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Deutsche Bank Markets Research

Global

Rates Credit

Date 17 January 2014

Global Fixed Income Weekly

________________________________________________________________________________________________________________

Deutsche Bank AG/London

DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013.

Francis Yared

Strategist (+44) 020 754-54017 [email protected]

Dominic Konstam

Research Analyst (+1) 212 250-9753 [email protected]

Strategically, there is still upside potential to UST 5Y yields, and scope for (more limited) tightening in peripheral spreads.

The market may remain in a range for now as a material repricing of monetary policy will require first some signs of normalization of inflation and positioning is more balanced.

An analysis of the shape of the money market curve suggests that a Dec-16 – Dec-18 flattener represents an asymmetric risk reward.

The declining excess liquidity in the Eurozone is mechanically putting upward pressure on spot money market rates. However, the market remains reasonably confident that the ECB is willing and able to control the front-end.

In Europe, we adapt our trade recommendations to the risk of a more aggressive ECB. We maintain Bund ASW wideners and switch periphery spread tighteners vs. swaps rather than vs. Bunds. We also recommend a 5Y-30Y steepener and a 5Y5Y-5Y30Y conditional steepener with payers.

Leading indicators point to a pick-up in wage growth in the US and UK this year, which would be a positive for B/Es, but may be a slow process; we see medium-term upside for B/Es. In RV, across markets, we prefer 30y UK RPI over 30y USD CPI and 1y1y EUR HICP v 1y1y FRF CPI. In USD, 5y CPI looks relatively low v 2y and 10y wings. In GBP and EUR, we find 10y RPI/CPI rich compared to 5y and 30y.

Our ongoing theme remains that though economic healing warrants rates well above the cyclical lows - and higher than current spot levels - the forwards are aggressively priced and we expect that rates will not beat the forwards at a 1y horizon. Though the historical data from recent decades encompass a secular bull market, we observe that bearish trades very rarely beat the forwards, particularly at one year horizons and expressed through 10y rates.

With spot and 1y forward 10y USD - EUR lingering near multi-year highs, we like spread tighteners as a moderately bearish trade, either outright or conditionally via payers.

Historically, shorting the market outright has not been a good trade because of the associated negative carry. Bearish investors with a high conviction that rates can move above forwards should look for ideal entry and holding periods. We analyze a combination of swap tenors and trade horizons to determine the shorts that could stand the highest chance of being profitable. Conditioned on the Fed hiking rates in the next 12 months, outright shorts in the 2y rate have historically been more successful than in 10s.

As an alternative to bearish trades in rates, investors should look for a good entry level to be short mortgages later this year based on the expected supply and demand imbalance amid taper and the seasonal issuance trend in MBS.

Table of contents

Bond Market Strategy Page 02

US Overview Page 07

Treasuries 4

Derivatives Page 20

Agencies Page 24

Mortgages Page 25

US Credit Strategy Page 34

Euroland Strategy Page 38

European ABS Update Page 44

Covered Bond Update Page 45

UK Strategy Page 48

Nordic Strategy Page 51

Japan Strategy Page 56

Global Relative Value Page 60

Dollar Bloc Strategy Page 68

Inflation-Linked Page 79

Global Inflation Update Page 83

17 January 2014



Global

Rates Gov. Bonds & Swaps Rates Volatility

Bond Market Strategy

Strategically, there is still upside potential to UST 5Y yields, and scope for (more limited) tightening in peripheral spreads

The market may remain in a range for now as a material repricing of monetary policy will require first some signs of normalization of inflation and positioning is more balanced

An analysis of the shape of the money market curve suggests that a Dec-16 – Dec-18 flattener represents an asymmetric risk reward

In Europe, we adapt our trade recommendations to the risk of a more aggressive ECB. We maintain Bund ASW wideners and switch periphery spread tighteners vs. swaps rather than vs. Bunds. We also recommend a 5Y-30Y steepener and a 5Y5Y-5Y30Y conditional steepener with payers.

Stuck

The view: Strategically, there is still upside potential to UST 5Y yields, and scope for (more limited) tightening in peripheral spreads. However, a material repricing of monetary policy will require first some signs of normalization of inflation. In Europe, we tweak our trade recommendations to account for the risk of a more aggressive ECB than we expect.

The rationale: In the US, the data remains broadly in line with our macro view (retail sales, regional surveys, jobless claims). As long as the data remains consistent with the FOMC’s projections, the December FOMC rate forecast should constitute a lower bound for front-end rates. The market should add some risk premium to the December “dots”, as the risk will remain tilted towards upward rather than downward revisions of the forecasts. However, such risk premium will likely remain modest without further hard evidence (so far lacking) that inflation is normalizing. Our analysis suggests that inflation should (slowly) normalize over the course of the year as wages and core inflation tend to be lagging indicators of unemployment and the ISMs. In the meantime, the front-end may remain stuck in a relatively narrow range, especially as positioning is now more balanced. Given our strategic view and current pricing (close to the dots), we nonetheless maintain our short 5Y recommendation.

Also, we find standard carry considerations in the front-end of the curve misleading. As long as the data supports rate hikes in H2 2015, a calendar based analysis (i.e. pricing vs. the FOMC forecasts on specific dates), will probably be a better reflection of the risk premium embedded in the front-end of the curve. Indeed, running a scenario analysis using the December distribution of rates forecasts by FOMC members, we find that a Dec-16 – Dec-18 flattener offers a particularly asymmetric risk/reward. It should perform under a scenario consistent with the more hawkish FOMC forecasts and even have limited upside under a scenario consistent with the more dovish FOMC forecasts.

In Europe, we continue to have a positive bias for peripheral spreads, but the upside prospects remain limited. Our base case remains that the data will be good enough for the ECB not to embark on any material additional easing. However, as pointed out by our economists, the threshold for more decisive

Francis Yared


Soniya Sadeesh

Strategist (+44) 0 207 547 3091 [email protected]

Abhishek Singhania


Jerome Saragoussi


17 January 2014



action has been lowered. Thus, we adapt our portfolio of recommendations to account for the risk of an ECB QE. More specifically, if the ECB moves to implement QE, it is likely to do so on a pro-rata basis along its capital keys, and avoid extending to the long-end of the curve. This should benefit the lower (marketable) debt-to-GDP countries and have limited impact beyond the 10Y point. At the margin, Italy, Belgium and France should benefit less than Spain, Germany and other semi-core names. Also, the long-end of the curve should remain steep.

The trades: We maintain the short 5Y UST, and receiving 10s in 5s10s30s. We also recommend a Dec-16 – Dec-18 ED flattener. In Europe, we rotate our long BTP-Bund into a BTP ASW tightener (in line with our Bund ASW bias). We also rotate our short Austria-Bund into a short France-Bund. We maintain our long Bund-ASW and long 5Y Breakevens. We also recommend a 5s30s steepener and a 5Y5Y-5Y30Y conditional bear steepener, attractive from a carry and vol perspective.

Waiting for the next trigger

Since the December FOMC meeting, the pricing of future Fed Funds rates by the market has hovered around the scenario implied by the median of FOMC dots. At the time of writing, the market is pricing the FOMC’s median forecast with a small risk premium of 5-10bp. We expect the FOMC dots to correspond to a lower bound for the market given:

Our constructive macro scenario based on an improving fiscal impulse and a robust credit impulse

The change in composition of the FOMC. Seven of the twelve voting members on the FOMC will have been replaced by the time of the March FOMC meeting. Bernanke, Duke and Raskin are leaving on the board, and rotating positions will be replaced by regional presidents that are on average more hawkish (for instance Evans and Rosengren replaced by Plosser and Fisher).

The limited impact of tapering on long-term forward rates such as 5y5y (as tapering was mostly priced in), but also on volatility and risky assets. In particular, the positive reaction of US equities gives the Fed little incentive to further strengthen its forward guidance. Indeed, the Fed strengthened its forward guidance most likely as a risk management tool ahead of tapering (as opposed to being fully consistent with the FOMC’s growth forecasts). Thus, if the data comes in line with the FOMC’s expectations, the Fed is more likely to revise upward than downward its rate forecast.

On this basis, the market should stabilize slightly above the median FOMC projections to embed a small risk premium, for instance 25bp above the median FOMC dots. For the market to price a sharper normalization of monetary policy, further evidence of a normalization of inflation is likely to be necessary. As we discuss below, our base case remains that core inflation will accelerate slowly by the end of the year and that wage inflation will increase. However in the short-run, inflation momentum remains mild, and there are no “smoking guns” to lead to a sharper repricing of the 5y sector.

On the wage front, the latest job report indicated some moderation in wage inflation relative to the previous month. Despite this decline, the upward trend in wage inflation is likely to resume, reflecting the reduction of the slack in the labour market, as summarized by the level of the unemployment rate excluding long-term unemployed (see graph below).

17 January 2014



Wage inflation is a lagging indicator of the

unemployment rate and has room to accelerate further

Core CPI YoY should drop to 1.6% before recovering

towards 1.9% by the end of the year

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Core CPI YoYDB Forecasts

Source: Deutsche Bank Source: Deutsche Bank

As for core inflation, the pipeline inflation picture is neutral (lower energy prices but recovering industrial metal prices) implying some stabilization of PPI inflation at a time when inflation from imported core goods seems to be bottoming. This suggests that inflation for core goods and services is likely to stabilize first and then recover slowly over the course of the year, pushing core CPI YoY towards 1.9% from 1.7% currently. However, core CPI could well drop towards 1.6% in the next couple of months on the back of significantly negative base effects on core CPI ex shelter in January and February. Moreover, the December CPI release revealed that medical care inflation was particularly soft, while shelter inflation remained strong. The combination of soft medical care inflation and resilient shelter inflation suggests that the wedge between core PCE and core CPI will remain wide in the short run (given the larger weighting of medical inflation in Core PCE basket and lower weighting of rent inflation in core PCE basket).

Market positioning (as per the CFTC data) does not send any short-term signal either. Speculative positioning in Treasury futures at a global level (i.e. from the 2Y futures to the long Bund futures) is close to neutral. Moreover models looking at the market reaction of the 10Y UST yield relative to theoretical market reactions implied by economic surprises indicate that recent market reactions are currently well aligned with theoretical moves implied by historical betas. This is consistent with a fairly neutral positioning and no substantial trading signal in the near term.

17 January 2014



Speculative position across the spectrum Treasury

futures is neutral on average

Positioning implied by market reaction to data surprises

shows market is mostly neutral

-12

-9

-6

-3

0

3

6

9

12

15

18

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Global Net speculative positions in Treasury futures (average % of open interest in 2Y, 5Y, 10Y, 30Y futures)

-1.5

-1

-0.5

0

0.5

1

1.5-5.00

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

Sep-11 Mar-12 Sep-12 Mar-13 Sep-13

Positioning index implied by UST10Y reaction to surprises

Subsequent 2M change in UST 10Y yield (rhs, inverted)


In the Global Relative Value section, we analyse more closely the shape of the money market curve between Dec-15 and Dec-18. We run scenario analyses based on the distribution of the FOMC rate forecasts using December “dots”. On this basis, we find that the Dec-16 –Dec-18 slope is probably too steep. For instance, in a scenario consistent with the 3rd most hawkish FOMC forecast, it should flatten by 80bp, helped by a particularly strong sell-off in Dec-16. However, even in a scenario consistent with the 3rd most dovish FOMC forecast, it should flatten by 4b as there is more room for a Dec-18 rally from current levels.

Adapting the portfolio to a more aggressive ECB

Given our macro outlook, we do not expect the ECB to embark on a material new easing. However, as pointed out by our economists, the threshold for more aggressive new measures, including QE has probably been lowered. In this context, we adapt our trade recommendations (which in any event would generally benefit from a more aggressive ECB) to such a scenario (see also Euroland Strategy for more details).

In a broad based QE, the ECB is likely to determine the proportion of buying of government bonds of Eurozone countries along its capital keys (i.e. close to GDP weighted). As a result, countries with lower (marketable) debt/GDP ratio will stand to benefit compared to countries with higher (marketable) debt/GDP ratios. Thus, Italy should benefit less than Spain, and Belgium and France should benefit less than other semi-core names, while Bunds could be one of the biggest beneficiaries. With this in mind, we maintain ASW widener on Bunds and recommend switching periphery spread tighteners vs. swaps rather than vs. Bunds. Also, we recommend switching our semi-core spread widener in Austria to France (vs. Bund).

17 January 2014



Countries with general govt. debt share lower than the ECB capital key

weights would stand to gain in a broad based ECB QE

(1) (2) [(1)-(2)]/(2)ECB capital key weight

General govt. debt share

Winners/ Losers

Germany 25.7% 23.6% 9.1%France 20.3% 21.0% -3.5%Italy 17.6% 22.8% -22.9%Spain 12.6% 10.4% 21.9%Netherlands 5.7% 4.9% 17.8%Belgium 3.5% 4.4% -19.0%Greece 2.9% 3.5% -16.5%Austria 2.8% 2.6% 9.7%Portugal 2.5% 2.4% 5.6%Finland 1.8% 1.2% 48.4%Ireland 1.7% 2.2% -26.2%Others 2.9% 1.2% 145.8%

0%

5%

10%

15%

20%

25%

30%

0% 5% 10% 15% 20% 25% 30%

Sha

re o

f Eur

ozon

e ge

nera

l gov

t. d

ebt

ECB capital key share (only Eurozone countries)

IT

ES

DE

Winners

Losers

Source: Deutsche Bank

In a broad based QE, the ECB will probably refrain from buying at the long-end of the curve to avoid increasing the pressure on the pension and insurance funds. This would suggest that the impact of an eventual QE would be limited beyond the 10Y point, and therefore be supportive for long-end steepeners (which should in general benefit from a more aggressive monetary policy).

We update our model for the 5Y-30Y slope, including Dutch pension fund solvency ratio as an explanatory variable (see Euroland Strategy for more details). The model shows that the EUR curve is close to fair value. Steepeners are nonetheless attractive given: (i) the positive carry on the trade, (ii) the fact that almost any form of ECB policy easing should support a higher risk-premium in the long-end of the curve (iii) the low level of long-dated forwards in EUR. In the Global Relative Value Section we recommend in particular a premium neutral 5Y fwd 5Y-30Y bear flattener which should benefit from the above-mentioned points with the additional benefit of an attractive vol picture.

Adding Dutch pension fund solvency

ratio to EUR 5Y-30Y slope model

EUR 5Y-30Y slope, sample daily data since Apr-2007Beta T-stat

EUR 2Y swap (%) -39.61 -79.4EUR 5Y5Y inflation swap (%) 31.34 18.3Italy-Germany spread (bp) -0.08 -21.0EUR 1Y30Y implied vol (bp) -0.36 -14.9Budget balance (% of GDP) -0.94 -4.0Dutch solvency ratio (%) 0.46 8.6R-sq 94.7%


17 January 2014



United States


US Overview

Our ongoing theme remains that though economic healing warrants rates well above the cyclical lows - and higher than current spot levels - the forwards are aggressively priced and we expect that rates will not beat the forwards at a 1y horizon. Though the historical data from recent decades encompass a secular bull market, we observe that bearish trades very rarely beat the forwards, particularly at one year horizons and expressed through 10y rates

With spot and 1y forward 10y USD - EUR lingering near multi-year highs, we like spread tighteners as a moderately bearish trade, either outright or conditionally via payers.

If recent economic forecasts, which reveal a high degree of consensus regarding the equity-bullish and bonds-bearish views, are in any way indicative of direction of the future market moves or positioning, the market could end up being exposed to adverse scenarios.

With current vol differentials, financing positions at the wings with 10Y vol allows for additional cushion for hedges against risk scenarios. We consider two different trades: 1) Vol flies: Sell $100mn 20bp wide 1Y10Y strangles vs. buy $200mn 1Y2Y and $25mn 1Y30Y straddles at zero net cost; 2) Financed payers in the wings by strangles in 10s: Sell $100mn 100bp wide 1Y10Y strangles vs. buy $200mn 1Y2Y and $25mn 1Y30Y ATMF payers at zero net cost

Historically, shorting the market outright has not been a good trade because of the associated negative carry. Bearish investors with a high conviction that rates can move above forwards should look for ideal entry and holding periods. We analyze a combination of swap tenors and trade horizons to determine the shorts that could stand the highest chance of being profitable. Conditioned on the Fed hiking rates in the next 12 months, outright shorts in the 2y rate have historically been more successful than in 10s.

The currently steep yield curve implies high forward rates relative to spot. The negative carry in many outright bearish trades and yield curve flatteners in rates is punitive; the hurdles to beat the forwards are high. As an alternative to bearish trades in rates, investors should look for a good entry level to be short mortgages later this year based on the expected supply and demand imbalance amid taper and the seasonal issuance trend in MBS.

Japanese investors are expected to fill some of the demand left by the Fed’s QE exit if Treasury yields remain attractive enough to JGBs. A stable US inflation rate, the expectations of further yen weakness, a potential for the BoJ to deliver more QE later this year, and the possibility of pent-up demand all argue for an increased buying of Treasuries from Japan in 2014.

Good shorts (are there any?)

Our ongoing theme remains that though economic healing warrants rates well above the cyclical lows - and higher than current spot levels - the forwards are aggressively priced and we expect that rates will not beat the forwards at a 1y horizon. Though the historical data from recent decades encompass a secular bull market, we observe that bearish trades very rarely beat the forwards, particularly at one year horizons and expressed through 10y rates.

Dominic Konstam


Aleksandar Kocic


Alex Li


Stuart Sparks


Daniel Sorid


Steven Zeng, CFA


17 January 2014



In the end of course the strength of the data and the Fed's reaction function will drive the market. As we discussed in our outlook pieces for 2014, we see three main scenarios for the forthcoming year. Steadfast Fed guidance in the face of ongoing economic healing, coupled with ongoing reductions in asset purchases could make the curve stubbornly steep, though we expect that the potential for bearish steepening is limited by risky assets' reactions to high long forward rates and potentially the asset allocation behavior of defined liability investors. Alternatively the curve could flatten bullishly - if data roll over - or bearishly if growth accelerates.

If it is right that potential growth is low, then a prolonged period of growth at Q3 levels would threaten inflation as a matter of time, with the operative question being simply when. Alternatively inflation is little threat if faster H2 2013 growth turns out to be a third post crisis "mini-cycle".

Alternatively it is plausible that potential could even have begun to creep back to or above pre-crisis levels, which would suggest that inflation remains low because of a widening output gap. Here accelerating growth would pose little problem for the Fed as real growth would bolster real rates but the Fed could have the luxury of allowing remaining slack to be absorbed.

Of these, the greatest threat to the scenario reflected in the forwards is perhaps the rapid growth/low potential combination. We have our doubts.

At this stage in the cycle, however, we favor looking at cross market opportunities. For example, spot and 1y10y USD-EUR remain near multi-year highs. A durable upturn in the US could restart the global growth engine, with a significant effect on Europe via global demand for Europe's capital goods exports. We would expect European rates to underperform the US in such a scenario. We note that - even if a small possibility - unsterilized ECB asset purchases could bolster longer traded inflation with a bearish effect on longer nominal rates.

In a more bearish economic outturn, weaker data could produce US outperformance as the market rallies back into the old range.

The forwards are nearly flat, with the 1y 10y USD- EUR spread only 3 bp wider than spot. USD vol, however, is significantly high. 1y10y USD vol is roughly 85bp, while it is 70 bp in EUR. This implies investors can enter (USD) BPV neutral cross market spread trades at zero premium outlay at levels better than the forwards.

Last week, we wrote that elevated forwards pose a major hurdle to bearish investors as outright short positions need to overcome a steep (negative) carry profile to become profitable. We calculated that since 1995 only 27 percent of outright shorts in the 10y rate were profitable over a one-year horizon, so an investor needs to have a high level of conviction, or a carefully executed strategy, or both, in order to profit from bearish trades.

The acute reader will ask “what about a short position in the 30y rate, or holding the trade for only three months instead of one year?” Our analysis attempts to answer that question. The tables below show the percentage of bearish trades that had beaten the forwards given various holding horizons and positions on different parts of the curve. The conclusion is that you can do better than the 27% success rate by executing a strategy different than paying 10s for 12 months. You can even get close to 2:1 odds at beating the forwards, but you must time your trade right.

17 January 2014



Percent of outright shorts that had beaten the forwards

over the trade horizon, 1995 – 2013


over the trade horizon, 2009H2 – 2013

1995 - 2013 Tenor2y 5y 7y 10y 15y 30y

1m 39% 40% 40% 41% 43% 45%3m 35% 35% 36% 40% 42% 43%6m 31% 34% 36% 39% 40% 42%9m 26% 28% 30% 32% 33% 35%1y 24% 23% 24% 27% 27% 30%

Trade Horizon

July 2009 - 2013 Tenor2y 5y 7y 10y 15y 30y

1m 35% 33% 36% 40% 44% 48%3m 21% 28% 31% 36% 41% 47%6m 12% 27% 35% 42% 49% 52%9m 6% 20% 28% 37% 43% 48%1y 2% 16% 22% 24% 27% 33%

Trade Horizon

Source: Bloomberg and Deutsche Bank Source: Bloomberg and Deutsche Bank

First, a couple of observations from the full-sample period study. Since 1996, no outright short strategy had been able to beat the forwards more than 50% of the time. Also, profitable bearish strategies have tended to have shorter horizons. Once a position is held for more than six months, the odds of being profitable dropped off considerably. Finally, an outright short in the 15y or the 30y rate has historically stood a better chance of beating the forwards than an outright short in 10s.

Looking at the post-crisis sample period which we define as 2009h2 and after, the percentage distribution of profitable shorts looks roughly the same with the exception of shorter tenor positions have had a much worse performance record than longer tenor positions. This makes sense, since short rates were held down by an ultra-dovish Fed over this entire period. However, if one thinks that the next 12 to 18 months will be an unwind of the Fed’s sponsorship of the front end, then the ideal location to put on an outright short should be in 2y rates.

To confirm this, we analyzed the profitability percentage distribution conditioned on the most recent tightening cycle, starting 12 months before the first hike and ending on the last hike date. Note that the distribution appears almost a mirror image of that of the last three years. Outright short positions in the 2y have had the most success, and the best holding horizon is six months to a year, which had been profitable two-thirds of the time. In contrast, shorting the 10y rate had only 50/50 odds of beating the forwards.


over the trade horizon, 3/2003 – 6/2006 (last hiking cycle)

6/2003 - 6/2006 Tenor2y 5y 7y 10y 15y 30y

1m 59% 50% 49% 48% 47% 46%3m 60% 42% 39% 54% 49% 46%6m 67% 46% 44% 52% 50% 49%9m 69% 52% 47% 41% 39% 40%1y 66% 39% 33% 47% 39% 37%

Trade Horizon

Source: Bloomberg and Deutsche Bank

An alternative to being short rates

The currently steep yield curve implies high forward rates relative to spot rates. The negative carry in many outright bearish trades and yield curve flatteners in rates is punitive. The hurdles to beat the forwards are high, especially in the intermediate sector of the yield curve. The one-year drop on the three- and five-year swap rates is more than 70bp.

17 January 2014



Being short the intermediate sector in US rates has punitive negative carry

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2yr 3yr 5yr 7yr 10yr 15yr 20yr 25yr 30yr

1yr


As an alternative to bearish trades in rates, investors should look for a good entry level to be short mortgages later this year based on the expected supply and demand imbalance amid taper and the seasonal issuance trend in MBS. The Fed has been a major buyer of MBS in QE3, in the order of 250% of the supply according to Flow of Funds data. Other investors, such as households, foreigners, mutual funds, and brokers/dealers have been net sellers. Once the Fed exits, those investors will have to step in to replace the Fed.

