Investment Research — General Market Conditions

10 August 2010

Flash Comment
FOMC: Preview
Contrary to market speculation, we do not expect any changes to policy measures or
the balance sheet management at today‟s FOMC meeting. Fed funds rate and expectations
4.5 4.5
% %
The recent deterioration in data should warrant a softer tone in the statement. The 4.0 4.0
growth section is likely to be downgraded, but with no material changes to the 3.5 3.5
3.0 Fed funds 3.0
outlook. 2.5 2.5
2.0 2.0
The „extended period‟ language should be retained and the forward-looking section is 1.5 1.5
Danske
likely to see a dovish twist indicating a softening in the policy stance. 1.0
Futures prisning
1.0
0.5 0.5
While the statement will fundamentally support the current low level of yields, the 0.0 0.0
08 09 10 11
market might be a bit disappointed when the Fed fail to announce further easing.
Hence, the risk-reward is for higher yields going into the meeting. Source: Bloomberg and Danske Markets

Activity
Economic data has weakened over the past couple of months and is now highlighting the
risk of a hard landing in H2. The combination of declining leading indicators, a
significant setback in housing data, soft consumer spending growth and a moderate
Probabilities for August 11 meeting
recovery in the labour market is likely to increase the concerns on the outlook at the
committee. On a positive note, improving financial conditions and robust household Probabilities for August meeting
incomes support the H2 outlook. The statement should acknowledge the recent DB Market*
Unchanged
weakening in data and reflect a less upbeat growth picture with increased downside risks. (0-0.25%) 100% 100%
We believe that the Fed will stick to its medium-term outlook for a moderate expansion. Hike to 0.50% 0% 0%
* B ased o n o ptio nsprices as o f settlement A ugust 6
Inflation
Source: Bloomberg and Danske Markets
Core inflation has fallen below the Fed‟s comfort zone and remains on a downward trend,
reinforced by the huge slack in the economy. 5y5y B/E inflation has declined recently but
other measures of inflation expectations remain stable. The risk of a change in the
inflation language is limited. The FOMC is likely to reiterate that inflation will remain
subdued for some time, but could skip the note about declining commodity prices. Fed funds expectations
Bias and policy outlook DB Market*
Unchanged 100% 100%
There have not been any big changes in communication from the central Fed members.
Hike to 0.50% 0% 0%
However, among the local Fed presidents the hawks have softened along with the * B ased o n o ptio nsprices as o f settlement June 21
deterioration in data. Market speculation of further easing has intensified following Source: Bloomberg and Danske Markets
reports in the news media that the Fed would be re-investing its proceeds from the MBS
portfolio to avoid tightening the balance sheet. We believe that such an announcement
would be premature but believe the Fed will indicate that the door is open should the
outlook deteriorate further. The ‘extended period’ language is likely to be retained at this
meeting and a dovish twist could be added to the forward-looking section. Furthermore,
we believe it unlikely that Hoenig will repeat his dissent, therefore adding to the
likelihood of a dovish shift in the bias.
Market pricing Senior Analyst
Signe Roed-Frederiksen
The market has postponed the initial Fed hike to November 2011. We believe that the
+45 45 12 82 29
market could initially be disappointed should the Fed fail to announce further easing. sroe@danskebank.dk
However, the statement is not expected to change the fundamental outlook for low rates, Senior Analyst
which is currently in the Fed‟s interest. E 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 … … but will the balance sheet be allowed to shrink?

2.50 9 2.50 7
% Thousand bn % Thousand bn
2.25 8 2.25 6
Size of Fed balance sheet >> << Fed funds rate
2.00 7 2.00 5
<< Fed funds rate
1.75 6
1.75 4
1.50 5
1.50 3
1.25 4
1.25 2
1.00 3 Size of Fed balance sheet >>
1.00 1
0.75 2
0.50 1 0.75 0

0.25 0 0.50 -1
90 92 94 96 98 00 02 04 06 08 10 03 04 05 06 07 08 09 10

Source: EcoWin and Danske Bank Source: EcoWin

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

Core PCE inflation is heading south… …breaking through the low end of the Fed’s comfort zone

6.0 6.0
% % % %
3.00 3.00
5.0 5.0 Core PCE
Core PCE 2.50 2.50
4.0 4.0
2.00 2.00
"Comfort zone"
3.0 "Comfort zone" 3.0
1.50 1.50

2.0 2.0 1.00 1.00

1.0 1.0 0.50 0.50

3mth AR
0.0 0.0 0.00 0.00
90 92 94 96 98 00 02 04 06 08 10 07 08 09 10

Source: EcoWin and Danske Bank

Source: EcoWin and Danske Bank
Note: Dark (light) shading indicates periods of tightening (easing)

