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Barclays Capital -Cliffhanger The election and rates

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					INTEREST RATES RESEARCH                                                                                               23 October 2012




Cliffhanger: The election and rates
markets
   There are three central issues at stake in the election for rates markets: a) does it   Rajiv Setia
   change the path of the fiscal cliff negotiations; b) does it potentially herald a       +1 212 412 5507
   regime shift at the Fed in 2014: and c) how and when does the next                      rajiv.setia@barclays.com
   administration credibly put the US on the path to fiscal sustainability?
                                                                                           Anshul Pradhan
   We believe that the chances of going off the fiscal cliff temporarily are higher if     +1 212 412 3681
   President Obama is re-elected. A six- to twelve-month extension for most                anshul.pradhan@barclays.com
   expiring provisions is far more likely under a new administration, although
   negotiations will likely continue until late December in either case.                   Amrut Nashikkar
                                                                                           +1 212 412 1848
   Any new Fed chairman after January 2014 in a Romney presidency is likely to be          amrut.nashikkar@barclays.com
   more hawkish than under an Obama presidency. Still, changes would likely be
   gradual, as a new chair will still need the support of the FOMC, and the Fed is         Piyush Goyal
   unlikely to change course drastically for fear of losing credibility. We think YE15     +1 212 412 6793
   fed funds expectations could be repriced higher by 50bp in a knee-jerk reaction         piyush.goyal@barclays.com
   to a Romney win, or 20bp lower in an Obama win.
                                                                                           www.barclays.com
   In our view, the US will finally put forth a plan in 2013 that seriously addresses
   concerns about its medium-term debt profile. As a result, fiscal tightening is
   likely to continue beyond 2013, irrespective of who controls policy.

   If the US embarks on fiscal consolidation in the years ahead, the experience of
   other developed economies should serve as a cautionary tale. Multiplier effects
   from consolidation have been far higher than forecasters initially estimated, and
   consensus growth forecasts in the US also suggest similar complacency.

   In our view, 10y rates could rally to 1.5% in an Obama win, with downside risks
   in the event the fiscal cliff is temporarily hit. A Romney win could lead 10s to sell
   off to 2% or slightly higher. Any significantly larger sell-off should be faded.

   While rate direction will take its cues from the election outcome, the Treasury
   curve is likely to flatten regardless. We reiterate our flattening view and expect
   7s30s to flatten to 150-160bp, with the lower end of the range more likely if
   Governor Romney wins.

   We believe risks are skewed towards long-end spreads widening, regardless of
   the election outcome. We recommend a 10s-30s swap spread curve steepener.

   In options, we like trades that perform well in a Romney win and offer a premium
   or lose very little in an Obama win. These are: a) long FVZ2 (or TYZ2) straddles;
   b) bear flatteners (buy ATM 2m*5y payer vs. 2m*30y payer); c) long 25bp high-
   strike digital cap – either 1m*5y 25high or 1m*(3y1y) 25 high; and d) short a 1x2
   payer spread – long $200mn high-strike vs. short $100mn ATM 2m*5y payer.




PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 17
Barclays | Cliffhanger: The election and rates markets



                                        Why the election matters for rates
                                        There are three questions at stake in the election that are important to the rates market:

                                             What are the chances of a resolution to fiscal cliff concerns by year-end?

                                             Who potentially replaces Chairman Bernanke after his term expires in January 2014?

                                             How might the candidates’ visions for achieving fiscal balance affect the growth
                                             trajectory in 2013 and beyond?

                                        None of these questions is likely to be answered right after the election; yet, the immediate
                                        market reaction will likely be binary, and based primarily on perceptions about how the first
                                        two issues will be settled.

                                        In our view, if Governor Romney wins, the chances of avoiding the fiscal cliff (for at least six
                                        months or longer) are higher than if President Obama is re-elected. In addition, given
                                        Romney’s comments that he would not reappoint the current Fed Chairman, regardless of
                                        who (and when) he eventually nominates a replacement, the knee-jerk market response will
                                        entail repricing Fed expectations and the outlook for easy monetary policy. A combination of
                                        these two effects can drive rates in the belly of the curve higher in the interim. Conversely, if
                                        Obama wins, we would expect rates to rally as QE expectations are reaffirmed and the market
                                        prices in a higher likelihood of hitting the fiscal cliff. The curve is likely to flatten in either
                                        scenario. In the former, a reversal of easy monetary policy would rein in the term premium,
                                        blunting the effect on long-term nominal yields. In the latter scenario, worries about hitting the
                                        fiscal cliff would outweigh the potential benefits of easy policy.

                                        Of course, the answer to the last question is far more important for markets in the longer
                                        term, but unfortunately it will not be answered for months to come. Despite vastly different
                                        stated policies, significant details are missing in the budget plans that are available from both
                                        sides. The next president will also face the daunting task of stabilizing the US fiscal profile
                                        over the medium term, and there are few ways of achieving this without increasing the
                                        headwinds to growth. For now, we examine this longer-term question using President
                                        Obama’s FY 13 budget and the Republican House FY 13 budget as blueprints for the two
                                        parties. If these plans are indicative of what ultimately transpires, we suspect that any
                                        inordinate rate sell-off would prove transitory and be an opportunity to go long. It is possible
                                        that eventually there will be less fiscal tightening than either party is proposing, but that is
                                        likely to occur if growth remains low, ie, a scenario in which rates are unlikely to sell off.

                                        We take a look at each of the questions in detail starting with the more immediate issues.

                                        What are the chances of going off the fiscal cliff?
                                        The grave consequences of going off the fiscal cliff have been well advertised for over a
                                        year; as a result, in a baseline view, it is reckless to assume that the cliff will be hit. Most
                                        economists assume the bulk of the expiring measures will be temporarily extended during
                                        the lame duck session of Congress. The market shares this view, with consensus economics
                                        forecasts for 2013 showing only a small decline in growth expectations between Q4 12 and
                                        Q1 13, suggesting modestly higher fiscal tightening, not a major policy mistake (Figures 1
                                        and 2). In comparison, our economists’ baseline forecast is for $200bn of fiscal tightening in
                                        2013 and growth in Q1 13 and Q2 13 to be 1% and 0.5% below Q4 12 levels respectively
                                        (click here for details). Hence, risks to the consensus remain skewed to the downside.