Supply and demand for Agency & GSE-backed Securities when there was no

QE

No QE: 3Q2011 2Q2011 3Q2011 Change % supplyHousehold sector 393$ 325$ (67)$ -938%Foreign investors 1,074$ 1,092$ 18$ 244%Fed 1,026$ 979$ (46)$ -646%Banks 1,560$ 1,577$ 17$ 236%Insurance 493$ 494$ 1$ 18%Pension 354$ 359$ 4$ 60%Money market funds 360$ 383$ 23$ 326%Mutual funds 685$ 757$ 72$ 1002%Brokers and dealers 175$ 167$ (8)$ -111%GSEs 368$ 368$ (0)$ -1%Other 1,091$ 1,085$ (7)$ -91%Agency & GSE-backed Securities supply 7,578$ 7,585$ 7$ 100%

The Fed continued the reinvestments of principal payments from its securities holdings. Source: Federal Reserve and Deutsche Bank

17 January 2014



Supply and demand for Agency & GSE-backed Securities during QE3

QE3 4Q2012 3Q2013 Change % supplyHousehold sector 184$ 133$ (52)$ -33%Foreign investors 1,004$ 883$ (121)$ -76%Fed 1,003$ 1,403$ 399$ 251%Banks 1,670$ 1,700$ 31$ 19%Insurance 474$ 480$ 5$ 3%Pension 418$ 444$ 26$ 16%Money market funds 344$ 354$ 11$ 7%Mutual funds 879$ 866$ (13)$ -8%Brokers and dealers 170$ 106$ (64)$ -40%GSEs 311$ 295$ (16)$ -10%Other 1,098$ 1,051$ (47)$ -30%Agency & GSE-backed Securities supply 7,555$ 7,714$ 159$ 100%

Source: Federal Reserve and Deutsche Bank

At the end of the day, supply is always equal to demand; the question is at what price levels. In 3Q2011, when there were no Fed purchases in Treasuries and MBS, foreigners, banks, mutual funds took down the lion share of the MBS supply. Our mortgage strategists have pointed out the supply and demand imbalance in MBS post QE, and have highlighted the seasonal issuance patterns in MBS. Assuming the Fed tapers $10 billion per FOMC meeting, the “cross-over point” between issuance and Fed purchases will probably happen around in Q2. That is the point when Fed purchases will drop below net MBS supply. The net supply of MBS is projected to be around $200 billion this year. MBS spreads will likely have to widen enough to attract domestic real money investors. Therefore, although it’s not an imminent trade, investors should look for a good entry level to be short mortgages, especially when the other options to be short rates are so unappealing from a carry standpoint.

Net supply of MBS

-400

-300

-200

-100

0

100

200

300

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500

600

700

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E

ARMs GN fixed Conv fixed


Can Japan fill the Fed’s void?

The Japanese are yield buyers. In the late 1990s, when the yield on US 10yr notes were 4 percentage points higher than the equivalent JGBs, Japanese banks, pensions and insurance companies owned a sum of foreign securities

17 January 2014



(mostly in US government and agency bonds) equal to half of their total JGB investments. During the 2000s, as global bond yields converged and the yield advantage of Treasuries over JGBs waned, Japanese demand for foreign bonds relative to domestic paper also declined. By 2011, the ratio of Japanese investments in foreign securities to JGBs fell to a decade-low of 1:4. Over the past two years, the UST-JGB spread reversed direction and pushed wider, once again making Treasuries attractive compared to the perennial low-yielding JGBs. The ratio of Japan’s foreign-domestic investments has since recovered to about 1:3.

10Y UST-JGB spread and Japanese investments in Treasuries relative to JGBs

0.20x

0.25x

0.30x

0.35x

0.40x

0.45x

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0.55x

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150

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350

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98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

bp 10Y TSY-JGB spread

Japanese Banks, Insur & Pension: foreign securities to JGBs (RHS)

Source: Bank of Japan, Haver Analytics and Deutsche Bank

A rebound in Japanese diversifying abroad is good news for Treasury investors. As the Fed prepares to wind down its QE operations, the question on many investors’ minds today is who will be the marginal buyers once the Fed is gone? The answer could be Japanese investors if the UST-JGB spread stays attractive enough. At the end of Q3 2013, Japanese banks, insurance and pensions held nearly $1.7 trillion of foreign securities to $5.2 trillion of JGBs on their balance sheets. So even just a 5 percent reallocation into Treasuries from JGBs could create demand for $260 billion of USD products, or the equivalent of three full months of QE purchases.

There are several good reasons for why we could see increased UST buying from Japan in 2014. The first is the difference in inflation trends in the US and Japan, where the prevailing low US inflation contrasts starkly with the rapidly-rising inflation in Japan. The latest Japanese CPI printed at a five-year high of 1.5%, a sign that the massive BoJ stimulus package launched last spring is working. Second, expectations are now for further yen weakness behind the BoJ’s pledge to lift inflation to 2% by 2015 and potentially delivering additional stimulus later this year to achieve that goal. The BoJ’s easy policy and resulting FX expectations should compel investors into moving out of yen assets and into USD assets. Third, more Japanese QE means more money will be moving offshore, and they will likely find a home in Treasuries. Finally, the flurry of Japanese buying many people expected to see following last April’s BoJ QE announcement never materialized. The US TIC report showed net selling of $12 billion Treasuries by Japan in Q2, and it wasn’t until Treasury yields rose substantially over JGB yields in Q3 when buyers from Japan turned up. As a result, it is possible that remaining pent-up demand from Japan will work its way into a bid for Treasuries in the coming months.

17 January 2014



U.S. vs. Japan inflation trend Japan net Treasury bonds and notes purchases

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15

US CPI yoy % Japan CPI yoy %

US forecast Japan Target

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

Source: Bureau of Labor Statistics, Bank of Japan and Deutsche Bank Source: Treasury and Deutsche Bank

17 January 2014



United States

Rates Gov. Bonds & Swaps

Treasuries

The currently steep yield curve implies high forward rates relative to spot. The negative carry in many outright bearish trades and yield curve flatteners in rates is punitive; the hurdles to beat the forwards are high. There is a chance that forwards is not fully net. Historically on average the market didn’t have a significant sell-off and curve flattening until a few months before the first Fed rate hike.

In the TIC data, Asia remained a good buyer of Treasuries in November, as China and Japan added, respectively, $10.7bn and $6.7bn.

Timing the Fed is a difficult task

The currently steep yield curve implies high forward rates relative to spot rates. The negative carry in many outright bearish trades and yield curve flatteners in rates is punitive. The hurdles to beat the forwards are high, especially in the intermediate sector of the yield curve. The one-year drop on the three- and five-year swap rates is more than 70bp.

Historically on average the market didn’t have a significant sell-off and curve flattening until a few months before the first Fed rate hike. The most extreme event was the 1999 Fed tightening cycle, when Treasury yields troughed in October 1998 during the LTCM crisis, about nine months before the first rate hike. 5s/30s started flattening also in October 1998 and continued into the first rate hike.

Change in 5yr yield in prior Fed tightening cycles

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

-500 -450 -400 -350 -300 -250 -200 -150 -100 -50 0 50 100 150 200 250Trading Days Relative to to tightening start date

5Y yield

2/4/1994 6/30/1999

6/30/2004 Average

Source: Bloomberg Finance LP and Deutsche Bank

Alex Li

Research Analyst (+1) 212 [email protected]

Steven Zeng, CFA


17 January 2014



Change in 2s/10s curve in prior Fed tightening cycles

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

-500 -450 -400 -350 -300 -250 -200 -150 -100 -50 0 50 100 150 200 250Trading Days Relative to tightening start date

2s/10s

2/4/1994 6/30/1999

6/30/2004 Average


Change in 5s/30s curve in prior Fed tightening cycles


17 January 2014



Being short the intermediate sector in US rates has punitive negative carry

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

2yr 3yr 5yr 7yr 10yr 15yr 20yr 25yr 30yr

1yr


TIC Update: Asia remained a good buyer of Treasuries in November

As the incoming economic data appeared to underpin economic recovery, Caribbean banking centers offloaded a record amount—$39.4bn—of Treasuries in November. France, Ireland and Luxembourg divested a net $8.3bn but Asia remained net buyer of $24.7bn of paper for the second straight month as China and Japan added, respectively, $10.7bn and $6.7bn. UK was a net buyer of Treasuries for the fifth month in a row but its net purchases fell sharply from $26bn in October to $12.4bn. Foreign official institutions accounted for $10.2bn of investments.

Net foreign Treasury purchases totaled -$3.4bn in November but foreigners’ T-bill holdings rose by $21.5bn during the month.

Net foreign purchases of US Treasuries Net foreign purchases of US Treasuries in November

-90

-60

-30

0

30

60

90

120

May-11 Nov-11 May-12 Nov-12 May-13 Nov-13

US Tsy Bills US Tsy Bonds

$bn

-50

-40

-30

-20

-10

0

10

20

UK

Oth

er E

urop

e

Japa

n

Chi

na HK

Oth

er A

sia

Bra

zil

Car

ibbe

an

Oth

er C

ount

ries

US Tsy Bills US Tsy Bonds

$b

n


Agency: Net foreign investments in Agency and mortgage backed securities were -$0.5bn. China and UK were net buyers of $4.1bn and $3.1bn, respectively, but the Caribbean and European (ex-UK) nations divested $1.8bn and $2.8bn, respectively. Japan was a net seller of $1.2bn.

17 January 2014



Corporate: Foreign investors turned net sellers of $0.5bn in US corporate bonds in November. Combined Asia and the Caribbean net investments of $3.9bn were almost entirely offset by net sales of European investors. UK offloaded $1.6bn while Japan was a net buyer of $1.2bn of securities.

US Bonds: Foreign investors were net sellers of $4.4bn of long-term U.S. Treasury, agency and corporate bonds in November. Caribbean banking centers shed $39.3bn of securities, the largest amount since March 2008, but Asia remained a net buyer of $29.9bn. UK added $14bn of securities for the fifth straight month but France and Ireland were net sellers of $5.4bn and $4.4bn, respectively.

Foreign purchases of US bonds by month, vs. 10Y yield level

1.0

1.5

2.0

2.5

3.0

3.5

-60

-30

0

30

60

90

120

May-11 Nov-11 May-12 Nov-12 May-13 Nov-13

Net Purchase of US Bonds Tsy 10Y (rhs)

Tsy

10Y

$bn

Source: US Treasury; Deutsche Bank

Auction preview: 3s, 10s, Bonds

Market supply includes $64bn of notional worth $57.4bn in ten-year equivalents through three- and ten-year notes and thirty-year bond auctions next week. These auctions will settle on the following Monday against $32.5bn of coupon securities maturing on December 15.

Customer participation the recent four auctions has been strong averaging 58.4% vs. 51.4% in the previous four as indirect bidders beat their average 35.1% takedown in each of the last six auctions. 3s and 10s were solidly bid in the last auction the demand for 30-year paper was weak.

The recent volley of economic data has forced the market to price-in a higher taper probability in next FOMC meeting resulting in elevated yield levels. Any disappointment should however result in sharp correction across the curve. We therefore expect decent customer participation in these auctions next week.

3-year note Indirect bidders beat their average 29.1% participation in each of the last seven auctions. Direct bidders too were solid in the recent three auctions versus their one-year average of 18.9%. Combined customer participation averaged 53.8% in the last four auctions and compares with its average level of 48%. Allotment shares to both fund and foreign investors were above the respective averages in November and the combined 41.7% share of the two investor classes was the largest since January. Last auction recorded an eight-month high bid-to-cover ratio of 3.46 (avg. 3.33) and stopped through fifth in a row.

17 January 2014



3-year note auction statistics

Size ($bn)

Primary Dealers

Direct Bidders

Indirect Bidders

Cover Ratio

Stop-out Yield

1PM WI Bid

BP Tail

1yr Avg $31.6 52.0% 18.9% 29.1% 3.33 -0.1

Nov-13 $ 30.0 47.3% 19.4% 33.3% 3.46 0.644 0.645 -0.1

Oct-13 $ 30.0 45.8% 19.7% 34.4% 3.05 0.710 0.7175 -0.8

Sep-13 $ 31.0 46.8% 20.0% 33.1% 3.29 0.913 0.918 -0.5

Aug-13 $ 32.0 44.7% 14.0% 41.4% 3.21 0.631 0.636 -0.5

Jul-13 $ 32.0 51.5% 13.0% 35.6% 3.35 0.719 0.721 -0.2

Jun-13 $ 32.0 58.4% 8.4% 33.1% 2.95 0.581 0.577 0.4

May-13 $ 32.0 54.7% 14.6% 30.7% 3.38 0.354 0.354 0.0

Apr-13 $ 32.0 64.9% 16.2% 19.0% 3.24 0.342 0.338 0.4

Mar-13 $ 32.0 56.0% 23.4% 20.6% 3.51 0.411 0.414 -0.3

Feb-13 $ 32.0 55.1% 26.9% 18.0% 3.59 0.411 0.412 -0.1

Jan-13 $ 32.0 45.2% 26.4% 28.4% 3.62 0.385 0.383 0.2

Dec-12 $ 32.0 53.3% 24.8% 21.9% 3.36 0.327 0.323 0.4 Source: US Treasury and Deutsche Bank

10-year note Customer participation has been solid in every first re-opening auction since November last year averaging 68.6%, which compares with its twelve-month average level of 60.8%. Indirect bidders beat their average takedown of 38.3% in each of the last six auctions offsetting weak directs. Combined 59.7% allotment share of fund and foreign investors in November was above its one-year average of 54.3% four in a row. However five of the last six auctions recorded below average (2.74) bid-to-cover ratio even as the last three stopped through heftily.

10-year note auction statistics

Size ($bn)

Primary Dealers

Direct Bidders

Indirect Bidders

Cover Ratio

Stop-out Yield

1PM WI Bid

BP Tail

1yr Avg $ 22.0 39.2% 22.5% 38.3% 2.74 -0.4

Nov-13 $ 24.0 33.8% 18.6% 47.7% 2.70 2.750 2.754 -0.4

Oct-13 $ 21.0 40.2% 21.2% 38.6% 2.58 2.657 2.667 -1.0

Sep-13 $ 21.0 33.8% 29.6% 36.6% 2.86 2.946 2.966 -2.0

Aug-13 $ 24.0 38.5% 15.2% 46.3% 2.45 2.620 2.62 0.0

Jul-13 $ 21.0 45.2% 16.3% 38.6% 2.57 2.670 2.668 0.2

Jun-13 $ 21.0 36.6% 11.7% 51.7% 2.53 2.209 2.208 0.1

May-13 $ 24.0 49.2% 16.9% 33.9% 2.70 1.810 1.799 1.1

Apr-13 $ 21.0 33.6% 29.1% 37.3% 2.79 1.795 1.791 0.4

Mar-13 $ 21.0 22.3% 30.0% 47.7% 3.19 2.029 2.052 -2.3

Feb-13 $ 24.0 47.7% 24.2% 28.0% 2.68 2.046 2.041 0.5

Jan-13 $ 21.0 56.7% 14.8% 28.5% 2.83 1.863 1.855 0.8

Dec-12 $ 21.0 33.1% 42.7% 24.2% 2.95 1.652 1.672 -2.0 Source: US Treasury and Deutsche Bank

30-year bonds November auction recorded below-average (53.5% vs. 54.2%) customer participation for the first time since June as indirect bidder participation fell to seven-month low level at 35.3%. However, direct bidders remained solid for the fifth straight month averaging at 19% versus their one-year average of 16.2%. Combined 45.6% allotment share to fund and foreign investors was the lowest in as many months and compares with its average level of 46.9%. Bid-

17 January 2014



to-cover ratio of 2.16 was weak as compared to the average 2.46 and auction generated a hefty tail of 1.5 basis points.

30-year bond auction statistics

Size ($bn)

Primary Dealers

Direct Bidders

Indirect Bidders

Cover Ratio

Stop-out Yield

1PM WI Bid

BP Tail

1yr Avg $14.0 45.8% 16.2% 38.0% 2.46 0.4

Nov-13 $ 16.0 46.5% 18.3% 35.3% 2.16 3.810 3.795 1.5

Oct-13 $ 13.0 35.5% 22.6% 41.9% 2.64 3.758 3.779 -2.1

Sep-13 $ 13.0 41.7% 20.6% 37.7% 2.40 3.820 3.827 -0.7

Aug-13 $ 16.0 42.7% 17.1% 40.2% 2.11 3.652 3.644 0.8

Jul-13 $ 13.0 43.4% 16.3% 40.2% 2.26 3.660 3.674 -1.4

Jun-13 $ 13.0 51.3% 8.5% 40.2% 2.47 3.355 3.324 3.1

May-13 $ 16.0 45.7% 15.5% 38.8% 2.53 2.980 2.990 -1.0

Apr-13 $ 13.0 49.3% 19.2% 31.4% 2.49 2.998 2.990 0.8

Mar-13 $ 13.0 53.1% 4.9% 42.0% 2.43 3.248 3.230 1.8

Feb-13 $ 16.0 49.1% 14.5% 36.4% 2.74 3.180 3.183 -0.2

Jan-13 $ 13.0 45.5% 16.7% 37.8% 2.77 3.070 3.083 -1.3

Dec-12 $ 13.0 46.1% 20.3% 33.7% 2.50 2.917 2.885 3.2 Source: US Treasury and Deutsche Bank

Fed buyback

Fed plans to remove about $12.4bn of notional worth $15.9bn in ten-year equivalents from the market through six purchase operations next week. Regular purchases on Monday, Wednesday and Friday will target the long-end of the curve while 5.75-7 year sector will be in focus on Thursday. Monday’s second buyback operation (at 1:15 pm) is targeted at 7.25-10 year sector of the curve whereas the TIPS purchases of the month will be carried out on Tuesday, December 10.

Fed buyback schedule: December 9-13

Date Operation

Type Maturity Range Avg Par

($bn) Avg

DV01 10yr Equiv

($bn) Sub/cover

(Last 4 avg) 9-Dec Treasury 2/15/36 11/15/43 1.500 16.61 2.91 3.37x 9-Dec Treasury* 2/15/21 11/15/23 3.125 8.12 2.97 3.36x

10-Dec TIPS 1/15/18 2/15/43 1.250 11.62 1.70 2.92x 11-Dec Treasury 2/15/36 11/15/43 1.500 16.61 2.91 3.37x 12-Dec Treasury 9/30/19 11/30/20 3.500 6.15 2.52 3.97x 13-Dec Treasury 2/15/36 11/15/43 1.500 16.61 2.91 3.37x

Total 12.375 15.93

Source: NY Fed, Deutsche Bank * This operation will be conducted at 1:15 pm

17 January 2014



United States

Rates Inflation Rates Volatility

Derivatives

If recent economic forecasts, which reveal a high degree of consensus regarding the equity-bullish and bonds-bearish views, is in any way indicative of the direction of future market moves or positioning, the market could end up being exposed to adverse scenarios.

With current vol differentials, financing positions at the wings with 10Y vol allows for additional cushion for hedges against risk scenarios. We consider two different trades:

Vol flies: Sell $100mn 20bp wide 1Y10Y strangles vs. buy $200mn 1Y2Y and $25mn 1Y30Y straddles at zero net cost

Financed payers in the wings by strangles in 10s: Sell $100mn 100bp wide

1Y10Y strangles vs. buy $200mn 1Y2Y and $25mn 1Y30Y ATMF payers at zero net cost

The poverty of expectations: Again for the first time

Recent economic forecasts reveal a high degree of consensus across the board with dominant theme centered on bullish equities and bearish bonds views. While this seems to be consistent with the recent market moves and the base case scenario of gradual rebound in growth, the year-end forecasts for the term structure, summarized in Table 1, seem to be at odds with the current constellation of risks and with market pricing. This is not the first time we’ve encountered this sort of situation. For the last three years, formation of consensus around an optimistic outlook has been a regular occurrence in the first quarter of the year. In that context, this is no exception. However, there are notable differences as market conditions and risks have shifted significantly, with a different Fed and the first steps towards changes in monetary policy already underway.

Figure 1: Summary statistics for the year-end economic forecast of the term

structure

2Y 10Y 30Y

median 0.80 3.45 4.27

fwd 1.11 3.23 3.99

stdev 33 26 28 Source: Bloomberg Finance LP

From the table above, the following patterns emerge. The highest confidence appears to be in the 10y sector with growing dispersion towards the wings. Except for a few outliers (one at 2.5% and one at 4%), most of the forecasts for the 10s reside in a tight range, 3.00-3.75%, with median about 20bp above the forward. The dispersion is slightly higher at the long end with similar spread of 30bp between the median forecast and the forward. In contrast, distribution for the short end is skewed to the left and reflects much less of consensus (std 25% higher than for 10s) with about 85% of probability being below the forward.

Aleksandar Kocic


17 January 2014



If taken at face value, the forecast summary is consistent with a view of long end steepener with constrained short end corresponding to forward guidance in an environment with continued growth with rising inflation expectations. If this is in any way indicative of the direction of future market moves or general sentiment likely to be reflected through positioning, the market could end up being exposed to adverse scenarios.

In terms of dispersion across the term structure, the forecasts are in conflict with the options market. Figure 2 shows the ratio of volatilites relative to 10Y points, both as reflected by the forecasts and as implied by the options market. While forecasts exhibit high dispersion in the wings, the options market prices 1Y10Y vol about 5-15% higher than the wings.

Figure 2: Comparing the relative confidence of the forecast with the vol

term structure

1.26

1.08

0.74

0.96

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1y2y/1y10y 1y30y/1y10y

Foreacst

Implied


In our view, this type of term structure of vol is consistent with gradual growth without inflation and does not capture the risks of deviation from it. In reality, the departures from either this or forecast-based scenarios can take place along several paths. Guidance in place implies further repricing of forwards at the short end. Its success would mean further sell-off at the long end with either a parallel shift or possibly 10s/30s steepener due to higher inflation expectations. Guidance challenged is a bear flattener led by the short end. In this case, short-tenor vol outperforms both 10Y and 30Y sector. An interesting situation could occur if we see a rise in inflation without changes in wage inflation (which has been residing near its all-time lows for the last 5 years). Such a development could reinforce bear flatteners due to expectations of preventive rate hikes as it would reduce purchasing power and adversely affect growth. In this case, the growth sensitive sector (10s) would remain stagnant while both wings could reprice higher. Growth with inflation is bearish across the curve with the short end leading the way due to repricing of Fed expectations while details at the long end would be a function of exact blending between the two macro drivers.

With current vol differentials, financing positions at the wings with 1Y10Y allows for additional cushion. We consider two different trades: vol flies and payers in the wings financed by strangles in 10s.

Sell $100mn 20bp wide 1Y10Y strangles vs. buy $200mn 1Y2Y and $25mn 1Y30Y straddles at zero net cost

17 January 2014



This is a vol RV trade with macro overtones. It has a positive carry of about $300K in the first 6M. Given the risks associated with probable rates paths, both 2Y and 30Y vol are seen as attractive insurance relative to 10Y vol, especially given their relationship across different macro environments. We are likely to see an additional rise in vol fly, Figure 3, as both rates and vol normalize with its value approaching zero corresponding to pre-crisis levels.