5y/5y B/E inflation declining... …but other measures are stable

5.0 5.0 4.0 4.0

% % % Michigan 5-year %
4.5 4.5 SPF 10-year inflation expectations
SPF 10-year 3.5 3.5
inflation forecast
4.0 inflation forecast 4.0
3.5 3.5 3.0 3.0

3.0 3.0 2.5 2.5

2.5 2.5
2.0 2.0
2.0 Michigan 5-year 2.0 Implied B/E inflation
inflation expectations 5y/5y forward TIPS
1.5 1.5 1.5 1.5
1.0 1.0
1.0 1.0
0.5 Implied B/E inflation 0.5
5y/5y forward TIPS 0.5 0.5
0.0 0.0
90 92 94 96 98 00 02 04 06 08 10 05 06 07 08 09 10

Source: EcoWin and Danske Bank

Source: EcoWin and Danske Bank
Note: Dark (light) shading indicates periods of tightening (easing)

2| 10 August 2010
www.danskeresearch.com
Flash Comment

Business confidence has peaked… …and will move lower during H2

65 65 65 65
Index Index Index Index
ISM non-manufacturing ISM non-manufacturing
60 60 60 60

55 55 55 55

50 50 50 50

45 45 45 Neutral zone 45
Neutral zone
40 40 40 40

35 35 35 ISM manufacturing 35
ISM manufacturing
30 30 30 30
90 92 94 96 98 00 02 04 06 08 10 04 05 06 07 08 09 10

Source: EcoWin and Danske Bank

Source: EcoWin and Danske Bank)
Note: Dark (light) shading indicates periods of tightening (easing)

Job gains has been accelerated by Census hiring … … but underlying labour indicators are improving
500 500
1000 persons, m/m 1000 persons, m/m 1000 persons, m/m 1000 persons, m/m
400 400
250 250 Private non-farm payrolls
200 200
3 mth. avg.
0 0
0 0
-250 -250
-200 -200

-500 -500 -400 -400

Private non-farm payrolls
-750 -750 -600 -600

-1000 -1000 -800 -800

90 92 94 96 98 00 02 04 06 08 10 07 08 09 10

Source: EcoWin and Danske Bank

Source: EcoWin and Danske Bank
Note: Dark (light) shading indicates periods of tightening (easing)

Consumer spending has recovered at a moderate pace… … and we expect some improvement in Q2
10.0 10.0 15 15
% y/y % y/y 3 mth chg, % AR 3 mth chg, % AR
7.5 Retail sales, CPI deflated 7.5 10 10
5.0 5.0 Real personal spending
5 5
2.5 2.5
0 0
0.0 0.0
-5 -5
-2.5 -2.5
-10 -10
-5.0 Real personal spending -5.0
-7.5 -7.5 -15 -15

-10.0 -10.0 -20 -20

Retail sales (CPI deflated)
-12.5 -12.5 -25 -25
92 94 96 98 00 02 04 06 08 10 07 08 09 10

Source: EcoWin and Danske Bank

Source: EcoWin and Danske Bank
Note: Dark (light) shading indicates periods of tightening (easing)

3| 10 August 2010
www.danskeresearch.com
Flash Comment

Sharp setback in housing indicators… … as the first-time homebuyer tax credit expires
2.5 12.5 900 1.4
Millions % y/y mln thousands
2.0 10.0 850 1.3
Real house prices (FHFA) >> New Home sales>>
800 1.2
1.5 7.5 750 1.1
1.0 5.0 700 1.0
0.5 2.5 650 0.9
600 0.8
0.0 0.0 550 0.7
-0.5 -2.5 500 << Existing home sales 0.6
-1.0 -5.0 450 0.5
400 0.4
-1.5 << Total home sales, -7.5 350 0.3
-2.0 deviation from exponential trend -10.0 300 0.2
75 80 85 90 95 00 05 10 03 04 05 06 07 08 09 10

Source: EcoWin and Danske Bank Source: EcoWin and Danske Bank

Mortgage and corporate funding costs close to record low... ...and money market spreads have narrowed again
12 12 8 8
% % % %
Moody's Baa corporate yield 90-day non-financial corporate
paper, A2/P2 rated
10 FRM 30-year mortgage lending rate 10
6 6
8 8

6 6 4 4

4 4 Fed funds
2 2
Fed funds
2 2
3 mth LIBOR
10-year Treasuries
0 0 0 0
90 92 94 96 98 00 02 04 06 08 10 03 04 05 06 07 08 09 10

Source: EcoWin and Danske Bank Source: EcoWin and Danske Bank

FOMC key statements

Bernanke (neutral, voter) – July 21, 2010 to the Congress: “One factor underlying the
Committee's somewhat weaker outlook is that financial conditions--though much
improved since the depth of the financial crisis--have become less supportive of economic
growth in recent months. Notably, concerns about the ability of Greece and a number of
other euro-area countries to manage their sizable budget deficits and high levels of public
debt spurred a broad-based withdrawal from risk-taking in global financial markets in the
spring, resulting in lower stock prices and wider risk spreads in the United States

As I noted earlier, the FOMC continues to anticipate that economic conditions are likely
to warrant exceptionally low levels of the federal funds rate for an extended period.

