192395 bb a4 the path to qexit qr lr

The Path to QExitFixed Income Focus

Marketing Communication

Fixed Income Focus The Path to QExit

Group Economics Macro & Financial Markets Research

DISCLAIMER: This report has not been prepared in accordance with the legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead. This report is marketing communication and not investment research and is intended for professional and eligible clients only.

3 June 2015

The next big thing is QExit The ECB’s asset purchase programmes have been a major force in financial

markets over the last year. The next big question for investors is how long will QE continue, or to put it another

way, when will it end? In this note we assess the timing of the ECB’s exit from QE – or QExit – given our view of

the macro outlook and the central bank’s reaction function. We also look at the impact on fixed income markets.

ECB to dismiss tapering fears in coming months We think the ECB will be unwavering in its commitment to

continue QE this year. We have only just seen signs of a more convincing recovery, while (core) inflation

remains low and below target. In addition, we think the ECB will want to fight against any early tightening of

financial conditions, as it could nip the economic recovery in the bud.

Early next year the tone could change However, as we move into next year, the ECB’s tone could change. By

then we would have seen several quarters of better growth, while bank loans will also have expanded. Core

inflation will have shown some signs of turning the corner, while inflation expectations will rise. The ECB’s

confidence that it will meet its inflation goal over the medium term should be stronger. It will be clearer that

September 2016 is very likely the end point for QE. The March 2016 policy meeting could be a watershed.

Bund sell off probably a false start Given that the ECB will re-enforce its commitment to QE, we think the

recent rise in Bund yields is unlikely to last. Indeed, with acute scarcity of AAA bonds likely to re-assert itself,

core bond yields will likely fall back. At the same time, we expect to see flatter curves (2s5s and 2s10s in

particular). In addition, further risk spread compression, especially in non-financial credits and peripheral

sovereigns is likely and the euro should decline further. Finally, Länder bonds could benefit from being included

in the ECB’s eligible universe.

Positioning for the QExit When expectations of the ECB’s exit from QE take hold from the turn of next year,

we would expect a sharp rise in core government bond yields and curves to steepen, mirroring the taper tantrum

in the US. It would make sense to then be short core government bonds, covered bonds, SSAs as well as short

duration. Meanwhile, the US experience suggests that credit spreads will actually tighten, likely helped by the

improved economic growth outlook. Overweighting credit in the belly of the curve could provide some relative

protection. As QExit expectations rise, we think the euro will rebound.

1 Fixed Income Focus: The path to QExit – 3 June 2015

About the authors

Nick Kounis (Head Macro & Financial Markets Research) Nick is responsible for research on the global economy, central banks, fixed income and FX strategy. He is widely quoted on the ECB’s monetary policy and eurozone economy. Nick was previously Chief European Economist at Fortis, and advised on economic policy at HM Treasury in the UK.

Joost Beaumont (Senior Fixed Income Strategist - Covered Bonds) Joost is a well-known analyst of euro-denominated covered bonds, with a particular expertise on the Dutch market. He previously held positions as Senior European Economist at ABN AMRO and Fortis and spent nearly seven years as a policy advisor at the central bank of the Netherlands Antilles.

Kim Liu (Senior Fixed Income Strategist - Rates) Kim is an experienced specialist in the Sovereign, Supranational and Agency bond markets as well as swaps. He previously worked as a government bond trader at ABN AMRO. Kim has also worked for the DSTA (Dutch State Treasury Agency), which is part of the Dutch ministry of Finance.

Aline Schuiling (Senior European Economist) Aline covers the eurozone economy, focusing on the cycle as well as the comparative fundamentals of the member states. Her recent thematic notes include an analysis of the state of structural reforms in different countries. She is also an ECB specialist. Aline has a vast experience as a market economist, working for several banks.

Hyung-Ja de Zeeuw (Senior Fixed Income Strategist – Corporate Bonds) Hyung covers EUR IG non-financials with an expertise in European utilities. She provides market analyses from a broad perspective and shares her views on sector developments. Hyung previously worked as a Fixed Income Portfolio manager Credits and as an Originator in the Debt Capital Markets.


About the authors

Nick Kounis (Head Macro & Financial Markets Research) Nick is responsible for research on the global economy, central banks, fixed income and FX strategy. He is widely quoted on the ECB’s monetary policy and eurozone economy. Nick was previously Chief European Economist at Fortis, and advised on economic policy at HM Treasury in the UK.

Joost Beaumont (Senior Fixed Income Strategist - Covered Bonds) Joost is a well-known analyst of euro-denominated covered bonds, with a particular expertise on the Dutch market. He previously held positions as Senior European Economist at ABN AMRO and Fortis and spent nearly seven years as a policy advisor at the central bank of the Netherlands Antilles.

Kim Liu (Senior Fixed Income Strategist - Rates) Kim is an experienced specialist in the Sovereign, Supranational and Agency bond markets as well as swaps. He previously worked as a government bond trader at ABN AMRO. Kim has also worked for the DSTA (Dutch State Treasury Agency), which is part of the Dutch ministry of Finance.

Aline Schuiling (Senior European Economist) Aline covers the eurozone economy, focusing on the cycle as well as the comparative fundamentals of the member states. Her recent thematic notes include an analysis of the state of structural reforms in different countries. She is also an ECB specialist. Aline has a vast experience as a market economist, working for several banks.

Hyung-Ja de Zeeuw (Senior Fixed Income Strategist – Corporate Bonds) Hyung covers EUR IG non-financials with an expertise in European utilities. She provides market analyses from a broad perspective and shares her views on sector developments. Hyung previously worked as a Fixed Income Portfolio manager Credits and as an Originator in the Debt Capital Markets.


Conviction views QE QExitGovernment bonds The recent sell-off in government bonds is a

false start. We expect yields to decrease as scarcity of core government bonds will kick in. We make a case for the inclusion of Länder bonds to decrease scarcity of German government bonds. Government bond curves are now steeper than before QE was announced. Flattening in 2s5s is supported by ongoing ECB buying. Peripheral country spreads have widened on Grexit concerns. We believe that in the end an agreement will be reached and are therefore supportive of peripheral country spreads.

We expect yields on government bonds to rise and curves to steepen. Impact on short maturing bonds will be less than on long end maturing bonds as excess liquidity will remain and as the ECB will keep its policy rates unchanged. Government bonds will likely underperform vs swaps. Performance in peripheral spreads is backed by improved economic sentiment and search for yield.

National agency bonds Underweight bonds issued by national agencies and European institutions. Bonds issued by the so called national agencies and European insitutions and which are eligible for QE purchases have outperformed significantly. These bonds are trading flat or very expensive to their respective government bonds. We are cautious to set up bullish trades in these names.

Underweight bonds issued by national agencies and European institutions. The national agency and European insitution bonds which have outperformed sovereign bonds during QE are likely to underperform once the ECB will stop buying these bonds. We are therefore not supportive of these names.

Covered Bonds Overweight periphery and non-CBPP3 eligible paper. Potential for tightening is the largest in the periphery, reflecting higher spread levels, as (semi) core covered bonds are already relatively expensive. Spreads of non-CBPP3 eligible paper (e.g. Canada and Australia) also offer potential to perform, as they are trading with a pickup versus the (semi) core.

Underweight peripheral covered bonds, as we think they will be hit hardest. Not only did these bonds benefit the most from CBPP3, but we also expect relatively more supply from the periphery than from the (semi) core. (Semi) core paper will remain relatively scarce, limiting its widening potential. Non-CBPP3 paper will end up in between, as it will be less attractive as a substitute for CBPP3 paper.

Credit Non-financial bonds Overweight non-financials. The purchase programme pushes investors into riskier assets of the spectrum resulting in spread compression and flattening credit curves. We prefer the BBB rated segment, hybrids and longer maturities.

Overweight non-financials. Improving economic conditions will trickle through to reported results at the company level. We prefer high beta BBB rated segment. Only hold hybrids if volatility is not an issue. Name selection will become more important as event risk increases when the economy strengthens. Move out of the longer end and into the belly of the curve.