Figure 3: 2s/10s/5s vol fly in terms of 1Y expiries

-35

-30

-25

-20

-15

-10

-5

0

5

10

15

20

06 07 08 09 10 11 12 13 14

vol fly


In terms of delta, a unilateral sell-off in 10s is also seen as an extreme dislocation, in the context of the curve fly, Figure 4. A sell-off in 10s of 25bp relative to the wings corresponds to extreme historical wides seen only as transient spikes in 2004 and 2009.

Figure 4: 2s/10s/30s curve fly: a 25bp unilateral sell off in 10s corresponds to

historical lows

-120

-100

-80

-60

-40

-20

0

20

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

2s/10s/30s fly

10s up by 25bp


A similar-looking trade with a completely different spirit consists of using 1Y10Y strangles to finance payers in the wings:

Sell $100mn 100bp wide 1Y10Y strangles vs. buy $200mn 1Y2Y and $25mn 1Y30Y ATMF payers at zero net cost

17 January 2014



This is not a vol RV, but an insurance trade. It has a negative carry around -$300K in the first 6M due to aggressive roll down at the front end of the curve and different decay rate in the wings vs. the financing leg. The “mismatch” between the instruments (payers vs. strangles) allows us to use wide strangles as a financing leg and provides a comfortable cushion of 50bp on each side.

Both trades are vulnerable to a unilateral move in 10s beyond the strikes on either side, with potentially unlimited downside. A unilateral 50bp sell-off in 10s, corresponding to the upper strike of the strangle, takes us way out of bounds defined by past movements, with fly around -130bp.

Aleksandar Kocic +1 212 250 0376

17 January 2014



United States

Rates Gov. Bonds & Swaps Credit Securitization

Agencies

Here are two charts showing just how quickly dealers are leaving the agency debt space, which could translate into further headwind for agency investors in the form of wider spreads.

The Federal Reserve reported last Thursday that primary dealer positions in federal agency securities dropped to just $20 billion as of Jan 1, the lowest level in 16 years. However, the reported figure was skewed by two factors. The first is seasonality; securities dealers are known to reduce their balance sheet usage toward quarter- and year-ends. Second, the size of the agency market has also been declining at a rapid rate, driven by the wind-down of Fannie and Freddie. To see the true implication of the reported dealer positions, we will need to adjust for seasonality and by the outstanding GSE debt.

The first chart shows dealer positions as a percentage of market size. The end of December figure was just 1.1%, which is indeed a record low. We can also see that for much of the post-crisis period, dealer’s market share was quite stable, fluctuating between 2% and 5%. In June, the sell-off in rates widened agency spreads, and dealer’s share tumbled below 2% for the first time and it has remained sub-2% ever since. It is possible that June sell-off spooked the dealer community, and with the eventual normalization of rates suggesting the potential for further spread widening, dealers have decidedly cut back on risk.

We also need to adjust for quarter-end effects. The chart on the right shows the average weekly changes to the dealers’ market share since beginning of the year from 2009 to 2012, and then for 2013 as a standalone series. The grey circles mark a clear pattern of contraction in dealer balance sheet going into the end of each quarter. Yet, in the four years prior to 2013, dealers ended the final quarter devoting the same balance sheet usage proportional to the market size as when the year started. In 2013, dealers’ share of the total market was 1.3% lower by year-end, a clear departure compared to the previous years.

By normalizing the dealer positions data, we can confidently conclude that dealers have reduced participation in the agency market; the timing of their withdrawal coinciding with the June 2013 sell-off suggests that higher yields and wider spreads could limit their future involvement in this space. For investors, less competition among dealers could mean a drop in liquidity and thus wider bid-offer spreads for agency securities in the foreseeable future.

Dealer positions as a share of the

market fell to a record low in 2H

2013

Dealers reduced balance sheet

allocation to agencies proportional to

the market in 2013

0%

1%

2%

3%

4%

5%

6%

7%

2007 2008 2009 2010 2011 2012 2013

Dealer positions as % of total GSE debt

Jun-13:rates selloff

Sep-08: Fannie/Freddie placed into conservatorship

Aug-12: PSPA amended with fulllsweep provision

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

0 4 8 12 16 20 24 28 32 36 40 44 48 52Week

Change in dealers market share since 1-Jan

2009-12 average

2013

quarter-end

Source: Federal Reserve ,FNMA, FHLMC, FHLB and Deutsche Bank

This article originally

appeared in the Global

Strategy Flash on January 14,

2014.

Steven Zeng, CFA


17 January 2014



United States

Credit Securitization

Mortgages

Originally published on 15 January 2014 in The Outlook in MBS and Securitized Products.

REIT valuations, MBS implications

When the equity market’s passion for mortgage REITs drove share prices above book value for long stretches in 2011 and 2012, it made sense for REITs to issue equity and become one of the biggest marginal buyers of agency MBS. But oh, how those passions have cooled. The average mortgage REITs now trades well below book value and has substantial incentive to repurchase stock. Repurchases would likely deleverage REITs, putting pressure on15-year pass-throughs and hybrid ARMs, where REITs own a significant portion of the outstanding float.

Mortgage REITs trading below book value A quick look across the largest agency mortgage REITs reveals at least one consistent observation—that as of the end of the third quarter of 2013, their equity traded below book value (Figure 1). On average, the group traded at a discount to book value of 80%. That picture likely hasn’t changed much since then.

Figure 1: Mortgage REIT equity trading at significant discount to book value

95%88% 85% 85%

81% 81% 80% 79% 79% 78% 78%

WMC TWO MTGE IVR MITT AMTG Wtd. Avg.

AGNC CYS NLY HTS

Pri

ce t

o b

oo

k

Note: All levels based on 9/30/2013 third quarter company disclosures. Source: Deutsche Bank, the companies

REIT valuations remain depressed due to market concern about their ability to weather some of the risks ahead in fixed income. For instance, potential spread widening in MBS would leave REITs exposed on the asset side of the balance sheet. The impact of Basel III could increase the cost of repo financing and hurt net interest margin. Pressure on margin and an inability to harvest gains could lead to lower dividends. All of this challenges mortgage REITs’ ability to deliver the stream of dividends built into their share prices during the

Steve Abrahams


17 January 2014



REIT heyday. But by driving share price so far below book, the equity market may have jumped ahead of fixed income and created a new opportunity for REIT shareholders: equity buybacks.

Assuming that REIT portfolio managers have marked their assets and liabilities at true liquidation values, then buying back shares at current marks should deliver returns equal to the difference between book and equity value. For instance, if a REIT’s shares trade at 80% of book value, then every dollar of equity repurchased should yield a 20% return. It’s hard to find that many fixed income trades, if any, that show that kind of potential.

Of course, to avoid simply leveraging up their balance sheets in the aftermath of a buyback, every dollar of equity repurchased will also need to be matched by the liquidation of assets and unwinding of hedges in proportion to the current leverage ratio. So if a mortgage REIT is currently seven times levered and repurchases $1 of equity, it would need to sell roughly $7 of MBS and possibly unwind some of the associated hedges.

Lately REIT leverage has decreased. In the second quarter of 2013, the average REIT examined here was levered 6.92 times. By the end of the third quarter, average leverage decreased by 32 bp (Figure 2).

Figure 2: Current REIT leverage

0

1

2

3

4

5

6

7

8

9


There’s also some question about how a REIT might deleverage if it choose to buy back stock. REITs can choose to deleverage actively through the sale of assets or passively through prepayments and amortization. However, passive deleveraging is inherently limited by the pace of prepayments. As rates rise and prepayments slow, the potential impact of passive deleveraging would decrease, limiting the ability to buy back stock by using this strategy. If a REIT were inclined to repurchase meaningful amounts of equity, they would likely have to sell assets to keep their leverage ratios constant.

Current mortgage REIT holdings Holdings among the REITs reviewed here are dominated by 15- and 30-year fixed-rated agency MBS. At the end of the third quarter, 30-year pass-throughs comprised nearly 50% of their mortgage holdings while 15-year pass-throughs made up nearly 25% (Figure 3). Combined residential MBS holdings for the group totaled $251 billion.

17 January 2014



Figure 3: Weighted average mortgage REIT MBS holdings

49.8%

24.5%

11.6%

4.2% 4.0% 3.9%1.0%

WA holding % total resi assets


Determining the exact coupons held within each product becomes a bit more art than science. However, most REITs report a weighted average coupon within each product (Figure 4). Based on disclosures, it appears the majority of holdings are in 30-year 3.50% and 4.00% pass-throughs and centered around 3.50%s in 15-year.

Market implications While 30-year MBS make up a large share of the REIT portfolios analyzed, REITs’ 30-year holdings look small relative to the outstanding balances net of pools included in CMOs and Fed holdings. Their holdings of 15-year MBS and hybrid ARMs, however, make up a much bigger share of outstanding market float despite being a smaller portion of their overall asset allocation. It is unclear what, if any, path REITs might take to deleverage. However, given their outsized holdings in relation to total outstanding float, hybrid ARMs and 15-year fixed-rate MBS appear to be particularly susceptible if mortgage REITs were to sell those assets (Figure 5).

Figure 4: Weighted average coupon by product for REIT universe

3.72% 3.63% 3.51%

2.28%

30Y Fixed 20Y Fixed 15Y Fixed Non-Agency

WA Cpn.

Note: All levels based on 9/30/2013 third quarter company disclosures. Source: Deutsche Bank, the companies.

17 January 2014



Figure 5: Nominal REIT holdings as a percentage of total free float

17.8%16.6%

9.7%8.6%

3.4%

Hybrid ARM 15Y Fixed 20Y Fixed 30Y Fixed CMO + IO

REIT holding % free float

Note: Percentages show total disclosed REIT holdings as of Q3 2013 as a percentage of free float net of Fed holdings and CMO in coupons 4.5% and below for each fixed-rate sector, and as a percentage of free float net of CMO for 5/1, 7/1 and 10/1 hybrid ARMs. Source: Deutsche Bank, CPRCDR

Conclusion So, for now, the agency REIT cycle has turned. Given the fairly substantial discount to book value where many REIT stocks trade, it appears that managers have significant incentives to repurchase stock. Buying back stock at a discount to book may provide managers with a reasonable alternative to reinvesting pay downs back in MBS that may offer limited upside given recent tightening. If managers were to buy back stock in excess of pay downs they would have to actively deleverage through asset sales. Based on their disproportionate share of outstanding float in 15-year pass-throughs and hybrid ARMs, the turn of the REIT cycle has added new risk to those sectors.

***

The view in rates Friday’s weak payrolls likely have given the market only temporary reprieve from slowly rising rates. The broader economic data—the ADP survey, weekly jobless claims, auto sales and trade numbers—still look encouraging. And the Fed still looks set to head down its announced path. That should eventually move the market back toward where it stood before last week’s number. Most importantly, that keeps most of the yield curve steep and the likely returns from rolling down the yield curve strong, especially in 5- to 10-year bullet debt.

The view in spread markets MBS have had a good run for most of the last month from a combination of low net supply and proportionally high Fed demand despite the beginning of the end for QE. As detailed here last week, the Fed in January is likely to take down 260% of January’s net fixed-rate MBS supply. The Fed bid should continue outstripping net supply through March before roughly matching and then falling below. As the Fed bid goes, arguably so goes spreads. With a crossover between Fed demand and supply almost bound to come within a handful of months, it’s risky to passively over-allocate to MBS. It looks better to go up in coupon where spread risk is thinner. The 15-year sector also has looked like a reasonable place to avoid basis risk, but the sector’s exposure to REIT holdings tempers that. We had recommended going overweight 15-year paper, but we trim that back to neutral.

17 January 2014



The view in mortgage credit The housing data have come in a little mixed lately. CoreLogic reported that the average US home price rose 0.1% in November and 11.8% over the prior year, a bit slower than the pace earlier in the year. The company expects a 0.1% price drop in December. Housing is on the cusp of the slowest months of the year. Stronger numbers should return in March and beyond.

Steven Abrahams (+1) 212 250-3125 Christopher Helwig (+1) 212 250-3033

Ian Carow (+1) 212 250-9370 Jeff Ryu (+1) 212 250-3984

A REIT reaches for the FHLBanks

The Two Harbors REIT announced recently that a newly formed insurance subsidiary has become a member of the FHLBank system, becoming the first public REIT and possibly the only REIT so far to get access to system financing. That should give Two Harbors a broader menu of funding and, in some cases, lower interest rates than offered either by competing repo markets or other sources of funds. The announcement highlights a growing trend of FHLBank lending to insurance companies and could encourage other REITs and mortgage investors to explore this novel approach.

FHLB membership process for insurance companies The legislation that created the FHLBank system in 1932 authorized it to lend to insurance companies from the outset, but insurance membership and lending has only really taken off in the last decade (Figure 6). Each FHLBank maintains unique standards for qualifying insurance companies for membership. Given the significant latitude the FHLBanks maintain in qualifying insurance members, it opens the door to other mortgage investors like REITs to gain access to FHLBank funding.

In the case of Two Harbors, neither the REIT nor FHLBank-Des Moines has disclosed any details on how this membership was structured. The only publicly available information is the 8K filed by Two Harbors, which merely states that the insurance subsidiary was approved for membership. As such, the nuances of this particular case are entirely unclear at this time. However, this is not the first time that banks and other entities have established an insurance subsidiary to access FHLB funding. Based on conversations with banks that have done this before, it involves a couple of steps.

17 January 2014



Figure 6: Insurance company advances on the rise post-crisis

0%

2%

4%

6%

8%

10%

12%

14%

0

10

20

30

40

50

60

2000 2002 2004 2006 2008 2010 2012

At

par

val

ue

($b

n)

Ins co advance amt As % tot advances (RHS)

Source: Deutsche Bank, FHLBank annual reports

Location, location, location The investor first has to establish the insurance entity that could be eligible for FHLBank membership. The parent company can either choose to form its insurer internally, or can go out and purchase a shell charter—effectively a dormant charter resulting from the merger of two insurance companies. Depending on the state where the insurance or reinsurance company is legally located, the insurance activities that the company engages in can be fairly minimal.

The process also involves finding the right state and the right FHLBank. Insurance company regulation varies from state to state, with some states being significantly more amenable to establishing these entities. The art of the deal is aligning a favorable state regulatory framework in a district with a FHLBank that would accept the new entity. FHLBank-Des Moines and FHLBank-Indianapolis have been notably active with insurers and maintain the greatest percentages of advances to insurance companies (Figure 7).

Figure 7: FHLB Des Moines and Indianapolis most active insurance lenders

0%

10%

20%

30%

40%

50%

60%

0

20

40

60

80

100

Ins

co a

dva

nce

s as

% t

ota

l

No

min

al a

dva

nce

am

t ($

bn

)

Advances to insurers Total advances

Ins co % of total advances (RHS)

Source: Deutsche Bank, Federal Reserve Bank of Chicago, “Understanding the relationship between life insurers and the Federal Home Loan Banks,” January 2014 Chicago Fed Letter

17 January 2014



The fine print Other details of each FHLBank matter, too. In much the same way that the various FHLBanks differ in their willingness to lend to insurance companies, they also differ on terms around membership, activity-based capital requirements, collateral pledge requirements, eligible collateral, collateral haircuts, advance rates, advance limits, and numerous other smaller factors. These can amount to a material difference. For example, all FHLBanks have some up-front membership capital requirement, but the required stock purchase amount may be assessed differently between different FHLBanks. In the past, the up-front capital requirement for an insurance company to gain membership has occasionally been quite large.

Setting up shop Upon gaining membership, transactions between the insurance company and the FHLBank can be fairly fluid. The parent entity can assign eligible mortgage assets to the insurance subsidiary, which the insurance company then pledges to the FHLBank as collateral in exchange for an advance, which then flows back to the parent entity. However, depending on the arrangement, assigning assets to the insurance subsidiary may even be unnecessary—the parent entity could simply transact directly with the FHLBank. While banks generally are not required to deliver collateral to the FHLBank, it appears that insurance companies would likely be required to deliver collateral versus advances.

Implications While the Two Harbors/Des Moines relationship is the first transaction of its kind, there are potential implications for the broader REIT community and other mortgage investors. Broad-based implementation of this structure would likely improve the manner in which the current market is funded. Funding would likely become stickier. Additionally, MBS investors would have access to longer-term funding and funding with embedded optionality, decreasing the duration of leverage currently funding MBS.

Nevertheless, it is unlikely that we see a structural change tomorrow in how agency MBS is funded. Ultimately, any spike in demand for advances would have to meet with equal demand from debt investors, who would need to buy the FHLBank debentures issued to offset the risk of the advance.

Steven Abrahams (+1) 212 250-3125 Christopher Helwig (+1) 212 250-3033

Ian Carow (+1) 212 250-9370

Larger issuers turn down the HARP volume

Some dramatic changes in the composition of the potential HARP-eligible universe imply that prepayment speeds for HARP-eligible collateral will continue to grind slower in 2014. Three of the largest lenders—Chase, Citi and Wells—comprise small proportions of the total potentially HARP-eligible universe. The vast bulk of what remains to be refinanced is serviced by Bank of America and smaller servicers (Figure 8). These volumes mean that changes in speeds for these three servicers/issuers just can’t move the needle very much on overall cohort speeds. Slower speeds for “other issuers” means that aggregate speeds for entire cohorts will approach those of these servicer cohorts, which are from 3 CPR to 8 CPR slower than speeds of the larger issuers.

17 January 2014



Figure 8: Big drops in outstanding pre-June, 2009

collateral during 2013

Figure 9: Issuer composition among MHA and high LTV

pools varies considerably by cohort

0

50

100

150

200

250

300

$ b

illio

ns

Dec. 2012 Dec. 2013

0%

20%

40%

60%

80%

100%

4.0

00

0 2

,00

94

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2,0

09

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84

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75

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55

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35

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09

5.5

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85

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26

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,00

86

.00

00

2,0

07

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00

0 2

,00

66

.00

00

2,0

05

6.0

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0 2

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46

.00

00

2,0

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0 2

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6.5

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86

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6.5

00

0 2

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6

Other Bank of America Citi Chase Wells

Source: Deutsche Bank, Fannie Mae via 1010data, Inc. Source: Deutsche Bank, Fannie Mae via 1010data, Inc.

The 2009 cohorts had the best credit profiles since they were originated to the tougher post-crisis underwriting standards. But they also had lower coupons, chiefly 4.0% and 4.5%. The biggest lenders focused on these “easier” cohorts to refinance first, leaving them with almost no remaining volume.

The flip side of HARP prepayments is issuance of MHA and high LTV pools. Market shares among this collateral for the large issuers fell during 2013. Even Quicken, which had aggressively refinanced others servicers’ HARP portfolios, saw its market share decline from more than 11% to 1%. As the share of the large lenders was decreasing, the share of “others” has increased to nearly 80% from just over 60% a year ago (Figure 10).

Figure 10: Market share among MHA and high LTV pools Figure 11: Slower aggregate prepayment speeds for

“other” servicers not in the “big 4”

0%

20%

40%

60%

80%

0%

3%

6%

9%

12%

15%

18%

1/01/13 4/01/13 7/01/13 10/1/2013

Bank of America CitiChase QuickenWells Other (RHS)

0

10

20

30

40

50

CP

R

Note: CR, CQ and 100% refi minimum 80% LTV pools. Source: Deutsche Bank, Fannie Mae via 1010data, Inc.

Note: coupons 4.0%–6.5% issued from 2001–May 2009. Source: Deutsche Bank, Fannie Mae via 1010data, Inc.

The final key to HARP-eligible prepayments grinding slower are slower speeds for “other’ lenders. Aggregate speeds for HARP-eligible cohorts among the “big 4” servicers were 3 CPR to 8 CPR faster than speeds for “other” servicers

17 January 2014



during 2013 (Figure 11). So even without any further increases in interest rates or behavior changes by either borrowers or lenders, aggregate speeds will likely fall by 2-3 CPR. Declines will likely be larger for the peak 2006–2008 cohorts and smaller for the earlier cohorts.

Doug Bendt (+1) 212 250-5442

17 January 2014



United States

Credit HY Strategy IG Strategy

US Credit Strategy The Staircase of HY Sector Valuations

Fundamentally-driven relative value analysis in HY In this report we focus on the question of relative valuations within HY credit, both in terms of credit qualities as well sectors. In doing so, we are taking a further step from our earlier analysis of spread differentials between rating categories, and look into spread per turn of leverage metrics across various market segments. Additionally, we put current levels of these metrics against their own historical ranges, and calculate percentile rankings to help us formulate opinions on relative value in credit qualities and industry sectors.

Rules & definitions We start with a sample of roughly 250 US HY nonfinancial issuers, both publicly traded and privately held. We exclude deeply distressed names from our analysis, where spread per turn becomes less of a useful measure of fundamentally adjusted valuations, as such names trade mostly on expected-dollar-recovery basis. We define such names as those levered over 10x or trading at 2,000bps spreads and wider. Finally, we are excluding names where one leg of the calculation is missing, i.e. both leverage and spread level have to be available on the date of calculation for a name to make it into our sample. In doing so, we are addressing the issue where a name is contributing a spread observation to our analysis, but not leverage, or the other way around, thus unnecessarily distorting whatever final picture we are looking at.

Race to the bottom Figure 1 presents results for alpha-numeric credit quality categories. Here, the blue bar represents historical range of spread per turn of leverage in each segment, and the red slider highlights the current level on that range. Figure 2 goes on to show percentile rankings of current observations against their respective historical ranges. In calculating percentile ranks we are looking at monthly observations for spread per turn of leverage in each category going back to Jan 2006; we exclude Oct 2008-Mar 2009 observations for all segments to prevent extreme levels from distorting our analysis. The scale in Figure 2 is 0 to 100, zero being historical minimum spread/turn, and 100 being the maximum. Of course, at current levels, the chart is not even showing the scale beyond 25%, implying the whole market and all of its segments trading within the tightest quartile measured against the last eight years of history.

Overweight low single-Bs, high CCCs In relative value terms, and the keyword here is relative, there appears to be some value left in the low-single-B to high-CCC segment of the market, where percentile ranks are still coming in at high teens. The rest of the market is trading around 10th percentile, with the tightest levels seen in lower-CCC ranges, although here readers should exercise caution in reading too much into results due to lower sample size (12-13 issuers, on average, vs 20-40 in other segments) and susceptibility to a breakdown in spread/turn usefulness as names approach distress (we relax conditions slightly for CCC2/CCC3 credits to <15x leverage, under 3,000bps spread). Broadly speaking, these results corroborate our existing overweight of single-Bs, and with this new datapoint we are adjusting it to B3/CCC1 overweight against the rest of the market.

Figure 1: Spread/turn of leverage

0 50 100 150 200 250 300 350

CCC2/CCC3

CCC1

B3

B2

B1

BB3

BB2

BB1

Spread/Turn, Current Level Historical Range (2006 - Present)


Figure 2: Percentile rank of current

spread/turn vs historical range

0 5 10 15 20 25

CCC2/CCC3

CCC1

B3

B2

B1

BB3

BB2

BB1

Percentile Rank (Current Spread/Turn vs Historical Range) 0..100


Oleg Melentyev, CFA


Daniel Sorid


17 January 2014



Mapping out HY sectors

In the next step, we extend the analysis described above to HY industry sectors. All selection criteria described above remain the same here, and some of the largest and most distressed names in the market, such as CZR and TXU, are excluded subject to leverage/spread thresholds applied. Results are presented in Figures 3 and 4 below, with the former showing historical ranges of spread per turn metrics in each sector, including current observations, and the latter going on to show percentile rankings. Sectors on both charts are ranked in the same way, according to their percentile scores, starting with widest at the top and running down to tightest at the bottom.

