Financial Market update from Union Bank- thank you Jim B

Financial Market Weekly

Christopher S. Rupkey, CFA

Next release January 3, 2014 Managing Director

Chief Financial Economist

FED RAISED INTEREST RATES AFTER 2001 RECESSION BEFORE CAPEX FULLY RECOVERED

A couple of points to make about business capex, defined here as real business spending on equipment in the GDP accounts. (1) It has fully recovered from the recession and is at record highs. (2) The Fed raised interest rates before business equipment purchases fully recovered after the 2001 recession, when spending continued to fall after the recession due to Iraq War uncertainty.

Business capital spending is normally thought of as being the fuel for economic growth: expenditures which help companies meet the increased demand for their goods and services from consumers. How is it doing? Real GDP spending on equipment was $930.4 billion in Q3 2013, a 5.9% share of $15.839 trillion real GDP-quite small relative to 67.8% for consumers. Spending is increasing more slowly after making a full recovery from the recession in the fourth quarter last year. Spending on equipment added 0.41 percentage point to 2012’s 2.8% real GDP. Business spending on software has been put in a new category of GDP called Intellectual Property Products: intellectual property products added 0.13 percentage points to 2012 real GDP.

　

Bernanke December 18, 2013 press conference

"I think there are a lot of reasons why investment is weaker than we would like. I think the first and most important reason is that the recovery is slow. I mean, investment is driven by sales, by the need for capacity. And, you know, with a slow growing GDP, slow growing economy, most firms do not yet feel that much pressure on their capacity to do major new projects. There’s also a variety of uncertainties out there, fiscal, regulatory, tax, and so on, that no doubt affect some of these calculations. … I think it’s going to take faster overall growth to get firms trying to expand capacity. And if consumer spending increases, as we think it will, and if exports increase, as they seem to be doing, hen we’ll probably see greater investment as well.

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Business spending on equipment is at a record high. 60065070075080085090095010009900010203040506070809101112136006507007508008509009501000$ bln 2001recessionQ3 00peak-30.6%First Fed rate hike from 1%-11.7%Q4 07peakQ3 13930.4Q2 13929.9Q1 13922.5First Fed rate hike from 0.25% … 2016?2007-09RecessionStart2007-09RecessionEndQE TwistQ4 12 Full recoveryReal Spending on Equipment (Capex) in GDP accountsFinancial Market Weekly 2

Business spending on equipment is adding less to the economy this year. Through the third quarter spending is running at a 1.7% rate down from 4.5% in 2012 and an 11.6% pent-up demand rise in 2011. Nothing looks worrisome at the moment. We will get the November report on durable goods orders on Tuesday, December 24. Within the report, nondefense capital goods orders ex-aircraft is our proxy for business capital spending; it was at record levels in June.

Business capital spending on equipment has recovered fairly quickly since the recession ended. Transportation equipment accounts for about half of the increase since the end of 2009 which makes sense as roughly half of the decline in equipment spending from 2007 to 2009 was transportation equipment; cars, light and heavy trucks, aircraft etc. Our conclusion is the equipment spending slowdown so far in 2014 does not merit serious concern even if it does contribute less to GDP growth. On the one hand, business capital spending is not enough to push GDP faster than 3% currently, but 2% GDP growth will be fast enough if it continues to bring down unemployment. Business Spending on Equipment "Capex" in real GDP-15.0-10.0 -5.0 0.0 5.0 10.0 15.000010203040506070809101112132013to Q3annualrate1.7%%Companies have made needed capitalinvestments to meet demand for now.Q4/Q4PercentChanges201020.8%11.64.54648505254565860626466687072200320042005200620072008200920102011201220134648505254565860626466687072heavy duty trucksrailroadsship & boat buildingoffice furnituremedical equipmentOct -0.6%Sep -1.2%Aug +1.0%$billionsfarm machineryconstruction machineryindustrial machinerymetal workingturbines & generatorscomputers/storageelectrical equipmentcommunicationsequipmentDec 2007 recession startLehmanJune2009recession endsJun 06lastFedhikeJuly 2012Weak exports?Nondefense capital goods orders(x-aircraft) equalsbusiness capital spendingNominal GDP expenditures onQ1 12Q2 12Q3 12Q4 12Q1 13Q2 13Q3 13 Equipment ($billion)895.4907.9902.2925.0928.0934.6935.8Information processing equipment290.1281.2277.5289.4286.2291.4291.6 Computers83.579.271.582.578.875.776.0 Other processing equipment 1206.6202.0206.0206.9207.5215.7215.6Industrial equipment190.1195.5195.9199.6200.1199.3206.6Transportation equipment209.0220.6212.3215.7211.5214.7217.8Other equipment 2206.3210.6216.5220.3230.2229.2219.71 Communication, medical, photocopy, office and accounting equipment; nonmedical instruments2 Furniture; agriculture, construction, mining/oilfield, and serivce industry machinery; electrical equipment

JOBLESS CLAIMS: 379K MEANS ECONOMY IS OUT OF THE FULL-EMPLOYMENT ZONE

Initial unemployment claims stayed high a second week at 379K in the December 14 week. The pattern of unemployment claims over the second half of 2013 defies reasoned analysis given the wide swings. Because the unemployment rate is lower and payroll jobs strong, we assume claims will settle back down below 325K at some point this winter. It is still broadly true that with claims in the 300-325K area, the economy is at full employment, exhibiting just frictional job losses, and the economic expansion is sustainable.