23 October 2012                                                                                                                           2
Barclays | Cliffhanger: The election and rates markets


Figure 1: Consensus forecast looks for only modest fiscal                      Figure 2: The distribution of growth forecasts seems to
tightening                                                                     understate the probability of lower growth in 2013

  Real GDP growth expectations, %                                               Distribution of growth forecasts, %
                                                                                35%
 3.0                                                               2.7
                           2.5                           2.5 2.5         2.5    30%
 2.5                                         2.3
                                                                                25%
               2.0   1.9                           2.0
 2.0     1.8                     1.8                                            20%
                                       1.5                                      15%
 1.5
                                                                                10%
 1.0
                                                                                  5%
 0.5                                                                              0%




                                                                                          1 - 1.25




                                                                                                                               1.75 - 2

                                                                                                                                          2 - 2.25




                                                                                                                                                                               2.75 - 3

                                                                                                                                                                                          3 - 3.25
                                                                                                     1.25 - 1.5

                                                                                                                  1.5 - 1.75




                                                                                                                                                     2.25 - 2.5

                                                                                                                                                                  2.5 - 2.75




                                                                                                                                                                                                     3.25 - 3.5

                                                                                                                                                                                                                  3.5 - 3.75
 0.0
          Q312       Q412        Q113        Q213        Q313      Q413
                     Bloomberg Consensus             Barclays                                         Q4/Q4 2013 Real GDP growth expectations
Source: Bloomberg forecasts, Barclays Research                                 Source: Bloomberg forecasts


                                              Furthermore, the election results matter hugely, as it is the path taken to arrive at the
                                              compromise on expiring provisions that matters to markets in the near term, not just the
                                              eventual compromise itself. We think that chances of going off the fiscal cliff temporarily
                                              are higher if Obama is re-elected than if Romney wins. Obama has pledged to increase
                                              revenues by allowing upper income tax cuts to expire, but we are hard pressed to see a
                                              Republican House pro-actively agreeing to such an increase. Letting all tax cuts expire
                                              temporarily would improve the longer-term bargaining position of the Democrats, in our
                                              view, although it would result in a negative economic shock in Q1 13. Even for Republicans,
                                              it may be far more politically expedient to go over the cliff, temporarily, and then agree to
                                              lower tax rates for middle-income households retroactively. Politically, this would enable
                                              them to avoid violating their campaign pledges not to raise taxes for anyone – pro-actively
                                              agreeing with the president to raise upper-income taxes would violate these pledges.

                                              If Obama wins, we believe the Republicans are likely to give in eventually on raising revenues
                                              from upper income taxpayers, but in our view, they are unlikely to volunteer to do so right
                                              after the election. In terms of timing, even in a best-case scenario in an Obama victory, where
                                              the cliff is pushed forward by six months or a year, the negotiations could stretch until late
                                              December, and uncertainty about hitting the cliff would continue. In a worst-case scenario,
                                              the cliff will temporarily hit, and the uncertainty about how it will be resolved, in conjunction
                                              with debt ceiling negotiations, could extend well into Q1 13.

                                              As a result, an Obama victory could lead the market to price in a far deeper hit to growth in
                                              Q1 13 than is currently expected, leading rates to rally sharply and the curve to flatten. On
                                              the other hand, Romney’s election would likely reduce the chances of a fiscal accident. We
                                              expect Democrats to give a new president some time to settle in, making a six-month or
                                              longer extension far more likely. While this may simply push the cliff negotiations out for
                                              some time, we expect the Democrats to respect the wishes of the electorate for a “mandate
                                              change” in this scenario and grant the new president some breathing room.

                                              Who will be the next Fed chairman?
                                              If Obama is re-elected, the market is likely to expect continuity in Fed policy. Although press
                                              reports have suggested that Chairman Bernanke may not want another term even in this
                                              scenario, the leading candidate to replace him would be Fed Vice Chair Janet Yellen, who, in
                                              our view, would likely provide seamless continuity. However, Romney has made it clear that

23 October 2012                                                                                                                                                                                                                3
Barclays | Cliffhanger: The election and rates markets


                                        he would prefer to replace Bernanke when his term expires 1. This likely means very little for
                                        actual Fed policy near term, as Bernanke would continue to drive the committee until his
                                        term expires in early 2014. In addition, we would be surprised if Romney announced his
                                        candidate for the position before next summer. However, markets would undoubtedly start
                                        to pull forward rate hike expectations.

                                        How much can fed funds expectations be repriced?
                                        One approach to gauging how the market will react is to see how the Fed’s reaction
                                        function is likely to vary across different chairmen. For instance, one of the candidates
                                        mentioned by Romney, John Taylor, would most likely prefer a very different reaction
                                        function than, say, Yellen.

                                        We quantify the potential effect of a regime shift on the fed funds rate using different
                                        versions of the Taylor Rule, where the

                                                     Fed funds rate = 4% + A * (inflation – 2%) + B * (5.6- unemployment rate)

                                        From what we have been able to glean, there appears to be little disagreement between Fed
                                        officials on the inflation coefficient (most agree A = ~1.5), but there is considerable
                                        disagreement on how responsive the funds rate should be to changes in unemployment
                                        rate. For instance, Yellen prefers to use an unemployment rate coefficient of 2.3 2, while John
                                        Taylor prefers using 1.15, and Greg Mankiw has espoused using 1.4 3.

                                        In Figure 3 we tabulate what the desired fed funds rate would be at the end of 2015 using
                                        different unemployment rate coefficients for given realized unemployment rates. For
                                        simplicity, we assume inflation is at the Fed’s desired target in all scenarios. Under the base
                                        case forecast of a 7% unemployment rate by the end of 2015 (median forecast at the latest
                                        primary dealer survey), the desired fed funds rate would shift to 1.9% from 0.8% if the
                                        unemployment rate coefficient moves from 2.3 to 1.5 (ie, from Yellen’s coefficient to
                                        Mankiw’s). Note while the desired fed funds rate under Yellen’s rule is higher than the
                                        market (which is pricing in ~70bp and was ~50bp at the beginning of the month), this
                                        mainly reflects the market’s relatively weaker economic outlook and inertia in Fed policy.


                                         Figure 3: Desired fed funds rate would rise if the new chairman focuses less on the
                                         unemployment rate

                                             Desired fed funds rate, %                                Unemployment rate coefficient

                                                                  Q415                  1.0                  1.5                    2.0    2.3

                                                                  6.25                 3.35                 3.03                    2.70   2.51

                                                                  6.50                 3.10                 2.65                    2.20   1.93
                                            Actual                6.75                 2.85                 2.28                    1.70   1.36
                                            Unemploym
                                            ent Rate, %           7.00                 2.60                 1.90                    1.20   0.78

                                                                  7.25                 2.35                 1.53                    0.70   0.21

                                                                  7.50                 2.10                 1.15                    0.20   -0.37

                                         Note: Inflation is assumed to be at the Fed’s desired target of 2% across all scenarios.
                                         Source: Federal Reserve, Barclays Research




                                        1
                                          http://www.foxbusiness.com/industries/2012/08/23/romney-qe2-not-effective-need-new-fed-chief/
                                        2
                                          http://www.federalreserve.gov/newsevents/speech/yellen20120606a.htm
                                        3
                                          http://www.nber.org/papers/w8471.pdf

23 October 2012                                                                                                                                    4
Barclays | Cliffhanger: The election and rates markets


                                                         In other words, the desired fed funds rate of the new chairman as of YE 15 could be 100bp
                                                         higher just moving from Yellen’s preferred rule to what Mankiw historically suggested. It
                                                         would rise a further 50bp or more under the original Taylor rule.

                                                         There are a few reasons why we believe the market reaction will be more muted.

                                                         First, these coefficients were estimated during the mid-1990s, without necessarily taking
                                                         the zero lower bound into consideration, and it is quite possible that these candidates will
                                                         take a fresh perspective once they are actually running monetary policy.