Once again, the broad takeaway here is that all sectors are trading somewhat tight, with even the widest ranking at sub-25th percentile ranges. Note, however, that even as all eight quality segments printed sub-20th percentile scores, certain industries are still averaging readings above that level, implying pure sectoral contribution to valuations. Similarly, while no quality group measured sub-5th percentile readings, there are three sectors producing low single-digit scores in Figure 4.

Figure 3: Spread/turn in HY sectors Figure 4: Pct rank of current spread/turn vs history

0 50 100 150 200 250 300 350 400

Metals

UtilitiesCapital Goods

Food

Real EstateAutomotive

Health Care

TelecommunicationsChemicals

Technology

MediaGaming, Hotels & …

Consumer ProductsEnergy

Commercial Services

RetailPackaging

Spread/Turn, Current Level Historical Range (2006 - Present)

0 5 10 15 20 25

MetalsUtilities

Capital GoodsFood

Real EstateAutomotiveHealth Care

TelecommunicationsChemicals

TechnologyMedia

Gaming, Hotels & …Consumer Products

EnergyCommercial Services

RetailPackaging

Percentile Rank (Current Spread/Turn vs Historical Range) 0..100


Another important attribute that we can learn from examining these charts is historical range, a proxy for volatility or cyclicality of each industry group. On this scale, Figure 3 highlights the widest ranges in metals, retail, tech, and automotive, while the tightest ranges have been observed in food, utilities, consumer products, and healthcare. So far, so good – all of the above conclusions come comfortably within what an educated guess would have helped us to expect.

What stands out the most: metals The most important part of this analysis comes, of course, from closer examination of specific sector positions in Figure 4, coupled with analytical judgment of where those sectors should be trading, given our understanding of their underlying fundamental trends. Lines that jump out the most, in our opinion, are metals on the tight end of distribution, and energy on the wide end. In metals, the current reading of spread/turn, at just under 100bp, is only 3rd percentile on historical scale, the tightest of any other sector, and obviously close to the tights against its own range. This comes at a surprising time when commodities in general, and metals specifically, are trading at weak levels and are not showing promising signs going forward, given a bleak

17 January 2014



growth outlook in EM. Even if one was to make an assumption that growth is just around the corner in EM and commodities should rebound from here, it appears to be the case that this sector is pricing in such an outcome to a large extent. We, for one, remain doubtful this is the most likely scenario to begin with. All in all, we believe this is the sector to be underweight at these levels. One note of caution on this is that the sector itself is relatively small (only five names in our sample) and could therefore be subject to greater distortions than others in our study.

Energy On the other end of the spectrum, or close to it, we were somewhat surprised to find energy among some of the widest sectors in HY, adjusted for their leverage. Aside from the obvious excitement around the energy story in the US that by now has gone mainstream, we believe a deeper question here is whether the market starts to question viability of some of those drilling projects, which continue to require significant capex investments to achieve desired production goals. We estimate that as a whole, HY energy companies in the US have been spending roughly 1.5x of their annual EBITDA on capex in recent years, a development that is both welcome from macro standpoint but also worrisome in terms of its longer-term sustainability. Our take is that for the time being the industry still has time to prove viability of its optimistic production goals at reduced capex rates in the future, but that time is not indefinite. We would imagine it is probably measured by 2-3 years, where if continued at present levels of required investments, we would see meaningful deterioration in investor patience. All in all, we think energy is still a good place to pickup extra spread and stay overweight, with an eye towards reducing such overweight if current investment trends do not begin to show signs of leveling off in the next few quarters.

Chemicals The final point we would like make here is related to chemicals, a sector that stands to be perhaps the biggest beneficiary of energy story in the US due to lower prices on feedstocks for plastics. At the moment, chemicals are trading at 80bps/turn, or 16th percentile against their historical range. While not high in absolute terms, this score puts them right in the middle of the stack of HY sectors. With positive tailwind coming from lower feedstock prices, this sector is poised to show improving fundamental trends for years to come. One offsetting factor to consider is that chemical companies are would also have to make heavy capex investments to fully leverage opportunities presented by the declining oil and nat gas prices in the US. Having said that, we believe potential benefits from such investments comfortably outweigh temporary headwinds that could emerge as a result of their borrowing needs as well as capex. The sector is also poised for meaningful pickup in consolidation, where larger players would try to capitalize on this emerging trend by snapping smaller issuers, usually a positive outcome for HY bond/loan investors. All in all, we believe a middle-of-the-stack placement of chemicals in our ranking makes them for a good longer-term overweight position in HY.

Broad-market implications Aside from helping to make specific sector-levels calls in HY, this framework also assists us in drawing some macro levels conclusions on the market. With all credit qualities and most industry sectors trading at sub 20th percentile ranges, these results provide further evidence of tightness in credit valuations at current levels. To be clear, sub-20th percentile, by definition, implies that there is more room left to go to reach historical minimums. And yet it also makes it evident that any distance left to reach the bottom is a lot shorter today than what separates us from the top. As the Fed continues to deliberate its path of deceleration in asset purchases, this picture should provide additional evidence for the FOMC to consider wider implications of their

17 January 2014



policies. With economy poised to show stronger performance in 2014, and with present-day monetary conditions in place, we believe it is more likely than not that we will see spreads being pushed to the tights before they engage on a sustained path wider in anticipation of the next credit cycle. A bump on this road to tighter spreads could still materialize from a reversal in flows we have discussed in detail in our year-ahead outlook. The probability of encountering such a bump appears to have been reduced by the recent market reaction to the initiation in tapering, although it remains to be seen whether the rest of of trip to zero-level purchases by the Fed continues to be as smooth as the ride so far.

Achieving such an outcome remains one of the priorities of FOMC. Judging from recent market performance since mid-December, their messaging strategy appears to have earned them an A on this score. We wonder however if any messaging strategy, no matter how perfect, could substitute for $85 billion being injected into the market every month. At the current stage, the risk of negative reaction in credit has transformed from initial tapering announcement to realization that the tapering may have to proceed at a faster pace than currently envisioned. Such a realization would come, most likely, along with stronger macro data, which in turn, would support credit spreads. All in all, we believe this still implies a potential for some widening as expectations get recalibrated, with stronger confidence than before that such a widening would be limited both in terms of extent and duration. If materialized, it would represent a good opportunity to step in, and increase portfolio risk further.

17 January 2014



Eurozone


Euroland Strategy

The declining excess liquidity in the Eurozone is mechanically putting upward pressure on spot money market rates. However, the market remains reasonably confident that the ECB is willing and able to control the front-end

The more aggressive course of action by the ECB including a broad based QE would require a significant decline in medium-term inflation expectations.

A broad based QE by the ECB is likely to be weighed by GDP or ECB capital keys, focused on government bonds and unlikely to extend to longer maturities as was the case in Fed, BoE or BoJ programmes.

Countries with lower debt/GDP ratios and where marketable debt accounts for a smaller proportion of outstanding govt. debt are likely to see a greater impact on the bond market

In such a scenario, all govt. bonds including periphery, should outperform swaps. We maintain our Bund ASW widener vs. Eonia and would recommend switching periphery spread tighteners vs. swaps rather than vs. Bunds

Although the EUR 5Y-30Y curve remains close to fair value at current levels, the positive carry and the potential for the curve to steepen in case of conventional or unconventional policy action from the ECB leads us to recommend a steepener

Moderate pressure on money market rates not enough to elicit ECB response as yet

Heightened dovishness at the January ECB meeting on Thursday combined with the weaker than expected payrolls (albeit weather affected) on Friday resulted in a moderate rally in core yields and a moderate sell-off in periphery at the end of last week. However, the on-going improvement in the outlook for the US was confirmed by retail sales and regional surveys released this week. Together with the on-going improvement in Eurozone data concerns regarding peripheral bond yields in particular have proven to be short lived; Italy and Spain 10Y bond yields are at or below the lows reached last week. Core bond yields meanwhile have been far less quick to reprice and remain reasonably lower than the levels of last week on account of the increased expectation of a potential broad based ECB QE.

Abhishek Singhania


17 January 2014



In addition to the above, money market yields have felt some upward pressure over the past week due to the evolution of liquidity conditions. The new MRO conducted this week saw a decline in take up of EUR 17.7bn while the 1M LTRO saw a decline in take up of EUR 3bn. Combined with the EUR 2.6bn decline in liquidity due to LTRO repayments announced last Friday excess liquidity declined to EUR 130bn on Wednesday. We have seen the amount of excess liquidity decline from about EUR 280bn to EUR 130bn in a matter of 15 days (Figure 1). This has resulted in an increase in Euribor and Eonia fixings and a moderate widening of the Euribor-OIS spread. However, we do not think that the ECB is uncomfortable with this moderate tightening of money market conditions. In its monthly bulletin the ECB states that the decline in excess liquidity is mainly a result of improved market access for euro-area banks and is likely to decline further. They also state that money market rates have remained largely stable and that in anticipation of further decline in excess liquidity future money market rates are unlikely to remain anchored to the deposit facility rate but should remain below the main refinancing rate.

The ECB would consider money market conditions to not be reflective of its monetary policy stance either because the EUR front-end responds to external factors such as the Fed monetary policy stance or because liquidity conditions have tightened the effective monetary policy stance of the ECB.

As far as the response of the EUR front-end to the Fed is concerned the Fed taper and the recent increase in USD front-end rates has had far less of an effect on EUR rates compared to that in June or September of last year (Figure 2). This should provide some comfort to the ECB.

As far as the liquidity position and its impact on the effective monetary policy stance is concerned in a liquidity neutral world Eonia would be expected to fix ~6bp above the main refi rate. Given that the ECB has already extended its fixed rate full allotment regime until mid 2015 unless forward Eonias exceed 25bp meaningfully before mid-2015 ECB should remain comfortable on the liquidity front.

Also, given that the ECB does not expect inflation to return to close to the 2% level for at least two years as long as the first rate hike is not priced in before Q1 2016 ECB should also be comfortable with its forward guidance language.

2: Moderate increase in money

market rates

3: Forward Eonia remain broadly in

line with ECB policy stance

0.00

0.20

0.40

0.60

0.80

1.00

1.20

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

USD 18x21 FRA EUR 18x21 FRA

0.00

0.25

0.50

0.75

1.00

1.25

Jan-14

Apr-14

Jul-14

Oct-14

Jan-15

Apr-15

Jul-15

Oct-15

Jan-16

Apr-16

Jul-16

Oct-16

Jan-17

1M Eonia

Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank

1: Excess liquidity has declined to

~EUR 130bn down from EUR 280bn

around year-end

0

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200,000

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400,000

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700,000

800,000

900,000

Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14

Excess liquidity (EUR mn)

Source: Deutsche Bank, Bloomberg Finance LP

17 January 2014



Further, even if the situation were to change and EUR money market rates do increase, it is likely to be easier for the ECB to address this by either cutting its main-refi rate/deposit facility rates, providing further liquidity or strengthening its forward guidance language. Therefore, while the front-end might face upward pressure mechanically as the excess liquidity in the system declines or because of developments elsewhere it is unlikely to overshoot given the ECB’s willingness and commitment to bring it under control. Therefore, it is no surprise to find that volatility on the EUR front-end remains low despite the grind higher in rates and the Eonia curve is moderately inverted following the recent increase in fixings.

Beneficiaries and the disadvantaged in a broad based ECB QE

ECB QE: A monetary policy tool not a credit policy tool At the January ECB meeting, President Draghi made repeated references to the Governing Council’s willingness to implement any measure permitted by the Treaty in order to achieve its price stability mandate. This has been interpreted by many (including us) to be a veiled reference to the possibility of a QE programme should inflation expectations deteriorate significantly. If an ECB QE programme is intended to be used as a monetary policy tool it would probably take the form of a broad based QE programme under which the ECB purchases government bonds of all Eurozone member states and not just the peripheral countries. This approach is likely to be easier to defend given the prohibition of monetary financing in the treaty. While a broad based QE programme is likely to lower Eurozone government bond yields across all countries there might still be some winners and losers in such a programme.

GDP weighted/ECB capital keys weighted QE should favour countries with lower debt/GDP ratios The country split of a broad based QE by the ECB is unlikely to be a function of their yield levels (i.e. more buying of higher yielding debt) or a function of outstanding government debt (i.e. more buying of the member states with greater debt). Instead, it is far more likely that the ECB in order to highlight the monetary policy nature of the QE programme would buy government debt of the member states in proportion of (i) their ECB capital keys or (ii) GDP.

The ECB capital keys are, themselves, a function of the GDP of the countries1 and therefore it is not surprising that in either of these two cases the absolute size of the buying is skewed in favour of the bigger Eurozone countries. It follows that in terms of the market impact, countries with lower debt/GDP ratios would stand to benefit compared to countries with higher debt/GDP ratio as the ECB purchases will account for a greater proportion of the outstanding govt. debt of the former group of countries.

We can define a simple metric to determine which countries stand to gain or lose based on an ECB capital key weighted purchase programme. The metric is the difference between a countries share in the ECB capital key and share of general govt. debt divided by its share of general govt. debt. The metric tells one how much a country stands to benefit from the ECB purchases based on capital key weights relative to its share of the general govt. debt.

The countries that stand to gain the most relatively would be Finland, Spain and Netherlands while the countries which would stand to lose the most, relatively, would be Italy, Belgium and Greece.

1 The ECB capital keys are based on population and GDP with an equal weighting given to both

4: Lower vol on EUR front-end

reflects greater ECB control

20

30

40

50

60

70

80

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

EUR 3M2Y rate (LHS)EUR 3M2Y vol (RHS)

Source: Deutsche Bank, Bloomberg Finance LP

5: Share of QE for Eurozone

countries according to ECB capita

key or GDP weight ECB Capital

key weights GDP weights*

Germany 25.7% 28.4%

France 20.3% 21.5%

Italy 17.6% 16.2%

Spain 12.6% 10.6%

Netherlands 5.7% 6.3%

Belgium 3.5% 4.0%

Greece 2.9% 1.9%

Austria 2.8% 3.3%

Portugal 2.5% 1.7%

Finland 1.8% 2.0%

Ireland 1.7% 1.7%

Others 2.9% 2.4% Source: Deutsche Bank, ECB *For the GDP weights we have used Eurostat’s 2013 forecasts of nominal annual GDP

17 January 2014



6: Countries with general govt. debt share lower than the ECB capital key

weights would stand to gain in a broad based ECB QE

(1) (2) [(1)-(2)]/(2)ECB capital key weight

General govt. debt share

Winners/ Losers

Germany 25.7% 23.6% 9.1%France 20.3% 21.0% -3.5%Italy 17.6% 22.8% -22.9%Spain 12.6% 10.4% 21.9%Netherlands 5.7% 4.9% 17.8%Belgium 3.5% 4.4% -19.0%Greece 2.9% 3.5% -16.5%Austria 2.8% 2.6% 9.7%Portugal 2.5% 2.4% 5.6%Finland 1.8% 1.2% 48.4%Ireland 1.7% 2.2% -26.2%Others 2.9% 1.2% 145.8%

0%

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ebt

ECB capital key share (only Eurozone countries)

IT

ES

DE

Winners

Losers


Structure of outstanding govt. debt matters At a macro level, the statement that countries with lower debt/GDP ratios relative to their ECB capital keys would stand to gain is correct. However, the structure of the outstanding government debt in the Eurozone countries could prove to be relevant for determining the market impact on govt. bonds and bills.

In particular, it is important to consider that the ECB buying is likely to be limited to EUR denominated, domestically issued central government bonds of the Eurozone member states. This is particularly relevant because securities which meet this criteria account for a varying proportion of total outstanding government debt in the Eurozone countries. For example, central government marketable debt accounts for 52% of German general govt. debt but as much as ~80% of the general government debt in Netherlands, Austria and Italy.

Given the pressures on the pension and insurance community in the Eurozone, it is also likely that the ECB would refrain from buying government bonds beyond the 10Y sector while bills have been excluded from the Fed, BoE and the BoJ QE programmes. In order to determine the market impact, it might be better to compare the ECB capital keys to the EUR denominated, central govt. domestic bonds issued with remaining maturity less than 10Y. On this basis we find that Germany and Spain could be beneficiaries while France and Italy could be at a disadvantage. Given the relatively limited outstanding amount of marketable debt in the countries which are either under or were under a full EU/IMF programme, it is not obvious whether an ECB QE would involve buying of debt of these countries. If bonds of these countries are indeed bought by the ECB they could stand to gain significantly.

Another way to compare the market impact of an ECB QE would be to compare the ECB capital key weights to the share of gross and net issuance of bonds from each of the countries. Comparing the possible ECB buying to gross issuance France and Italy would be at a disadvantage while Germany and Spain would gain. However, comparing the possible ECB buying to net issuance Germany would stand to gain while Spain, Italy and France would stand to lose.

17 January 2014



7: ECB capita key compared to govt.

bonds <10Y maturity

8: ECB capital key compared to

gross and net issuance (1) (2) [(1)-(2)]/(2)

ECB capital key weight

Govt. bonds <10Y

Winners & Losers

Germany 25.7% 17.2% 49.1%

France 20.3% 30.7% -33.9%

Italy 17.6% 23.7% -25.8%

Spain 12.6% 9.8% 29.0%

Netherlands 5.7% 5.3% 7.1%Belgium 3.5% 4.4% -19.8%

Greece 2.9% 0.8% 260.7%

Austria 2.8% 3.0% -5.0%

Portugal 2.5% 1.7% 48.7%

Finland 1.8% 1.2% 49.9%

Ireland 1.7% 1.4% 16.9%

Others 2.9% 0.8% 267.6%

(1) (2) (3)

ECB capital key weight

2014 Gross issuance

2014 Net issuance

Germany 25.7% 19.3% 11.7%

France 20.3% 21.8% 27.9%

Italy 17.6% 28.5% 26.3%

Spain 12.6% 14.8% 26.7%

Netherlands 5.7% 5.1% 5.7%Belgium 3.5% 3.9% 3.2%

Greece 2.9% 0.0% -6.1%

Austria 2.8% 3.1% 2.0%

Portugal 2.5% 1.3% 0.4%

Finland 1.8% 1.2% 1.6%

Ireland 1.7% 0.9% 0.4%

Others 2.9% #N/A #N/A


Conclusion — A broad based ECB QE is likely to use GDP or ECB capital keys as a

metric to determine the proportion of buying of govt. bonds of Eurozone countries

— Countries with lower debt/GDP ratio will stand to benefit compared to countries with higher debt/GDP ratios

— Countries with lower share of marketable govt. debt will stand to benefit as the market impact of ECB’s purchases is likely to be greater

— The ECB will probably refrain from buying at the long-end of the curve to avoid pressures on the pension and insurance funds

— While the periphery will stand to benefit from a broad based QE it might not result in a spread tightening vs. Bunds as Bunds could be one of the biggest beneficiaries

— All govt. bonds including periphery should outperform swaps. We maintain our ASW widener on Bunds for now and would recommend switching periphery spread tighteners vs. swaps rather than vs. Bunds

— Amongst the semi-core names France and Belgium are likely to benefit less than Netherlands and Austria. We recommend switching our semi-core spread widener in Austria to France

EUR 5Y-30Y steepeners

The moderate pressures on the front-end have resulted in some flattening pressures on the EUR curve. However, as argued above, we believe that any meaningful upward pressure on money market rates can be easily addressed by the ECB. Further, if instead of tighter money market conditions it is a deterioration in medium term inflation expectations which warrants further ECB action in the form of a broad based QE, the 5Y-30Y or 10Y-30Y curve is likely to steepen as QE will push real yields in the belly of the curve lower. The outlook for the 5Y-10Y part of the curve in such an environment is not clear and could depend on the magnitude of the decline in medium-term inflation expectations, the confidence in the ECB’s ability to reflate and the exact nature of the ECB’s purchases. Irrespective of the response of the 5s10s slope, if the ECB refrains from buying at the long-end of the curve to avoid exaggerating the low yield environment faced by pension and insurance funds the long-end of the curve should steepen.

17 January 2014



To our model of the EUR 5Y-30Y slope (which includes as explanatory variables front-end rates, medium-term inflation expectations, change in ECB balance sheet size, peripheral spreads, implied volatility on long tenor swaptions and expected budget balances), we add the solvency ratio of Dutch pension funds as another explanatory variable. The coefficient on the solvency ratio of Dutch pension funds has the appropriate sign, suggesting the curve steepens as the solvency ratio improves and flattens as the solvency ratio deteriorates. We note the coefficient is statistically significant as well.

The model shows that the EUR curve is close to fair value. However, we are comfortable with a steepener recommendation given (i) the positive carry on the trade, (ii) the belief that either of the two ECB policy actions is likely to result in a steepening of the curve and (iii) also to position for a normalisation of long-dated forwards in EUR, which still remain very low.

10: EUR 5Y-30Y curve is close to fair value 11: Carry and roll down remains attractive on steepeners

-30

-20

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0

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30

Jan-08

Jan-09

Jan-10

Jan-11

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Jan-14

EUR 5s30s slope residual

0

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15

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25

1Y 2Y 3Y 4Y 5Y 7Y 10Y 12Y 15Y 20Y 25Y 30Y

6M carry and roll down


9: Adding Dutch pension fund

solvency ratio to EUR 5Y-30Y slope

model

EUR 5Y-30Y slope, sample daily data since Apr-2007Beta T-stat

EUR 2Y swap (%) -39.61 -79.4EUR 5Y5Y inflation swap (%) 31.34 18.3Italy-Germany spread (bp) -0.08 -21.0EUR 1Y30Y implied vol (bp) -0.36 -14.9Budget balance (% of GDP) -0.94 -4.0Dutch solvency ratio (%) 0.46 8.6R-sq 94.7%


17 January 2014



Europe

Credit Covered Bonds Securitisation

European ABS Update Excerpt from European Asset Backed Barometer at https://gm.db.com/absEurope

European ABS secondary markets have begun 2014 in earnest and picked up where 2013 left off, with strong volumes and price performance. While GBP UK Prime is tighter by c.5-10 bps, the Dutch RMBS curve is tighter by 10-15 bps. In the periphery, sovereign yield compression has been the prominent theme. We highlighted in our Outlook 2014 publication that Portuguese RMBS particularly stands to benefit from such compression – indeed since the beginning of the year, 5-year Portuguese sovereign yields have tightened by c.1%, which has been followed by RMBS seniors from the region higher by 2-3 points. Selected Italian senior RMBS from shelves such as BPMO, BERCR and CORDR are tighter by about 30 bps since Christmas, dovetailing the 5-year BTPs.

While the primary in ABS has yet to open its account for 2014, there has been EUR 20 bn of bank senior unsecured, and EUR 10 billion of covered bond issuance in 2014 YTD, as the chart of the week below shows. The pipeline for ABS however remains active, with CLOs featuring prominently (some 8 transactions announced). Primary activity in peripheral financial credit further points to a move towards core pricing for ABS credit in the periphery. The pricing of BBVA and SANTAN senior unsecured bonds for example at MS + 118 bps (5 year @ 2.375% coupon) and MS + 93 bps (2 year issue @ 1.45% coupon) respectively indicates that secured RMBS seniors (currently trading at 150-200 bps for decent names/deals) from Spain could have further room to rally as relative value decisions come to the fore.