TREASURIES: RISING YIELD TREND WITH FED TAPERING ON DECEMBER 18

The yield curve between 2-yrs and 10-yrs was +251 bps on Friday versus +254 bps last week. 10-yr yields stayed in a narrow 2.82 to 2.96% trading range despite all the news. The 10-yr was 2.87% at the 2pm EST Fed QE tapering announcement on Wednesday, jumping to 2.92% before falling to the low yield of the week of 2.82% during Bernanke’s press conference with dovish "forward guidance." 30-SepQ4Q1Q2Q3Q420132013201420142014201430-Yr Bond3.693.904.004.204.304.4010-Yr Note2.612.903.003.203.403.50 2-Yr Note0.320.500.701.001.902.403-month Libor0.250.250.300.400.901.30Federal Fund Rate0.250.250.250.250.501.002s/10s spread229240230220150110-150-100 -50 0 50 100 150 2700278028602940302031003180 M2012AMJJASONDJ2013FMAMJJASONDJ2014 PrivatepayrollemploymentNov +196KOct +214KSep +168KPayroll jobsleftaxis Dec 7, 20132.884 million 275300325350375400425 275300325350375400425 I2010IIIIIIVI2011IIIIIIVI2012IIIIIIVI2013IIIIIIVGoodFridayholidayS&PU.S.AA+ SandyApr 27327KGovtshutdownCalif.computersMar 24 363KFirst-timeclaimsDec 14 379KDec 7 369KNov 30 305KNov 23 321KSep 132008pre-LEHMERAIG449KFinancial Market Weekly 3 180190200210220230240250 180190200210220230240250 AUG2013SEPOCTNOVDEC Oct 22148KjobsOct 31Chicago PMOct 65.9 Dec 5Daybefore203KjobsNo QEtaperSep 6169KjobsNext Supply:Th1-2TBA3s/10s/30sJan 7-9 -80-60-40-20 0 20 40 J2011ASONDJ2012FMAMJJASONDJ2013FMAMJJASONDJul -10.1Aug -2.1Sep +6.7Oct +26.5Nov +34.5Dec 18+31.9Financial Market Weekly 4

FEDERAL RESERVE POLICY

The Fed met December 17-18 to consider its monetary policy. They said in the press statement released at 2pm EST Wednesday that they would taper for the first time since the first "half" of its monthly $85 billion QE purchases program was announced on September 13, 2012. They made $5 billion cuts to both their Treasury and MBS purchases and will now buy $35 billion MBS and $40 billion Government securities purchases per month for a grand total of $75 billion. If there was a battle over this decision there may be some more color in the release of the FOMC meeting minutes at 2pm EST Wednesday, January 8.

Future QE tapering moves? They put in the statement, "the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings." The market seems to have interpreted "measured steps" as $10 billion cuts which means 7 or 8 meetings, if they do it at every meeting, before QE is wound down. We do not view this as the most likely outcome, especially as the $75 billion monthly purchases do not look like they are doing anything at all: the announcement effect of "helping" is long gone and of course, the purchases are not holding down long-term interest rates.

Forward guidance. There are all sorts of words that can be used in communication to tell the market interest rates will stay low for a long time. But soothing words are trumped by the FOMC Fed funds rate forecasts. Forecasts are always subject to change of course. But at the moment, the forecast that the Fed funds rate will be 1.75-2.0 percent at the end of 2016 is something that keeps the 10-yr Treasury yield from falling very far.