                                                         Second, the unemployment rate alone may not best characterize the Fed’s mandate “to
                                                         promote effectively the goals of maximum employment” in this economic cycle, as a large
                                                         share of the improvement in the rate has simply been due the decline in the labor force
                                                         participation rate. Recently, various Fed speakers (and not just Bernanke) have noted that
                                                         the committee needs to look at a variety of measures to gauge the labor market outlook.
                                                         For instance New York Fed President Dudley has noted that he will be looking at “a range of
                                                         indicators, including the unemployment rate, payrolls, the participation rate, the
                                                         employment to population ratio and job finding rates, as well as the growth momentum
                                                         within the economy.” 4 Hence, repricing the fed funds rate on the basis of the
                                                         responsiveness to the unemployment rate alone may be too one-dimensional.

                                                         Third, a new Fed chairman will still need the support of the committee to change monetary
                                                         policy, and the Fed is unlikely to change course drastically for fear of losing credibility.
                                                         Therefore, it is important to put the chairman’s desired fed funds rate in the context of the
                                                         committee’s forecasts. In Figure 4, we plot the distribution of interest rates forecasts made
                                                         by FOMC members for Q4 15. As the distribution shows, at least 10 members see the fed
                                                         funds rate at 1% or lower at end-2015, and the median forecast is 1%. The composition of
                                                         the voting committee in 2015, coupled with our dove-hawk line up, suggests the mean of
                                                         the 11 voting members would be ~1.2% (assuming the most dovish member has the lowest
                                                         rates forecast). Hence, the chairman under a Romney administration would have to pull the
                                                         committee towards higher rates, which is likely to be a gradual process.




Figure 4: FOMC members voting in 2015 are relatively more                                            Figure 5: Market pricing of the fed funds rate could revert to
dovish than all members in aggregate                                                                 post-January FOMC levels

  Number of FOMC members                                                                               Average 3m Fed funds rate, %
 8                                                                                                    2.0
 7                                             Mean = 1.7%, Median = 1%                               1.8
 6                                                                                                    1.6
 5                                                                                                    1.4

 4                                                                                                    1.2
                                                                                                      1.0
 3
                                                                                                      0.8
 2
                                                                                                      0.6
 1                                                                                                    0.4
 0                                                                                                    0.2
                 0.5 - 1




                                     1.5 - 2




                                                             2.5 - 3




                                                                                 3.5 - 4
       0 - 0.5




                           1 - 1.5




                                               2 - 2.5




                                                                       3 - 3.5




                                                                                           4 - 4.5




                                                                                                      0.0
                                                                                                        Dec-12            Dec-13       Dec-14      Dec-15       Dec-16
                  Year end 2015 Target Fed Funds Rate, %                                                         Latest            Post-Jan12 FOMC        Oct 3 (lows)
Source: Bloomberg, Barclays Research                                                                 Source: Bloomberg, Barclays Research



                                                         4
                                                             http://www.newyorkfed.org/newsevents/speeches/2012/dud120918.html

23 October 2012                                                                                                                                                          5
Barclays | Cliffhanger: The election and rates markets


                                        Hence, pricing in hikes before late 2014 makes little sense. Even if a new chairman wants to
                                        change course completely, a number of intermediate steps are required. The Fed would first
                                        have to stop asset purchases, stop reinvestments, modify its forward rate guidance, initiate
                                        temporary reserve draining operations and then raise the target fed funds rate (and the
                                        interest on excess reserves).

                                        Therefore, one way to estimate how much fed fund expectations could be repriced following a
                                        Romney win is to look at what the market was pricing in when the Fed extended its rate
                                        guidance to late-2014 (ie, following the January 2012 FOMC meeting). This would imply a
                                        reversal of the latest Fed initiative of extending the guidance to mid-2015 and its pledge to
                                        keep policy accommodative for a considerable time even after the recovery strengthens.

                                        Figure 5 shows that following the January FOMC announcement, the market was pricing the
                                        fed funds rate to rise to ~1.1% by Q4 15 and 1.8% by Q4 16, 50-60bp higher than current
                                        levels. This would imply a 30bp selloff in spot 5y rates. It is worth noting that in early 2012,
                                        the average real GDP growth forecast for 2012 (Q4/Q4), at 2.3%, was higher than the
                                        current consensus forecast of ~1.75%. Therefore, some of the rally would have occurred
                                        even in the absence of the change in the Fed’s reaction function.

                                        In all, a 50bp repricing of fed funds expectations 3-4 years out as a knee-jerk reaction to a
                                        Romney win is possible. Of course if the president is re-elected, the market should at least
                                        revert to the levels early this month, when the same fed fund expectations were ~20bp
                                        lower (Figure 5). The risk of the fiscal cliff hitting would push them even lower.

                                        Short-term market response to the election outcome
                                        Duration – A wide range
                                        If Obama is re-elected, the market likely would worry about the higher probability of hitting
                                        the fiscal cliff, and easy monetary policy would become further entrenched. We expect 10y
                                        yields to decline to 1.5% under this scenario, with risks to the downside from the fiscal
                                        cliff actually hitting. 10y real yields are trading at -0.75%, just 25bp lower than the level
                                        that prevailed around the middle of the year following the extension of Operation Twist. We
                                        believe real yields should trade well through -1%. The bar for stopping asset purchases is
                                        very high, in our view, and the time needed to gauge whether there has been a substantial
                                        improvement in the labor market outlook implies that the current pace of purchases will be
                                        maintained at least through the middle of next year, if not well into next year. Therefore, a
                                        conservative estimate would be that the Fed absorbs $500bn of 10y equivalents from the
                                        market. Historical sensitivity suggests that real yields should decline through -1%. If the
                                        fiscal drag next year is higher, real yields could fall even more. Were the Fed to keep buying
                                        till the end of next year at $85bn/m in this scenario, it could end up absorbing ~$900bn 10y
                                        equivalents and real yields could decline to -1.4%.

                                        If Romney wins, we would expect the market to question how long Fed policy will remain as
                                        easy as it is now. We expect the market to reprice fed funds expectations three to four years
                                        out higher. In the near term, we have a hard time seeing 5y yields selling off more than
                                        25bp or 10y yields rising above 2%, based purely on Fed policy repricing. A larger sell-off
                                        than this also would require the market to revise its growth expectations higher under a
                                        Romney administration. For this to occur, the deteriorating fiscal profile would need to be
                                        tackled in a way that simultaneously raises growth prospects. But getting such an optimal
                                        plan as the outcome of a process of political compromise appears difficult. Nonetheless, in
                                        such a scenario, all else equal, our forecast for 10y yields at 1.5% in H1 13 would certainly
                                        be subject to upward revision.


23 October 2012                                                                                                                        6
Barclays | Cliffhanger: The election and rates markets


                                             Curve – Flatter in either case
                                             While the near-term direction of rates is likely to depend on the election outcome, the curve
                                             should be flatter whether Romney or Obama wins. In the latter case, the increased
                                             likelihood of the fiscal cliff hitting and the resulting growth effect would outweigh any
                                             stimulative policy from the Fed puts, flattening the curve. In the former case, a perceived
                                             hawkish shift in Fed policy should rein in the term premium, and the long end of the curve
                                             would not get hurt as much as the front to the intermediate sector. Therefore, curve
                                             flatteners should perform in either scenario. We expect the 7s30s Treasury curve to flatten
                                             to 150-160bp and the 10s30s curve to 100-108bp, with the lower end of the range to realize
                                             if Romney wins.