Euro Interest Rate Forecasts*denotes forecasts

Outright Yield 3m 1m Now 2015Q4* 2016Q1* 2016Q4*Deposit facility -0.20 -0.20 -0.20 -0.20 -0.20 -0.20Refi 0.05 0.05 0.05 0.05 0.05 0.05Marginal lending 0.30 0.30 0.30 0.30 0.30 0.30Eonia -0.05 -0.08 -0.14 -0.08 -0.08 -0.081m Euribor 0.00 -0.03 -0.05 -0.05 -0.05 0.053m Euribor 0.04 0.00 -0.01 0.00 0.00 0.102y Germany -0.23 -0.26 -0.23 -0.20 0.10 0.205y Germany -0.10 -0.10 0.02 0.00 0.40 0.6010y Germany 0.30 0.16 0.55 0.50 1.00 1.4030y Germany 0.96 0.61 1.19 1.10 1.70 2.202y IRS 0.10 0.07 0.11 0.10 0.20 0.305y IRS 0.26 0.21 0.38 0.30 0.60 0.8010y IRS 0.67 0.51 0.91 0.80 1.30 1.6030y IRS 1.20 0.81 1.36 1.20 1.80 2.30

Curve Spreads 3m 1m Now 2015Q4* 2016Q1* 2016Q4*Germany 2s5s 13 16 25 20 30 40Germany 5s10s 40 26 53 50 60 80Germany 10s30s 67 45 64 60 70 8010y Bond Swap Spread 37 35 37 30 30 20IRS 2s5s 16 15 28 20 40 50IRS 5s10s 41 29 53 50 70 80IRS 10s30s 53 30 44 40 50 70

10y Government Bond Yield Spreads 3m 1m Now 2015Q4* 2016Q1* 2016Q4*Finland 2 6 6 3 3 2Netherlands 5 15 20 5 4 3Austria 8 12 14 8 6 4Belgium 24 27 31 20 10 8France 28 26 30 25 20 10Ireland 58 56 71 40 35 20Italy 105 129 135 95 90 50Spain 98 124 130 90 80 30Portugal 171 182 193 145 100 80Greece 894 1256 1121 900 750 450

Forecasts: ABN AMRO Group Economics


Euro Interest Rate Forecasts*denotes forecasts

Outright Yield 3m 1m Now 2015Q4* 2016Q1* 2016Q4*Deposit facility -0.20 -0.20 -0.20 -0.20 -0.20 -0.20Refi 0.05 0.05 0.05 0.05 0.05 0.05Marginal lending 0.30 0.30 0.30 0.30 0.30 0.30Eonia -0.05 -0.08 -0.14 -0.08 -0.08 -0.081m Euribor 0.00 -0.03 -0.05 -0.05 -0.05 0.053m Euribor 0.04 0.00 -0.01 0.00 0.00 0.102y Germany -0.23 -0.26 -0.23 -0.20 0.10 0.205y Germany -0.10 -0.10 0.02 0.00 0.40 0.6010y Germany 0.30 0.16 0.55 0.50 1.00 1.4030y Germany 0.96 0.61 1.19 1.10 1.70 2.202y IRS 0.10 0.07 0.11 0.10 0.20 0.305y IRS 0.26 0.21 0.38 0.30 0.60 0.8010y IRS 0.67 0.51 0.91 0.80 1.30 1.6030y IRS 1.20 0.81 1.36 1.20 1.80 2.30

Curve Spreads 3m 1m Now 2015Q4* 2016Q1* 2016Q4*Germany 2s5s 13 16 25 20 30 40Germany 5s10s 40 26 53 50 60 80Germany 10s30s 67 45 64 60 70 8010y Bond Swap Spread 37 35 37 30 30 20IRS 2s5s 16 15 28 20 40 50IRS 5s10s 41 29 53 50 70 80IRS 10s30s 53 30 44 40 50 70

10y Government Bond Yield Spreads 3m 1m Now 2015Q4* 2016Q1* 2016Q4*Finland 2 6 6 3 3 2Netherlands 5 15 20 5 4 3Austria 8 12 14 8 6 4Belgium 24 27 31 20 10 8France 28 26 30 25 20 10Ireland 58 56 71 40 35 20Italy 105 129 135 95 90 50Spain 98 124 130 90 80 30Portugal 171 182 193 145 100 80Greece 894 1256 1121 900 750 450

Forecasts: ABN AMRO Group Economics


Introduction The ECB’s asset purchase programmes have been a major force in financial markets over the last year. QE had a long-run up, with a significant impact on asset prices as expectations built that the central bank would finally take the road well-trodden by other central banks. However, it has continued to have an impact on markets following both the announcement and implementation. Government bond yields have seen a long downward trend, though they have recently retraced some of their falls. The next big question for investors is how long will QE continue, or to put it another way, when will it end? In this note we assess the likely timing of the ECB’s exit from QE – or QExit – given our view of the macro outlook and the central bank’s reaction function. We also look at the impact on fixed income markets. Conditions necessary for QExit The ECB has set out its framework for deciding how long QE will last. President Mario Draghi has stated that ‘purchases are intended to run until the end of September 2016 and, in any case, until we see a sustained adjustment in the path of inflation that is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term’. The ECB head clarified that the ECB would look through ‘transient’ effects on inflation, suggesting that an uptrend in core inflation is a key element in assessing the success of the policy. Developments necessary to ensure this are ‘a further improvement in the economic outlook, a reduction in economic slack and a recovery in money and credit growth’. In addition, the ECB is looking for a ‘firm anchoring of inflation expectations’, suggesting these need to move back up to levels consistent with the price stability goal. The ECB’s inflation problem HICP inflation, % yoy

Source: Thomson Reuters Datastream, ABN AMRO Group Economics

GDP growth to strengthen this year We expect GDP growth to step up a gear in the coming quarters. Net exports should benefit from the sharp depreciation of the effective euro exchange rate since the middle of last year, which was largely due to the anticipation and implementation of the ECB’s QE policy. The effective euro has fallen by more than 10% and we expect another depreciation of around 5% during the rest of this year. Combined with a strengthening of the global economy after a weak Q1, this should result in eurozone exports accelerating. On top of this, domestic demand should gather momentum. To begin with, the drop in oil prices in the second half of last year will continue to work its way through to domestic demand, boosting GDP growth by around 1 percentage point on average during the year. Fall in the euro will lift net exports Contribution to yoy GDP growth, % % yoy


Consumers getting a windfall from lower oil prices Net gain from USD 50 drop in oil prices, % GDP


Moreover, financial conditions will continue to improve on the back of the ECB’s QE policy. This should also support private consumption and investment. Indeed, banks have eased lending conditions and the bank credit channel is working again, both in the core eurozone countries and in the

-1

0

1

2

3

4

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15Total Core rate ECB target

-20-15-10-505101520-2.0

-1.5-1.0-0.50.00.51.01.52.0

98 00 02 04 06 08 10 12 14

Net exports (lhs) Euro trade-weighted (rhs, reversed)

0.0

0.5

1.0

1.5

2.0

2.5

BE GR NL PT ES FI EZ DE AT IE FR IT


Introduction The ECB’s asset purchase programmes have been a major force in financial markets over the last year. QE had a long-run up, with a significant impact on asset prices as expectations built that the central bank would finally take the road well-trodden by other central banks. However, it has continued to have an impact on markets following both the announcement and implementation. Government bond yields have seen a long downward trend, though they have recently retraced some of their falls. The next big question for investors is how long will QE continue, or to put it another way, when will it end? In this note we assess the likely timing of the ECB’s exit from QE – or QExit – given our view of the macro outlook and the central bank’s reaction function. We also look at the impact on fixed income markets. Conditions necessary for QExit The ECB has set out its framework for deciding how long QE will last. President Mario Draghi has stated that ‘purchases are intended to run until the end of September 2016 and, in any case, until we see a sustained adjustment in the path of inflation that is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term’. The ECB head clarified that the ECB would look through ‘transient’ effects on inflation, suggesting that an uptrend in core inflation is a key element in assessing the success of the policy. Developments necessary to ensure this are ‘a further improvement in the economic outlook, a reduction in economic slack and a recovery in money and credit growth’. In addition, the ECB is looking for a ‘firm anchoring of inflation expectations’, suggesting these need to move back up to levels consistent with the price stability goal. The ECB’s inflation problem HICP inflation, % yoy


