VIEWS: 19 PAGES: 55 POSTED ON: 3/27/2012
INTEREST RATES RESEARCH Global Rates Strategy | 9 March 2012 GLOBAL RATES WEEKLY PSI gone, inflation up Global Views on a Page 2 The Greek PSI has been agreed but the ECB’s upwardly revised inflation forecasts limit Global Traders’ Guide 45 further stimulus for the European economy. Global Economics Calendar 46 United States Global Supply Calendar 50 Treasuries: A new Twist 3 Global Bond Yield Forecasts 51 We expect the effect of sterilized QE3 to be small on front-end rates, as Fed hikes expectations should be simultaneously pushed out in such a scenario. The stock effect of such a program should also be lower than that of Operation Twist. United States Agencies: A return to normalcy? 7 Ajay Rajadhyaksha +1 212 412 7669 Swaps: Revisiting the refinancing wavelet 10 firstname.lastname@example.org Money Markets: Bank funding rates: Survey or transaction? 14 TIPS: Higher energy prices twist the breakeven curve 17 Michael Pond Volatility: Hedge with Bermudans 20 +1 (212) 412 5051 Europe email@example.com Euro: Greek PSI: almost done, with success 24 Rajiv Setia Greek PSI deal to go ahead: 95.7% participation reached after use of CACs on domestic +1 212 412 5507 law bonds. Headline risk now lower. firstname.lastname@example.org Money Markets: Money markets: low rates, and more stability 26 Europe Sovereign Spreads: Spain vs Italy 29 Laurent Fransolet +44 (0) 20 7773 8385 UK: Tangled up in red 32 email@example.com The public finance projections in the Budget on 21 March are likely to be broadly akin to those published in November 2011. We retain our current view for gilt issuance of Alan James £185bn. The risk to this number lies towards a lower number given uncertainties over +44 (0) 20 7773 2238 the timing of cash measures. firstname.lastname@example.org Euro Inflation-Linked: Bracing for a Q2 supply bonanza 37 Japan Volatility: EUR 5y tails: Too high to buy 39 Chotaro Morita +81 (3) 4530 1717 Australia email@example.com Model update: AU curve still too flat, despite recent steepening 41 Earlier this week, we recommended an AU 3s10s curve steepener at 37bp www.barcap.com Japan EUROMONEY FIXED INCOME INVESTORS Market’s response function to investor sentiment 42 SURVEY 2012 JGB market sentiment peaked last December, but we have not seen the usual pattern, in Voting has begun for the Euromoney Fixed which a peak is followed immediately by a bearish market. We attribute this largely to Income Investors Survey 2012. Barclays Capital would welcome your support. To the impact of the BoJ’s latest easing. However, we should also recall the case of 2003, vote, please click on the Euromoney Survey. when sentiment eventually began to weaken with a significant lag after hitting its peak. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 52 Barclays Capital | Global Rates Weekly VIEWS ON A PAGE US EUROPE JAPAN Direction 10y yields likely to remain range-bound around 2%, given The passage of the Greek PSI deal removes a key uncertainty from Given the BoJ’s latest easing, we believe the short end of the modest growth expectations and the threat of fiscal the market. Focus will now turn to the political process and curve will remain flat for a prolonged period. tightening. upcoming elections. However, if the 2y-5y spread drops below 20bp, there could With talk of sterilized QE picking up, we are turning neutral on QE has been extended by £50bn, with the BOE’s purchase be an eventual rebound. our 2s3s steepener view, as the payoff no longer seems programme continuing to see a net duration withdrawal from Overall, we maintain our forecast of bear steepening and asymmetric the market over the next three months. recommend a short position at around 10y 0.9%. Stronger data should steepen the curve, but weaker data could flatten the curve, as odds of sterlization would increase at the same time. Curve/ We are turning neutral on our 10s30s Treasury curve Keep Schatz/Bund steepener. JGB2-5-10 short Curvature steepeners view, given the 5bp steepening since the Hold onto long EUR 2s/5s/10s 6m fwd. JGB 10-30 flattener beginning of the month. For long-end steepening, receive EUR 5y5y fwd/5y10y Swap 10s20s bull steepener. Expectations of QE3 have been greatly pared back. We fwd/5y15y fwd and long EUR 5s/10s/30s. Swap 10s20s steepener. remain long the 5s10s30s fly. UK: the redefining of the maturity baskets for the BOE’s reverse operations leaves potential buying more evenly distributed. The 20y sector has borne the brunt of the curve correction but should stabilise here. Fall in realised vol leaves carry/vol ratio highest for bonds in the 2017-2020 part of the gilt curve. Change in MPC rhetoric should see bearish resteepening of the GBP forward curve. Pay GBP 1y2yf/1y4yf spread. Swap 2y1y-4y1y curve flattener as a positive carry protection trade EUR: Keep short Bund ASW view on a medium- to long-term 20y ASW long vs 3m. spreads against risk returning. basis. Long 10y ASW. Receive 7s-10s-30s (2/3:1:1/3 wts) as a dislocation trade. GBP: 10y10y fwd ASW is cheap relative to other parts of the Short 5Y ASW. 30y spread tighteners for asymmetric tightening risk. ASW curve. Long 20yr ASW vs 10yr ASW. Other Front-end agencies have continued to outperform Treasuries; Retain long Gilts versus Bunds. Yield plus roll and carry pick-up 20y 3v6 tightener. spread we recommend moving out to the 5y sector (and 10y, where is of increasing interest to international investors. 