On the regulatory front, late on Tuesday, US regulators announced that US banks could continue to retain interests in TruPS CDOs, with some qualifications. However, a decision on whether investments in CLO debt would qualify towards the Volcker rule exemption is still being awaited – the definition of “ownership interest” currently also encompasses debt investments in leveraged loan CLOs due to “removal for cause” clauses, which industry bodies have pushed back on. In Europe, clarifications regarding risk retention have meant that CLO 1.0s would be grandfathered. A series of European regulatory announcements around Solvency II, risk weights, risk retention and LCR to name a few marked the latter half of December. We published a summary of these announcements in a report published last Friday – please ask us if you would like a copy.

Chart of the week: YTD primary issuance from Western European banks

0

5

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15

20

25

Senior Unsecured Covered Subordinated ABS

2014

ytd

issu

ance

(EU

R b

n)

Core Periphery

Source: Deutsche Bank, Informa

Other Articles in the European Asset

Backed Barometer include

RMBS/ABS Noticeboard Expert Group reviews

repossession processes in Ireland

Conor O'Toole


17 January 2014



Global

Credit Covered Bonds

Covered Bond Update

Despite a somewhat struggling new issue of PBB Pfandbriefe (8Y ms+17bp), the primary market for EUR benchmark covered bonds remained very strong, particularly in case of prime peripheral covered bonds, confirmed by an over two times oversubscribed orderbook for 10Y UniCredit covered bonds and a new issue spread which was 75bp tighter than Italian sovereign bonds.

Covered bonds tightened significantly since Sept 2012, particularly peripheral covered bonds. For example, Portuguese covered bonds tightened from over 800bp versus swaps to below 200bp. However, iBoxx EUR Covered still trades wider versus iBoxx Pfandbriefe than end of 2009 and certainly still significantly wider than pre-crisis. Given our overall constructive view on Spanish and Italian sovereign bonds, iBoxx EUR Covered should tighten further versus iBoxx EUR Pfandbriefe.

Despite declining versus 2013, net supply of Eurozone sovereign bonds will still be at around EUR 270bn in 2014, compared to negative net supply of around EUR 50bn in case of EUR benchmark covered bonds. Consequently, the share of iBoxx EUR covered in iBoxx EUR bonds will decline further in 2014. Given the low yield environment, this remains supportive for higher yielding covered bonds. Key risk is that this seems a full consensus trade.

With banks accounting for 62% in case of new 5Y Aareal, 52% in case of 10Y UniCredit Austria and 41% in case of 3Y UniCredit frn, bank buying of covered bonds remains significant. In our view, while not being a crucial topic for spreads of EUR benchmark covered bonds, covered bonds getting recognition as Level 1 LCR asset under CRR is not completely off the table yet (in case of covered bonds rated at least AA-). Overall, we think banks will remain large buyers of EUR benchmark covered bonds.

Moody's upgrading numerous Spanish Cedulas end of Dec and affirming the A3 of Sabadell Cedulas this week (despite the recent downgrade of the unsecured rating to Ba2), confirms the trend of stabilising covered bond ratings. While downgrade of the unsecured rating increased the expected loss of Cedulas, the high OC held by Sabadell in both cover pools (130.3% in case of CH and 102% in case of CT) compensates the increase. A multiple-notch downgrade of Sabadell Cedulas might occur in case of (1) a sovereign downgrade, (2) a multiple-notch unsecured downgrade or (3) a material reduction of the pool value, confirming that macro topics remain crucial for covered bond ratings in general.

Depfa ACS are the highest yielding non-peripheral covered bonds. As of 30 Sep 2013, Depfa ACS Bank had EUR 20.6bn of outstanding Asset Covered Securities (A3s/BBBs/An) backed by a cover pool amounting to EUR 22.8bn. Nominal OC was 10.8%. With 29.6%, German assets dominated the cover pool, followed by the US (21.9%), Spain (12.2%), Belgium (7.3%), Netherlands (5.5%), France (5.3%), Nordic (3.1%), Austria (2.8%), Canada (2.5%), Italy (2.3%) and others.

On 26 Aug 2013, a public tender offer for Depfa Bank Plc was launched by its parent, Hypo Real Estate (HRE). If no buyer is found at an acceptable price - which is the real challenge - Depfa will continue to be in orderly wind down under German government ownership without significant risk

Bernd Volk


17 January 2014



for unsecured and particularly for covered bond investors. The EU is not forcing privatisation at uneconomic prices, i.e. in case bids are too low, there will be no privatisation. While privatisation and resulting rating downgrade risk seems binary, we remain constructive.

The current outstanding volume of German Pfandbriefe amounts to around EUR 450bn and, in our view, will decline by at least EUR 25bn in 2014. With German insurance companies and pension funds desperate for alternatives that provide at least some yield, besides others, local sovereign debt is in focus. It seems, unless there is an explicit government guarantee, the standard rating/duration-driven spread risk formula of Solvency 2 applies, requiring capital charges for local sovereign debt. However, it seems also possible to use internal models positively impacting capital charges. In our view, capital charges for sub-sovereign debt will be low, if any. We highlight that European local sovereigns do usually not benefit from an explicit guarantee but from support mechanisms, supervision and potential interventions differing significantly between countries.

Please find more details in our separate publications "Covered Bond and Agency Update".

Figure 1: EUR covered and unsecured bonds issued this week Ticker Coupon Maturity Volume

(bn) Announcement

Date Type Spread Ratings

ABNANV 2.375 23-Jan-24 1.50 16-Jan-14 Covered ms+35bp Aaa/AAA/AAA

DEXGRP 2.000 22-Jan-21 1.25 15-Jan-14 Gov guaranteed ms+42bp Aa3/AA/AA

RABOBK 1.750 22-Jan-19 1.50 15-Jan-14 Unsecured ms+63bp Aa2

UCGIM 3.000 31-Jan-24 1.00 15-Jan-14 Covered ms+98bp A2/-/A+

PBBGR 1.875 21-Jan-22 0.50 14-Jan-14 Covered ms+17bp Aa2/AA+/-

POPSM 2.500 1-Feb-17 0.50 13-Jan-14 Unsecured ms+190p Ba3/-/BB+/AL

ISPIM 3.500 17-Jan-22 0.75 13-Jan-14 Unsecured ms+175bp Baa2/BBB/BBB+/AL

VICEN 3.500 20-Jan-17 0.50 13-Jan-14 Unsecured ms+300bp -/BB/BB+/BBB

BESPL 4.000 21-Jan-19 0.75 13-Jan-14 Unsecured ms+285bps -/-/BB-/BBBL

AARB 1.125 21-Jan-19 0.50 13-Jan-14 Covered ms flat -/ -/ AAA/-

BACA 2.375 22-Jan-24 0.50 13-Jan-14 Covered ms+35bp Aa1/-/- Source: Deutsche Bank

17 January 2014



Figure 2: iBoxx Euro Covered versus iBoxx Euro Germany

Covered

Figure3: Share of iBoxx EUR Covered in iBoxx EUR total

declined since Jan 2012

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iBoxx Euro Germany Covered

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9000 Covered Sub-SovereignCorporates FinancialsOther Collateralized SovereingsShare of covered(rhs)

Source: iBoxx Source: iBoxx

17 January 2014



United Kingdom

Rates Gov. Bonds & Swaps Inflation Rates Volatility

UK Strategy

The decline in inflation to target will prolong the goldilocks period the economy has been enjoying, and provide the MPC with some relief even as the unemployment target is being reached faster than expected

Looking at the front end over historical periods of rates on hold, current valuations do not appear excessive

The long end “excess richness” that was prevalent last year remains in place, and looking at the 10Y30Y50Y fly suggests that it is the 30Y sector in particular that has richened of late.

From an RV perspective, the 20Y has cheapened against the 10Y (UKT 34_23 spread), while 10Y spreads start to look rich against the wings

Meeting all the targets

Spot CPI declined back to target for the first time in four years and the possibility of it declining, albeit temporarily, below target over the coming quarter remains. The November labour market report released next week is also expected to show a further decline (DBe 7.2%, current bbg consensus 7.3%), bringing it closer to the 7% threshold.

As noted in our outlook, the decline in inflation will prolong the goldilocks period the economy has been enjoying, providing the MPC with some relief even as the unemployment target is being reached faster than expected.

That the 7% is not a trigger arguably is priced, with the first hike fully priced around March 15. The initial pace of hikes is 72bps in the first twelve months. Looking at the independent BoE’s record, previous hiking cycles have not exceeded twelve months, and ranged between 75-100bp of hikes.

Previous monetary policy cycles, post independence

Start Rate End Rate Duration Amount NotesHike Jul-97 6.75 Jun-98 7.5 11 75Cut Oct-98 7.25 Jun-99 5 8 -225Hike Sep-99 5.25 Feb-00 6 5 75Cut Feb-01 5.75 Nov-01 4 9 -175

Feb-03 3.75 1 dissentJul-03 3.5 1 dissent

Hike Nov-03 3.75 Aug-04 4.75 9 100Aug-05 4.5 split vote 5:4

Hike Aug-06 4.75 Jul-07 5.75 11 100Cut Dec-07 5.5 Mar-09 0.5 15 -500

Source: Deutsche Bank, BoE

There are a few periods in which rates remained on hold, with the average “turnaround” time around 8 months. We consider three specific periods where rates were on hold and followed by a hiking cycle - Jul-Nov 2003, Aug 05-Aug 06, Feb 10-Oct11 - and look at what was priced by the front end, specifically, the spread of 1Y1Y over Base Rates. In the 2003 period it averaged 98bp, in

Soniya Sadeesh

Strategist (+44) 0 207 547 3091 [email protected]

17 January 2014



the second 27bp, and the most recent 76bp, and currently around 40bp. In that context, the front end does not appear excessively priced at current valuations.

Pre crisis Post crisis

-1.50

-1.00

-0.50

0.00

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1.00

1.50

2.00

0

1

2

3

4

5

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Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Base Rate

1Y1Y-Base

Ave 27bp

Ave 98bp

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Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Base Rate

1Y1Y-BaseAve 76bp

Source: Deutsche Bank, Bloomberg Financial LP Source: Deutsche Bank, Bloomberg Financial LP

The surprise decline in the Oct unemployment rate to 7.4% has started to raise questions already of how policy will evolve once the 7% is reached.

As our economist noted the week before, there are several options open to the BoE. It’s unclear how much time pushing out the threshold would buy - most consensus forecasts do not extend beyond 6.9% level (BoE plateaus at 6.9% under market rates, HMT consensus forecasts is 6.9% for Q414). In addition, assuming the medium term NAIRU forecasted by the Bank remains 6.5%, it would arguably be more of a trigger than the 7% would be.

Indeed, the forward guidance publication in August 2013 notes that “ To ensure that CPI inflation remains on track to return to the 2% target, the Committee will need to withdraw some of the monetary stimulus before the unemployment rate falls back to its medium-term equilibrium. The unemployment rate threshold therefore needs to be set somewhere between the current unemployment rate of 7.8% in the three months to May 2013 and Bank staff’s estimate of the medium-term equilibrium rate of around 6.5%.”

Thus, while the Bank’s next move will clearly be a focus, history suggests valuations will remain highly data dependent. A fuller repricing of the rate cycle is likely to require more evidence of a sustainable recovery via a pick up in real wage growth and investment. Additionally, there may be more scope for macroprudential interventions, (for example alterations to Help-to-Buy) to cause a moderation in pricing to the extent it is expected to slow growth momentum. This week’s FPC testimony , however, indicates that for the time being, it is content to let housing momentum continue.

On an RV basis, the 20Y has cheapened against the 10Y (UKT 34_23 spread), while 10Y spreads start to look rich against the wings.

10Y20Y ASW Box 5Y10Y30Y ASW

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5Y10Y30Y (18_23_44)


17 January 2014



Deficits improve, long end richness remains The improvement in longer yields and risk asset performance seen over the past year, has helped drive an improvement in funding ratios. The long end “excess richness” that was prevalent over the second half of 2013 remains in place, and looking at the 10Y30Y50Y fly suggests that it is the 30Y sector in particular that has richened of late.

Ultra long end curve also too rich 10Y30Y50Y vs 10Y

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10Y30Y50Y Fly

Residual v 10Y


In aggregate, net purchases of Gilts amounted to GBP 7.4bn in third quarter (both linkers and conventional). Pension funds were net buyers of GBP 7.7bn, up from GBP 4.6bn in the second quarter. In the third quarter however, the bulk was in linkers ( + GBP 5.2bn) with GBP 2.4bn in conventional, compared to the previous quarter where demand was largely all conventionals. Insurers disposed of GBP 0.9bn, selling GBP 2.3bn nominals, while buying GBP 1.4bn linkers.

Aggregate Gilts Aggregate risk asset allocations

-7000.0

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All Gilts

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Q1-

09

Q3-

09

Q1-

10

Q3-

10

Q1-

11

Q3-

11

Q1-

12

Q3-

12

Q1-

13

Q3-

13

Overseas corp bondsOverseas equityUK corporate bonds+pref sharesUK equities

Source: Deutsche Bank, ONS Source: Deutsche Bank, ONS

Pension funds Insurers, long term funds

-8000

-6000

-4000

-2000

0

2000

4000

6000

8000

10000

Q1-

05

Q3-

05

Q1-

06

Q3-

06

Q1-

07

Q3-

07

Q1-

08

Q3-

08

Q1-

09

Q3-

09

Q1-

10

Q3-

10

Q1-

11

Q3-

11

Q1-

12

Q3-

12

Q1-

13

Q3-

13

Conventionals

IL

Pension Funds, GBP, mn

-8000.0

-6000.0

-4000.0

-2000.0

0.0

2000.0

4000.0

6000.0

8000.0

Q1-

05

Q3-

05

Q1-

06

Q3-

06

Q1-

07

Q3-

07

Q1-

08

Q3-

08

Q1-

09

Q3-

09

Q1-

10

Q3-

10

Q1-

11

Q3-

11

Q1-

12

Q3-

12

Q1-

13

Q3-

13

Conventionals

IL

Insurance Co, GBP mn

Source: Deutsche Bank, ONS Source: Deutsche Bank, ONS

17 January 2014



Europe


Nordic Strategy

Sweden – surprise to inflation but don’t be too hawkish

The December inflation report surprised to the upside. CPI came in at 0.14% YoY compared to -0.1% expected while CPIF increased by 0.76% YoY vs. 0.6% expected. Overall for 2013 headline CPI remained flat while core-inflation increased by 0.9%. The report was better than expected and reduces deflation risks as well as concerns about further interest rate cuts in 2014. However, we highlight that inflation continues to be significantly below the target of 2.0% and will in our view not reach the target until Q2-15. Furthermore we got house prices this week which surged to a new all time high in December. The YoY increase exceeded 5% again for the first time since Q1-13. This further contributes to the concerns of a housing bubble in Sweden and also reduces the risk of additional interest rate cuts.

Market reaction – sell off in short end of SEK curve but long end almost unchanged The market bear flattened on the back of the better than expected data releases. However, while the short end closed the week ~4bp higher (3Y at 1.56) the 5Y to 10Y sector rallied later in the week and remained hardly unchanged (5Y at 2.11 +1bp and 10Y -1bp).

Interest rate expectations – market turned a bit more hawkish For the Feb-meeting the market expects the Riksbank to remain on hold at 0.75%. In addition the market has fully priced out the probability of another interest rate cut in 2014 and now expects the Riksbank to hike to 1.00% by Q2-15. We continue to expect the Riksbank to remain on hold until the end of 2014 before we forecast the first interest rate hike to 1.00% in Feb-15.

Inflation remains key for monetary policy As highlighted in our previous Nordic/Swiss Weekly next to the recovery of the Euro-area – Sweden’s main export market - we believe spot inflation will be the key driver for the Riksbank’s monetary policy over the next couple years. Although the previous interest rate cut will weigh on headline inflation in the short term, we nevertheless believe that underlying economic data will be supportive for a pickup in inflation pressure over the course of 2014. We forecast CPI to come in at 1.0% in 2014 (Riksbank: 0.6%). However even in case our above consensus view on inflation pressure for 2014 will be realized we don’t expect this to be enough to justify rate hikes by the Riksbank to be moved into 2014. This said we believe that inflation expectations at the end of 2014 will be high enough to start the hiking cycle in early 2015.

Housing market – how long can the

rally last?

-10%

-5%

0%

5%

10%

15%

20%

1800

1900

2000

2100

2200

2300

2400

Jan-

10

Apr

-10

Jul-1

0

Oct

-10

Jan-

11

Apr

-11

Jul-1

1

Oct

-11

Jan-

12

Apr

-12

Jul-1

2

Oct

-12

Jan-

13

Apr

-13

Jul-1

3

Oct

-13

Real Estate: Average Purchase Price in Thous. Kronor % change YoY - rhs

Source: Deutsche Bank, Haver Analytics

Interest rate expectations in Sweden

Swedenrepo rate

path

rate expectations on Thursday

weeklychange in bp

DBforecast

Q1-14 0.73 0.75 1.0 0.75Q2-14 0.71 0.75 1.0 0.75Q3-14 0.71 0.74 1.3 0.75Q4-14 0.71 0.78 2.0 0.75Q1-15 0.89 0.90 2.8 1.00Q2-15 1.25 1.07 5.0 1.00Q3-15 1.59 1.20 3.5 1.25Q4-15 1.88 1.39 4.0 1.50

Sweden

Source: Deutsche Bank, Riksbank, Bloomberg Financial LP

Christian Wietoska


Abhishek Singhania


17 January 2014



Inflation – above expectations in Dec but inflation pressure remains on the low side – HCPI comparison (YoY) Riksbank

forecast for DecDec-13 Nov-13 Q4-13 2013

Harmonized consoumer prices - 0.36% 0.29% 0.27% 0.44%National CPI -0.07% 0.14% 0.12% 0.07% -0.04%CPIF 0.57% 0.76% 0.74% 0.70% 0.86%

weightingsfor CPI

Dec-13 Nov-13 Q4-13 2013

Food / nonalcoholic beverages 13% 1.03% 1.58% 1.41% 2.21%Alcoholic beverages 4% 1.17% 1.26% 1.26% 1.46%Clothing and shoes 5% 1.12% 0.39% 0.72% 0.69%

Housing 26% -0.12% 0.50% 0.20% -0.77%Household furnishings 5% -1.43% -1.57% -1.70% -2.43%Healthcare 4% 2.21% 1.78% 1.92% 1.90%

Transport 14% -0.15% -1.01% -1.01% -0.96%Post and telecommuncations 4% -2.88% -1.33% -1.92% -2.24%Reacreation and culture 12% -0.65% -1.52% -1.22% -0.77%Restaurants and accommodation 6% 1.25% 1.02% 1.26% 1.87%Various goods and services 6% 1.12% 1.09% 1.01% 0.96%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Jan/

09

Apr

/09

Jul/

09

Oct

/09

Jan/

10

Apr

/10

Jul/

10

Oct

/10

Jan/

11

Apr

/11

Jul/

11

Oct

/11

Jan/

12

Apr

/12

Jul/

12

Oct

/12

Jan/

13

Apr

/13

Jul/

13

Oct

/13

Sweden Norway Euro-area Germany

Source: Deutsche Bank, Haver Analytics Source: Deutsche Bank, Haver Analytics

Norway – Trade Balance – it’s worth a closer look

Trade Balance highlight of the week The week has been light in terms of economic data releases in Norway. We only got the trade balance for Dec on Thursday which came in at NOK 33.4bn compared to 33.9bn in Nov. This accounts to a surplus of NOK 371bn in the balance of trades compared to NOK 428bn in 2012. Total exports in goods decreased by 3.8% while imports surges by 4.3%.

Distinguish between oil related exports and “Others” It is worth pointing out that exports excl oil related goods account for only 40% of total exports while imports of the same category account for 98% of total imported goods. This said the balance of trades excl oil related goods has consistently been negative for the last few years and showed in 2013 with NOK -155bn the widest negative gap since at least 2000. In fact as % of GDP the balance of trades for the first three quarters of 2013 decreased to a new record of -5.2% while the current account balance also decreased to +13.1% - but from a record high of +15.1% in 2012. The share in exports has remained more or less unchanged since 2000 but slightly increased vs. 2012 (+2pp) driven by a better development of non-oil related exports compared to oil-related exports (+1.2% vs. -7.2%).

Norway’s international trades in more detail It is not a surprise that the development of total exports depends significantly on oil related products. Looking into the details we see that petroleum and gas related products account for ~67% of total exports in goods. Other than that only “Fish” (7%) and to some extent “Industrial Products” (>4%) can be seen as important exports. Looking into the distribution of products we highlight that nearly 85% of the products are sold to countries in the Europe while Asia and North America account for only 7.5% and 5.9%, respectively.

Sweden the different export market In 2013, Sweden’s exports have been hit hard by the European debt crisis and in particular by decreasing demand from the core countries of the Euro-area (Germany, Netherlands and France). Until Nov-13 total exports in goods were down ~7.5% YoY vs. -3.5% in 2012. If we don’t see a significant rebound for Dec this is the second largest decrease since 1990. In this context we highlight that the expected increase in GDP for 2013 of 0.9-1.0% was mainly driven by strong domestic demand.

Trade balance excl oil and gas with

widest gap in NOK since

-180,000

-160,000

-140,000

-120,000

-100,000

-80,000

-60,000

-40,000

-20,000

0

050,000

100,000150,000200,000250,000300,000350,000400,000450,000500,000

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Balance of tradesBalance of trade (ex oil, natural gas & condensates) - rhs

Source: Deutsche Bank, Haver Analytics

Exports by countries Norway vs.

Sweden

Norway%

of total2013YoY

Sweden% of total

2013YoY*

UK 24% -11% Norway 11% -3%Netherlands 13% 3% Germany 10% -7%Germany 13% 4% UK 8% -22%France 6% 4% Finland 7% 3%Sweden 6% -12% USA 7% -11%USA 5% -12% Denmark 7% -3%Denmark 4% -7% Netherlands 6% -9%Belgium 3% 13% France 5% -8%Italy 2% 0% China 3% 4%Spain 2% 12% Poland 3% -6%China 2% 17% Italy 2% -5%Poland 2% 14% Russia 2% -5%Other 18% 21% Other 29% -3%

Source: Deutsche Bank, Haver Analytics, Note: Data for Sweden based on data until Nov-13

17 January 2014



Exports by Product for Norway and Sweden

Norway%

of total2013

in NOK2013YoY

Sweden%

of total2012

in SEK2013YoY

Exports by Product 899,746 -3.8% Exports by Product 1,170,100 -7.5%Petroleum and

prodcuts37% 336,753 -9.0%

Machinery&

Transport equipment39% 451,102 -8.0%

Natural and

manufactures gas29% 263,462 -5.2%

Manufactured goods

classified chiefly by material19% 220,832 -10.0%

Fish 7% 60,375 18.8% Chemicals&related products 11% 131,003 -0.2% Nonferrousmetals 4% 35,802 -10.2% Mineral fuels and lubricants 10% 117,540 -21.9%

Industrial machinery 2% 19,158 15.7% Mis. manufactured products 9% 106,333 -5.0%

Specialized machinery 2% 16,057 1.9% Inedible crude materials 7% 77,716 -10.2%

Electrical machinery

and apparatus2% 14,294 14.3% Food and live animals 4% 48,360 10.9%

Other 17% 153,872 4.1% Other 1% 17,544 -9.2%

Source: Deutsche Bank, Bloomberg Haver Analytics, Note: Data for Sweden based on data until Nov-13

Details in Swedish exports Looking into the details of the Swedish export structure we see that the Euro-area remains with ~50% of total exports the main market. From the product side Sweden exports in particular “Machinery (39%)”, “Manufactured goods (19%)” and “Chemicals (11%)” more sensitive to the business cycle.