They did give some updated forward guidance we guess in terms of the 6.5% unemployment rate threshold where Bernanke has said the Committee will sit down and discuss whether to raise interest rates. They are extending this now saying they will likely keep rates low "well past the time that the unemployment rate declines below" 6.5%. This may be a bow more to the new reality that 6.5% unemployment is now in very close range with last month’s 0.3 drop to 7.0%. Hiking rates the first time "well past" 6.5% fits better with Q4 2015’s unemployment rate forecast of 6.0% too. Our first take on the meeting statement and press conference this week is that there has been little change in their view of the timing of the first rate hike; at most we can say a majority looks for the first hike in October 2015 versus a call of September 2015 from the September 2013 meeting forecasts. We still believe they will find it appropriate to raise interest rates by late in 2014. Fed's Unemployment ForecastsFOMC Central tendency midpoints (Q4 averages)FedLongerMeeting201120122013201420152016RunApr 20118.67.87.05.4Jun 20118.88.07.35.4Nov 20119.18.68.05.4Jan 20128.7a8.47.87.25.6Apr 20128.7a7.97.57.15.6Jun 20128.7a8.17.87.45.6Sep 20128.7a8.17.87.06.45.6Dec 20128.7a7.97.67.16.35.6Mar 20138.7a7.8a7.46.96.35.6Jun 20138.7a7.8a7.36.76.05.6Sep 20138.7a7.8a7.26.66.15.75.5Dec 20138.7a7.8a7.16.56.05.65. Selected Fed assets and liabilitiesSep 10Fed H.4.1 statistical release2008**billions, Wednesday data18-Dec11-Dec4-Dec27-Novpre-LEHFactors adding reservesU.S. Treasury securities2197.2922185.7192169.7882163.666479.782Federal agency debt securities57.22157.22158.37258.3720.000Mortgage-backed securities1485.4071482.9661439.8641439.8540.000Primary credit (Discount Window)0.0150.0130.0030.01223.455Term auction credit (TAF auctions)0.0000.0000.0000.000150.000Asset-backed TALF0.9800.9800.9800.980Maiden Lane (Bear)1.5191.5201.5191.51729.287Maiden Lane II (AIG)0.0630.0630.0630.0630.000Maiden Lane III (AIG)0.0220.0220.0220.0220.000Central bank liquidity swaps0.2730.2720.2720.27262.000Federal Reserve Assets4050.83975.33975.33968.7961.73-month Libor %0.250.240.240.242.82Factors draining reservesCurrency in circulation1232.4901229.7461228.5691227.294834.477Term Deposit Facility0.0000.0000.0000.0000.000Treasury supplemental bill auctions0.0000.0000.0000.0000.000Reserve Balances (Net Liquidity)2465.9322540.7222510.6252488.38724.964 Treasuries within 15 days0.0010.0000.0000.00114.955 Treasuries 16 to 90 days0.2970.2980.2980.00331.549 Treasuries 91 days to 1 year0.1770.1770.1770.47269.272 Treasuries over 1-yr to 5 years748.008748.015742.894726.355170.807 Treasuries over 5-yrs to 10 years871.606864.707858.356871.17491.863 Treasuries over 10-years577.203572.522568.064565.661101.337**September 10, 2008 is pre-Lehman bankruptcy of 9-15-08 Financial Market Weekly

CORPORATES BONDS: MGM RESORTS, MICHAELS STORES, THE KROGER CO.

Corporate bond offerings were $2.2 billion in the December 20 week versus $13.9 billion in the December 13 week. On Monday, The Kroger Co. sold $2.0 billion 2.75s/5s/7s/FRNs. It priced $700 million 3.3% 7-yrs (m-w +16bp) at 110 bps (Baa2/BBB). The supermarket and convenience store operator will use the proceeds to finance a portion of its Harris Teeter Supermarkets acquisition. Corporate bonds (10-yr Industrials rated A2) were 90 bps above 10-yr Treasuries on Friday versus 93 bps last Friday.

TREASURY MARKET OUTLOOK

EXPECTED 10-YR

2-3 WEEK

TRADING RANGE

2.50% to 3.00%

Week’s 10-YR Range

HIGH 99-12 2.82%

Wednesday, December 18, made in first 15 minutes of Bernanke QE taper press conference

LOW 98-05+ 2.96%

Friday, December 20, Q3 real GDP revised to +4.1% from +3.6% 158 bps in November (5.38% vs 3.80%) 50100150200250300350 50 100150200250300350 77798183858789919395979901030507091113RecessionDec 07Jun 09Shaded areasrecessions freezeAug08265bps 52.903.003.10 0 51015202530 70 80 90 100110120130 A2011SONDJ2012FMAMJJASONDJ2013FMAMJJASOND Financial Market Weekly 6

Analyst Certification

The views expressed in this report accurately reflect the personal views of Christopher S. Rupkey, the primary analyst responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein.

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About UnionBanCal Corporation & Union Bank, N.A.

Headquartered in San Francisco, UnionBanCal Corporation is a financial holding company with assets of $105.5 billion at September 30, 2013. Its primary subsidiary, Union Bank, N.A., is a full-service commercial bank providing an array of financial services to individuals, small businesses, middle-market companies, and major corporations. The bank operated 422 branches in California, Washington, Oregon, Texas, Illinois, and New York, as well as two international offices, on September 30, 2013. UnionBanCal Corporation is a wholly-owned subsidiary of The Bank of Tokyo-Mitsubishi UFJ, Ltd., which is a subsidiary of Mitsubishi UFJ Financial Group, Inc. Union Bank is a proud member of the Mitsubishi UFJ Financial Group (MUFG, NYSE:MTU), one of the world’s largest financial organizations.

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