Sequester Politics, Freddie Mac Earnings, Home on the Range

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FI SPECIAL
March 4, 2013

Sequester Politics, Freddie Mac Earnings, Home on the Range

■ This is the economy under the sequester.

The $85bn of sequester cuts have now officially gone into effect. Two Senate bills - one from either party - aimed at reworking or providing more flexibility for the cuts, failed votes of cloture and are provisionally dead. To sidestep the next hurdle of the fiscal crisis, House Republicans are said to be drafting a bill that will fund the government for the remainder of the fiscal year. On the upside, this is an attempt to remove the threat of a government shutdown before the existing continuing resolution (CR) expires on March 27th. On the downside, it probably means there is virtually no possibility that a compromise exchanging tax reform for entitlement reform will be forthcoming from this Congress.

■ Freddie Mac reported near-record earnings in the 4Q 2012, with comprehensive income of $5.7bn and net income of $4.5bn.

On an annual basis, Freddie Mac reported $11.0bn in net income for 2012, exceeding its prior peak of $10.1bn in 2002. In light of the August 2012 amendment to the Preferred Stock Purchase Agreement which replaced the fixed 10% dividend with a net worth sweep, Freddie Mac will remit $5.8bn to the Treasury in March 2013, instead of the previous quarterly dividend of $1.8bn on its $71.3bn of Treasury preferred stock. So, that's about $20bn per quarter remitted to the Treasury from the Federal Reserve, $5.8bn next quarter from Freddie Mac, let's guess $4-6bn next quarter from Fannie Mae - well, well, well, that totals about $30bn next quarter that the Federal Reserve and the GSEs will remit to the Treasury. Call us crazy (no, not really) but if we put this into perspective, there seems to be an awful lot of misplaced hysteria over $85bn in cuts from a $3.5trn budget.

■ Don't like the rally, too early to reset shorts.

Our economists project a +225k gain in nonfarm payrolls and a drop to 7.8% unemployment for the Friday, March 8th report. Although encouraging if it materializes, given the rally we doubt it would be enough to have Treasuries break through the upper end of the range (2.04% on 10yT) by week-end. A flat curve and range-bound yields (sigh) beg for the old standby strategies of selling volatility via selling straddles, strangles, or buying callable bonds. For those highly motivated to avoid extension risk, we recommend buying step-ups with high reset coupons or premium callables.

■ Market Impact

Estimates of the economic impact due to the sequester range from a 0.4% to 0.7% drag on GDP growth this year. The bulk of this appears to be priced in by the markets, though the relentless name calling and blame shifting by politicians on TV appears to be extracting a toll on the national mood despite solid if unspectacular economic data. Passage of a CR extending funding through September should be a positive for equities and spur a modest relief sell-off in Treasuries.

Mary Beth FISHER