Oil demand/price key for exports in Norway while Sweden’s exports sensitive to Euro-area recovery We compared the impact of a) GDP Euro-area b) natural gas prices and c) the oil price on the development Sweden’s and Norway’s exports. For Norway we see that the development of the oil price (with 1Y lag) has the most significant impact on the export market. While the development of GDP in the Euro-area has also a positive impact on Norway’s exports (given the positive correlation between oil prices and GDP growth in Euro-area) the impact is more significant on Swedish exports (correlation 74% vs. 58%). This is in line with what we would have expected by looking into the details of the Swedish export structure. We also ran a Principal Component Analysis (PCA) which shows that the oil price is the key variable for export growth in Norway while GDP growth in the Euro-area is the key variable in Sweden.

What does this tell us Overall we remain constructive on the economies in Norway and Sweden and expect both countries to show strong GDP growth rates in 2014 (Sweden 2.4% and Norway 2.5%). However, while both countries will benefit from a gradual recovery in the Euro-area Sweden should disproportional benefit given their above mentioned export structure. We believe exports will contribute positive to real GDP in 2014 following 2013 where exports of goods were down almost 8.0% YoY. In Norway we believe the environment for exports will be more challenging. Although exports of goods excl. oil/gas should show another increase over the year in particular supported by the rapid depreciation of NOK in 2013 (-13% vs. the Euro) oil related exports could once again underperform in 2014. However, overall we expect total exports in Norway to be flat to slightly positive.

Implications for trade recommendations in Nordics

Implications for our trade recommendation Long SEK vs. NOK We currently favor to remain short NOK vs. SEK in swaps (3Y and 10Y sector). While we like the positive carry in this trade we also highlight that we see rates in the NOK swap curve as too low – historically and on a cross-country basis. In the 10Y sector we justify our view with the fact that in

Demand for oil related products key

for Norway while Sweden sensitive

to Euro-area recovery

CorrelationNatural

GasOil Price -

1 lagGDP Euro -

AreaNorwayExports

SwedenExports

NorwayExports

51.3% 75.0% 58.0% 100.0% 66.7%

SwedenExports

15.0% 41.9% 73.7% 50.9% 100.0%

Source: Deutsche Bank, Bloomberg Financial LP, Haver Analytics

17 January 2014



our view the market has not yet fully priced in the higher inflation pressure over the next few years. In the short end we like the trade given our view that the Riksbank will not deliver its current interest rate path of 4 ½ hikes until the end of 2015. Given the low inflation pressure we could see the Riksbank to remain on hold for longer if markets don’t reprice global interest rate expectations. On the other hand we see further interest rate cuts by the Norges Bank as unlikely given the robust economic activity, inflation pressure close to the target of 2.5% and the high credit growth. Hence in our view the spread in 3Y NOK-SEK could widen to 75bp (currently at 46bp).

Risks to our Long SEK vs. NOK position However, in the following economic scenario we see the risk that the NOK-SEK spread could tighten further over the next few months. In our base case scenario we assume a gradual economic recovery of the Euro-area driven in particular by the core-European countries. However, as highlighted above in case of significant upside surprises to growth in the Euro-area in addition with flat to low increases in oil-related products the Swedish exports should disproportional benefit relative to Norway. In this case the market could start to price in earlier a more aggressive interest rate path for Sweden. However, we could only see this scenario to be realized in Sweden if in addition inflation surprises significantly to the upside or macroprudential measures currently in place have no impact on the pace of credit growth.

Risks limited in the medium term Although we could see markets to price in higher interest rates in Sweden in the short term on the back of positive momentum in domestic spot inflation and improvements in exports as well as upside to growth in the Euro-area we don’t expect the Riksbank to deliver even in this scenario. We continue to see it as rather unlikely that the Riksbank can aggressively hike interest rate much earlier than other central banks. Firstly, despite further improvements in economic activity the Swedish economy is not yet over the hill. Secondly, even in case our above consensus view on inflation for 2014 (1.0% in headline CPI vs. Riksbank’s forecast of 0.6%) would be realized we don’t expect this to be enough to justify rate hikes by the Riksbank to be moved into 2014. Last but not least we also doubt that the Riksbank will realize its very steep interest rate path given the high share of mortgages on floating rates. In case aggressive hikes will be realized by the Riksbank this will have a significant impact on domestic demand and therefore GDP. Hence we expect the hiking cycle to be smooth and with not more than 2-3 hikes a year.

3Y NOK-SEK spread remains at tight levels Riksbank vs. Norges Bank – current paths imply the

spread to narrow over the next few years

0

20

40

60

80

100

120

140

160

180

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jan/08

May/08

Sep/08

Jan/09

May/09

Sep/09

Jan/10

May/10

Sep/10

Jan/11

May/11

Sep/11

Jan/12

May/12

Sep/12

Jan/13

May/13

Sep/13

Jan/14

3Y SEK 3Y NOK Spread in bp - rhs

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Feb/

08

Aug

/08

Feb/

09

Aug

/09

Feb/

10

Aug

/10

Feb/

11

Aug

/11

Feb/

12

Aug

/12

Feb/

13

Aug

/13

Feb/

14

Aug

/14

Feb/

15

Aug

/15

Feb/

16

Aug

/16

Repo Rate in Sweden Deposit Rate in Norway

Source: Deutsche Bank, Bloomberg Financial LP Source: Deutsche Bank, Riksbank, Norges Bank, Bloomberg Financial LP

17 January 2014



The week ahead in Nordics

The week ahead in Sweden The upcoming week is rather light in term of economic data releases. We get the employment report for Dec on Thursday (8.0% SA in Nov). Overall the labor market has surprised to the upside in 2013 and if nothing exceptional happens the unemployment rate should come in at 8.0% for 2013 compared to 8.0% in 2012.

The week ahead in Norway Similar to Sweden the data flow in Norway is again on the light side. However, on Monday we will get house price data for Q4-13. Following a rapid increase in house prices over the last four years (prices up almost 30% since Q3-09) fears have intensified that Norway could face a strong decline in house prices over the course of the year. Although house prices have dropped by 1.8% QoQ in Q3-13 and the YoY-increase fell to 2.9% - the lowest increase in four years - we nevertheless highlight that the reading has still been positive YoY. Overall we believe that house prices will decline modestly by ~3% in 2014 (for further information please refer to the Nordic/Swiss 2014 Outlook).

Increased focus on housing market in Norway Robust employment market situation in Sweden

expected to remain well supported in 2014

-10%

-5%

0%

5%

10%

15%

20%

80

100

120

140

160

180

Q1-

04Q

3-04

Q1-

05Q

3-05

Q1-

06Q

3-06

Q1-

07Q

3-07

Q1-

08Q

3-08

Q1-

09Q

3-09

Q1-

10Q

3-10

Q1-

11Q

3-11

Q1-

12Q

3-12

Q1-

13Q

3-13

Housing Price IndexYoY % change in House Prices - rhsAverage monthly increase (YoY) - rhs

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0Q

1-07

Q3-

07

Q1-

08

Q3-

08

Q1-

09

Q3-

09

Q1-

10

Q3-

10

Q1-

11

Q3-

11

Q1-

12

Q3-

12

Q1-

13

Q3-

13

Q1-

14

Q3-

14

Q1-

15

Q3-

15

unemployment rate (SA YoY %-change) - Riksbank's December forecast

Source: Deutsche Bank, Haver Analytics Source: Deutsche Bank, Riksbank

17 January 2014



Japan


Japan Strategy

Overview

We are basically bullish on Japanese equities given that the Abe Cabinet is likely to remain in office until at least 2016 and will probably make full use of monetary and fiscal policy to shore up its approval rating if the economy falls into recession. However, defeat for the candidate supported by the ruling Liberal Democratic Party in the upcoming Tokyo gubernatorial election could potentially weaken the perceived mandate of the Abe government.

Domestic private-sector banks have accelerated their lending but still face a combined deposit-loan gap in excess of JPY180 trillion as funds continue to flow into deposits. Domestic banks have been net sellers of foreign bonds since April (overall), suggesting that they are not yet earning ample carry on foreign bond positions. We continue to recommend staying long JGBs, believing that banks as a whole remain keen to buy into any temporary weakness (rises in yields).

Tokyo gubernatorial election a potential threat to equities

The Nikkei 225 has lost a little ground after rising past 16,000, with weak December US jobs data and a brief strengthening of the yen seemingly contributing factors. However, we expect equities prices to continue climbing in the longer term. Our basically bullish view is based not on fundamentals, but on the likelihood that Prime Minister Shinzo Abe and his government will remain in office until at least 2016 given that upper and lower house elections do not need to be held before that time. Prime Minister Abe will however need to maintain a comparatively high public approval rating, which could prove difficult unless economic growth remains strong and equities keep climbing. History has shown a tendency for Cabinet approval ratings to rise soon after a new government takes office, but then fall in the event of sluggish stock price performance. We therefore expect to see rapid political intervention if the economy looks to be threatened by either domestic or overseas factors. For example, a downturn in exports due to a deterioration in the global economy would probably see the government step up its "national resilience" infrastructure strengthening initiatives and other fiscal stimulus measures, while a sharp appreciation of the yen would likely be countered by yen-selling intervention and additional Bank of Japan easing. The ruling Liberal Democratic Party (LDP) / New Komeito coalition currently controls both the lower and upper houses and is thus able to make full use of its policy tool kit (whereas the Obama government continues to be constrained by the Republican-controlled House). We therefore expect to see a strong response from the government in the event that the Japanese economy takes a turn for the worse, and believe that this safety net should help to keep equities in bull mode for the foreseeable future.

Makoto Yamashita, CMA


17 January 2014



Figure 1: Cabinet approval rating vs. Nikkei 225

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

7000

8000

9000

10000

11000

12000

13000

14000

15000

16000

17000

18000

19000

2006 2007 2008 2009 2010 2011 2012 2013 2014

(%)(JPY)

Nikkei 225 (lhs) Cabinet approval rating (rhs)

LDP government→ DPJ government → LDP government

Note: Vertical lines denote changes of Cabinet Source: Nikkei Research, Bloomberg Finance LP, Deutsche Securities

The key proviso is that the Abe government will need to maintain a sufficiently high approval rating. Prime Minister Abe's approval rating has fallen to 56% following passage of the controversial law toughening penalties for those who leak state secrets, while the LDP's approval rating has dropped from as high as 56% to 42%. The percentage of "uncommitted" voters has risen to 32% as the opposition Democratic Party of Japan is no longer picking up the slack. The upcoming Tokyo gubernatorial election—to be officially declared on January 23 and held on February 9—warrants close attention in this regard. Former health minister Yoichi Masuzoe will be running with official LDP backing, but former Prime Minister Morihiro Hosokawa has also indicated that he will contest the race on an "anti-nuclear" platform with the support of former Prime Minister Junichiro Koizumi. A Hosokawa victory would not immediately derail the Abe government's plans to restart idled nuclear reactors, but could make the prime minister and the LDP less popular among voters, thereby making it more difficult for the government to deploy the various policy measures necessary to keep the stock market in bull mode.

Figure 2: Party approval ratings

0

10

20

30

40

50

60

05 06 07 08 09 10 11 12 13

LDP DPJ Undecided%

Note: Vertical lines denote changes of Cabinet Source: Nikkei Research, Deutsche Securities

17 January 2014



Banks still have ample surplus funds to invest in domestic bonds

Principal Figures of Financial Institutions show growth in outstanding loans and discounts for major and regional banks accelerating from +2.4% YoY in November to +2.6% in December, reflecting particularly strong growth for city banks. Growth in deposits and CDs slowed from +4.0% to +3.8%, but deposit balances still exceed loan balances by more than JPY180 trillion for the banking sector as a whole, meaning that there are ample funds to channel into JGBs and other domestic (JPY-denominated) assets.

Figure 3: Bank lending versus real deposits (year-on-year growth rates)

-4

-3

-2

-1

0

1

2

3

4

5

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Lending Real deposits + CDsyoy, %

Source: Bank of Japan, Deutsche Securities

Banks appear to be well on track to meet their FY2013 profit targets, but could face a somewhat more challenging investment climate in FY2014. From a fundamentals perspective interest rates are liable to face at least some upward pressure as the BOJ targets +2% inflation and the Abe government looks to shore up its approval rating by stimulating the economy. Portfolio managers might therefore be tempted to cut back their JGB holdings and exposure to duration risk, but doing so would make it difficult to secure sufficient market investment returns. Assuming that banks are reluctant to take on greater FX risk or significantly increase their allocations to equities, they may ultimately see little option but to invest in foreign bonds using funds raised overseas. Banks were big net sellers of foreign bonds & notes in April–June 2013, and while they did start to buy once the 10y UST yield moved above 2.5%, still ended up selling some JPY1.5 trillion more than they bought over the April–December period, suggesting that they are not yet earning sufficient carry from foreign bond holdings. We therefore see only limited potential for JGB yields to move higher, believing that domestic banks will be keen to buy into any temporary weakness.

17 January 2014



Figure 4: Foreign bond investment by the banking sector vs. 10y UST yield

1.0

1.5

2.0

2.5

3.0

3.5

-4000

-3000

-2000

-1000

0

1000

2000

3000

4000

11 12 13

Investment in foreign bonds & notes (lhs)

10y UST yield (rhs)

(Billion yen) (%)

Source: Ministry of Finance, Deutsche Securities

Makoto Yamashita, +81 (3) 5156-6622

17 January 2014



Europe Eurozone United States

Trade Recommendation


Global Relative Value

This week we look at optimal ways to position for a repricing of the 5y sector in the US towards higher levels i.e. for a repricing of the pace of rate hikes. We also look at an attractive carry trade in Europe benefiting both from curve and vol carry.

How to position for a more aggressive Fed hiking cycle? The aim of this section is to provide investors with insight as for the optimal points and slope trades to choose in the belly of the US curve to express a bearish view in the 5y sector. Optimal points are those that are likely to sell-off the most once the market starts pricing in a more aggressive Fed rate hike cycle (beyond the one implied by the median FOMC dots which is currently priced in) and that are also likely to suffer the least from an adverse scenario of poor macro data and more dovish. Similarly optimal slope trades should benefit from a repricing of a more aggressive hiking cycle while being fairly immunized in case of renewed Fed dovishness. The methodology consists in calculating the fair value of key forward rates in the 2015-2018 sector for different symmetrical dovish and hawkish Fed scenarios. More precisely, we consider the rate hike cycles implied by the December dots of the 3rd and 5th most dovish FOMC members and by the dots of the 3rd and 5th most hawkish FOMC members. We can then calculate the average expected P&L of being short these different forward rates, the dispersion of the P&L, the resulting Sharpe ratio, and the convexity of the returns (max gain against max loss or average gain against average loss). Being short the 3Y1Y rate and the Dec-16 and Jun-17 Eurodollar contracts stand out as the best opportunities outright. The analysis also suggests that the most asymmetrical way to position for a higher rate scenario is the Dec-16 vs. Dec-18 ED flattener or 3Y1Y-4Y1Y swap flattener. Indeed while hawkish scenarios would imply a bear flattening of the ED strip in this sector, dovish scenarios would also imply some mild bull flattening pressures, hence particularly convex trades.

Conditional bear steepener-buy 5y30y ATMF payer vs sell 5y5y OTM+30bp payer, premium neutral: The 5Y fwd 5s30s steepener is a particularly attractive carry trade thanks to the shape of the curve and of the vol surface. The 5y fwd 5y-30y slope is virtually flat (~5bp), while the 5s30s spot slope is around 155bp, hence about 30bp of average annual curve carry. Simultaneously the 5y5y to 5y30y implied normal vol ratio is close to historically high levels providing an opportunity to implement the bear steepener at zero cost by setting the strike on the 5y5y payer 30bp OTM relative to the 5Y30Y leg. The strike slope of the premium neutral conditional bear steepener is worth -25bp. The 5s30s spot slope has never been more inverted than -25bp historically while the 30y rate has generally been higher than what is currently priced by the 5y30y forward rate hence an extremely low empirical probability to suffer a loss at expiry. Moreover we find that the high vol ratio is already fully reflecting the directionality of the curve and that the forward slope is too flat relative to the low vol regime. The ATMF vol roll is flat for the first couple of years but the higher rates roll down and steeper payer skew on the 5y5y leg make the vol ratio

Jerome Saragoussi


17 January 2014



roll very favorably. Carry, therefore, looks particularly attractive both from a curve and vol perspective, protecting against substantial bear flattening.

# 1 – How to position for a more aggressive Fed hiking cycle?

The aim of this section is to provide investors with insight as for the optimal points and slope trades to choose in the belly of the US curve to express a bearish view in the 5y sector. Optimal points are those that are likely to sell-off the most once the market starts pricing in a more aggressive Fed rate hike cycle (beyond the one implied by the median FOMC dots) and that are also likely to suffer the least from an adverse scenario of poor macro data and more dovish Fed. Similarly optimal slope trades should benefit from a repricing of a more aggressive hiking cycle while being fairly immunized in case of renewed Fed dovishness.

The 5y sector has sold off substantially since the December FOMC meeting. At the time the market was pricing in an aggressive explicit change in forward guidance but the Fed simply projected marginally lower short rates relative to September without changing the definition of forward guidance. The market therefore repriced the Fed Funds strip higher towards the new median projections of the target rate by the FOMC. The market is currently pricing in a target rate at roughly 75bp in Dec-15, 130bp in Jun-16 and 180bp in Dec-16, in other words the market is embedding a marginal 5bp risk premium above the median FOMC dots. We expect these median FOMC forecasts to be a lower bound for market expectations given the positive macro outlook (positive fiscal impulse and credit impulse), upcoming rotation of dovish voting members replaced by more hawkish regional presidents, and the positive reaction of US risky assets since December in spite of a higher 5y rate.

In order to identify sweet spots, we calculate the fair value of key forward rates in the 2015-2018 sector implied by four symmetrical dovish and hawkish Fed rate hike scenarios. More precisely we consider the rate hike cycles implied by the December dots of the 3rd and 5th most dovish FOMC members and by the dots of the 3rd and 5th most hawkish FOMC members. The two dovish and two hawkish rate hike cycle scenarios are described in the table and charts below (first hike ranges between Mar-15 and Mar-16 and pace between 25bp and 50bp per quarter).

Figure 1: Rate hike scenarios from most dovish and most

hawkish FOMC members

Figure 2: Description of the hawkish and dovish FOMC

scenarios

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5th dove Dec-15 25bp per quarter Dec-19

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Pace of rate hikes in first year


17 January 2014



Once we have the fair value of the different forward starting swaps and Eurodollar rates implied by these rate projections we calculate the implied sell-off or rally that market rates would have to go through in order to match these fair value levels. We can then calculate the expected P&L for being short these different forward rates in each scenario and obtain a global average expected P&L, we also obtain the dispersion of the P&L in these different scenarios. We then calculate the resulting Sharpe ratio i.e. the expected average return divided by the dispersion of these expected returns. We finally extract some measures of convexity of returns (ratio of maximum expected P&L gain against maximum expected P&L loss, as well as ratio of average gain against average loss). We show the results in the table below:

Figure 3: Table of results

3rd most 5th most 5th most 3rd most Avg Sharpe Worst Max Convexity

dovish dovish hawkish hawkish P&L Ratio loss gain Max gain Avg gain

Outright short Change in rates from current (in %) to Max

lossto avg loss

1y1y (0.31) (0.20) 0.32 0.72 0.13 0.28 (0.31) 0.72 2.33 2.06

2y1y (0.61) (0.36) 0.66 1.23 0.23 0.27 (0.61) 1.23 2.02 1.96

3y1y (0.55) (0.33) 0.98 1.43 0.38 0.40 (0.55) 1.43 2.62 2.76

4y1y (0.57) (0.42) 0.93 0.94 0.22 0.26 (0.57) 0.94 1.65 1.88

Dec-15 (0.51) (0.28) 0.55 1.19 0.24 0.31 (0.51) 1.19 2.36 2.22

Jun-16 (0.55) (0.30) 0.74 1.29 0.29 0.34 (0.55) 1.29 2.34 2.39

Dec-16 (0.54) (0.29) 0.93 1.43 0.38 0.41 (0.54) 1.43 2.67 2.87

Jun-17 (0.52) (0.29) 1.00 1.50 0.42 0.43 (0.52) 1.50 2.90 3.12

Dec-17 (0.54) (0.39) 1.09 1.26 0.35 0.37 (0.54) 1.26 2.30 2.50

Jun-18 (0.59) (0.44) 0.91 0.91 0.20 0.24 (0.59) 0.91 1.55 1.77

Dec-18 (0.58) (0.43) 0.62 0.62 0.06 0.09 (0.58) 0.62 1.07 1.23

Flatteners

2y1y-4y1y (0.03) 0.06 (0.26) 0.28 0.01 0.05 (0.26) 0.28 1.06 1.16

3y1y-4y1y 0.02 0.09 0.05 0.49 0.17 0.76 0.02 0.49 ∞ ∞

dec16-dec18 0.04 0.14 0.31 0.81 0.33 0.95 0.04 0.81 ∞ ∞

Jun16-Jun18 0.04 0.14 (0.17) 0.38 0.10 0.42 (0.17) 0.38 2.25 1.10

Steepeners

1y1y-2y1y (0.30) (0.16) 0.34 0.51 0.10 0.25 (0.30) 0.51 1.7092 1.85

1y1y-3y1y (0.24) (0.13) 0.66 0.71 0.25 0.50 (0.24) 0.71 2.9943 3.72


We note being short the 3Y1Y rate and the Dec-16 and Jun-17 Eurodollar contracts are the best opportunities outright. Indeed the average expected P&L on these short positions is the highest, assuming that the four scenarios have the same probability to happen. Relative to other rates they present a more substantial risk of sell-off while they are unlikely to rally more than the other rates. We note they offer the best Sharpe ratio but also the best convexity.

The analysis also suggests that the most asymmetrical way to position for a higher rate scenario is via the Dec-16 vs. Dec-18 ED flattener or 3Y1Y-4Y1Y swap flattener. Indeed while hawkish scenarios would imply a bear flattening of the ED strip in this sector (the 3y1y sector has also more room to sell-off in a repricing of the hiking cycle than the 4y1y rate which is already close to 3.5%), dovish scenarios would also imply some mild bull flattening pressures. In other words while the P&L of these flatteners is expected to be significantly positive in case of repricing of an aggressive rate hike cycle, the P&L could well be

17 January 2014



close to flat or marginally positive in an adverse scenario of soft macro and dovish Fed (which would affect the perception of the long term equilibrium FF rate, would increase QE expectations without delaying considerably the timing of the first hike). In other words these flatteners are likely to be profitable in both bearish and bullish environments, making these trades very convex.