GDP growth to strengthen this year We expect GDP growth to step up a gear in the coming quarters. Net exports should benefit from the sharp depreciation of the effective euro exchange rate since the middle of last year, which was largely due to the anticipation and implementation of the ECB’s QE policy. The effective euro has fallen by more than 10% and we expect another depreciation of around 5% during the rest of this year. Combined with a strengthening of the global economy after a weak Q1, this should result in eurozone exports accelerating. On top of this, domestic demand should gather momentum. To begin with, the drop in oil prices in the second half of last year will continue to work its way through to domestic demand, boosting GDP growth by around 1 percentage point on average during the year. Fall in the euro will lift net exports Contribution to yoy GDP growth, % % yoy


Consumers getting a windfall from lower oil prices Net gain from USD 50 drop in oil prices, % GDP


Moreover, financial conditions will continue to improve on the back of the ECB’s QE policy. This should also support private consumption and investment. Indeed, banks have eased lending conditions and the bank credit channel is working again, both in the core eurozone countries and in the

-1

0

1

2

3

4

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15Total Core rate ECB target

-20-15-10-505101520-2.0

-1.5-1.0-0.50.00.51.01.52.0

98 00 02 04 06 08 10 12 14

Net exports (lhs) Euro trade-weighted (rhs, reversed)

0.0

0.5

1.0

1.5

2.0

2.5

BE GR NL PT ES FI EZ DE AT IE FR IT


periphery. Furthermore, bank lending conditions for SMEs are now easing faster than for large firms. Overall, we expect growth to strengthen to levels of around 0.6-0.7% qoq in the second half of 2015, which is well above the potential rate of around 0.2-0.3%. In 2016, quarterly growth is expected to settle at a slightly lower rate of around 0.5%. Banks easing lending standards to companies % net tightening

Source: Thomson Reuters Datastream, ECB Bank Lending Survey

Bank loan rates to companies falling Loans up to EUR 1 million, %


Core inflation will follow, but with a lag We expect core inflation to remain low in 2015, but to rise significantly in 2016. Economic growth rates of 1.5-2% may seem too moderate to trigger inflationary pressures on the surface. However, trend growth has slowed considerably in recent years. For instance, the OECD and European Commission estimate that trend growth is now around 1%. That means that economic slack should fade over coming quarters, partly reflected in a significant decline in unemployment, which should eventually impact wage growth. The figure below shows that changes in the output gap leads service sector inflation with a lag of around a year. Our projection of the output gap – using our own estimates for

growth – signals that service sector inflation should start to rise later this year, but much more significantly in 2016. Closing of output gap should push up core inflation

%


The past fall in the euro should also push up core inflation next year. Our indicator of external price pressures – made up of global prices divided by the euro effective exchange rate – has risen sharply over recent months due to the euro’s decline. That suggests import prices will follow. In turn, core goods price inflation follows import price inflation with a long lag (around one and a half years). Fall in the euro should push up import prices

% yoy


Inflation expectations to increase Inflation expectations dropped sharply in the second half of 2014. This was reflected in several financial market and survey based measures and was a key reason that triggered the ECB to start its QE policy. Anchoring the expectations for inflation in the medium to longer term is of vital importance to the ECB, as its only policy target is to make sure that inflation is below, but close to 2% in the medium term.

-20-10

010203040506070

03 04 05 06 07 08 09 10 11 12 13 14 15

Large firms SMEs

Easier

Tighter

2.0

3.0

4.0

5.0

6.0

7.0

03 04 05 06 07 08 09 10 11 12 13 14 15

Loans up to 1 year Loans 1-5 years

0.5

1.0

1.5

2.0

2.5

3.0

3.5

-5-4-3-2-101234

97 99 01 03 05 07 09 11 13 15 17

Output gap (lhs) Service price inflation (rhs)

-15-10-505101520

-6-4-202468

06 07 08 09 10 11 12 13 14 15

import prices ex. energy (lhs) global prices/EER (rhs)


periphery. Furthermore, bank lending conditions for SMEs are now easing faster than for large firms. Overall, we expect growth to strengthen to levels of around 0.6-0.7% qoq in the second half of 2015, which is well above the potential rate of around 0.2-0.3%. In 2016, quarterly growth is expected to settle at a slightly lower rate of around 0.5%. Banks easing lending standards to companies % net tightening

Source: Thomson Reuters Datastream, ECB Bank Lending Survey

Bank loan rates to companies falling Loans up to EUR 1 million, %


Core inflation will follow, but with a lag We expect core inflation to remain low in 2015, but to rise significantly in 2016. Economic growth rates of 1.5-2% may seem too moderate to trigger inflationary pressures on the surface. However, trend growth has slowed considerably in recent years. For instance, the OECD and European Commission estimate that trend growth is now around 1%. That means that economic slack should fade over coming quarters, partly reflected in a significant decline in unemployment, which should eventually impact wage growth. The figure below shows that changes in the output gap leads service sector inflation with a lag of around a year. Our projection of the output gap – using our own estimates for

growth – signals that service sector inflation should start to rise later this year, but much more significantly in 2016. Closing of output gap should push up core inflation

%


The past fall in the euro should also push up core inflation next year. Our indicator of external price pressures – made up of global prices divided by the euro effective exchange rate – has risen sharply over recent months due to the euro’s decline. That suggests import prices will follow. In turn, core goods price inflation follows import price inflation with a long lag (around one and a half years). Fall in the euro should push up import prices

% yoy


Inflation expectations to increase Inflation expectations dropped sharply in the second half of 2014. This was reflected in several financial market and survey based measures and was a key reason that triggered the ECB to start its QE policy. Anchoring the expectations for inflation in the medium to longer term is of vital importance to the ECB, as its only policy target is to make sure that inflation is below, but close to 2% in the medium term.

-20-10

010203040506070

03 04 05 06 07 08 09 10 11 12 13 14 15

Large firms SMEs

Easier

Tighter

2.0

3.0

4.0

5.0

6.0

7.0

03 04 05 06 07 08 09 10 11 12 13 14 15

Loans up to 1 year Loans 1-5 years

0.5

1.0

1.5

2.0

2.5

3.0

3.5

-5-4-3-2-101234

97 99 01 03 05 07 09 11 13 15 17

Output gap (lhs) Service price inflation (rhs)

-15-10-505101520

-6-4-202468

06 07 08 09 10 11 12 13 14 15

import prices ex. energy (lhs) global prices/EER (rhs)


Since the start of this year, inflation expectations have started to recover. Although the announcement of the ECB’s QE policy might have played some part, the rise in inflation expectations seems to be mainly due to oil prices rebounding (just as falling inflation expectations last year had coincided with the sharp drop in oil prices) and headline inflation moving higher (from -0.6% yoy in January to 0.0% in April). Indeed, inflation expectations for the short to medium term tend to move closely in sync with current levels of inflation (see graph below). As we expect the headline inflation rate to jump higher around the end of this year on the back of higher food- and energy price inflation, inflation expectations will probably jump higher as well. Indeed, we expect the inflation expectations to rise to levels closer to the ECB target around the end of this year. Rising import prices to push up core inflation

% yoy


Inflation expectations follow current inflation % % yoy


In the medium term, leaving commodity prices and exchange rate effects aside, inflation is driven by wage increases. In turn, wages are driven by the situation on the labour market. In short, eurozone inflation can only return to the ECB’s target if

the economy grows at a pace sufficient to reduce slack and unemployment in particular. As mentioned earlier in this note, we judge that the outlook is encouraging as the economy appears to be gaining momentum and unemployment has trended lower for some time, a development we expect to continue. ECB unlikely to waver this year The big question is how the ECB will respond to this base scenario. We think that President Mario Draghi’s message will be unwavering this year, starting with the June press conference following the Governing Council meeting. He will state clearly that there will be no early tapering and that QE will be implemented in full. Mr. Draghi will have the evidence on his side. We have only just seen signs of a more convincing recovery, while core inflation remains low, below target and with no signs yet of turning up. Inflation expectations have risen but remain at historically low levels. Moreover, the QE programme is only a few months old. So, we think the ECB will want to fight against any early tightening of financial conditions due to higher bond yields and a stronger euro, as it could nip the economic recovery in the bud. Forecasters see less downside risk Inflation 5 years ahead, probability distribution, %