5-10y Tibor-Libor spread steepener. (Note: for clarity, Tibor- sectors feasible). For investors uncomfortable with extending out the Long 30y gilts versus Germany or AAA Europe. Libor widener means that the swap rate against Tibor curve, MTNs pick up several bp to front-end bellwethers while SEK: Hold SEK/EUR 2y2y/5y5y fwd steepeners. and 5y SGB (1050) increases more than the swap rate against Libor. Therefore, giving up relatively little liquidity. ASW tighteners. ,Hold Dec 12/Dec 12 3m FRA steepeners. steepener means that the 10y Tibor-Libor spread widens We remain constructive on Canadian covered bonds, given NOK: Hold cross-market tighteners in 5y5yfwd versus EUR. more than the 5y Tibor-Libor spread. In previous issues, we their relative isolation from Europe and continued significant Hold BTP and Spain 2s/10s flatteners. called it a 5-10y Tibor-Libor spread flattener.) spread pickup to agencies. Long 5yr Netherlands versus 50% 5yr France and 50% Belgium. Inflation Long longer-dated forward breakevens, as the market has not Front end euro linkers value given rising short-term inflation Take profit on long BEI. priced in enough risk premium. prospects, 5-10y upside limited by potentially heavy Q2 supply Positive on short breakevens, hedged with crude puts. Long Front end breakevens are supported by oil while longer dated front-end TIPS ASW for better carry, hedged with 2y floors. linkers may be supported by asset allocation out of nominal Long the belly of Jan16-Apr16-Jul16 real yield fly, as the floor gilts premium on new 5s could rise with risk aversion. Volatility Sell mid-tail gamma (3m*10y, TYM2) to benefit from ECB-on-hold expectations should pull mid-left and 5y tails lower. Long 3mx10y volatility. rangebound rates. Sell 2y5y as part of 2y5y versus 2y30y bear steepener (along with Buy 1y*1y payer spreads to hedge an unexpected blow-out in selling 5y-30y curve cap). FRA-OIS. Buy EUR 3y*10y high-strike payer vs. US 3y*10y high-strike payer to Initiate 2y*10y versus 2y*30y bear steepeners to benefit from position for richening of EUR vol and skew relative to the US. steepening of the rate and vol curve. Source: Barclays Capital 9 March 2012 2 Barclays Capital | Global Rates Weekly UNITED STATES: TREASURIES A new Twist Anshul Pradhan We expect the effect of sterilized QE3 to be small on front-end rates, as Fed hikes +1 212 412 3681 expectations should be simultaneously pushed out in such a scenario. The stock effect firstname.lastname@example.org of such a program should also be lower than that of Operation Twist. The recently released flow of funds data suggest that supply-demand dynamics should remain in balance post-Operation Twist; however the long end may have to cheapen to encourage long term investors to reverse their reduced involvement. The Treasury market remained largely range-bound over the week, as a spike in risk aversion in the middle of the week faded as a majority of investors agreed to participate in the Greek debt swap; equity markets and VIX reversed their mid-week moves. Economic data were, on the margin, stronger than expected; ISM non-manufacturing, factory orders and unit labor costs surprised to the upside. The payroll report was also stronger, as prior months gains were revised up 61K; the unemployment rate remained unchanged as the labor participation rate rose. Offsetting this was a downward revision to Q1 GDP estimates (our economists are now tracking 1.5%) and the news about sterilized QE3, which was perceived as increasing the odds of QE3 itself, as the Chairman’s latest testimony did not mention further stimulus. Sterilized QE3 is very similar to Operation Twist: in both programs, the purchase of longer duration securities is being funded with sales of shorter tenor securities. In the latter, this was done via selling 3m-3y Treasuries; in the former, this could be achieved by doing reverse repurchase operations (or term deposits). In both cases, the level of excess reserves stays unchanged. Our money market strategist expects short rate to rise 10-15bp if the Fed goes down this route (please see “Weekly Fed update” for details); however, one should not expect short-term coupon Treasuries to cheapen by the same magnitude, for a few reasons. First, for sterilized QE3 to happen, the case for QE3 itself needs to be strong. Weakening data should push out Fed hike expectations, putting downward pressure on 2-3y Treasuries (Figure 1). Second, the program is unlikely to run parallel with Operation Twist, given that Figure 1: Sterilized QE should have a limited effect on front Figure 2 : Tsy-OIS basis unlikely to cheapen as much as end rates as Fed hike expectations should be pushed out under Operation Twist 0.8 16 0.7 14 0.6 12 0.5 10 0.4 8 0.3 6 8-9bp 0.2 4 0.1 2 0.0 0 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Fed Funds Rate as implied by FF futures, % 2y Tsy-OIS basis, bp Source: Bloomberg Source: Treasury 9 March 2012 3 Barclays Capital | Global Rates Weekly the earliest it can be announced is at the April FOMC meeting. To the extent there is a flow effect, sterilized QE3 would be simply replace Operation Twist. Third, the stock effect of such a program should be lower than that of Operation Twist because the market is also likely to price in the scenario in which inflation concerns recede, which presumably was the reason to sterilize to begin with, and the Fed would stop sterilizing and let excess reserves rise. Hence, expectations of a hypothetical 2y term repo rates should rise less than the spot repo rates. In contrast, under Operation Twist, the stock of debt held by private investors has permanently gone up. Judging from the market reaction to Operation Twist, only a 5bp or so effect on the 2y Tsy-OIS should be expected (Figure 2). Finally, it is entirely possible that the Fed cuts the IOER to mitigate the effect on front-end rates. Hence, if 2y Treasuries were to breach 35bp, we would recommend going long. Flow of funds: Gauging the supply/demand dynamics Supply dynamics remain favourable Earlier in the week, the Federal Reserve released the flow of funds data for Q4 11, which suggested there continues to be almost no net issuance outside the Treasury market. Figure 3 shows net issuance of fixed income products split between coupon Treasury and spread products over a one-year period for the past decade. As can be seen, even though Treasury issuance is well above pre-crisis levels, overall fixed income issuance is well below. While Corporates have been issuing bonds to take advantage of