The charts below illustrates the still remarkable historical steepness of the current slopes EDZ6-EDZ8 on the one hand (constant time period), and 3Y1Y-4Y1Y (constant forward starting time implying varying time frames).

Figure 4: Extreme steepness of ED slope Dec16/Dec18 Figure 5: Still impressive steepness in 3y1y/4y1y

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The risk of these trades would be one of extreme delay of the first rate hike well into 2016 or 2017, followed by a very fast normalization in 2017 or 2018. This could limit the magnitude of the sell-off in ED Dec-16 or in 3Y1Y relative to the sell-off in ED Dec-18 or 4y1y.

# 2 – EUR 5Y fwd 5Y-30Y conditional bear steepener

We recommend investors willing to position for a strategic carry trade to implement a premium neutral EUR 5Y fwd 5Y-30Y conditional bear steepener with OTM payers. The trade would consist in buying EUR100Mln 5Y30Y ATMF payer vs. selling EUR418Mln of 5Y5Y OTM+30bp, premium neutral.

1. The trade benefits from very attractive curve carry. The 5y fwd 5y-30y slope is virtually flat (~5bp only), while the 5s30s spot slope is ~155bp. As time goes by the slope will have a propensity to steepen back by 150bp. Average annual carry is thereby around 30bp but is not linear. In the first year carry is 22bp and then it increases to 28bp, 32bp, 34bp and 30bp. This carry is currently close to historically high levels (see figure 2 below).

17 January 2014



Figure 1: Attractive roll of the 5Y fwd slope towards spot Figure 2: Historically high positive carry

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Term structure of forward 5s30s slope

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Carry on the 5y fwd 5s30s steepener


2. Simultaneously the trade benefits from a very attractive vol ratio. The 5y5y to 5y30y implied normal vol ratio is close to historically high levels around 1.24 (see figure 3 below) providing an opportunity to implement the bear steepener at zero cost by setting the strike on the 5y5y payer 30bp OTM relative to the 5Y30Y leg. This has many benefits:

a. It lowers the delta on the short 5y5y payer position so that the net delta of the position is not perfectly neutral any longer. The premium neutral structure trades slightly short, reducing the marked to market risk in case of short term bear flattening.

b. It accelerates the time decay on the short 5y5y payer as time goes by and as 5y5y rate rolls down towards lower levels.

c. The 5y5y payer skew is more expensive i.e. steeper than 5y30y payer skew so that the vol ratio captured by the trade is higher than the ATMF vol ratio at nearly 1.27 instead of 1.24.

d. Finally it makes the strike slope negative at -25bp. In other words the slope needs to be steeper than -25bp at expiry for the trade to be in the money in a higher rate environment.

3. Historically the 5s30s spot slope has never been more inverted than the strike slope of -25bp while the 30y rate has generally traded substantially above the level of 3.10% currently priced by the 5y30y forward rate over the past 15 years (see figure 4). The empirical probability of being in the money is therefore particularly elevated.

17 January 2014



Figure 3: Extreme ratio of EUR 5y5y to 5y30y implied

normal volatility

Figure 4: Empirical likelihood to end up making money at

expiry is extremely high (higher rate and slope >-25bp)

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5s30s vs. 30y5y30y strike

strike slope

P&L>0

Neutral P&L

P&L<0


4. The historical high vol ratio is already fully pricing in the directionality of the slope: looking at the relationship between the vol ratio and the actual rolling beta of the 5y fwd 5s30s slope vs. 5y5y rate, we find that the vol ratio is in fact overestimating a bit the recent regime of directionality of the slope with the level of 5y5y rate (see figure 5 below). From this perspective there is increasingly limited room for further outperformance of 5y5y vol vs. 5y30y. Moreover part of the recent cheapening of 5y30y vol has been seasonal, related to expectations of an increase of callable issuance in Q1. This wave of vol supply still has to materialize. Going forward a higher rate environment may reduce the need for German insurers to sell some optionality to capture higher yields which could reduce supply at the bottom right corner of the vol surface, contributing to the outperformance of 5y30y vol vs. 5y5y.

5. The forward slope 5y fwd 5s30s is too flat relative to vol/convexity: the forward slope 5y5y vs. 5y30y is a spread between two long dated forward rates supposed to both reflect long term expectations of nominal GDP growth in Europe. The difference between the two rates comes from a term premium which tends to make the slope positive, and from the pricing of a convexity advantage for longer dated forward rates, which tends to invert the slope. In a high vol environment the expected excess returns on 5y30y vs. 5y5y (due to higher convexity for the 5y30y swap) leads to a richening of 5y30y vs. 5y5y and to an inversion of the spread. Currently the low vol regime suggests that the forward slope should be steeper and converge towards its pre crisis equilibrium around 20bp (see figure 6).

17 January 2014



Figure 5: 5y5y to 5y30y vol ratio is already adequately

reflecting the directionality of the slope with rates

Figure 6: The forward slope 5y fwd 5s30s could be

steeper given the lack of vol at the long end

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6. Forward 5s30s slopes would likely steepen if the ECB delivers QE: the context of persistently soft inflation in Eurozone increases the likelihood of a new monetary stimulus by the ECB in the next 12 months, in the form of a vLTRO or of a QE program (which would be concentrated in the front and intermediate part of the curve but would avoid the long end to avoid negative implications of pension funds) should help compressing the belly of the curve and containing vol on EUR rates, which would contribute to steepening pressures. Moreover the positive impact of QE on inflation expectations and on the chance of success to boost the EU economy could lead to an increase in inflation risk premium and term premium at the long end, contributing to some steepening.

7. Beyond the favorable rates roll down, the vol roll and skew roll are also source of positive carry: while the vol ratio between ATMF 5y5y and 5y30y is expected to be stable in the next couple of years with the ATMF 3y5y vs. 5y30y vol ratio also at 1.24, the trade should actually benefit from the fact that the roll down on the 5y5y rate will push the 5y5y payer struck OTM+30bp (3.35% at the time of writing) more and more out of the money over time relative to the underlying rate. Given the steepness of the payer skew on the 5y tenor (outright and relative to 30y tenor), the effective vol roll would instead be very favorable to the trade. After one year the 4y5y rate at 2.78% (assuming roll down is realized) would make the 4y5y payer OTM by nearly 60bp and would imply a vol roll up from 85.8bp on the 5y5y 30bp OTM payer to 89.7bp on the 4y5y 60bp OTM payer. In comparison the 4bp 1y roll down on the 5y30y rate would only make the 4y30y payer OTM by 4bp after one year. Given a relatively flat skew slope that would push the 5y30y payer vol from 67.7bp at inception to 68bp only after one year. In other words the vol ratio should increase from 1.27 to 1.32. After 2 years, the 3y5y payer would be OTM by 90bp (vol would jump to 92.3bp) while the 3y30y payer would be OTM by 10bp (vol would be 67bp) and the vol ratio would increase further mechanically towards 1.37. Consequently the carry profile of the trade would be significantly positive: providing ~EUR750k for an unchanged curve and vol surface after 6M (using 100Mln notional on 5Y30Y leg), ~EUR1.5Mln after 1Y, ~EUR2.7Mln after 2Y, ~EUR3.3Mln after 3Y (see figure 7 below). Carry is so significant that even assuming a 1.3 beta going forward between the 5y5y rate and the 5y30y rate (i.e. a bear flattening dynamics or bull steepening dynamics, worse than the one recently observed with beta around 1.2), the trade would provide a positive P&L after one year in a -100bp / +100bp range for the 5y30y rate (see figure 8). A 1.3 beta means

17 January 2014



that in a 100bp sell-off in 5y30y, the 5y5y rate would sell-off by 130bp and the slope would bear flatten by 30bp.

Figure 7: Strong carry from curve and vol provides

attractive P&L profile in parallel shift of the curve

Figure 8: Attractive P&L profile after one year even in

adverse slope scenario (bear flattening with 1.3 beta)

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P&L profile after 6MP&L profile after 12MP&L profile after 2YP&L profile after 3YInstantaneous P&L profile

Parallel shift of the curve

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P&L in 1Y assuming 5y5y moves with 1.1 beta vs 5y30yP&L in 1Y assuming 5y5y moves with 1.2 beta vs 5y30yP&L in 1Y assuming 5y5y moves with 1.3 beta vs 5y30yInstant P&L assuming 5y5y moves with 1.1 beta vs 5y30yInstant P&L assuming 5y5y moves with 1.2 beta vs 5y30yInstant P&L assuming 5y5y moves with 1.3 beta vs 5y30y

Shift in 5Y30Y rate


The risk of the trade would be a very sharp bear flattening of the curve in the near term and a massive inversion of the 5s30s spot slope below -25bp in a rate sell-off in 5 years time.

17 January 2014



Pacific Australia New Zealand


Dollar Bloc Strategy

The AUD front-end rallied on weak employment data and is now pricing

around a 50% chance of a rate cut by mid-year. We would characterise current market pricing as being broadly in line with the domestic data. We don’t think pricing of rate cuts can extend much further unless the unemployment rate clearly starts to trend higher.

The 10Y ACGB/UST spread is back to where it was in October. Looking forward we expect the 10Y ACGB/UST spread to narrow to at least 100bp over the course of 2014 and quite possibly to around 75bp. We see this happening in a bearish fashion. That is, by a rise in the 10Y UST yield relative to the 10Y ACGB rather than by a drop in the 10Y ACGB yield toward the 10Y UST. For this to happen requires the US front-end to price more Fed rate hikes into 2015 than is currently the case.

Soft December employment report has AUD front-end thinking about a rate cut Australian employment fell 22.6k in Australia, after a revised gain of 15.4k in November. This number, the first major Australian data release of 2014, came in well below market expectations - though the stability of the unemployment rate at 5.8% tempered the weakness somewhat. Having said that, the job loss was concentrated in full-time so hours worked were flat for the month and are now up just 0.3% over the year.

Employment growth soft in December

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The softness in employment continues to be at odds with the range of partial labour market indicators that we look at. Our economists are left thinking that we are in the (always) uncomfortable period between leading labour market indicators turning (job ads, business surveys and consumer sentiment etc) and that being reflected in actual hiring and the official employment data. They remain of the view that the gap evident between these indicators and the

David Plank

Macro strategist (+61) 2 8258-1475 [email protected]

Ken Crompton


17 January 2014



ABS's official employment data will ultimately be revised in favour of stronger employment growth.

And continues to run well behind the partial indicators

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The market reacted to the data as we might expect, by increasing the pricing of a near-term rate hike. On a 6 month time horizon the market is pricing around a 50% chance of a rate cut. Beyond that point the market starts to scale back the chance of a cut, with only a few basis points of cuts priced for the end of 2014.

Market pricing for the RBA cash rate in 6M time

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Cash rate implied by 6th IB contract

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We would characterise current market pricing as being broadly in line with the domestic data. This is in contrast to pricing in 2012 when the market was prepared to run well ahead of the data.

17 January 2014



Market pricing broadly in line with the data

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Source: Deutsche Bank, Bloomberg Financial LP

That it isn’t doing so now reflects the actual level of the cash rate and the global environment, in our view. That is, globally things are looking up, the Fed has changed direction and the RBA has already taken the cahs rate to a record low. Against this backdrop we think it is difficult for the AUD front-end to pre-empt the data in the manner it did during 2012. Thus we don’t think pricing of rate cuts can extend much further unless the unemployment rate clearly starts to trend higher.

Since we aren’t expecting this to happen should we take advantage of the recent rally to go short? The problem is that we don’t think the unemployment rate is going to trend lower anytime soon either. This means we have no expectation that the AUD front-end is going to price rate hikes. Rather we can see it bouncing round in a relatively narrow range for an extended period, until the unemployment rate starts trending in one way or the other. For now, pricing simply isn’t far enough away from where we think it ‘should be’ to entice us into recommending a specific front-end trade.

10Y ACGB/UST spread back to where it was in October The weak Australian employment data came on a day when the 10Y UST yield was pushing higher. As a consequence the 10Y ACGB/UST spread fell back a few basis points to 130bp. It has remained around that level even as the 10Y UST has rallied overnight.

17 January 2014



10Y ACGB/UST spread vs front-end pricing

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Source: Deutsche Bank, Bloomberg Financial LP

Given the relative shift in front-end pricing caused by the employment data we might have expected a bigger move in the 10Y spread. But the 10Y spread appears to have been too tight compared to relative front-end pricing since the later part of December. In effect the front-end has caught up to the 10Y spread in the past few days.

We don’t actually think it was the lower 10Y spread that ‘caused’ the front-end spread to narrow. We usually think of causality as running the other way. There are plenty of occasions when the two spreads diverge for a period, however, as even the above chart shows over a relatively limited time frame. But there is a very strong tendency for any gaps that open up to close, as evidenced by the stability of the relationship over many years.

Looking forward we expect the 10Y ACGB/UST spread to narrow to at least 100bp over the course of 2014 and quite possibly to around 75bp. We see this happening in a bearish fashion. That is, by a rise in the 10Y UST yield relative to the 10Y ACGB rather than by a drop in the 10Y ACGB yield toward the 10Y UST. For this to happen requires the US front-end to price more Fed rate hikes into 2015 than is currently the case.

Is spread compression a trade worth implementing? The negative carry on the trade over the course of a year is a reasonable hurdle to overcome. Spread compression to 100bp will beat the negative carry, but about half the move will be lost. We want a wider entry point than something around 130bp to entice us into the trade.

David Plank +61 2 8258 1475

17 January 2014



Dollar Bloc Relative Value

Semi spreads to both bond and swap are generally near their tightest levels for several years, although there has been a little weakness since the New Year began, especially in the 4Y sector.

Our models show the QTC Sep-17 to be trading somewhat dear, whilst the WATC Jun-16 is a little cheap.

The past month has seen significant cheapening of most Semi butterflies, especially the WATC curve. One butterfly that has lagged and which we think has some potential to cheapen from current levels, is the TCorp Feb-18 / May-20 / Apr-23 butterfly. In Semi pair trades, we note that the QTC Feb-18 has cheapened to the SAFA Sep-17 whilst the QTC Sep-17 has richened relative to the WATC Jun-17.

SSAs have generally outperformed Semis over the past month. The TCV Nov-16 and Nov-17 look especially cheap to the KfW Jul-16 and IBRD Jan-18 respectively.

2Y to 3Y bonds from TCorp and QTC lead the list of most attractive Semis on a carry/breakeven basis, i.e. the bonds which have a relatively lower chance of losses on a carry basis over 12 months.

Trades we recommend: Sell the belly of the TCorp Feb-18 / May-20 / Apr-23 bond butterfly; buy QTC Feb-18 vs SAFA Sep-17; buy TCV Nov-16 against KfW Jul-16 and buy TCV Nov-17 against IBRD Jan-18.

Semi performance relative to swap over the past month has been mixed. 2Y bonds from most issuers have seen especially good demand with swap spreads tightening by as much as twelve basis points (in the case of the Tascor Apr-15).

Ten best performing Semis vs swap since 13 Dec Best Semis vs Swap Maturity S/Q ASW Δ1W Δ1M

TASCOR 6.00 15-Apr-15 -1 -1.2 -11.9

WATC 6.00 23-Jul-25 26 0.0 -9.1

SAFA 6.00 20-Apr-15 3 -1.1 -9.0

WATC 5.75 15-Apr-15 3 -1.2 -8.3

QTCG 6.00 14-Oct-15 -8 -1.0 -7.6

NSWTC 6.00 1-Apr-15 -2 -1.2 -7.2

TCVIC 3.50 17-Nov-26 15 -0.4 -5.6

NSWTCG 6.00 1-May-23 -2 -1.1 -5.1

SAFA 4.00 20-May-21 25 -2.0 -5.0

TASCOR 6.25 8-Mar-22 29 -1.8 -4.7Source: Deutsche Bank

Amongst the wideners over the past month the 4Y sector has seen the weakest performance led by a 5bp widening to swap by the QTC Feb-18.

Ten worst performing Semis vs swap since 13 Dec Worst Semis vs Swap Maturity S/Q ASW Δ1W Δ1M

QTC 2.75 21-Feb-18 14 4.3 4.9

WATC 6.00 15-Jul-17 12 4.6 4.9

NSWTC 6.00 1-Feb-18 6 4.2 4.2

NSWTC 4.00 20-Mar-19 9 3.5 3.8

WATC 6.00 15-Oct-19 20 4.4 3.0

TCVIC 3.50 15-Nov-18 5 4.3 2.8

QTC 6.00 21-Sep-17 9 3.0 2.7

TCVIC 4.00 17-Nov-17 3 2.4 2.4

QTC 6.00 21-Jun-19 20 3.4 2.2

TCVIC 4.00 15-Nov-16 -1 2.3 1.9Source: Deutsche Bank

17 January 2014



Overall, however, spreads are generally at their tightest levels to both swap and bond since mid-2011.

Spreads to bond and swap are both at recent lows

-20.0

0.0

20.0

40.0

60.0

80.0

100.0

Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13 Jul-13 Dec-13

10Y AAA Semi to Swap

10Y AA Semi to Swap

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13 Jul-13 Dec-13

10Y AAA Semi to ACGB

10Y AA Semi to ACGB

Source: Bloomberg Financial LP, Deutsche Bank

Semi Curve Relative Value: Bond cheap/dear and butterflies Each day we use market observed yields for Semi bonds to build a zero curve for each Semi issuer. Typically, we find that the bonds tend to trade a few basis points rich or cheap to these fitted curves.

17 January 2014



QTC cheap/dear vs spline curve

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Nov-14 Mar-17 Jul-19 Nov-21 Mar-24 Jul-26 Nov-28 Mar-31

QTC

Cheap (+) / Dear (-)


At present, the QTC Sep-17 and WATC Jun-16 stand out as being the most mispriced Semis relative to the fitted curve. The QTC Sep-17 is 2.8bp rich whilst the WATC Jun-16 is 3.1bp cheap.

WATC cheap/dear vs spline curve

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

Apr-14 Sep-15 Feb-17 Jul-18 Dec-19 May-21 Oct-22 Mar-24

WATC

Cheap (+) / Dear (-)


Our principal components analysis (PCA) model also identifies the QTC Sep-17 as being dear, to a statistically significant extent.

17 January 2014



PCA analysis of QTC curve

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Oct

-15

Apr

-16

Sep

-17

Feb-

18

Jun-

19

Feb-

20

Jun-

21

Jul-2

2

Jul-2

3

Jul-2

4

<-D

ear /

Che

ap ->

QTC


Interestingly, however, the PCA model identifies the WATC Jun-16 as being close to fair, whilst the WATC Oct-19 is statistically cheap.

PCA analysis of WATC curve

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Apr-15 Jun-16 Jul-17 Oct-19 Jul-21 Oct-23

<-De

ar /

Chea

p ->

WATC


The cheapness of the WATC Oct-19 identified by the PCA model is the legacy of a significant shift in the WATC butterfly over the past month – as the graph below shows the WATC Jun-16/Oct-19/Oct-23 ‘fly has moved from +5bp to +21bp since late November.

WATC Jun-16 / Oct-19 / Oct-23 ‘fly

0

5

10

15

20

25

Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14

WATC Jun-16 / Oct-19 / Jul-25 'fly


17 January 2014



Although the WATC Oct-19 is now considered cheap on the PCA analysis, it is still trading rich relative to the fitted WATC curve. Additionally, the WATC ‘fly itself is not compellingly cheap after its recent correction.

TCorp PCA analysis

-2.0-1.5-1.0-0.50.00.51.01.52.0

Apr-1

5

Apr-1

6

Feb-

17

Feb-

18

Mar

-19

May

-20

Mar

-22

Apr-2

3

Aug-

24

<-De

ar /

Chea

p ->

NSWTC


Instead, the butterfly that stands out to us is the TCorp Mar-19/May-20/Mar-22 butterfly. The TCorp May-20 appears rich on the PCA model against the Feb-18 and Apr-23. The butterfly is currently at -2.2bp, just short of its lowest levels since July.

Belly of the TCorp Feb-18 / May-20 / Apr-23 ‘fly is rich

-6

-4

-2

0

2

4

6

Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14

NSWTC Feb-18/May-20/Apr-23 'fly


We recommend paying the belly of the butterfly at the current level of -2bp, looking for a rise toward +3bp. The key risk of the trade is a flattening of the long end of the TCorp 5Y/10Y slope.

Semi pair trades: Buy QTC Feb-18 vs SAFA Sep-17; Sell QTC Sep-17 vs WATC Jun-17 Two moves in spreads over the past three months stand out to us are the widening of the QTC Feb-18 relative to the SAFA Sep-17 and the widening of the WATC Jul-17 to the QTC Sep-17.

17 January 2014



QTC Feb-18 has cheapened to SAFA Sep-17

-10

-5

0

5

10

15

20

Oct-13 Oct-13 Nov-13 Nov-13 Dec-13 Dec-13 Jan-14

SAFA Sep-17 swap spreadQTC Feb-18 swap spread


The QTC Sep-17 appeared statistically rich on our QTC PCA model – the Jul-17 is also a little rich on a WATC PCA analysis, although not to a statistically significant amount.

Sell rich QTC Sep-17 to buy WATC Jun-17

-5

0

5

10

15

20

Oct-13 Oct-13 Nov-13 Nov-13 Dec-13 Dec-13 Jan-14

QTC Sep-17 swap spreadWATC Jul-17 swap spread


Of these two trades, we prefer the QTC vs SAFA because we think that QTC’s long term fundamentals are stronger. Thus we recommend buying the QTC Feb-18 against the SAFA Sep-17 – the key risk to the trade is that the QTC Feb-18’s relative cheapness is extended further.

Carry vs Breakeven: 2Y to 3Y QTC and TCorp bonds offer best protection of carry income Carry income relative to alternative investments – typically either ACGBs or swap – is one of the key reasons that investors buy spread products. The risk, however, is that extra income from carry can be offset or even eliminated by unfavourable movements in spreads.

17 January 2014



Top breakeven/carry ratios Semi bond Carry (over ACGB) 12M breakeven spread Ratio

QTCG Oct-15 9.5 13.1 1.4

QTC Oct-15 21.3 28.7 1.3

NSWTC Apr-16 20.8 18.1 0.9

QTC Apr-16 27.4 22.7 0.8

WATC Jun-16 31.2 23.0 0.7

TCVIC Nov-16 23.4 13.5 0.6

NSWTC Feb-17 28.1 14.5 0.5

NSWTCG Mar-17 17.9 9.1 0.5

WATC Jul-17 33.6 14.7 0.4

QTCG Sep-17 16.1 6.6 0.4Source: Deutsche Bank

We use the “breakeven” to measure the change in spread required to negate carry income. The key variable in determining breakeven is the width of the spread to begin with and the duration of the bond.

The full carry/breakeven tables can be found at the end of this Monthly, but the table above shows the Semis with the highest ratio of breakeven to carry. The list of bonds is dominated by 2Y to 3Y bonds from QTC and TCorp (both CGG and SGG) although a notable “outlier” in the list is the TCV Nov-16, which trades at a spread of just over 23bp to ACGB curve. TCV/ACGB spread would need to widen more than 13bp over the coming year for the TCV holder to suffer net underperformance relative to the ACGB.

Kenneth Crompton +61 2 8258 1361

17 January 2014



United States


Inflation-Linked

The December CPI report points to a benign inflation outlook. In February, TIPS carry will be negative from the shortest issues out to the 2019 maturity. We believe TIPS breakevens moved too high relative to Treasury yields from early December to early January, and therefore, are vulnerable, particularly in the five-year sector. We favor being short five-year breakevens.