                                             Figure 6 shows that long-term inflation expectations have benefited from easy monetary
                                             policy. 10y CPI swap rates widened to 2.5% from 1.25% during QE1, to 2.75% from 2%
                                             during QE2 and, more recently, to 2.75% from 2.5% following the latest announcement of
                                             QE3 and the strengthening of the rate guidance. The stock market has also benefited during
                                             periods of asset purchases. Hence, even as real yields rise in response to a hawkish shift,
                                             long-term breakevens could tighten and stocks may fall, blunting the impact on 10y and
                                             30y nominal yields.

                                             To gauge how much the curve can flatten, we use a fair value model for the 7s30s curve that
                                             is a function of intermediate yields, long-term breakevens and the flattening effect of
                                             Operation Twist. Figure 7 shows that the curve is currently trading close to fair value given
                                             these factors. However, if intermediate yields rise 25bp and long-term breakevens tighten
                                             25bp (ie, if they were to reverse the widening move heading into/following the September
                                             FOMC meeting), historical sensitivities suggest that the 7s30s curve could flatten 20-25bp. A
                                             similar framework for the 10s30s curve suggests that it could flatten 15bp. In other words,
                                             even if 5-7y yields sell off 25-30bp, the 30y may not sell off much, probably just 5-10bp.

                                             If the president is re-elected, the risk of hitting the fiscal cliff and Fed purchasing long-term
                                             Treasuries for longer should also flatten the curve. While QE getting entrenched may bias
                                             long-term inflation expectations higher, breakevens could tighten tactically, given reduced
                                             growth expectations. We expect the 7s30s curve to flatten to 160bp and the 10s30s curve to
                                             flatten to 108bp in this scenario. Were the cliff actually to hit, the curve could flatten more.


Figure 6: Easy monetary policy has boosted stocks and long-                  Figure 7: A hawkish shift could flatten the 7s30s Treasury
term inflation expectations                                                  curve by 20-25bp
1,800                                                                 3.50
                                                                               7s30s curve, %
1,600                        QE1               QE2      Twist                 2.6
1,400                                                                 3.00    2.4
1,200                                                                         2.2
                                                                      2.50    2.0
1,000
                                                                              1.8
  800                                                                         1.6
                                                                      2.00
  600                                                                         1.4
  400                                                                 1.50    1.2
  200                                                                         1.0
                                                                QE3           0.8
     0                                                                1.00
     Jan-07     Mar-08      May-09        Jul-10     Oct-11     Dec-12        0.6
                                                                                Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12
              S&P 500, lhs                10y CPI Swap (%, RHS)                                      Actual              Estimate


Source: New York Fed, Barclays Research                                      Source: Barclays Research


23 October 2012                                                                                                                              7
Barclays | Cliffhanger: The election and rates markets


                                              One risk to a flattener is a ratings downgrade, but that is an issue both candidates will need
                                              to contend with. Negotiations on fiscal reform likely will continue well into 2013, and the
                                              rating agencies are likely to await the outcome before changing ratings. In other words, a
                                              ratings downgrade should not be of immediate concern, but it is an issue for H2 13.

                                              Why any large post-election rates sell-off should be faded
                                              As the immediate uncertainty surrounding the fiscal cliff resolution and a potential Fed regime
                                              shift fades, investors will need to assess how the next president will stabilize the medium-term
                                              fiscal profile, which will be a key driver of whether the election-driven sell-off fades over time.

                                              Our view is that, regardless of the outcome of the election, pressure on ratings and
                                              longstanding concerns on the fiscal outlook mean that the US will finally put forth a plan that
                                              seriously addresses concerns about its medium-term debt profile in 2013. As a result, fiscal
                                              tightening is likely to continue beyond 2013, irrespective of who controls policy. In other
                                              words, the so called “cliff” of 2013 may be somewhat of a misnomer: fiscal tightening is more
                                              likely to be a plateau, which, while helping longer-term growth prospects, is likely to exert a
                                              drag for a number of years to come. While it is possible that eventually there will be less fiscal
                                              tightening than either parties are proposing, we believe the chances of that happening are far
                                              greater if growth remains low; ie, a scenario in which rates are unlikely to sell off.

                                              How do the two budget plans compare?
                                              As a starting point, we compare the budget plan put forward by the president with the one
                                              passed by the House in early 2012. While high uncertainty remains on whether either candidate
                                              will follow through on their proposals, for now, we use these plans as blueprints for what the
                                              two parties might be looking to achieve. Ultimately, the budgets will clearly be the product of
                                              extensive political bargaining and a function of the growth environment. We also compare
                                              them with a fiscally neutral plan (ie, one in which there is no further consolidation over and
                                              above a cyclical improvement in the deficit). 5 Although not a prediction of the outcome,
                                              analysis of these plans is instructive about the magnitude of fiscal tightening that the US could
                                              experience over the coming years if a deficit-stabilizing plan does materialize in 2013.


Figure 8: Both parties are looking to tighten fiscal policy                        Figure 9: … which would exert a drag on growth over the
aggressively…                                                                      coming years

  Primary Balance, % GDP                                                              Average yearly drag over the next five years, %
  2%                                                                                 0.0%
  1%                                                                                -0.1%
                                                                                    -0.2%
  0%
                                                                                    -0.3%
 -1%                                                                                -0.4%
 -2%                                                                                -0.5%
                                                                                    -0.6%
 -3%
                                                                                    -0.7%
 -4%                                                                                -0.8%
 -5%                                                                                -0.9%
                                                                                    -1.0%
 -6%
                                                                                                  Overall           Spending           Revenues
 -7%                                                                                                               Contribution       Contribution
    2012        2013      2014        2015     2016         2017      2018
               Neutral Policy             President                House                               President's Budget            House Budget

Source: CBO’s analysis of the President Budget, March 2012 Baseline /              Source: CBO’s analysis of the President Budget, March 2012 Baseline /
Alternative Scenario and the House budget plan, Barclays Research                  Alternative Scenario and the House budget plan, Barclays Research
                                              5
                                               The CBO’s alternate scenario adjusted for permanent extension payroll tax cuts and overall non-interest spending
                                              remaining constant as a share of GDP, with the exception of outlays related to income security (which are allowed to
                                              decline gradually).

23 October 2012                                                                                                                                                      8
Barclays | Cliffhanger: The election and rates markets


                                                                     Figure 8 shows the path of the primary deficit (as a share of GDP) under the three plans. As
                                                                     can be seen, the House budget plan is more aggressive in reining in deficits than the
                                                                     president’s, and, more importantly, both are far more aggressive than a fiscally neutral plan.
                                                                     The House budget envisages a primary surplus by 2015, compared with 2018 under the
                                                                     president’s plan. Under a fiscally neutral policy, primary deficits decline marginally into large
                                                                     structural deficits. Figure 9 shows that even assuming modest fiscal multipliers, 6 the annual
                                                                     fiscal drag could average 0.6% over the next five years under the president plan and 0.9%
                                                                     under the House budget.