Source: Thomson Reuters Datastream, ECB Professional Forecasters

Another reason for the ECB not to consider an early tapering to their programme is the situation around Greece. So far, the continued difficulties around the Greek situation have not led to significant contagion to other peripheral bond markets. This is possibly partly because of the ECB’s asset purchase programme. The ECB would certainly not want to risk unsettling financial markets. Situation could change at the turn of the year However, as we move into next year, the ECB’s tone could change. By then we would have seen a number of quarters of

-0.5

0.0

0.5

1.0

1.5

2.0

-6-4-202468

06 07 08 09 10 11 12 13 14 15

import prices (lhs) core cpi ind goods (rhs)

-1.0-0.50.00.51.01.52.02.53.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jan-12 Jan-13 Jan-14 Jan-152y ahead Medium-term to long-term HICP inflation (rhs)

10

15

20

25

30

35

11 12 13 14 15

Probability of inflation below target Probability of above target


Since the start of this year, inflation expectations have started to recover. Although the announcement of the ECB’s QE policy might have played some part, the rise in inflation expectations seems to be mainly due to oil prices rebounding (just as falling inflation expectations last year had coincided with the sharp drop in oil prices) and headline inflation moving higher (from -0.6% yoy in January to 0.0% in April). Indeed, inflation expectations for the short to medium term tend to move closely in sync with current levels of inflation (see graph below). As we expect the headline inflation rate to jump higher around the end of this year on the back of higher food- and energy price inflation, inflation expectations will probably jump higher as well. Indeed, we expect the inflation expectations to rise to levels closer to the ECB target around the end of this year. Rising import prices to push up core inflation

% yoy


Inflation expectations follow current inflation % % yoy


In the medium term, leaving commodity prices and exchange rate effects aside, inflation is driven by wage increases. In turn, wages are driven by the situation on the labour market. In short, eurozone inflation can only return to the ECB’s target if

the economy grows at a pace sufficient to reduce slack and unemployment in particular. As mentioned earlier in this note, we judge that the outlook is encouraging as the economy appears to be gaining momentum and unemployment has trended lower for some time, a development we expect to continue. ECB unlikely to waver this year The big question is how the ECB will respond to this base scenario. We think that President Mario Draghi’s message will be unwavering this year, starting with the June press conference following the Governing Council meeting. He will state clearly that there will be no early tapering and that QE will be implemented in full. Mr. Draghi will have the evidence on his side. We have only just seen signs of a more convincing recovery, while core inflation remains low, below target and with no signs yet of turning up. Inflation expectations have risen but remain at historically low levels. Moreover, the QE programme is only a few months old. So, we think the ECB will want to fight against any early tightening of financial conditions due to higher bond yields and a stronger euro, as it could nip the economic recovery in the bud. Forecasters see less downside risk Inflation 5 years ahead, probability distribution, %

Source: Thomson Reuters Datastream, ECB Professional Forecasters

Another reason for the ECB not to consider an early tapering to their programme is the situation around Greece. So far, the continued difficulties around the Greek situation have not led to significant contagion to other peripheral bond markets. This is possibly partly because of the ECB’s asset purchase programme. The ECB would certainly not want to risk unsettling financial markets. Situation could change at the turn of the year However, as we move into next year, the ECB’s tone could change. By then we would have seen a number of quarters of

-0.5

0.0

0.5

1.0

1.5

2.0

-6-4-202468

06 07 08 09 10 11 12 13 14 15

import prices (lhs) core cpi ind goods (rhs)

-1.0-0.50.00.51.01.52.02.53.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jan-12 Jan-13 Jan-14 Jan-152y ahead Medium-term to long-term HICP inflation (rhs)

10

15

20

25

30

35

11 12 13 14 15

Probability of inflation below target Probability of above target


better economic growth, while credit to the private sector will also have expanded. Core inflation will have shown some signs of turning the corner. Headline inflation will be much higher, while inflation expectations will have risen further. The Governing Council’s confidence that it will meet its inflation target over the medium term should be stronger. Overall, it will become clearer that September 2016 is very likely the end point for QE. ABN AMRO inflation forecast % yoy


March 2016 ECB meeting could be a watershed The Governing Council meeting of March 2016 could be a pivotal one. The ECB will publish updated forecasts for growth and inflation, but will also extend its forecasting horizon to 2018. The central bank is currently projecting inflation roughly on target in 2017 at 1.8%, assuming QE continues until September 2016. Therefore, by then it could start showing inflation around the goal in 2018 as well. ECB projections in March 2015 %

Source: Thomson Reuters Datastream, ECB

Communicating the QExit In the US, when the FOMC judged that the point to wind down QE was advancing, it started to change its tone, so that

financial markets had time to adjust to the idea. In May 2013, the previous Fed Chairman, Ben Bernanke, said in comments to Congress ‘that if we see continued improvement, and we have confidence that that is going to be sustained, in the next few meetings we could take a step down in our pace of purchases’. The tapering of purchases preceded in December of that year, with a small reduction in the monthly pace of asset purchases, and the programme was wound down completely by October 2014. The ECB could also decide to taper purchases rather than end the programme in one step in September 2016. In any case, we think Mr. Draghi could well signal that conditional on the data, QE will end later in the year. He will also likely emphasise that policy rates will remain at current levels far beyond that point. Key assumptions in our base case On balance, we think that the most likely scenario is that the ECB will finish the purchasing programme it is committed to. There is, however, a chance that they will announce a gradual tapering of the programme in the second half of next year. The latter can only happen if the economy continues to grow above trend, inflation, inflation expectations and inflation forecasts move higher and the euro crisis does not re-escalate. Two other key judgements are important. First of all, that there will be a relatively benign resolution to the Greek crisis. Second, that the Fed will raise its key policy rates later this year, which should assist the ECB in keeping downward pressure on EUR/USD. If the Fed were to wait longer, this could put upward pressure on the euro, which would also increase the possibility that the ECB needs to signal an extension of QE to keep the euro on a downward trend. Bond yields are expected to fall again So what does our base scenario mean for fixed income markets? The recent surge in government bond yields raises the question whether eurozone QE is becoming a textbook example and following the same development as US Treasury yields did under the Fed’s QE (see chart below). We do not think so. We think the drivers of the sudden rise in yields are mostly temporary in nature or are simply misplaced. A big difference between the Fed’s QE programme and the ECB’s PSPP is that the US government was running large deficits when the Fed started buying bonds. Even after the Fed’s purchases, net bond supply was positive. The situation in the eurozone is different. Germany, for example, is running a modest budget surplus. So after the ECB’s purchases of Bunds, net supply is actually significantly negative. The recent

-1.0-0.50.00.51.01.52.02.5

13 14 15 16 17 18

All items Core

1.5

1.92.1

0.0

1.51.8

0.0

0.5

1.0

1.5

2.0

2.5

2015 2016 2017

GDP HICP








-1.0-0.50.00.51.01.52.02.5

13 14 15 16 17 18

All items Core

1.5

1.92.1

0.0

1.51.8

0.0

0.5

1.0

1.5

2.0

2.5

2015 2016 2017

GDP HICP








-1.0-0.50.00.51.01.52.02.5

13 14 15 16 17 18

All items Core

1.5

1.92.1

0.0

1.51.8

0.0

0.5

1.0

1.5

2.0

2.5

2015 2016 2017

GDP HICP


rise in eurozone yields came at a time in which net supply in government bonds was temporarily positive. This therefore weighed on the market. However, if we look beyond and focus on the months to come, we calculate that net bond supply will become significantly negative again. Impact of US QE on 10y Treasury yields 10y, %