low yields, the steady shrinkage of the securitized universe is providing an offset (Figure 4). This year, net term FI supply should decline even further, led by lower net coupon Treasury issuance. Were the Treasury to keep gross coupon issuance sizes the same through the end of the year, net coupon issuance should be $975bn, as compared with $1.3trn in 2011, as the amount of debt coming up for maturity in 2012 is much higher than that in 2011. We believe the trend will continue into 2013, with net issuance of $910bn. There is a risk of a faster decline if the Treasury reduces front end coupon sizes to preserve the amount of very short- term high grade assets (T-bills and potential FRNs). While corporates are likely to continue to issue debt, the securitized universe should also keep shrinking, providing an offset, and with GSEs in run-off mode, we expect there to be no reversal in trends there either. Figure 3: Total net FI issuance well below pre-crisis levels, Figure 4: …as shrinkage in securitized products and agency net issuance of spread products remain close to nil… debt continues to offset corporate issuance. 1y Net Supply, $bn $bn 2,500 1,500 1,319 1,250 2,000 -$1trn 1,000 695 623 750 1,500 500 272 282 284 178 146 94 1,000 250 0 500 -250 -59 -132 -500 -249 0 Agency Agency Securitized Munis Treasuries Corp Bonds Debt MBS ex-bills Other -500 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Fixed Income Treasury ex-bills Spread Products Net Issuance, 2007 Net Issuance, 2011 Source: Federal Reserve Source: Federal Reserve 9 March 2012 4 Barclays Capital | Global Rates Weekly Aggregate domestic demand remains strong At the same time, domestic demand remains strong, even as foreign demand has declined somewhat. In Figure 5, we tabulate the net demand across products and across investor classes for 2011. While the Fed was by far the largest buyer in the Treasury universe, that was not the case when looking at the overall fixed income universe. Mutual funds bought ~$457bn in FI securities, though mostly in the agency and corporate universes, slightly more than the $444bn bought by the Fed. Similarly, while foreign investors bought $369bn in US treasuries, they purchased $258bn of overall FI Securities. Pension funds and insurance companies bought more. Hence, it seems that the US fixed income market is becoming less reliant on foreign inflows thanks to the relatively higher savings rate. Figure 5: Ex-Fed, net fixed income supply was mainly absorbed by domestic investors Net Supply-Demand of FI Treasury- ex- Municipal Agency Corporate Securities, 2011 bills Securities Securities bonds* Total Mutual Funds 63 17 164 212 457 Federal Reserve 642 0 -198 0 444 Pension / Insurance 106 5 14 145 270 Rest of the World 369 11 -56 -66 258 Banking Sector -29 43 141 -15 140 Money Market Funds 78 -38 1 -25 16 Treasury 0 0 -118 0 -118 Households 40 -79 -23 -105 -166 Others 53 -14 38 -124 -47 Total 1,323 -53 -37 22 1,254 Note: Corporate bonds include securitized products. Agency securities include debt and MBS. Others include broker/dealers. Source: Federal Reserve As the Fed steps back, private investors need to step up. However, with net Treasury coupon issuance declining ~$350bn in 2012 vs. 2011, the gap that needs to be filled on an aggregate level is much lower, at ~$100bn. We believe in an environment of moderate growth, this additional demand is likely to come from terming out of short-term assets. Figure 6 shows that since the beginning of the year, money market funds have shrunk in favour of longer duration assets. While outflows out of equity funds have declined, that has not come at the expense of inflows into bond funds. Unless growth expectations are revised up significantly, which was the case in early 2011, when inflows into bond funds did indeed slow, such inflows are likely to keep increasing. Figure 6: Investors terming out of money market funds into Figure 7: Demand for Treasuries from private pension funds bond funds as well as equity funds has slowed down 2M annualized inflows, $bn Private Pension Funds, Net Demand over a 1 year period, $bn 600 300 400 200 200 100 0 -200 0 -400 -100 -600 -200 -800 -1,000 -300 -1,200 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Credit Market Instruments Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 of which Treasuries Equity Funds Bond funds of which Agency securities Money Market Funds Corporate Equities Source: Haver Analytics Source: Federal Reserve 9 March 2012 5 Barclays Capital | Global Rates Weekly While ex-ante demand is likely to be in spread-products, with little net issuance outside the Treasury universe, investors would invariably get displaced into the Treasury market. For instance, in 2011, the Fed and the Treasury sold $315bn in agency MBS, which was absorbed by the mutual funds and the banking sector. With very marginal flows of this kind in 2012 (Treasury had only $28bn left to sell at the end of 2011) and agency MBS having richened significantly, demand from these investors should be more balanced. We expect Treasury issuance post Fed involvement to be mainly accounted for by foreign investors, mutual funds, banks and pension/insurance companies. As discussed below, the latter group would require higher term premium to step up its purchases of the long end. Long-term investors have reduced involvement in the Treasury market Even though aggregate demand is likely to keep pace with supply, there are signs that investors have stepped back from long end Treasuries due to a flatter curve. As the Fed completes Operation Twist by the middle of this year, the long end needs to cheapen relative to the rest of the curve to attract these investors back into the Treasury market. Figure 7 shows private pension funds bought ~$80bn in Treasuries in 2011, compared with ~$175bn in 2010. While their demand for overall fixed income securities remained stable at ~$100bn, as they continued to move away from equities, the switch from Treasuries to Agency