                                                                     The two plans achieve fiscal tightening very differently. The drag under the House plan could
                                                                     be even higher than under Obama’s plan. The latter relies mainly on higher upper income tax
                                                                     revenues, whereas the House plan relies mainly on lower spending (Figure 10). Since social
                                                                     security and Medicare outlays are largely untouched in the House plan, these reductions come
                                                                     mainly from other mandatory programs, including Medicaid (Affordable care act) and income
                                                                     security programs. It is possible that since these outlays are more likely to be spent than upper
                                                                     income tax cuts, the drag may be higher under this plan. 7

                                                                     So, ironically, rates will likely sell off if Romney wins, but if the Republicans follow through
                                                                     on their mandate to “fix fiscal issues”, it may actually pull forward the fiscal drag, resulting
                                                                     in lower medium-term growth and rates remaining low for a long time.

                                                                     What is the outlook for the US sovereign ratings?
                                                                     It is tempting to argue that immediately following an election, neither side would want to go
                                                                     down the path of fiscal tightening, particularly if Romney wins. However, in our view, the
                                                                     pressure from rating agencies would ensure that sometime during 2013, a credible plan to
                                                                     tackle the growth in public debt is put in place. If not, then the US rating is likely to be
                                                                     downgraded to one notch below the top rating both by Moody’s and Fitch, which then, in
                                                                     our view, would lead to the adoption of a credible plan.

                                                                     Moody’s, which has a Negative ratings outlook on the US long-term sovereign rating, has
                                                                     noted that the direction of the rating will most likely be determined by the negotiations
                                                                     during the course of 2013. If the resulting policies lead to stabilization and then a downward


Figure 10: The House budget plan entails significantly lower                                                                              Figure 11: Status quo is not an option
government outlays

  House vs President's budget plan, Difference over                                                                                         Federal Debt/GDP, %
  2013-2022, $bn                                                                                                                           100%                                                                    93%
     0
                                                                                                                                            95%
  -500                   -205                                                                  -352                                         90%
-1,000
                                     -770                                                                                                   85%
-1,500
                                                                                                                                            80%
-2,000                                           -1,572
           -2,036                                                          -1,895                                                           75%
-2,500
                                                                                                -2,758                                      70%
-3,000
                                                                                                                                            65%
                          Medicare
              Revenues




                                      Medicaid




                                                                                                Discretionary (Base)
                                                   Health Care Law


                                                                             Other Mandatory




                                                                                                                       Primary Deficits




                                                                                                                                            60%
                                                                                                                                            55%
                                                                                                                                            50%
                                                                                                                                                2012       2014             2016       2018         2020           2022
                                                                                                                                                           Current Policy             President             House

Source: CBO’s analysis of the president’s budget and House budget, Barclays                                                               Source: CBO long-term budget outlook, June 2012, CBO’s analysis of the
Research                                                                                                                                  president’s budget and the House budget

                                                                     6
                                                                         IMF study 0.9-1.7% multipliers – we assume the lower end.
                                                                     7
                                                                         http://www.cbo.gov/sites/default/files/cbofiles/attachments/08-23-2012-RecoveryAct.pdf

23 October 2012                                                                                                                                                                                                           9
Barclays | Cliffhanger: The election and rates markets


                                               trend in the ratio of federal debt to GDP, the outlook would revert to Stable. If not, the rating
                                               would be downgraded to Aa1 from Aaa. Regardless of the election outcome, the
                                               administration and Congress will remain under pressure to come up with a credible fiscal
                                               plan sometime during 2013.

                                               Figure 11 shows that under the current policy (tax provisions are extended, sequestration is
                                               rolled back), the CBO forecasts a debt/GDP ratio of 93% by 2022. A back-of-the-envelope
                                               calculation suggests that if the debt/GDP ratio has to be lowered to 75% from 93%, then
                                               total deficit reduction of ~$4.5trn (and primary deficit reduction of ~$3.7trn) is needed
                                               (=18% * USD24.7trn in terminal nominal GDP).

                                               The president’s plan cuts $3.7trn in primary deficits over the next 10 years (versus the
                                               CBO’s alternative scenario) by relying on $2.7trn in higher revenues and $1trn in lower
                                               outlays (mainly war related). The House budget plan, on the other hand, relies mainly on
                                               $6trn in spending cuts (versus CBO’s alternative scenario), mostly in mandatory programs,
                                               such as Medicaid and income security. Under the president’s plan, debt/GDP would peak at
                                               80% and fall to ~75%; under the House plan it would fall to 62%. In our view, a fiscal profile
                                               in line with the president’s plan is the bare minimum need to avoid a downgrade; the House
                                               plan seems to go well beyond what is needed.

                                               If Republicans do not relent on higher revenues, Democrats are unlikely to agree to $2.7trn
                                               in spending cuts (even assuming ~$1trn in lower war spending). Similarly, Republicans are
                                               unlikely to agree to $2.7trn in higher revenues without massive entitlement reform. A grand
                                               bargain which achieves $4trn in savings over a decade would stave off a downgrade for
                                               now, but would require political willingness to compromise, which has hitherto been
                                               absent. However, a status quo election outcome with no clear mandate for either party
                                               likely would make a grand bargain harder to achieve, and would make a ratings downgrade
                                               inevitable in late 2013.

                                                Of course, our prior work (Please see “Beyond the Supercommitee”, November 18, 2011)
                                               highlighted that even a target of $4trn in primary savings will ultimately be insufficient to
                                               stabilize the realized debt/GDP profile. In our view, a reasonable primary savings target,
                                               which accounts for the negative impact of austerity on growth, is closer to $ 6trn. In this
                                               context, we now discuss the recent experience of other developed countries that have
                                               embarked on austerity programs.

Figure 12: Forecasters have underestimated the ease of                        Figure 13: Fiscal slippage was highest in developed
fiscal consolidation                                                          economies that experienced poor growth

  190                                                                             Δ 2014
                                                                                debt/gdp
  170
                                                                                 forecast
  150                                                                              (%)
                                                                                40
  130                                                                                                                         IR
                                                                                30
  110                                                                                                                     PT
                                                                                                      GR
   90                                                                           20
   70                                                                           10
                                                                                                                                   ES         JP
   50
                                                                                 0                                                                 US
            GR              IR            IT          PT          ES
                                                                                                                                         UK
                                                                               -10                                                      FR
                                                                                                                                   IT               DE
               Jul-09            Nov-09          May-10       Nov-10           -20         Δ cum real gdp (%)
               Apr-11            Sep-11          Apr-12                              -15        -10          -5           0               5              10

Source: IMF WEO databases                                                     Source: IMF WEO database, Haver Analytics


23 October 2012                                                                                                                                               10
Barclays | Cliffhanger: The election and rates markets


                                             Fiscal tightening in other developed markets: Are there any
                                             lessons for the US?
                                             Since the beginning of the debt crisis, policymakers and market participants have
                                             underestimated the difficulty of fiscal consolidation. Figure 12 shows how the 2014
                                             debt/GDP forecasts for peripheral Europe have evolved over the past three years, based on
                                             the IMF projections published in its semiannual Global Financial Stability Review. With the
                                             exception of Italy, debt forecasts were revised higher over this period in all the countries.
                                             This suggests that forecasters underestimated how difficult it would be to achieve fiscal
                                             consolidation.