Source: Thomson Reuters Datastream

Scarcity of AAA bonds will remain a key driver QE purchases will decrease the availability of outstanding bonds to other investors in the coming months. We calculate that especially core bond markets will be severely impacted (see table below). This will, in time, create acute scarcity, with the outstanding stock of AAA government bonds shrinking significantly after ECB purchases. 2015 Net flow in eurozone government debt

Country Net supply* Purchases

in 2015

Adjusted

Net Flow

Net flow %

Total market**

DE 4 118 -114 -15

NL 9 26 -18 -7

AT 4 13 -9 -5

FI 5 8 -3 -4

PT 8 11 -4 -4

BE 13 16 -3 -1

IT 81 81 0 0

SP 60 58 2 0

FR 109 93 16 1

IR 14 8 6 6

Total 306 432 -126 *Includes issuance of fixed coupon bonds, linkers and FRNs

**Includes 2-30y government bonds, net flow is corrected for supply

Source: ABN AMRO Group Economics, Bloomberg, National DMOs

ECB purchases will lead to Bund scarcity… In EUR bn

Source: Bloomberg, ABN AMRO Group Economics

… especially in Summer and in December In EUR bn


Covered bond redemptions peak in June Redemptions of euro benchmark covered bonds (EUR bn)

Source: Markit, Bloomberg, ABN AMRO Group Economics

The (expected) impact of scarcity will likely push yields lower in coming months. Since the ECB will only buy bonds with yields higher than -20bps, we think that as yields decline, the self-reinforcing QE circle of lower yields will emerge again. This reflects that as yields fall the universe of eligible bonds will become smaller making scarcity more acute, and increasing

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

08 09 10 11 12 13 14Tapering QE periods Tapering dry run 10yr yield

-120

-60

0

60

120

180

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Net adjusted flow Issuance Redemptions

-30

-20

-10

0

10Ja

n

Feb

Mar

ch Apr

May

June

July

Aug

Sept

Oct

Nov Dec

Net adjusted flow

0

5

10

15

20

25

30



rise in eurozone yields came at a time in which net supply in government bonds was temporarily positive. This therefore weighed on the market. However, if we look beyond and focus on the months to come, we calculate that net bond supply will become significantly negative again. Impact of US QE on 10y Treasury yields 10y, %


Scarcity of AAA bonds will remain a key driver QE purchases will decrease the availability of outstanding bonds to other investors in the coming months. We calculate that especially core bond markets will be severely impacted (see table below). This will, in time, create acute scarcity, with the outstanding stock of AAA government bonds shrinking significantly after ECB purchases. 2015 Net flow in eurozone government debt

Country Net supply* Purchases

in 2015

Adjusted

Net Flow

Net flow %

Total market**

DE 4 118 -114 -15

NL 9 26 -18 -7

AT 4 13 -9 -5

FI 5 8 -3 -4

PT 8 11 -4 -4

BE 13 16 -3 -1

IT 81 81 0 0

SP 60 58 2 0

FR 109 93 16 1

IR 14 8 6 6

Total 306 432 -126 *Includes issuance of fixed coupon bonds, linkers and FRNs

**Includes 2-30y government bonds, net flow is corrected for supply

Source: ABN AMRO Group Economics, Bloomberg, National DMOs

ECB purchases will lead to Bund scarcity… In EUR bn


… especially in Summer and in December In EUR bn


Covered bond redemptions peak in June Redemptions of euro benchmark covered bonds (EUR bn)

Source: Markit, Bloomberg, ABN AMRO Group Economics

The (expected) impact of scarcity will likely push yields lower in coming months. Since the ECB will only buy bonds with yields higher than -20bps, we think that as yields decline, the self-reinforcing QE circle of lower yields will emerge again. This reflects that as yields fall the universe of eligible bonds will become smaller making scarcity more acute, and increasing

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

08 09 10 11 12 13 14Tapering QE periods Tapering dry run 10yr yield

-120

-60

0

60

120

180


Net adjusted flow Issuance Redemptions

-30

-20

-10

0

10Ja

n

Feb

Mar

ch Apr

May

June

July

Aug

Sept

Oct

Nov Dec

Net adjusted flow

0

5

10

15

20

25

30



the downward pressure on yields and so on. Over the summer, net supply of government bonds after ECB purchases becomes deeply negative again. This also holds for the covered bonds, as June will be the peak month in terms of redemptions, money that investors need to put to work again. Moreover, covered bond spreads should narrow again as this is the third consecutive year of negative net supply. Meanwhile, in the case of agencies scarcity is even more acute than in the case of government bonds, which should see them outperform.

Box 1: When scarcity kicks in, what will the ECB do? ECB President Mario Draghi has mentioned on several occasions that the QE programme has a flexible set up and that it can change over time. We judge that when scarcity kicks in, the ECB will once again change the programme by increasing the universe of eligible bonds. Alternative options to alleviate scarcity of government bonds include the lowering of the forward guidance, detaching the floor of –20bps, breaching the maximum amount held by Collective Action Clause and abandoning the ECB capital key for the composition of its purchases. However, we think that an expansion of the universe would be the most plausible as other alternatives will be either politically not feasible or ineffective. The trump card: inclusion of Länder bonds The most effective way from a big picture perspective to alleviate scarcity of especially AAA bonds is to include German Länder bonds. If the ECB were to decide to add Länder bonds to its list, we calculate that it would alleviate scarcity of German bonds significantly. However, we also come to the conclusion that scarcity of German government bonds will not be fully eradicated. We think that including Länder bonds will at best bring scarcity of Bunds more into line with other core eurozone government bond markets. Including this new asset class would make sense, as it makes up for the largest sub sovereign market in the eurozone. Total outstanding Länder bonds between 2 and 30 years, equate to around one third of the German government bond market. In addition, the credit quality of Länder bonds is high, which would be important for the Bundesbank. The strong credit quality can be explained by the implicit guarantee of the German Federal government, the equal footing of the German states with the Federal government and the solidarity principle between German states. Although it makes sense from an economic perspective to include Länder bonds, we do think

that before Länder bonds can be included, some political obstacles will first need to be solved in the Governing Council. Inclusion of corporate bonds is unlikely but still an option Another option to alleviate the tightness in the government bond and SSA markets would be to include nonfinancial corporate bonds in the eligible universe. ECB Governing Council member Hansson said in an interview in April that the expansion of the list of eligible institutions was a “first stage” in the discussion of what else could be included. He also said that in the “second stage” in the coming months, it will be discussed if and how much corporate debt should be included. The total pool of senior bonds of eurozone nonfinancial investment grade issuers is EUR 500bn. Still, there are some issues with corporate bonds. For example, the ECB concluded earlier this year that the credit easing potential of corporate bond issues would be rather small, given the market size and the yield level at that time. However, the ECB did not exclude broadening its scope to corporate bonds in the future. Another issue is liquidity in the secondary corporate bond market. The liquidity in the secondary market for corporate bonds is already much lower than is the case in the government bond market or covered bond market.

Ongoing QE supportive of 2s5s flatteners We judge that the ongoing QE purchases will push core government bond yields down, although we do not think we will reach the lows seen earlier in the year. The downward move in yields will mostly be accompanied by curve flattening, especially in 2s5s, which is much steeper than even before the announcement of QE. We are also supportive of country spreads, as we think that risk sentiment will improve further on the back of improved economic momentum and the search for yield. As noted above, this assumes crucially that there will be an agreement between Greece and its creditors. Ongoing QE supportive of spreads We expect credit spreads to slowly grind tighter as the QE programme progresses. A major driver of spreads will be supply. We expect that many issuers still want to make use of the low yield environment as long as it lasts. If the primary market succeeds in controlling the volume of new deals to a digestible flow, it will be supportive for spreads and we will revisit the levels seen earlier in the beginning of March. On the other hand, if we return to the high volumes of February and March, the secondary market won’t be able to absorb the flow and spreads will be pushed wider.


the downward pressure on yields and so on. Over the summer, net supply of government bonds after ECB purchases becomes deeply negative again. This also holds for the covered bonds, as June will be the peak month in terms of redemptions, money that investors need to put to work again. Moreover, covered bond spreads should narrow again as this is the third consecutive year of negative net supply. Meanwhile, in the case of agencies scarcity is even more acute than in the case of government bonds, which should see them outperform.