Of course, even as the Federal Reserve continues prudent planning for the ultimate
withdrawal of extraordinary monetary policy accommodation, we also recognize that the
economic outlook remains unusually uncertain. We will continue to carefully assess
ongoing financial and economic developments, and we remain prepared to take further
policy actions as needed to foster a return to full utilization of our nation's productive
potential in a context of price stability”

4| 10 August 2010
www.danskeresearch.com
Flash Comment

Extracts from FOMC minutes, June 22-23 meeting

“In their discussion of the economic situation and outlook, meeting participants generally
saw the incoming data and information received from business contacts as consistent with
a continued, moderate recovery in economic activity (...) financial markets were generally
seen as recently having become less supportive of economic growth, largely reflecting
international spillovers from European fiscal strains. In part as a result of the change in
financial conditions, most participants revised down slightly their outlook for economic
growth, and about one-half of the participants judged the balance of risks to growth as
having moved to the downside.”

“On balance, meeting participants revised down modestly their outlook for inflation over
the next couple of years; they generally expected inflation to be quite low in the near term
and to trend slightly higher over time (...) A few participants cited some risk of deflation.
Other participants, however, thought that inflation was unlikely to fall appreciably further
given the stability of inflation expectations in recent years and very accommodative
monetary policy”

“The economic outlook had softened somewhat and a number of members saw the risks
to the outlook as having shifted to the downside. Nonetheless, all saw the economic
expansion as likely to be strong enough to continue raising resource utilization, albeit
more slowly than they had previously anticipated. In addition, they saw inflation as likely
to stabilize near recent low readings in coming quarters and then gradually rise toward
more desirable levels. In sum, the changes to the outlook were viewed as relatively
modest and as not warranting poliiy accommodation beyond that already in place.
However, members noted that in addition to continuing to develop and test instruments to
exit from the period of unusually accommodative monetary policy, the Committee would
need to consider whether further policy stimulus might become appropriate if the outlook
were to worsen appreciably.”

See Flash Comment - FOMC minutes: more downbeat but the bar is set high for further
QE
Statement from June 22-23 meeting
Information received since the Federal Open Market Committee met in April suggests
that the economic recovery is proceeding and that the labor market is improving
gradually. Household spending is increasing 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
nonresidential structures continues to be weak and employers remain reluctant to add to
payrolls. Housing starts remain at a depressed level. Financial conditions have become
less supportive of economic growth on balance, largely reflecting developments abroad.
Bank lending has continued to contract in recent months. Nonetheless, the Committee
anticipates a gradual return to higher levels of resource utilization in a context of price
stability, although the pace of economic recovery is likely to be moderate for a time.

Prices of energy and other commodities have declined somewhat in recent months, and
underlying inflation has trended lower. 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 0 to 1/4 percent
and continues to anticipate that economic conditions, including low rates of resource
utilization, subdued inflation trends, and stable inflation expectations, are likely to
warrant exceptionally low levels of the federal funds rate for an extended period.

5| 10 August 2010
www.danskeresearch.com
Flash Comment

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.

Voting for the FOMC monetary policy action were: 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
Committee‟s flexibility to begin raising rates modestly.

See Flash Comment - FOMC: no Midsummer surprises

FOMC ornithology

HAWKISH
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
NEUTRAL 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

6| 10 August 2010
www.danskeresearch.com
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 research 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 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.

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
Bank‟s 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
herein. The Equity and Corporate Bonds analysts are not permitted to invest in securities under coverage in their
research sector. This publication is not intended for retail customers in the UK or any person in the US. Danske
Markets is a division of Danske Bank A/S. Danske Bank A/S is authorized by the Danish Financial Supervisory
Authority and is subject to provisions of relevant regulators in all other jurisdictions where Danske Bank A/S
conducts operations. Moreover Danske Bank A/S is subject to limited regulation by the Financial Services
Authority (UK). Details on the extent of our regulation by the Financial Services Authority are available from us
on request. Copyright (C) Danske Bank A/S. All rights reserved. This publication is protected by copyright and
may not be reproduced in whole or in part without permission.

This publication has been prepared by the correspondent of Auerbach Grayson & Company Incorporated
(“AGC”) named above on the date listed above.
We are distributing this publication in the U.S. and any U.S. person receiving this report and wishing to effect
transactions in any security discussed herein, should do so only with a representative of Auerbach Grayson &
Company Incorporated. Additional information on recommended securities is available on request.

7| 10 August 2010
www.danskeresearch.com