                                             Figure 13 shows the main reason why the debt profile deteriorated between 2009 and 2012.
                                             Countries that saw the largest increase in their 2014 debt/GDP projection also experienced
                                             a dramatic economic slowdown over this period. In many of these countries, aggressive
                                             fiscal consolidation plans have themselves driven the downturns. Recent empirical evidence
                                             suggests that economic forecasts at the time deficit cuts were planned underestimated the
                                             potential drag 8.

                                             The y-axis of Figure 14 shows the difference between the IMF’s year-ahead growth
                                             forecasts and actual growth over the years 2010-2011, based on projections made in the its
                                             World Economic Outlook. The x-axis shows how much fiscal consolidation was forecast to
                                             occur over the same period (in terms of the structural balance as a percentage of potential
                                             GDP). The figure shows a relationship between these two factors 9. Countries where
                                             aggressive fiscal consolidation was planned saw the greatest slippage relative to forecasts.
                                             The IMF has argued that the growth forecasts underestimated the drag that fiscal
                                             consolidation would exert on the economy.




Figure 14: Countries where near-term fiscal tightening was                        Figure 15: Unemployment has surprised to the upside in
planned to be the highest saw the largest growth slippages                        countries where planned fiscal consolidation was higher
                                                                                                             Unemp fc.
                       8         2010
                                                                                                                 error
                                growth
                                                                                                             3.5
                       6       forecast
                                                                                                             3.0
                                 error
                       4                                                                                     2.5
                                                                                                             2.0
                       2                                                                                     1.5
                                                                                                             1.0
                       0                                                                                     0.5
                                       2010-2011 planned consolidation                                       0.0
                      -2
                                                                                                            -0.5
                      -4                                                                                    -1.0
                                                                                                            -1.5
                                  R² = 0.5065
                      -6                                                                                    -2.0
                                                                                     -4            -2             0             2             4                 6
                      -8
   -5                      0                     5                      11                               Planned cut in struct deficit
Source: IMF World Economic Outlook, October 2012, Figure 1.1.1                    Source: IMF World Economic Outlook, April 2010 and April 2011


                                             8
                                              See “Coping with High Debt and Sluggish Growth”, IMF World Economic Outlook, October 2012.
                                             9
                                              Some reports have suggested that these results are not significant after excluding Germany and Greece. However,
                                             we find a significant relationship even after excluding them, using the dataset published with the Oct 2012 WEO.

23 October 2012                                                                                                                                                 11
Barclays | Cliffhanger: The election and rates markets


Figure 16: A significant drag next year is possible even if the major provisions are extended for a year


                                                                                 CBO Avg.             All Provisions
Calendar Year Basis                                 $bn          % GDP           Multipliers              expire          Democrats              Republicans

Lower-Middle Income Tax Cuts/AMT
                                                    -273          -1.7%              0.90                  -1.5%
Patch/Estate and Gift Taxes
Upper Income Tax Cuts                               -56           -0.3%              0.35                  -0.1%             -0.1%
Sequestration                                       -73           -0.4%              1.50                  -0.7%
Payroll Tax Cut                                     -127          -0.8%              0.90                  -0.7%             -0.7%                   -0.7%
LT Unemployment Benefits                            -35           -0.2%              1.25                  -0.3%             -0.1%                   -0.3%
Affordable Care Act Tax                             -24           -0.1%              0.35                  -0.1%             -0.1%
Other Tax provisions                                -88           -0.5%              0.55                  -0.3%             -0.1%
Other Spending Provisions                           -73           -0.4%              1.50                  -0.7%             -0.5%                   -0.5%
Total                                               -747          -4.6%                                    -4.3%             -1.6%                   -1.5%
Note: Other tax provisions include partial expensing of investment property and tax extenders, which typically have been extended. Other spending provisions mainly
capture the budget caps and cuts to Medicare physician payments. Specifically, the difference between likely discretionary outlays (ie, baseline adjusted for lower war
spending and reversal of sequestration) and the levels had they risen in line with nominal GDP. Fiscal year numbers, where the provisions expire at the end of calendar
year, have been annualized to convert them into calendar year numbers. Unemployment benefits assumed to be phased out by Democrats. Source: CBO Analysis of
the President Budget, March 2012 Baseline/Alternative Scenario, House budget plan, August 2012 ARRA report, Barclays Research.


                                               The IMF study also reports that this finding is robust to a number of other explanatory
                                               factors (such as the starting level of indebtedness, trade imbalances or additional
                                               unexpected fiscal consolidation), as well as other sources of forecasts (such as those from
                                               OECD and the European Commission). One possible reason for this underestimation is that
                                               forecasters relying on historical experience possibly did not account for the simultaneous
                                               fiscal tightening across countries, as well as the zero lower bound in rates which likely has
                                               diminished the effectiveness of monetary policy.

                                               Based on the World Economic Outlook databases of April 2010 and April 2011, we
                                               constructed a similar chart showing how forecasts underestimated the effect of fiscal
                                               consolidation on unemployment at the end of 2010. 10 The y-axis of figure 15 shows the
                                               difference between forecast for the end-2010 unemployment rate and its eventual
                                               realization. The x-axis shows how much the structural deficit was expected to be cut over
                                               2010. On an average, for every planned 1%-of-GDP cut in the structural deficit,
                                               unemployment at the end of the year was 25-30bp higher than expected, again suggesting
                                               that forecasts underestimated the effect of fiscal consolidation.

                                               Is the market underestimating the potential fiscal drag in the US?
                                               As we have noted before, the distribution of US growth forecasts for 2013 is skewed to the
                                               upside (Figure 2). Only 15% of forecasters expect real GDP growth to be 1-2%, compared
                                               with almost 80% at 2-3%. This could be due to three possible reasons: 1) GDP growth
                                               expectations, before taking into account any fiscal effects, are north of 3%; 2) forecasters
                                               are expecting little actual fiscal tightening to occur; or 3) the effects of fiscal tightening on
                                               growth are expected to be marginal. Regardless of who wins the election, we find it striking
                                               that the market is expecting such low fiscal drag. Of course, it is possible for baseline
                                               growth to be even higher if the housing recovery gains momentum and the drag from
                                               state/local government subsidies decreases.

                                               In Figure 16 we tabulate the list of provisions that are set to expire/come into effect next
                                               year. The key components are Bush-era tax cuts, sequestration and payroll tax cuts/long-
                                               term unemployment benefits. Other tax provisions are set to change next year, such as the


                                               10
                                                    Note that this is not the same time period as the IMF study

23 October 2012                                                                                                                                                     12
Barclays | Cliffhanger: The election and rates markets


                                             affordable care act tax, benefits related to partial expensing of investment property and
                                             others that typically are extended. On the spending side, even if sequestration is rolled back,
                                             budget caps would remain, which, in addition to lower war-related outlays, would result in
                                             cuts relative to a scenario in which spending remains constant as a share of GDP. In all,
                                             these provisions add up to ~4.6% of GDP.