Box 1: When scarcity kicks in, what will the ECB do? ECB President Mario Draghi has mentioned on several occasions that the QE programme has a flexible set up and that it can change over time. We judge that when scarcity kicks in, the ECB will once again change the programme by increasing the universe of eligible bonds. Alternative options to alleviate scarcity of government bonds include the lowering of the forward guidance, detaching the floor of –20bps, breaching the maximum amount held by Collective Action Clause and abandoning the ECB capital key for the composition of its purchases. However, we think that an expansion of the universe would be the most plausible as other alternatives will be either politically not feasible or ineffective. The trump card: inclusion of Länder bonds The most effective way from a big picture perspective to alleviate scarcity of especially AAA bonds is to include German Länder bonds. If the ECB were to decide to add Länder bonds to its list, we calculate that it would alleviate scarcity of German bonds significantly. However, we also come to the conclusion that scarcity of German government bonds will not be fully eradicated. We think that including Länder bonds will at best bring scarcity of Bunds more into line with other core eurozone government bond markets. Including this new asset class would make sense, as it makes up for the largest sub sovereign market in the eurozone. Total outstanding Länder bonds between 2 and 30 years, equate to around one third of the German government bond market. In addition, the credit quality of Länder bonds is high, which would be important for the Bundesbank. The strong credit quality can be explained by the implicit guarantee of the German Federal government, the equal footing of the German states with the Federal government and the solidarity principle between German states. Although it makes sense from an economic perspective to include Länder bonds, we do think

that before Länder bonds can be included, some political obstacles will first need to be solved in the Governing Council. Inclusion of corporate bonds is unlikely but still an option Another option to alleviate the tightness in the government bond and SSA markets would be to include nonfinancial corporate bonds in the eligible universe. ECB Governing Council member Hansson said in an interview in April that the expansion of the list of eligible institutions was a “first stage” in the discussion of what else could be included. He also said that in the “second stage” in the coming months, it will be discussed if and how much corporate debt should be included. The total pool of senior bonds of eurozone nonfinancial investment grade issuers is EUR 500bn. Still, there are some issues with corporate bonds. For example, the ECB concluded earlier this year that the credit easing potential of corporate bond issues would be rather small, given the market size and the yield level at that time. However, the ECB did not exclude broadening its scope to corporate bonds in the future. Another issue is liquidity in the secondary corporate bond market. The liquidity in the secondary market for corporate bonds is already much lower than is the case in the government bond market or covered bond market.

Ongoing QE supportive of 2s5s flatteners We judge that the ongoing QE purchases will push core government bond yields down, although we do not think we will reach the lows seen earlier in the year. The downward move in yields will mostly be accompanied by curve flattening, especially in 2s5s, which is much steeper than even before the announcement of QE. We are also supportive of country spreads, as we think that risk sentiment will improve further on the back of improved economic momentum and the search for yield. As noted above, this assumes crucially that there will be an agreement between Greece and its creditors. Ongoing QE supportive of spreads We expect credit spreads to slowly grind tighter as the QE programme progresses. A major driver of spreads will be supply. We expect that many issuers still want to make use of the low yield environment as long as it lasts. If the primary market succeeds in controlling the volume of new deals to a digestible flow, it will be supportive for spreads and we will revisit the levels seen earlier in the beginning of March. On the other hand, if we return to the high volumes of February and March, the secondary market won’t be able to absorb the flow and spreads will be pushed wider.


Credit resilient during Bund tantrum Index %


Covered bonds also resilient during Bund tantrum Asw-spread iBoxx euro benchmark covered bond index (bps)


Tightening of covered bond spreads in bps (asw-spread)


Spreads of covered bonds are also expected to continue to tighten, albeit to a lesser extent than in previous years. The ECB has bought around EUR 11-12bn a month of covered bonds since the start of the year and although we still expect purchases to slow somewhat during the remainder of the year, CBPP3 will result in paper becoming increasingly scarce. We

have estimated that negative net supply will amount to EUR 17bn this year, but correcting for the ECB’s purchases in the primary market, this amount might rise to EUR 50bn. We think that the potential for tightening of spreads of covered bonds is the largest in the periphery, reflecting higher spread levels, as covered bonds are already quite expensive in the (semi) core countries. Spreads of non-CBPP3 eligible paper, such as Canadian and Australian covered bonds, are also expected to tighten further, as they are trading with a pickup versus (semi) core covered bonds. Further euro weakness ahead Ongoing QE and – as a result – lower core government bond yields should put downward pressure on the euro in the coming months. At the same time, we expect the Fed to hike its policy rates in September, which should see a stepping up of investor expectations for US short term interest rates. This policy divergence should see the EUR/USD falling significantly further. Lessons from the US taper ‘dry-run’ Looking further forward, how will the ECB’s QExit impact markets? Again we can draw on lessons from the US. US Treasury yields rose significantly after the previous Fed Chairman, Ben Bernanke, raised the possibility that the Fed would taper its asset purchases (see graph below). Increase of yield after the taper speech 10y, %


00.10.20.30.40.50.60.70.8

2030405060708090

1/1/15 1/2/15 1/3/15 1/4/15 1/5/15

iBoxx Non-financials (lha) 10y Bund yield (rha)

-50

0

50

100

150

200

250

07 08 09 10 11 12 13 14 15

CBPP3

97

-36

72 67

-89-65

-33 -16

-100

-50

0

50

100

150

2008 2009 2010 2011 2012 2013 2014 2015

1.5

2.0

2.5

3.0

May-13 Jun-13 Jul-13 Aug-13 Sep-13

10y Treasury

Bernanke taper speech


Credit resilient during Bund tantrum Index %


Covered bonds also resilient during Bund tantrum Asw-spread iBoxx euro benchmark covered bond index (bps)


Tightening of covered bond spreads in bps (asw-spread)


Spreads of covered bonds are also expected to continue to tighten, albeit to a lesser extent than in previous years. The ECB has bought around EUR 11-12bn a month of covered bonds since the start of the year and although we still expect purchases to slow somewhat during the remainder of the year, CBPP3 will result in paper becoming increasingly scarce. We

have estimated that negative net supply will amount to EUR 17bn this year, but correcting for the ECB’s purchases in the primary market, this amount might rise to EUR 50bn. We think that the potential for tightening of spreads of covered bonds is the largest in the periphery, reflecting higher spread levels, as covered bonds are already quite expensive in the (semi) core countries. Spreads of non-CBPP3 eligible paper, such as Canadian and Australian covered bonds, are also expected to tighten further, as they are trading with a pickup versus (semi) core covered bonds. Further euro weakness ahead Ongoing QE and – as a result – lower core government bond yields should put downward pressure on the euro in the coming months. At the same time, we expect the Fed to hike its policy rates in September, which should see a stepping up of investor expectations for US short term interest rates. This policy divergence should see the EUR/USD falling significantly further. Lessons from the US taper ‘dry-run’ Looking further forward, how will the ECB’s QExit impact markets? Again we can draw on lessons from the US. US Treasury yields rose significantly after the previous Fed Chairman, Ben Bernanke, raised the possibility that the Fed would taper its asset purchases (see graph below). Increase of yield after the taper speech 10y, %


00.10.20.30.40.50.60.70.8

2030405060708090

1/1/15 1/2/15 1/3/15 1/4/15 1/5/15

iBoxx Non-financials (lha) 10y Bund yield (rha)

-50

0

50

100

150

200

250

07 08 09 10 11 12 13 14 15

CBPP3

97

-36

72 67

-89-65

-33 -16

-100

-50

0

50

100

150

2008 2009 2010 2011 2012 2013 2014 2015

1.5

2.0

2.5

3.0

May-13 Jun-13 Jul-13 Aug-13 Sep-13

10y Treasury

Bernanke taper speech


Steepening of Treasury 5s10s after tapering in bps


During this period which we refer to as the tapering dry run, the Treasury curve steepened (see graph above for 5s10s). During the tapering dry run, US credit spreads were resilient. Although they widened initially, they started to tighten again before long. Indeed, despite the increased volatility in the credit market, spreads on balance tightened (see graphs below and above on the right). Equity markets also performed well. The resilience of risky assets could reflect that Fed tapering was also seen as a sign of confidence in the economic outlook, which may have led investors to ratchet up their growth expectations. Impact of dry-run on US non-financial spreads Bps (asw-spread)