securities suggests that duration of their fixed income portfolio may have shrunk. To incentivize them to extend duration again, term premium at the back end needs to be higher. Similarly, life insurance companies have also slowed their purchases of Treasuries, though to a much lesser extent, as they were not large participants in the Treasury market to begin with. Figure 8 shows that they bought $5bn in 2011 as compared with $25bn in 2010. Again, this was offset by higher purchases of agency securities. Aggregated across long-term investors, public/private pension funds and life insurance companies, net purchases of Treasuries declined to $90bn 2011 from $210bn in 2010 (Figure 9). On the other hand, we expect the Treasury to issue ~$195bn at the long end ($168bn in 30y nominal Treasury and another $27bn of 30y TIPS) over the one year following Operation Twist. In the absence of the Fed, these investors will need an incentive to step up to fill the gap. We expect the Treasury curve gradually to steepen and long-end swap spreads to tighten for the same reason as well. Figure 8: The same is the case for life insurance companies Figure 9: Long end needs to cheapen relatively to attract long-term investors Life Insuance Companies, Net Demand over a 1 year period, $bn Net Treasury Purchase of Long term investors, $bn 200 250 150 100 200 50 150 0 -50 100 -100 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 50 Credit Market Instruments of which Treasuries of which Corporate bonds 0 of which Agency securities Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Source: Federal Reserve Source: Federal Reserve 9 March 2012 6 Barclays Capital | Global Rates Weekly UNITED STATES: AGENCIES A return to normalcy? James Ma We continue to recommend 5y agencies versus Treasuries, given the steep rolldown +1 212 412 2563 along the spread curve. Supply technicals could paint a more positive picture for USD email@example.com covered bonds and SSA paper in the near to medium term. Rajiv Setia Spreads stabilize +1 212 412 5507 With the exception of the very front end, agency bellwether valuations have generally firstname.lastname@example.org remained stable over the past two weeks. We maintain our view that the agency-Treasury spread curve appears steep, and continue to recommend owning the 5y sector (at T+24bp) to investors looking for pickup over Treasuries, especially given the spread rolldown into the front end (5bp in 2s and 11bp in 3s). Further in the curve, we believe that very front-end sectors are now more susceptible to new supply activity. Even as 2-3y Treasury yields have backed up to the high end of their recent range, agency-Treasury spreads have tightened to levels not reached since Q2 11. Agencies have also kept pace with the dramatic compression in front-end swap spreads, and 2y in the L-20bp region appear to be the most likely point for new supply. At these valuations, investors will likely demand a hefty new-issue concession. To be clear, we are not looking for any significant cheapening in agency spreads; the rich valuations are merely symptomatic of favorable supply technicals and a lack of high-quality alternatives across sectors. As another example of this, consider that par-price new-issue callable yields in the front end are converging to those of similar-maturity bullets: a 3nc2 European structure yields 0.61%, versus FNM 3/15s at 0.58%. On an LOAS basis, the callable (at L-17bp) even appears rich to the bullets at L-11bp. SSA/covered bonds supply and spreads Recall that earlier this year, we had opined on the somewhat counterintuitive dynamics between supply and spreads in the SSA and covered bond markets; along with agencies, both asset classes outperformed despite significant new issuance activity. We believe that recent price action in those same markets is more consistent with supply activity, and Figure 1: Agency-Treasury spread curve stays steep Figure 2: USD SSA and covered bond supply diverges Agy-Tsy spd crv, bp $ bn 40 35 35 30 30 25 25 20 20 15 15 10 10 5 5 0 -5 0 Mar-10 Aug-10 Jan-11 Jun-11 Nov-11 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 3s-5s 3s-10s SSA Covered Source: Barclays Capital Source: Barclays Capital 9 March 2012 7 Barclays Capital | Global Rates Weekly expect this pattern to drive valuations in the near term. Consider that while USD SSA issuance activity has plummeted month-to-date after a torrid January-February, supply activity in USD covered bonds has ramped up (Figure 2). USD covered bonds In the USD covered bond space, the recent spate of issuance – totaling $8.5bn in just the past two weeks – has put a temporary halt to covered bonds’ recent outperformance, especially in Canada and Australia (Figure 3). However, we do not think USD covered bonds’ previous outperformance is out of line relative to the recent performance of the issuing banks’ unsecured debt, as well as the tightening in sovereign CDS globally (Figures 4 and 5). Our European colleagues expect the global pickup in covered bond supply to continue this month (across currencies) before reducing in April. 1 Much of this is predicated on European banks’ funding through the LTRO, which would be unavailable to larger USD issuers. Thus, we believe the outlook for potential USD covered bond issuance is somewhat more mixed in the near term, but paints a rosier picture longer term regarding the supply technical. We continue to favor names that are relatively isolated from Europe, such as Australian and Canadian issuers; the majority of the latter also benefit from a government guarantee on the cover pool collateral, and Canada’s fiscal metrics generally compare favorably with, for example, those of the US. SSA paper By contrast, our European colleagues expect SSA issuers to steadily reduce their funding activity from now through April; EIB and KFW, the two largest issuers, are already 35% and 40% through their 2012 funding slates as of this writing, respectively. Together with the seasonal lull in issuance activity that could last until late summer, we would expect a positive supply technical to keep grinding SSA valuations tighter to agencies. Recall that we had recommended SSA paper over agencies earlier, and continue to do so with KFW and EIB at 15bp and 35bp behind agencies, respectively. 