We expect Treasury to introduce smaller and more frequent five-year TIPS auctions this year; two new five-year TIPS CUSIPS per year followed by one or two reopening auctions are likely. If the supply in five-year TIPS increases due to smaller and more frequent auctions, it will likely compress five-year breakevens, in our view.

5yr TIPS breakevens seem high on Treasury yield levels

y = -0.4792x + 2.5472R² = 0.6498

1.50

1.75

2.00

2.25

2.50

0.50 0.75 1.00 1.25 1.50 1.75 2.00

5yr T

IPS

BEs

5yr Treasury yield

past 1yr's data 1/17/2014


Good Luck Beating 5yr Inflation Breakevens

The December CPI report points to a benign inflation outlook with the year-over-year NSA CPI at 1.50%. While the housing inflation was strong (+2.5% on the OER), core CPI ex-housing was weak. The year-over-year rate in our NSA CPI forecast drops to below 1.00% in the February data before returning to 1.50% area by midyear. In February, TIPS carry will be negative from the shortest issues out to the 2019 maturity. The five-year TIPS will have about -1.4bp carry in February. There is small positive carry ranging from +0.2bp to +0.5bp in the 2022 maturity and longer sector.

We believe TIPS breakevens moved too high relative to Treasury yields from early December to early January, and therefore, are vulnerable, particularly in the five-year sector (breakevens currently at 1.87%). There is probably too much core inflation priced into the five-year breakevens that is unlikely to be fully realized.

Alex Li


Steven Zeng, CFA


17 January 2014



On supply, we expect Treasury to introduce smaller and more frequent five-year TIPS auctions this year; two new five-year TIPS CUSIPS per year followed by one or two reopening auctions are likely. Treasury has no plans to change the supply in 10s and 30s; it plans to make an announcement on TIPS issuance on February 5, 2014. If the supply in five-year TIPS increases due to smaller and more frequent auctions, it will likely compress five-year breakevens, in our view.

The risk in our trade is a sharp increase in five-year breakevens, which we believe is unlikely in light of the recent inflation data.

TIPS carry in February

-18.0-16.0-14.0-12.0-10.0

-8.0-6.0-4.0-2.00.02.0

TII 1

.625

% 0

1/15

TII 0

.5%

04/

15TI

I 1.8

75%

07/

15TI

I 2%

01/

16TI

I 0.1

25%

04/

16TI

I 2.5

% 0

7/16

TII 2

.375

% 0

1/17

TII 0

.125

% 0

4/17

TII 2

.625

% 0

7/17

TII 1

.625

% 0

1/18

TII 0

.125

% 0

4/18

TII 1

.375

% 0

7/18

TII 2

.125

% 0

1/19

TII 1

.875

% 0

7/19

TII 1

.375

% 0

1/20

TII 1

.25%

07/

20TI

I 1.1

25%

01/

21TI

I 0.6

25%

07/

21TI

I 0.1

25%

01/

22TI

I 0.1

25%

07/

22TI

I 0.1

25%

01/

23TI

I 0.3

75%

07/

23TI

I 2.3

75%

01/

25TI

I 2%

01/

26TI

I 2.3

75%

01/

27TI

I 1.7

5% 0

1/28

TII 3

.625

% 0

4/28

TII 2

.5%

01/

29TI

I 3.8

75%

04/

29TI

I 3.3

75%

04/

32TI

I 2.1

25%

02/

40TI

I 2.1

25%

02/

41TI

I 0.7

5% 0

2/42

TII 0

.625

% 0

2/43

TIPS carry from 1/31/14 to 2/28/14


Auction preview: 10-year TIPS

Treasury is offering a new ten-year TIPS for $15bn of notional next week. The auction will settle on Friday, January 31. Indirect bidder participation has been strong in the last six auctions averaging 53.3% as compared to 44% in the prior six. However this strength was tempered by direct bidder takedown which average at 9.9% in 2013 versus 13.9% in the year before. But direct bidders were unusually solid in the last auction taking down 21.5% of the supply picking up the slack from indirect bidders. Indirect bidders were at 46.7% in November as compared their one-year average of 53.3%. Foreign investors’ 33.7% allotment share however was a record since at least January 2001. But Fund investors’ share hit the lowest level of 32.4% in the last 21/2 years. Bid-to-cover ratio was slightly above the average at 2.59 but the last auction came through by a hefty 4.4 basis points.

17 January 2014



10yr TIPS auction statistics

Size ($bn)

Primary Dealers

Direct Bidders

Indirect Bidders

Cover Ratio

Stopout Yield

1PM WI Bid

BP Tail

Direct + Indirect

1yr Avg 13.67$ 36.8% 9.9% 53.3% 2.56 -0.6 63%Nov-13 13.00$ 31.8% 21.5% 46.7% 2.59 0.560 0.604 -4.4 68%Sep-13 13.00$ 44.6% 1.6% 53.8% 2.38 0.500 0.475 2.5 55%Jul-13 15.00$ 35.4% 6.9% 57.7% 2.44 0.384 0.410 -2.6 65%

May-13 13.00$ 30.9% 12.4% 56.8% 2.52 -0.225 -0.243 1.8 69%Mar-13 13.00$ 43.0% 5.7% 51.3% 2.74 -0.602 -0.600 -0.2 57%Jan-13 15.00$ 35.4% 11.3% 53.3% 2.71 -0.630 -0.620 -1.0 65%Nov-12 13.00$ 41.3% 10.4% 48.3% 2.52 -0.720 -0.751 3.1 59%Sep-12 13.00$ 48.5% 7.7% 43.8% 2.36 -0.750 -0.810 6.0 51%Jul-12 15.00$ 39.7% 16.1% 44.2% 2.62 -0.637 -0.650 1.3 60%

May-12 13.00$ 34.5% 14.8% 50.7% 3.01 -0.391 -0.350 -4.1 66%Mar-12 13.00$ 38.5% 21.1% 40.4% 2.81 -0.089 -0.102 1.3 62%Jan-12 15.00$ 50.3% 13.4% 36.3% 2.91 -0.046 -0.010 -3.6 50%Nov-11 11.00$ 42.1% 11.6% 46.3% 2.64 0.099 0.085 1.4 58%Sep-11 11.00$ 33.9% 35.7% 30.4% 2.61 0.078 0.057 2.1 66%Jul-11 13.00$ 44.6% 13.7% 41.6% 2.62 0.639 0.670 -3.1 55%

May-11 11.00$ 56.3% 3.1% 40.7% 2.66 0.887 0.875 1.2 44%Mar-11 11.00$ 67.7% 7.1% 25.2% 2.97 0.920 0.965 -4.5 32%Jan-11 13.00$ 58.8% 3.2% 37.9% 2.37 1.170 1.111 5.9 41%

Source: US Treasury, SMR, and Deutsche Bank

Whither inflation?

The December CPI-U NSA Index came in at 233.049 versus 233.16 forecasted by DB. The seasonally-adjusted monthly change was 0.3%, and the annual inflation rate rose to 1.5% from 1.2% in November. The inflation print was soft against expectations for a third consecutive month.

Details of the report showed an unchanged pace of food inflation from last month (0.1% m/m), a rebound in energy prices (2.1% m/m), and a slowdown in core inflation (0.1% m/m). Within the core inflation basket, the prices of core goods were unchanged from last month, while the prices of core services rose just 0.1%, the smallest increase in eight months. The weakness in core services was contributed by a 0.4% drop in transportation services prices. Shelter, the largest component of core services by weight, held decent at 0.2% m/m, where it’s been in 22 of the last 30 months.

The inflation trend has been weak in the last couple of months. As we discussed last week, changes in retail gas prices have historically been a good predictor of changes in the headline inflation. A regression of 108 monthly data points has an r-square of 87%. As the right chart shows, over the last three months, headline inflation has been running softer than predicted by retail gas prices.

Our projection for January CPI is 233.677, or a 0.27% month-over-month increase. We expect headline inflation to reach the 2% annual rate in the middle of 2015.

17 January 2014



Annual rate of inflation is projected to rise to 2 percent in

mid-2015

Headline inflation has been softer than predicted by retail

gasoline prices in the final quarter

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

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

%y/y CPI-U

Projected

y = 0.0595x + 0.1424R² = 0.8666

(2.5)

(2.0)

(1.5)

(1.0)

(0.5)

0.0

0.5

1.0

1.5

(40) (30) (20) (10) 0 10 20

% M

oM c

hang

e in

CPI

-U N

SA

% MoM change in retail gasoline prices

2005 to present

Oct-13

Nov-13

Dec-13


17 January 2014



Global

Economics Rates Gov. Bonds & Swaps Inflation

Global Inflation Update

Leading indicators point to a pick-up in wage growth in the US and UK this year, which would be a positive for B/Es, but may be a slow process; we see medium-term upside for B/Es.

In RV, across markets, we prefer 30y UK RPI over 30y USD CPI and 1y1y EUR HICP v 1y1y FRF CPI. In USD, 5y CPI looks relatively low v 2y and 10y wings. In GBP and EUR, we find 10y RPI/CPI rich compared to 5y and 30y.

B/E curves flattened this week, with valuations falling in USD and EUR, and (up to 15y) rising in GBP; yields declined, at least in EUR and GBP. The December CPI prints were close to expectations and did not bring significant further insights into the underlying inflation trend, which remains relatively subdued for now. Past declines in commodities prices mean that food and energy inflation are expected to remain weak (and even fall further), and lower imported costs are weighing on the recovery in domestic inflation as well. We see core inflation rising slightly in EUR (but remaining at subdued levels), trending broadly sideways to marginally higher in the US, and sideways to lower in the UK in the coming months. Economic data are expected to provide some support for B/Es, and recent trends would seem consistent with a pick-up in domestic drivers of inflation (chart 1). While this may be a slow process any signs of rising wage growth in our view would be a positive for B/Es. While the tactical case for long B/Es is less clear in this environment, we continue to see medium-term upside for valuations. This week we focus on RV.

Cross markets: Chart 3 shows (6m, 1y and 2y) z-scores for cross-market spreads between CPI swaps, for 2y, 5y, 10y and 30y maturities. USD/EUR spreads remain at least one standard-deviation above historical averages, for all maturities. To a large extent, higher US B/Es would however seem justified given differences in the macro backdrop. Regressing spreads on the exchange

3. Cross-market spreads: z-scores 4. USD/EUR CPI spreads v FX, PMIs, spot CPI, oil & risk

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y

6M 1Y 2Y

USDEUR GBPUSD GBPEUR FRFEUR

CPI swap spreads: z-scores

-40

-30

-20

-10

0

10

20

30

40

50

60

2y 5y 10y

residual, USD/EUR CPI swap spread

stdev max min -stdev last -1w

USD rich v EUR


1. US wage growth to rise

-0.5

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1.5

2.5

3.5

4.5

5.53500

4500

5500

6500

7500

8500

9500

10500

1988 1991 1994 1997 2000 2003 2006 2009 2012 2015

unemplyt ex LT, 18m lead (lhs, inverted)

earnings, % y/y (rhs)

2. Swap-bond B/E spreads

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

TIIJ

an18

OB

Lei1

8

UKT

i17

TIIJ

an22

DB

Rei

23

UKT

i22

TIIF

eb40

OA

Tei4

0

UKT

i40

swap-bond B/E spread, 1y z-score



Markus Heider


17 January 2014



rate, oil prices, risk proxies and spreads in PMIs and spot inflation would suggest that 10y and 30y B/E spreads are close to fair, while EUR swaps would look slightly cheap v USD in 2y and 5y (chart 4). We would have a marginal preference for 5y EUR into the January CPI prints, which remains somewhat cheaper against baseline inflation forecasts.

GBP RPI has recently underperformed USD CPI, with 3m (not shown) and 6m z-scores of spreads in negative territory across all maturities (chart 3). 2y z- scores remain mostly positive, but this is impacted by the 2012 uncertainty about RPI statistics. The 10y spread looks close to fair against regressions on macro variables (similar to those shown in chart 4), and in 5y GBP looks marginally (but not significantly) cheap. Over the medium-term, we would probably see more upside for 5y GBP B/Es, which are relatively cheaper against our baseline inflation forecasts, but given FX trends and the risk of lower RPI inflation into this spring, we would be neutral for now. We see the best opportunity in 30y where we would prefer GBP over USD. This applies above all to swaps, given that 30y TIPS B/Es are more than one standard-deviation cheap relative to swaps when compared to 1y averages (chart 2).

FRF CPI swaps from 5y are cheap relative to EUR when compared to past averages—more than one standard-deviation in 10y (chart 3). The Livret A rate is likely to remain low, and better economic prospects could lead to some re-allocation into other investments. At the same time, higher yields would mean better hedging terms and a rising probability of pent-up hedging demand materializing. We would have a bias towards wider FRF/EUR spreads in 10y. At the short-end, we prefer EUR over FRF. 2y spreads are high relative to past averages (chart 3), and in our view too wide relative to the economic and inflation outlook. Rising VAT may well push French inflation above the EUR aggregate in early 2014, but leading indicators, such as business surveys of price setting intentions, have been weaker in France than elsewhere. We are short 1y1y FRF CPI against EUR.

USD: Chart 7 shows (3m, 6m, 1y and 2y) z-scores for some USD CPI curve spreads and flies. The 5y point appears to be sticking out as relatively cheap by historical standards. 2y5y is flatter than average and 5y10y steeper than 6m, 1y or 2y averages, despite having flattened somewhat over the past three months (chart 7). As a result, the 2y5y10y fly is about one standard-deviation below longer averages (chart 7), although off the extremes seen around the turn of the year (chart 5). 10y30y looks somewhat steep relative to the ‘twist’ period, but is in line with more recent averages.

7. USD CPI spreads & flies: z-scores 8. GBP RPI spreads & flies: z-scores

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2Y5Y 5Y10Y 10Y30Y 2Y5Y10Y 5Y10Y20Y 5Y10Y30Y

3m 6M

1Y 2Y

USD CPI swaps: z-scores

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0


3m 6M

1Y 2Y

GBP CPI swaps: z-scores


5. USD 5y CPI cheap v 2y/10y

-10

-5

0

5

10

15

20

25

Jan-12 Jun-12 Nov-12 Apr-13 Sep-13

US5 US2 US10

average


6. GBP 10y RPI rich v 5y/30y

-25

-20

-15

-10

-5

0

Dec-10 May-11 Oct-11 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13

UK10 UK5 UK30

average


17 January 2014



GBP: Chart 8 shows equivalent z-score metrics for GBP RPI. 2y5y looks steep v past averages, but that would seem justified given that (i) spot inflation has eased a little from the unusually high levels seen over the past few years and (ii) an economic recovery and resulting policy rate normalization could be expected to benefit 5y B/Es via expectations of a rise in cyclical inflation, higher MIPS inflation and wider inflation risk premia. We would see scope for further 1y5y steepening, and see medium-term upside for 5y B/Es.

With 5y10y still somewhat steep, and 10y30y having flattened ahead of long-end supply later this month, 10y looks rich in the 5y10y30y fly (chart 8) which has moved towards extremes recently (chart 6). We would expect the long-end to recover post UKTi syndication and into the more LDI active period at the end of the fiscal year, and like short 10y v 5y and 30y RPI.

EUR: The EUR swap curve remains very steep out to 10y, despite some flattening since the start of the year, with 2y5y and 5y10y spreads significantly above past averages; 10y30y on the other hand is not particularly steep by historical standards (chart 11). A subdued near-term inflation outlook probably justifies the wide 2y5y spread, and we would see scope for 2y1y or 3y1y forwards to rise if spot inflation stabilizes and economic growth continues to recover as we expect.

The 10y point on the other hand looks extreme; the 5y10y30y fly is well above past averages (chart 11), and remains close to 3y highs (chart 9). It has shown some directionality in the past, with 10y outperforming in a B/E sell-off, so being short this fly would likely benefit from any normalization in B/Es. On the other hand, should deflation concerns increase significantly, 9y1y at around 2.50% (more than 100bps above 2y1y) could fall, and 10y30y steepen.

FRF: Contrary to EUR, 10y looks somewhat cheap on the FRF CPI curve. 5y10y has recently flattened (while remaining relatively steep from a long-term perspective, chart 12), and 10y20y has steepened significantly through 2013 (chart 10); as a result, the 5y10y20y fly is about one standard-deviation cheap compared to past averages (chart 12). To some extent, the 10y20y steepening in 2013 can however probably be seen as a normalisation from unusually flat levels on the back of strong hedging demand in 5y and 10y (chart 10), and this slope still remains less steep than in EUR.

11. EUR HICP spreads & flies: z-scores 12. FRF CPI spreads & flies: z-scores

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0


3m 6M

1Y 2Y

EUR HICP swaps: z-scores

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0


3m 6M

1Y 2Y

FRF CPI swaps: z-scores


9. EUR 10y HICP rich v 5y/30y

-12

-10

-8

-6

-4

-2

0

2

4


EU10 EU5 EU30

average

10. FRF CPI: 10y20y steeper in 2013

-5

0

5

10

15

20

25

30


FR20 FR10

average



17 January 2014



Auction Calendar Market Ticker/Coupon/Maturity Date Tap/New Issue Size

AUSTRALIA ACGB 4.75% 04/27 Fri, 24 Jan 2014 Tap AUD 800 mn AUSTRIA Nothing Expected BELGIUM Nothing Expected CANADA Nothing Expected

DENMARK DGB 1.5% 11/23DGB 4.5% 11/39

Tue, 21 Jan 2014 Tue, 21 Jan 2014

Tap Tap

TBA

FINLAND Nothing Expected FRANCE

BTF 0% 04/14BTF 0% 06/14BTF 0% 01/15 BTNS 0.45% 07/16FRTR 0.25% 07/18FRTR 0.25% 07/24 FRTR 3.25% 04/16FRTR 1% 05/18FRTR 1% 05/19

Mon, 20 Jan 2014 Mon, 20 Jan 2014 Mon, 20 Jan 2014 Thu, 23 Jan 2014 Thu, 23 Jan 2014 Thu, 23 Jan 2014 Thu, 23 Jan 2014 Thu, 23 Jan 2014 Thu, 23 Jan 2014

New Issue Tap Tap Tap Tap Tap Tap Tap New Issue

Upto EUR 4.5 bnUpto EUR 2.2 bnUpto EUR 2.2 bn EUR 1.2-1.7 bn EUR 7.0-8.0 bn

GERMANY BKO 0% 12/15 Wed, 22 Jan 2014 Tap EUR 4 bn GREECE Nothing Expected IRELAND Nothing Expected ITALY Nothing Expected

JAPAN JGB 0% 03/14JGB 1.4% 12/18 JGB 0% 04/14JGB 1.9% 12/33

Tue, 21 Jan 2014 Tue, 21 Jan 2014 Thu, 23 Jan 2014 Thu, 23 Jan 2014

New Issue Tap New Issue Tap

JPY 2500 bn JPY 2700 bn JPY 5700 bn JPY 1200 bn

NETHERLANDS DTB 0% 04/14DTB 0% 06/14

Mon, 20 Jan 2014 Mon, 20 Jan 2014

Tap Tap

Upto EUR 2 bn Upto EUR 2 bn

NEW ZEALAND Nothing Expected NORWAY Nothing Expected PORTUGAL Nothing Expected SOUTH AFRICA SAGB 8% 01/30

SAGB 8.5% 01/37SAGB 8.75% 02/48

Tue, 21 Jan 2014 Tue, 21 Jan 2014 Tue, 21 Jan 2014

Tap Tap Tap

ZAR 550 mn ZAR 1 bn ZAR 800 mn

SPAIN SGLT 0% 07/14SGLT 0% 01/15

Tue, 21 Jan 2014 Tue, 21 Jan 2014

Tap New Issue

TBA

SWEDEN SWTB 0% 04/14SGBi 0.5% 06/17

Wed, 22 Jan 2014 Thu, 23 Jan 2014

Tap Tap

SEK 10 bn SEK 1 bn

SWITZERLAND SWISTB 0% 04/14 Tue, 21 Jan 2014 New Issue TBA

UK UKT 2.25% 09/23UKTB TBA

Thu, 23 Jan 2014 Fri, 24 Jan 2014

Tap Tap

GBP 3.25 bn TBA

US B 0% 04/14 B 0% 07/14B 0% 02/14TII 0.5% 01/24

Wed, 22 Jan 2014 Wed, 22 Jan 2014 Thu, 23 Jan 2014 Fri, 24 Jan 2014

Tap Tap TBA New Issue

USD 28 bn USD 25 bn TBA USD 15 bn


17 January 2014



Contacts Name Title Telephone Email

EUROPE

Francis Yared Head of European Rates Research 44 20 7545 4017 [email protected]

Alexander Düring Euroland & Japan RV 44 207 545 5568 [email protected]

Markus Heider Global Inflation Strategy 44 20 754 52167 [email protected]

Bernd Volk Covered Bonds/SSA 41 44 227 3710 [email protected]

Jerome Saragoussi Global RV & Rates Vol 33 1 44 95 64 08 [email protected]

Abhishek Singhania Euroland Strategy/ EUR Govt. bonds 44 20 754 74458 [email protected]

Soniya Sadeesh UK Strategy & Money Markets 44 20 7547 3091 [email protected]

Christian Wietoska Nordic & Swiss Strategy 44 20 7545 2424 [email protected]

Nick Burns Credit Strategy 44 20 7547 1970 [email protected]

Stephen Stakhiv Credit Strategy 44 20 7545 2063 [email protected]

Sebastian Barker Credit Strategy 44 20 754 71344 [email protected]

Conon O’Toole ABS Strategy 44 20 7545 9652 [email protected]

Paul Heaton ABS Strategy 44 20 7547 0119 [email protected]

Rachit Prasad ABS Strategy 44 20 7547 0328 [email protected]

US

Dominic Konstam Global Head of Rates Research 1 212 250 9753 [email protected]

Steven Abrahams Head of MBS & Securitization Research 1-212-250-3125 [email protected]

Aleksandar Kocic US Rates & Credit Strategy 1 212 250 0376 [email protected]

Alex Li US Rates & Credit Strategy 1 212 250 5483 [email protected]

Richard Salditt US Rates & Credit Strategy 1 212 250 3950 [email protected]

Stuart Sparks US Rates & Credit Strategy 1 212 250 0332 [email protected]

Daniel Sorid US Rates & Credit Strategy 1 212 250 1407 [email protected]

Steven Zeng US Rates & Credit Strategy 1 212 250 9373 [email protected]

ASIA PACIFIC

David Plank Head of APAC Rates Research 61 2 8258 1475 [email protected]

Makoto Yamashita Japan Strategy 81 3 5156 6622 [email protected]

Kenneth Crompton $ bloc RV 61 2 8258 1361 [email protected]

Sameer Goel Head of Asia Rates & FX Research 65 6423 6973 [email protected]

Linan Liu Asia Strategy 852 2203 8709 [email protected]

Swapnil Kalbande Asia Rates Strategy 65 6423 5925 [email protected]

Kiyong Seong Asia Strategy 852 2203 5932 [email protected]

CROSS-MARKETS

George Saravelos Head of European FX and cross markets strategy

44 20 754 79118 [email protected]


17 January 2014



Appendix 1

Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Francis Yared/Dominic Konstam

17 January 2014



Regulatory Disclosures

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3. Country-Specific Disclosures

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GRCM2014PROD031217

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