Impact of dry-run on risky assets in %


Steepeners and short duration on QExit… When expectations of the ECB’s exit from QE take hold at the turn of next year, we would expect a sharp rise in government bond yields and curves to steepen, mirroring the taper tantrum in the US. Upward yield movements of shorter maturing bonds will be compressed by the ongoing availability of excess money market liquidity. We also think that the ECB will keep its monetary policy rates unchanged for the foreseeable future, which will also dampen the impact on short end government bonds. In such an environment, short duration and steepening trades would likely make sense. …and tighter swap and peripheral spreads… In the run up to QE, we have also observed a strong performance of cash government bonds vs swaps. We expect this ASW move to reverse as yields on government bonds are likely to rise. With regards to country spreads, we remain largely supportive, especially for peripheral spreads. Spreads of core government bonds are already trading at very tight levels, almost as close to pre-crisis levels. Therefore we do not see much value in these spreads. The relative value perspective in peripheral spreads is better, especially as spreads on the back of a possible Grexit have underperformed. We expect that as expectations about the economic outlook improve and a Greek exit will be avoided investors will search for yield and that peripheral spreads will benefit from this. Of course a lot depends on levels when QExit expectations start to build. …as well as credits Meanwhile, the US experience suggests that credit spreads could actually tighten, also likely helped by the improved economic growth outlook. Overweighting credit in the belly of the curve could provide some relative protection. By the time the QExit is announced, companies will report better results on the back of improving economic conditions. Growth prospects

20406080

100120140

08 09 10 11 12 13 14

QE Tapering dry run Tapering US 5s/10s (lhs)

120

130

140

150

160

170

180

May-13 Jun-13 Jul-13 Aug-13

-3

-2

-1

0

1

2

3

1US IG credit US HY creditS&P 500 Dow JonesUS 10y Treasury (% pt.)


Steepening of Treasury 5s10s after tapering in bps


During this period which we refer to as the tapering dry run, the Treasury curve steepened (see graph above for 5s10s). During the tapering dry run, US credit spreads were resilient. Although they widened initially, they started to tighten again before long. Indeed, despite the increased volatility in the credit market, spreads on balance tightened (see graphs below and above on the right). Equity markets also performed well. The resilience of risky assets could reflect that Fed tapering was also seen as a sign of confidence in the economic outlook, which may have led investors to ratchet up their growth expectations. Impact of dry-run on US non-financial spreads Bps (asw-spread)


Impact of dry-run on risky assets in %


Steepeners and short duration on QExit… When expectations of the ECB’s exit from QE take hold at the turn of next year, we would expect a sharp rise in government bond yields and curves to steepen, mirroring the taper tantrum in the US. Upward yield movements of shorter maturing bonds will be compressed by the ongoing availability of excess money market liquidity. We also think that the ECB will keep its monetary policy rates unchanged for the foreseeable future, which will also dampen the impact on short end government bonds. In such an environment, short duration and steepening trades would likely make sense. …and tighter swap and peripheral spreads… In the run up to QE, we have also observed a strong performance of cash government bonds vs swaps. We expect this ASW move to reverse as yields on government bonds are likely to rise. With regards to country spreads, we remain largely supportive, especially for peripheral spreads. Spreads of core government bonds are already trading at very tight levels, almost as close to pre-crisis levels. Therefore we do not see much value in these spreads. The relative value perspective in peripheral spreads is better, especially as spreads on the back of a possible Grexit have underperformed. We expect that as expectations about the economic outlook improve and a Greek exit will be avoided investors will search for yield and that peripheral spreads will benefit from this. Of course a lot depends on levels when QExit expectations start to build. …as well as credits Meanwhile, the US experience suggests that credit spreads could actually tighten, also likely helped by the improved economic growth outlook. Overweighting credit in the belly of the curve could provide some relative protection. By the time the QExit is announced, companies will report better results on the back of improving economic conditions. Growth prospects

20406080

100120140

08 09 10 11 12 13 14

QE Tapering dry run Tapering US 5s/10s (lhs)

120

130

140

150

160

170

180

May-13 Jun-13 Jul-13 Aug-13

-3

-2

-1

0

1

2

3

1US IG credit US HY creditS&P 500 Dow JonesUS 10y Treasury (% pt.)


will improve and balance sheets will strengthen further. We expect spreads to tighten during this phase of the cycle. We would position ourselves overweight credit, in particular in high beta BBB rated segment and hybrids category if volatility is not an issue. However, name selection will be more important as event risk rises. We also expect that the steepening of the Bund curve will move investors out of the longer end and into the belly of the curve. Agencies could underperform… In sub sovereign (national agency) names we are very selective. Names which are eligible for QE buying have outperformed government bonds and have been or are in some cases trading flat to their comparable government bonds. We do not think that these names will continue to trade as close to the government bond curves when QExit approached.. …as could covered bonds, especially peripherals In the event of a QExit, we think that peripheral covered bonds will be hit hardest. Not only did these bonds benefit the most from CBPP3 (in terms of spread tightening), but we also expect relatively more supply from the periphery than from the (semi) core. This is based on the fact that peripheral banks borrowed relatively large amounts from the ECB (in the LTROs), which they are unable to match in the TLTRO operations. As a result, peripheral banks will have a funding gap. We think they will partially fill this gap by issuing more covered bonds, as this has become increasingly attractive for peripheral banks. Brightening economic prospects could work in the opposite direction, keeping investors in the periphery and dampening the spread widening. In the (semi) core, we expect spreads of covered bonds to widen more modestly than in the periphery. Bonds from the (semi) core were hit less during the taper dry-run in the US. Moreover, their spreads have tightened more moderately than their peripheral counterparts during QE in the eurozone, which also limits the widening potential. Furthermore, we expect supply by banks in (semi) core countries to remain suppressed as they will increasingly use TLTROs. This is likely to replace some other types of funding, such as covered bonds. Overall, this will increase scarcity of (semi) core paper, which will dampen the widening of spreads in the (semi) core as well. Euro to revive on QExit Finally, as QExit expectations rise, we think the euro exchange rate will rebound. By that point, the Fed rate hike cycle will be largely priced in, while eurozone core bond yields will rise as investors factor in the end of asset purchases. This means the

bond yield spread between the US and Germany would narrow again, which is usually euro supportive.


will improve and balance sheets will strengthen further. We expect spreads to tighten during this phase of the cycle. We would position ourselves overweight credit, in particular in high beta BBB rated segment and hybrids category if volatility is not an issue. However, name selection will be more important as event risk rises. We also expect that the steepening of the Bund curve will move investors out of the longer end and into the belly of the curve. Agencies could underperform… In sub sovereign (national agency) names we are very selective. Names which are eligible for QE buying have outperformed government bonds and have been or are in some cases trading flat to their comparable government bonds. We do not think that these names will continue to trade as close to the government bond curves when QExit approached.. …as could covered bonds, especially peripherals In the event of a QExit, we think that peripheral covered bonds will be hit hardest. Not only did these bonds benefit the most from CBPP3 (in terms of spread tightening), but we also expect relatively more supply from the periphery than from the (semi) core. This is based on the fact that peripheral banks borrowed relatively large amounts from the ECB (in the LTROs), which they are unable to match in the TLTRO operations. As a result, peripheral banks will have a funding gap. We think they will partially fill this gap by issuing more covered bonds, as this has become increasingly attractive for peripheral banks. Brightening economic prospects could work in the opposite direction, keeping investors in the periphery and dampening the spread widening. In the (semi) core, we expect spreads of covered bonds to widen more modestly than in the periphery. Bonds from the (semi) core were hit less during the taper dry-run in the US. Moreover, their spreads have tightened more moderately than their peripheral counterparts during QE in the eurozone, which also limits the widening potential. Furthermore, we expect supply by banks in (semi) core countries to remain suppressed as they will increasingly use TLTROs. This is likely to replace some other types of funding, such as covered bonds. Overall, this will increase scarcity of (semi) core paper, which will dampen the widening of spreads in the (semi) core as well. Euro to revive on QExit Finally, as QExit expectations rise, we think the euro exchange rate will rebound. By that point, the Fed rate hike cycle will be largely priced in, while eurozone core bond yields will rise as investors factor in the end of asset purchases. This means the

bond yield spread between the US and Germany would narrow again, which is usually euro supportive.