2 However, as we remain wary of headline risks driven by lingering European sovereign debt concerns, we would turn neutral if the outperformance continues for another 5-10bp. Figure 3: USD covered bond outperformance has paused Figure 4: Australian covered bonds vs. senior debt, CDS L Spd, bp bp 160 210 140 190 120 170 100 150 80 130 60 110 40 90 20 70 0 50 26-May-11 26-Aug-11 26-Nov-11 26-Feb-12 21-Nov-11 18-Dec-11 14-Jan-12 10-Feb-12 8-Mar-12 CS 2.6 5/16 BNS 2.15 8/16 ANZ 2.45 11/16 (Cov) ANZ 3.25 3/16 (Snr) SPNTAB 2.125 8/16 ANZ 2.4 11/16 5y Aus CDS Source: Barclays Capital Source: Barclays Capital 1 “Short-term supply update,” The AAA Investor, 2 March 2012. 2 “A fat year or a lean year,” Market Strategy Americas, 9 February 2012. 9 March 2012 8 Barclays Capital | Global Rates Weekly Freddie Mac 4Q11 earnings: First impressions Shortly before press time, Freddie Mac reported its 2011 financial results, posting a Q4 gain of $619mn before paying $1.7bn in preferred dividends to the Treasury. At first glance, we believe the following were major drivers of the improvement: Net interest income was $4.7bn in Q4, a slight improvement from $4.6bn in Q3, as the decline in funding costs continued to outstrip the decline in portfolio coupon income. Derivative fair-value losses declined sharply, to $770mn in Q4 from $4.8bn in Q3; this was consistent with relatively rangebound rates during the period. Credit loss provisioning continued to reduce, to $2.6bn in Q4 from $3.6bn in Q3. This squares with our view that the GSEs have already taken cumulative provisions equal to the vast majority of credit losses from the legacy g-book. After subtracting dividends from net income, the loss to taxpayers of $1.0bn was offset by a roughly $850mn mark-up in AOCI, reducing ultimate draws on the Treasury to just under $150mn (keeping cumulative draws at just over $72bn). We find this consistent with our earlier projections that the GSEs should be on the cusp of profitability (before dividends to the Treasury) in 2012. However, we believe Treasury will need to amend the 10% senior preferred dividend rate by year-end to soothe investor concerns in 2013. FHFA releases timeline for Strategic Plan Also shortly before press time, the FHFA provided a roadmap for its previously announced Strategic Plan, designed to continue oversight of FNM/FRE in conservatorship, in the absence of a housing finance reform plan. Some relevant milestones: September 30, 2012: Prepare for competitive disposition of a pool of NPA and a pilot REO sales program and undertake further risk-sharing transactions. December 31, 2012: Develop a plan for a single securitization platform that can serve FNM/FRE and a post-conservatorship market independent of taxpayer support. While FHFA is clearly proposing serious steps to reform housing finance, the bottleneck is likely to be in Congress, where little progress is expected until well into 2013, if not later. Figure 5: Canadian covered bonds vs. unsecured Figure 6: SSA outperformance in USD of late CCDJ 2.65 9/15 (Snr) ASW, bp 140 100 130 120 80 110 60 100 90 40 80 20 70 60 0 50 40 -20 20 40 60 80 100 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 CCDJ 2.55 9/15 (Cov) FNM 5y FRE 5y KFW 5y EIB 5y Source: Barclays Capital Source: Barclays Capital 9 March 2012 9 Barclays Capital | Global Rates Weekly UNITED STATES: SWAPS Revisiting the refinancing wavelet Amrut Nashikkar Talk of sterilized mortgage purchases and another presidential proposal have led to a +1 212 412 1848 renewed discussion of issues related to mortgage refinancing. We think that modified email@example.com HARP in its current form will have a small duration effect. For a significant effect, a much more drastic program would be needed. Over the past week, press reports led to some speculation in the market about the possibility of the Fed conducting mortgage purchases and sterilizing them by conducting reverse repos. This has some significance because in a recent white paper that the Fed submitted to Congress, it identified housing finance as a key constraint for the economic recovery. At the same time, the effects of the administration’s changes to the Homeowner Affordable Refinancing Program (HARP 2.0) are filtering through, the president has a new housing proposal, and banks have been discussing expansions of their mortgage businesses as HARP 2.0 is implemented. In our piece titled Refi wave: Only a wavelet in rates, 6 October 2011, we had considered some of the issues raised by HARP 2.0. But as time has passed, there has been more clarity around both the implementation and the effects of HARP 2.0. What was HARP 2.0? From the point of view of the duration market, the major changes in HARP were generally of two types. Expanding the HARP universe, such as removing the 125 LTV cap. However, the more drastic changes that we had imagined in our previous piece, such as extending HARP 2.0 to mortgages originated after June 2009, are not under consideration. Increasing the efficiency of refinancing. These include simplifying loan level pricing adjustments, harmonising the Freddie and Fannie refinancing processes, using the automated appraisal system, and changing the reps and warranties policies regarding refinanced loans. Figure 1: As rates have rallied, speeds have increased on Figure 2: Pre-2009 fixed rate 30y mortgages have already HARP eligible vintages shrunk considerably $tn 1m CPR % 3.5 32 4.3 30 3.0 4.2 28 2.5 26 4.1 2.0 24 4.0 22 1.5 20 3.9 1.0 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 FNCL 5.5 2006 FNCL 5.0 2006 FNCL 6.0 2006 Avg par coupon, RHS 30y fixed pre Jun 09 balance Source: Barclays Capital Source: CPR-CDR 9 March 2012 10 