                                             There is a fair bit of uncertainty surrounding the effects of fiscal tightening on the economy.
                                             In part, fiscal multipliers also depend on the channel of fiscal tightening (Figure 17). For
                                             instance, for federal government purchases of goods and services, the CBO estimates that
                                             the multiplier can be as low as 0.5 and as high as 2.5 (the average is used in Figure 16). If
                                             we use the low estimates for every category, Figure 18 shows that the drag would be ~0.5%
                                             under both election outcomes. However, if we use the high estimate for every category, the
                                             drag on GDP could be as high as 2.7-2.9%. Our economists believe the multipliers are about
                                             0.7, closer to the lower end of the CBO’s range.

                                             The Bloomberg median forecast of real GDP growth of 2.3% next year (Q4/Q4) also
                                             suggests that the market is likely assuming ex-fiscal drag growth of ~3%, along with fiscal
                                             multipliers towards the low end of the range.

                                             It is not clear how much we should extrapolate the experience of a cross-section of other
                                             developed economies to the US. However, we believe that it is a cautionary tale for the US. If
                                             the US experiences multiplier effects from fiscal consolidation comparable to those seen by
                                             other countries, it would present a significant downside risk to the US. While the true effects
                                             of fiscal tightening will be known only after the year passes, the fear of slippage could mean
                                             that large sell-offs resulting from the election should reverse.




Figure 17: High uncertainty about the output multipliers                   Figure 18: Market may be priced for the low end of the
                                                                           estimate
                                                                             0.0%
                                  Low      High
Output Multipliers              Estimate Estimate         Average           -0.5%
Purchase of Goods and                                                                    -0.5%-0.5%
Services by the Federal                                                     -1.0%
Govt.                              0.5         2.5           1.50
Transfer Payments to                                                        -1.5%
Individuals                        0.4         2.1           1.25                                                    -1.5%
                                                                                                                -1.6%
Tax cuts for lower/middle                                                   -2.0%
income people                      0.3         1.5           0.90
Tax cuts for higher income                                                  -2.5%
people                             0.1         0.6           0.35                                                                       -2.5%
                                                                                                                                   -2.6%
Corporate Tax Provisions           0.0         0.4           0.20           -3.0%
                                                                                         Low Estimate             Average         High Estimate
                                                                                                          Democrats       Republicans
Source: CBO’s estimate of the effect of ARRA spending, August 2012         Source: CBO, Budget.house.gov, Barclays Research


23 October 2012                                                                                                                                   13
Barclays | Cliffhanger: The election and rates markets


                                         Implications for interest rate derivatives
                                         Long-end swap spreads could tighten in a Romney win, but should be wider
                                         longer term
                                         As is the case with rates, the reaction of swap spreads to the election is likely to be binary.
                                         We believe that long-end swap spreads are driven by expectations of future long-term
                                         deficits. Figure 19 shows the relationship between the five-year-ahead cumulative deficit/
                                         GDP ratio based on forecasts made by the CBO and 30y swap spreads. In our view, potential
                                         fiscal consolidation is likely to bias 10y and 30y spreads wider over the longer term. From a
                                         risk-reward perspective, our suggested trade for the elections is a 10s-30s spread curve
                                         steepener (30s widen relative to 10s).

                                         In the near term, we believe that the outcome of the fiscal cliff will determine the reaction of
                                         spreads. Under the CBO’s baseline forecasts (which assume that the fiscal cliff hits and all
                                         provisions expire), the average deficit/GDP ratio over the five years starting with 2012 is
                                         about 3%, while under the CBO alternate baseline, which represents a large part of this
                                         tightening being extended permanently, the average is 5.6%. To put some bounds around
                                         the potential reaction of swap spreads, we use our fair value framework. We estimate that
                                         every 1% reduction in average five-year-ahead deficits corresponds to a nearly 10bp
                                         widening in 30y spreads and a 5bp widening in 10y spreads. Figure 20 shows the fair value
                                         of 10y and 30y spreads under our framework for various scenarios of the cumulative five-
                                         year-ahead deficit/GDP ratio.

                                         Our framework suggests that the market is pricing in a five-year-ahead cumulative deficit/
                                         GDP of c.5%. Therefore, all else equal, if the fiscal cliff hits and a resolution appears
                                         impossible, it has the potential to widen 30y spreads to -3bp, and 10y spreads to 13bp,
                                         other things unchanged. On the other hand, 30y spreads could tighten to -29bp and 10y
                                         spreads to zero if it appears that the expiring fiscal provisions with the exception of the
                                         payroll tax cuts and unemployment benefits are extended for five years.

                                         While the near-term effect of a Romney win could be a tightening in 30y spreads as the chances
                                         of an extension increase, we suggest fading such a move. Over a longer horizon, fiscal
                                         consolidation under the House budget is even more aggressive than Obama’s budget – the five-
                                         year-ahead average deficit/GDP under the plan is 3.6%, as opposed to the president’s budget,

Figure 19: Historically, long-end swap spreads have been                 Figure 20: Fair value of spreads under various fiscal scenarios
correlated with deficit expectations

 160                                                               20                                                                    10s-
 140                                                                                                                                      30s
                                                                   10                               5y avg                              spread
 120
                                                                                                    fiscal           10y        30y      curve
 100                                                               0      Scenario                 bal/GDP         spreads    spreads     (bp)
   80
                                                                   -10    Market                     -5.0               3       -24      -27
   60
   40                                                              -20    Fiscal cliff               -3.2               13      -3       -16
   20                                                                     Extension                  -5.6               0.5     -29     -29.5
                                                                   -30
    0
                                                                          Obama budget               -4.8               4.5     -20     -24.5
  -20                                                              -40
    Jan-91    Sep-94 Apr-98 Dec-01        Jul-05   Feb-09                 Ryan plan                  -3.6               11      -7       -18

                    10y swap spreads, bp, LHS
                    CBO 5y fiscal balance projection, % GDP, RHS


Source: CBO, Barclays Research                                           Source: CBO, House Budget, Barclays Research


23 October 2012                                                                                                                                 14
Barclays | Cliffhanger: The election and rates markets


                                            where it is 4.8%. Thus, longer term, the market should expect spreads to be unchanged under an
                                            Obama presidency. Under a Romney administration that adopts the House budget as a blueprint,
                                            we believe that 30y spreads should widen to -7bp and 10y spreads to 11bp.

                                            Overall, our analysis suggests that 10s-30s spread curve steepeners appear to be attractive
                                            from a risk-reward point of view. In Figure 20, the 10s-30s spread curve is flatter than the
                                            market only under the CBO alternate baseline scenario, which assumes that most expiring
                                            provisions, including the upper income tax cuts, are extended. While such a scenario would
                                            be consistent with the initial market reaction to a Romney victory, we believe that over time,
                                            the spread curve will begin pricing in more fiscal consolidation, and long-end spreads will
                                            widen. The spread widening is likely to be more instantaneous after an Obama election
                                            because of the chance of the fiscal cliff hitting.