DISCLAIMER ABN AMRO Bank Gustav Mahlerlaan 10 (visiting address) P.O. Box 283 1000 EA Amsterdam The Netherlands This material has been generated and produced by a Fixed Income Strategist (“Strategists”). Strategists prepare and produce trade commentary, trade ideas, and other analysis to support the Fixed Income sales and trading desks. The information in these reports has been obtained or derived from public available sources; ABN AMRO Bank NV makes no representations as to its accuracy or completeness. The analysis of the Strategists is subject to change and subsequent analysis may be inconsistent with information previously provided to you. Strategists are not part of any department conducting ‘Investment Research’ and do not have a direct reporting line to the Head of Fixed Income Trading or the Head of F ixed Income Sales. The view of the Strategists may differ (materially) from the views of the Fixed Income Trading and sales desks or from the view of the Departments conducting ‘Investment Research’ or other divisions This marketing communication has been prepared by ABN AMRO Bank N.V. or an affiliated company (‘ABN AMRO’) and for the purposes of Directive 2004/39/EC has not been prepared in accordance with the legal and regulatory requirements designed to promote the independence of research. As such regulatory restrictions on ABN AMRO dealing in any financial instruments mentioned in this marketing communication at any time before it is distributed to you do not apply.

This marketing communication is for your private information only and does not constitute an analysis of all potentially material issues nor does it constitute an offer to buy or sell any investment. Prior to entering into any transaction with ABN AMRO, you should consider the relevance of the information contained herein to your decision given your own investment objectives, experience, financial and operational resources and any other relevant circumstances. Views expressed herein are not intended to be and should not be viewed as advice or as a recommendation. You should take independent advice on issues that are of concern to you. Neither ABN AMRO nor other persons shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this communication.

Any views or opinions expressed herein might conflict with investment research produced by ABN AMRO.

ABN AMRO and its affiliated companies may from time to time have long or short positions in, buy or sell (on a principal basis or otherwise), make markets in the securities or derivatives of, and provide or have provided, investment banking, commercial banking or other services to any company or issuer named herein. Any price(s) or value(s) are provided as of the date or time indicated and no representation is made that any trade can be executed at these prices or values. In addition, ABN AMRO has no obligation to update any information contained herein. This marketing communication is not intended for distribution to retail clients under any circumstances. This presentation is not intended for distribution to, or use by any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation. In particular, this presentation must not be distributed to any person in the United States or to or for the account of any “US persons” as defined in Regulation S of the United States Securities Act of 1933, as amended. CONFLICTS OF INTEREST/ DISCLOSURES This report contains the views, opinions and recommendations of ABN AMRO (AA) strategists. Strategists routinely consult with AA sales and trading desk personnel regarding market information including, but not limited to, pricing, spread levels and trading activity of a specific fixed income security or financial instrument, sector or other asset class. AA is a primary dealer for the Dutch state and is a recognized dealer for the German state. To the extent that this report contains trade ideas based on macro views of economic market conditions or relative value, it may differ from the fundamental credit opinions and recommendations contained in credit sector or company research reports and from the views and opinions of other departments of AA and its affiliates. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and reports. In addition, strategists receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, trading desk and firm revenues and competitive factors. As a general matter, AA and/or its affiliates normally make a market and trade as principal in securities discussed in marketing communications. ABN AMRO is authorised by De Nederlandsche Bank and regulated by the Financial Services Authority; regulated by the AFM for the conduct of business in the Netherlands and the Financial Services Authority for the conduct of UK business.

Copyright 2015 ABN AMRO. All rights reserved. This communication is for the use of intended recipients only and the contents may not be reproduced, redistributed, or copied in whole or in

part for any purpose without ABN AMRO's prior express consent.


DISCLAIMER ABN AMRO Bank Gustav Mahlerlaan 10 (visiting address) P.O. Box 283 1000 EA Amsterdam The Netherlands This material has been generated and produced by a Fixed Income Strategist (“Strategists”). Strategists prepare and produce trade commentary, trade ideas, and other analysis to support the Fixed Income sales and trading desks. The information in these reports has been obtained or derived from public available sources; ABN AMRO Bank NV makes no representations as to its accuracy or completeness. The analysis of the Strategists is subject to change and subsequent analysis may be inconsistent with information previously provided to you. Strategists are not part of any department conducting ‘Investment Research’ and do not have a direct reporting line to the Head of Fixed Income Trading or the Head of F ixed Income Sales. The view of the Strategists may differ (materially) from the views of the Fixed Income Trading and sales desks or from the view of the Departments conducting ‘Investment Research’ or other divisions This marketing communication has been prepared by ABN AMRO Bank N.V. or an affiliated company (‘ABN AMRO’) and for the purposes of Directive 2004/39/EC has not been prepared in accordance with the legal and regulatory requirements designed to promote the independence of research. As such regulatory restrictions on ABN AMRO dealing in any financial instruments mentioned in this marketing communication at any time before it is distributed to you do not apply.

This marketing communication is for your private information only and does not constitute an analysis of all potentially material issues nor does it constitute an offer to buy or sell any investment. Prior to entering into any transaction with ABN AMRO, you should consider the relevance of the information contained herein to your decision given your own investment objectives, experience, financial and operational resources and any other relevant circumstances. Views expressed herein are not intended to be and should not be viewed as advice or as a recommendation. You should take independent advice on issues that are of concern to you. Neither ABN AMRO nor other persons shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this communication.

Any views or opinions expressed herein might conflict with investment research produced by ABN AMRO.

ABN AMRO and its affiliated companies may from time to time have long or short positions in, buy or sell (on a principal basis or otherwise), make markets in the securities or derivatives of, and provide or have provided, investment banking, commercial banking or other services to any company or issuer named herein. Any price(s) or value(s) are provided as of the date or time indicated and no representation is made that any trade can be executed at these prices or values. In addition, ABN AMRO has no obligation to update any information contained herein. This marketing communication is not intended for distribution to retail clients under any circumstances. This presentation is not intended for distribution to, or use by any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation. In particular, this presentation must not be distributed to any person in the United States or to or for the account of any “US persons” as defined in Regulation S of the United States Securities Act of 1933, as amended. CONFLICTS OF INTEREST/ DISCLOSURES This report contains the views, opinions and recommendations of ABN AMRO (AA) strategists. Strategists routinely consult with AA sales and trading desk personnel regarding market information including, but not limited to, pricing, spread levels and trading activity of a specific fixed income security or financial instrument, sector or other asset class. AA is a primary dealer for the Dutch state and is a recognized dealer for the German state. To the extent that this report contains trade ideas based on macro views of economic market conditions or relative value, it may differ from the fundamental credit opinions and recommendations contained in credit sector or company research reports and from the views and opinions of other departments of AA and its affiliates. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and reports. In addition, strategists receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, trading desk and firm revenues and competitive factors. As a general matter, AA and/or its affiliates normally make a market and trade as principal in securities discussed in marketing communications. ABN AMRO is authorised by De Nederlandsche Bank and regulated by the Financial Services Authority; regulated by the AFM for the conduct of business in the Netherlands and the Financial Services Authority for the conduct of UK business.

Copyright 2015 ABN AMRO. All rights reserved. This communication is for the use of intended recipients only and the contents may not be reproduced, redistributed, or copied in whole or in

part for any purpose without ABN AMRO's prior express consent.

192395 bb a4 the path to qexit qr lr

Documents