Barclays Capital | Global Rates Weekly Separately, last week, the administration around changes to the FHA program (Ginnie Maes), such as reducing MIPs, to spur refinancing. Have prepayment speeds picked up? Figure 1 shows, through the example of 2006 30y fixed mortgages, that as rates have rallied over the past few months, there has been an increase in prepayment speeds. This is generally true across all HARP-eligible vintages. However, it is unclear how much of the most recent rise is attributable to rates, and how much of it was because of HARP changes. Given that changes to the program would have a lagged effect, the question for rates investors is whether these changes will cause an unexpected increase in mortgage duration supply that the market will have to take down over the next few months. How much refinancing had already occurred through HARP? Figure 2 shows the outstanding balance of pre-2009 30y fixed rate conventional mortgages, which is a proxy for the size of the HARP-eligible universe. As can be seen, by December 2011, it was already nearly half of what it was in 2009. There were a couple of reasons for this decline. Many of these loans had already slowly prepaid over the previous three years. Others went delinquent and were bought out by the GSEs. As a result, there has not been a significant duration effect as the mortgage universe has slowly reconfigured. If the new HARP rules had been implemented at the inception of the program, they would have resulted in significantly higher duration supply and, as a consequence, had a much bigger rate effect than they will now. How much of an effect will HARP changes have on the duration market? Figure 3 shows the 1y S-curves for the pre-HARP 30y fixed-rate mortgage universe and our mortgage modeling team’s expectation of what the S-curve could look like under HARP 2.0. It also shows the S-curve for post June 2009 vintages, excluding those loans that were originated through the HARP channel (these loans are likely to prepay slowly). There are two key takeaways from the chart. First, modifications to the HARP program are likely to result in increased speeds of 5-10CPR at an aggregate level on the HARP eligible universe. Considering that the universe of 30y fixed-rate loans originated prior to June 2009 had shrunk to nearly $1.4tn by December, this would imply mortgage originations of $70-140bn. Figure 3: S-curves of pre-2009 mortgages are considerably Figure 4: Primary mortgage rates quite sticky even when flat, but could get bumped higher because of HARP 2.0 secondary yields rally 1y CPR % bp % 35 130 4.5 30 125 25 4.0 120 20 15 115 3.5 10 110 3.0 5 105 0 25 50 75 100 125 100 2.5 Pre June 2009 WAC-mtge rate (bp) Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 HARP 2 projected Prim-Sec Spd, LHS Par cpn, RHS Post June 2009 (ex HARP loans) Primary, RHS Source: CPR-CDR. Barclays Capital Source: Barclays Capital 9 March 2012 11 Barclays Capital | Global Rates Weekly By our estimates, roughly a fifth of these mortgages are held by the Fed, meaning that absent QE3, the supply the market will need to take down will be between $60-110bn. Even if all of this was hedged, it would imply duration shedding needs of $30-$50bn. In all likelihood, the actual amount would probably be smaller than that. In our view, $100bn in 10y supply pushes rates up by 10bp (for details, please refer to the discussion in Refi wave: Only a wavelet in rates, 6 October 2011). As a result, the duration effect of HARP 2.0, in its current form, would be in the single digits in terms of basis points. What would happen in a rally in rates? The second takeaway from figure 3 is what would happen in a rally in rates. The bulk of loans outstanding in the pre-HARP universe are in the 75-175bp zone, where the S-curve is flat. This suggests that putting the effect of HARP 2.0 aside, even a rally in mortgage rates may not increase speeds dramatically. This is compounded by the fact that primary- secondary spreads widen out when rates rally (Figure 4), as a result of which it would take a rally of 40bp in the par-coupon mortgage rate in order to reduce primary rates by 25bp. This further underscores the difficulty the Fed will have in stimulating the economy through the housing channel if were to conduct QE3 in mortgages (whether sterilized or not). What could lead to a mortgage led sell-off in the duration market? We believe that there could be an impact on rates markets if there are further program changes as we head into election season. The most important of these, in our view, would be if HARP is extended to mortgages originated after May 2009 or, alternately, if a streamlined refinancing program were to be put into place. As figure 3 shows, prepay speeds on those loans that were originated after 2009 through non HARP channels are higher, and streamlining could lead to a big change in the situation. Post HARP 30y fixed rate mortgages ($1.35tn as of Dec 11) now are nearly comparable in outstanding balance to pre 2009 vintages ($1.4tn), and streamline refis could lead to a bigger increase in their speeds than the latter. If we get a rise of 20CPR on this portion of the universe, it would mean an additional $135bn in 10y duration supply. Together with HARP2.0, this could lead to a sell-off, which could be exacerbated by duration shedding by mortgage hedgers. If the changes are unexpected, duration supply hitting the market in a short time would be a surprise. However, even in this scenario, a 2003-like experience is unlikely to be repeated. Figure 5: Even with changes, speeds should be well short of Figure 6: 2003 was a much more dramatic event even the 2003 experience though mortgage rate incentives were similar 1y CPR % bp bp 75 4 150 65 55 2 100 45 0 50 35 -2 25 0 -4 15 -50 5 -6 0 50 100 150 200 -100 -8 WAC-mtge rate (bp) HARP 2 projected -10 -150 1997 1999 2001 2003 2005 2007 2009 2011 2003 experience 1m WAC chg (LHS) Primary - WAC (RHS) Source: Barclays Capital, CPR-CDR Source: Barclays