particular for short maturities. There will be a significant steepening of the 5-30 and 10-30 Treasury curve. The US swap spread curve would flatten. The money market basis might widen because of stress in the money market, which in turn would push swap spreads versus short maturity Treasuries wider. For longer maturities, this is likely to be countered by rising credit premiums on Treasuries. Yields on Bunds would decline on safe-haven flows and the spread versus 10-year and 30-year Treasuries would widen (i.e. US minus German yield). In this scenario the 10-30 EUR swap could flatten due to the risk of hedging flows in the European life and pensions sector.
Equities: In our view, a negative 10% reaction should be anticipated until the

policymakers get their grip on the situation and come up with some short- and longterm solutions on the debt issue. As in our main scenario, the matter of potential systemic risks (see page 5) would spur uncertainty. Furthermore, the US debt jitters would be likely to trigger European stock market outperformance of Wall Street as the eurozone debt crisis has finally found its match. Global financial stocks would be likely to continue to underperform other GICS sectors.

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US dollar: A bigger sell-off in risky assets coinciding with general deleveraging could

lead to an unwinding of short dollar positions (which according to, for example, IMM data have been building further over the past month). This should mitigate the negative dollar effects, at least against the cyclical currencies, and potentially even see the dollar gain against the EM and commodity currencies. USD/JPY and USD/CHF should be expected to test new lows and modest support would perhaps even form for GBP/USD and EUR/USD in what would be likely to be high-volatility trading. Short US dollar positions against the most liquid currencies should perform and, in general, illiquid currencies (e.g. the Scandinavian currencies) and carry target currencies (e.g. Australian dollar, New Zealand dollar and Mexican peso) are likely to come under pressure. Our favoured positions would be long a basket of highly liquid currencies against low liquidity and cyclical currencies (e.g. long Japanese yen, Swiss franc, euro and British pound versus short Australian dollar, New Zealand dollar, Turkish lira and Swedish krona).

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Disclosure
This research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank"). The authors of this research report are Allan von Mehren (Chief Analyst), Morten Kongshaug (Chief Strategist), Peter Possing Andersen (Senior Analyst) and Kaspar Kirkegaard (Senior Analyst). Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analysts personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorized and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Services Authority (UK). Details on the extent of the regulation by the Financial Services Authority are available from Danske Bank upon request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest 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 research policies of Danske Bank. 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 the Research Management and the Compliance Department. Danske Bank Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the over-all 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. 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.

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