                                            The options market does not appear priced for a Romney victory
                                            For most of 2012, the vol surface has drifted lower, steepening along expiries as well as
                                            tails. This is because rates have remained in a fairly tight range and the curve has tended to
                                            steepen in a sell-off, and vice versa. As Figure 21 shows, 1y*10y vol has drifted from
                                            105bp/y at its peak in March to roughly 80bp/y now. 11 However, over the same period,
                                            long-tail gamma has resisted a decline, leading to a stretched vol surface (Figure 23).

                                            This makes us believe the options market is even less prepared than the bond market for a
                                            more hawkish Fed. Essentially, the Fed has depressed even the intermediate expiry volatility
                                            of short tails with its rate guidance (Figure 22). Implied volatility of 2y*1y declined
                                            conspicuously in August 2011, when the Fed first committed to keeping the funds rate low
                                            until mid-2013; the sector fell further when guidance was pushed to end-2014. There was a
                                            small effect even at the September FOMC meeting, despite already low levels.

                                            Given such attractive option pricing, we recommend option trades that appear favorable
                                            under a Romney win (flattening sell-off) and either lose little or gain if Obama wins
                                            (flattening rally). In order of preference:

                                                   Long FVZ2 (or TYZ2) straddles


Figure 21: 1y*10y has steadily come off in 2012                                    Figure 22: Vol on short tails has been crushed by the Fed

 110                                                                               120
                                                                                   110
 105
                                                                                   100
 100
                                                                                     90
   95                                                                                80

   90                                                                                70
                                                                                     60
   85
                                                                                     50
   80                                                                                40

   75                                                                                30
    Jan-12     Feb-12       Apr-12 May-12        Jul-12   Sep-12   Oct-12             Jun-11      Aug-11     Nov-11      Feb-12     May-12       Jul-12     Oct-12
                                   1y*10y (bp/y)                                                                    2y*1y             3m*5y
Source: Barclays Research                                                          Source: Barclays Research


                                            11
                                              We have been bearish on mid-tails for the past several months and have benefited from the risk in our trade
                                            portfolio. For details, please see “Sell 1y*10y”, May 25 2012; “Better short than sorry”, June 29, 2012; and “A time to
                                            sell”, September 7, 2012.

23 October 2012                                                                                                                                                       15
Barclays | Cliffhanger: The election and rates markets


                                             Bear flattener – 2m*5y versus 2m*30y

                                             Long 25bp high-strike digital cap – either 1m*5y 25 high or 1m*(3y1y) 25 high

                                             Short 1x2 payer spread – long $200mn high-strike vs. short $100mn ATM 2m*5y payer

                                        Long FVZ2 (or TYZ2) straddles
                                        Short-dated vol on 5y and 7y tails is low. Currently, FVZ2 and TYZ2 straddles are priced at
                                        55bp/y and 84bp/y, respectively. This implies that ~5y rates are priced to move about 13bp
                                        and ~7y about 20bp in either direction in the next one month. These rates have risen more
                                        than 15bp during the past few weeks and could retrace quickly if Obama wins. This should
                                        help recoup the cost of the options. However, a likely 25-30bp sell-off in the belly in the
                                        event of a Romney win would deliver significant gains.

                                        Bear flattener
                                        The trade details are as follows:

                                             Buy $440mn 2m*5y ATM payer

                                             Sell $100mn 2m*30y ATM payer

                                             This is a flattener at 176 when the spot 5s-30s curve is trading at 179.

                                             Premium intake of $1.2mn, as of October 23, 2012

                                        Due to the extreme difference in vol (Figure 23), in this case with 2m*5y at 54bp/y
                                        compared with 90b/y for the 2m*30y leg, the trade allows investors to enter a flattener
                                        trade and take in premium simultaneously. If rates do not sell off, as we expect, in an
                                        Obama win, investors keep the option premium. If Romney wins and the belly sells off as
                                        the market prices in a more hawkish fed, the trade should work as a flattener.

                                        Furthermore, the position can be struck at higher rates for a safer trade, one that is less
                                        likely to be affected by an unexpected bear steepening. At ATM + 25bp, the premium intake
                                        would be smaller, at ~$700k, but the position would provide more comfort with the curve/
                                        rate correlation view.

                                        High-strike digital cap
                                             Buy 1m*5y 25bp high-strike digital cap; or

                                             Buy 1m*(3y1y) 25bp high digital cap

                                        Depending on the bid-offer, the payout could be more than 10 times the premium outlay. Note
                                        that similar limited-loss payer spreads have a less attractive risk/reward profile (worse than 1:5).

                                        One drawback to the trade is that it needs to be held to expiry. If the sell-off occurs well
                                        before expiry, investors still have to wait until option expiry to capture the full risk/reward
                                        and could lose the entire investment if the sell-off reverses. We believe a sell-off of at least
                                        25bp is possible if Romney wins and think it would likely persist for at least a month.
                                        Therefore, we prefer to strike the option 25bp higher.

                                        1x2 payer spread
                                             Sell $100mn 2m*5y payer ATM

                                             Buy $200mn 2m*5y payer 15 high




23 October 2012                                                                                                                          16
Barclays | Cliffhanger: The election and rates markets


Figure 23: Gamma on 30y tails is rich to mid-tails                           Figure 24: Short 1x2 payer spread would do well in a sell-off

 2.2                                                                                     400
                                                                                                              1m           2m
 2.0                                                                                     350
                                                                                         300
 1.8
                                                                                         250
 1.6                                                                                     200




                                                                              p&l, cts
 1.4                                                                                     150

 1.2                                                                                     100
                                                                                         50
 1.0
                                                                                           0
 0.8
                                                                                         -50
 0.6                                                                                 -100
   Apr-94 May-97            Jun-00    Jul-03   Aug-06   Sep-09                          0.50%           1.00%              1.50%               2.00%
                                     3m*30y/ 3m*5y                                                            5y swap rate

Source: Barclays Research                                                    Note: Scenario analysis for 1- and 2m (expiry) horizon. Long $200mn 2m*5y
                                                                             high strike payer vs. short $100mn 2m*5y ATM payer. For 1m horizon, the ATM
                                                                             normal vol is assumed constant. Source: Barclays Research


                                               This trade requires no premium outlay (or can be structured such that it requires none). As
                                               a result, if the Fed is not re-priced, all options would expire worthless and the trade incur no
                                               P&L. In a marginal sell-off, the trade would incur losses, although they would be limited. If
                                               rates sell off more than 30bp, the trade will realize gains. Figure 24 shows the pay-off at
                                               expiry and performance of the trade at a one-month horizon under a variety of scenarios.

                                               So this is a limited-loss trade. If Obama wins, the position expires worthless or realizes a
                                               limited loss. If Romney wins and a less accommodative Fed is priced in, the trade should
                                               realize a solid gain. Furthermore, unlike the digital cap, this trade would gain on a mark-to-
                                               market basis; therefore, gains can be monetized at any time after entering the position.




23 October 2012                                                                                                                                       17
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