Capital 9 March 2012 12 Barclays Capital | Global Rates Weekly Why is the situation different from 2003? During the refinancing wave in 2003, portions of the mortgage universe prepaid at speeds in excess of 60CPR. This can be seen from figure 5, which shows a comparison between the projected S-curve recently and the 2003 experience. The main difference between the current situation and that of 2003 is timing. Figure 6 shows a time series of the weighted average coupon of the mortgage universe plotted against primary rates for 30y conventional fixed rate loans. This measure roughly approximates the refinancing incentive for the fixed-rate mortgage universe. As can be seen, the incentive today is roughly comparable to what it was during the 2003 refinancing wave. In 2003, a large portion of the mortgage universe refinanced very quickly. For example, the WAC of fixed-rate mortgages fell by nearly 70bp from nearly 7% to 6.3%. This process has been much slower post 2009, but has been going on nevertheless. While the WAC only fell by 20bp in 2011, since the inception of HARP in 2009, the overall decrease in WAC has been comparable to what occurred during 2003 refi wave. At this stage, the loans which have not been refinanced have been adversely selected against for a very long time. Figure 6 also plots the 1m change in the WAC. When there is a greater refinancing incentive we would expect the WAC of the fixed rate universe to drop quickly, which is what the figure shows. In 2003, the WAC of the fixed rate universe was dropping at 8-10bp a month, when the rate incentive was more than 100bp. In contrast, even though the incentive has been higher than 100 for most of the post 2009 period, the WAC has dropped at 2-3bp a month. It suggests that refinancing activity in 2003 was nearly three times than has been the case recently, even though the refinancing incentive is roughly comparable. All said, for a government-induced refinancing program to produce a 2003-like convexity event in the rates market, it would have to triple prepayment speeds for the entire universe of mortgages at the current (sticky) level of primary mortgage rates. The duration market will get significantly impacted if we get a program that brings about that kind of a dramatic change. HARP even in its modified form, is unlikely produce that. 9 March 2012 13 Barclays Capital | Global Rates Weekly UNITED STATES: MONEY MARKETS Bank funding rates: Survey or transaction? Joseph Abate The technicals behind the setting of Libor rates have received a fair bit of attention +1 212 412 6810 recently. But these mechanics raise a more fundamental issue: how does one measure firstname.lastname@example.org bank funding costs? Unsecured bank financing costs can be measured either from a survey or based on actual transactions. But both approaches have limitations. There is some evidence of an anonymity value in the setting of survey rates. The effect grows when financial conditions are stressed. Transacted rates are often infrequent and in times of financial market stress exhibit “success effects.” They also tend to be noisier. The British Bankers’ Association recently noted that regulators and bankers are meeting to discuss “future developments” related to the technical details of the rate survey. 3 We prefer to look at a broad array of data to assess unsecured bank funding conditions. Survey says How should unsecured bank Recently, the technical details behind the measurement and behavior of Libor have received a funding costs be measured? fair bit of attention. However, we believe the more fundamental issue might be how to measure short-term unsecured bank funding costs. And, unfortunately, there is no obvious answer. The 3m dollar Libor rate is derived from a survey of banks with significant dollar operations in London. Each panel member is asked where it could raise funds in reasonable size in the inter- bank market across different currencies and tenors. The answers are tallied and a trimmed mean is calculated, removing the highest and lowest quartiles of submissions. Libor is not the only survey measure of bank funding costs. Since mid-2008, a similar version has been collected in New York. A key difference between Libor and the New York funding rate (NYFR) is that the latter is an anonymous survey. Its sample size can vary and the participating names (along with their corresponding submissions) are unknown. Additionally, the wording of the survey question is a little different in the NYFR sample. Banks are instead asked where they think a “representative” A1/P1 bank could raise money, not where they themselves judge they could fund. And unlike the Libor panel question, the amount of money is left undefined, although the “reasonable size” criterion in the Libor submissions is also vague. Anonymous There is an anonymity value in Differences in the wording and the sample members should produce a spread between the two surveyed rate postings survey measures. A priori we would expect these definitional differences to make the spread stable over time. But it is not (Figure 1). And importantly, it appears to be correlated with financial market conditions. We judge this reflects the existence of a shifting “anonymity” value in the NYFR. To the extent that the Libor survey postings are highly visible and interpreted as signals of funding conditions, a high posting might actually dissuade would-be lenders, instead of attracting new money. In times of financial stress, when the scrutiny of individual settings is highest, borrowers seem to attach more value to anonymity – that is, they might be more willing to borrow at a higher rate if they could keep their name “off screen.” As illustrated in Figure 1, anonymity value increased during recent waves of the financial crisis (rising to as much as 10bp) and since the December LTRO has come down sharply. 3 See “Regulators consider Libor overhaul”, B. Masters and C. Binham, Financial Times, March 5, 2012. 9 March 2012 14 Barclays Capital | Global Rates Weekly In a study of wholesale bank funding markets, Skeie, Kuo, and Vickery found that Libor tracks average wholesale bank borrowing transacted rates (as measured by a unique dataset of matched Fedwire “buys” and “sells”) fairly well but does a poor job of capturing the large dispersion in individual Libor postings over 2007-09. 4 In recent months, the spread between the maximum and minimum Libor postings has become very wide as a percentage of the underlying rate and is near 2009 levels (Figure 2). The recent widening has been driven by falling minimum postings, rather than increasing maximum postings. Transacted rates There are relatively few There are relatively few direct and systematically observable measures of transacted observable transacted rates unsecured funding rates. Of course, this is not the only front-end market where details and data on transactions activity are inadequate – Adrian et al note the same problems affect the tri-party repo market. 5 The closest equivalent to Libor might be the 3m AA financial CP rate published by the Federal Reserve. This is calculated as the weighted average of CP sales (either directly placed paper or debt that is instead sold to dealers). Under most circumstances, the surveyed rates (Libor and NYFR) and the AA financial CP rate are fairly close. But as we observed earlier this year, this spread widened sharply during the recent financial strains. Indeed, the spread between these two measures of 3m unsecured funding costs widened to over 30bp by late last year. As we noted then, the CP rate is likely somewhat distorted because of a “success effect” that is especially apparent when financial conditions deteriorate (Figure 3). Only institutions that are able to issue paper are captured in the Fed’s data. Institutions that are not interested in raising unsecured money or cannot access the new-issue market are not captured. Consequently, this measure of actual transacted bank funding rates may have a downward bias that tends to grow in periods of stress but that may ultimately tend to understate the “true” cost of unsecured bank funding for most banks. Transacted rates also tend to be noisier than rate measures based on surveys (Figure 4). This reflects the fact that the sample of issuers captured in the CP data, for instance, changes from day to day. The mix between “strong” and “weak” issuers can change every Figure 1: NYFR-Libor, 3m (%) Figure 2: Libor, maximum less minimum posting (% of Libor) 12 100 Europe 90 10 8 80 Ireland 70 6 Greece 60 4 50 2 40 0 30 -2 20 -4 10 Debt ceiling -6 0 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Barclays Capital Source: Bloomberg, Barclays Capital 4 See “How well did Libor measure bank wholesale funding rates during the crisis?”, D. Skeie, D. Kuo,, and J. Vickery, Federal Reserve Bank of New York Conference presentation, September 29, 2010. 5 See “Repo and Securities Lending”, T. Adrian, B. Begalle, A. Copeland, and A. Martin, Federal Reserve Bank of New York, December 2011. 9 March 2012 15 Barclays Capital | Global Rates Weekly day, based on the maturity cycle of their debt. As a result, there can be significant day-to- day swings in these rates that have little to do with underlying market fundamentals but instead just reflect the daily composition of borrowers. On any given day, banks may or Even if these data were available on a consistent basis, the information might not be may not need to raise particularly useful. On any day, a bank may or may not need to raise unsecured money, or term unsecured it could decide to shift the maturity distribution of its unsecured short-term borrowings by letting 3m paper roll off and replacing it with shorter (or longer) maturity paper. Consequently, individual bank issuance tends to be sporadic and lumpy. For example, across a sample of issuers in the (direct offer) CP market since the beginning of the year, there were some instances where institutions posted no offerings in either 1 or the 3m sectors for as long as a week. Beyond rates Ultimately, both survey and transacted measures of interest rates have limitations as indicators of unsecured bank funding costs. Moreover, neither measure indicates the level of activity in funding markets, which can often be more revealing than the price (rate) data. A market where just a few banks are issuing a small amount of overnight paper at very low rates is significantly different from one where the amount of daily issuance is high but rates are low. Consequently, while we scrutinize the Libor settings as intensely as every other analyst, we consider Libor to just be one piece in overall bank funding market conditions that needs to be weighted against trends in CP issuance, tenors, and money fund investment behavior. That said, it is unclear what regulators, panel member banks, and the British Bankers’ Association will decide with respect to the technical issues on the construction of Libor. Figure 3: Libor-AA financial CP, 3m (%) Figure 4: Standard deviation financial CP and Libor (20d mavg, bp) 50 14 CP 40 12 30 10 20 8 Libor 10 6 0 4 -10 2 -20 0 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Source: Federal Reserve, Barclays Capital Source: Federal Reserve, Barclays Capital 9 March 2012 16 Barclays Capital | Global Rates Weekly UNITED STATES: INFLATION-LINKED MARKETS Higher energy prices twist the breakeven curve Michael Pond The drop in the forward breakeven implied by TIIApr14s and TIIApr15s does not appear +1 212 412 5051 justified by rising energy prices and we recommend longs at 1.65% with a stop at 1.50% email@example.com and target of 1.90% Higher oil price and near-term forwards Chirag Mirani +1 212 412 6819 Last week, we discussed the effect of higher energy prices on spot short-end breakevens. The impact in breakevens has not all been one way, though. An increase in oil and gasoline firstname.lastname@example.org prices should be positive for spot short-end breakevens because the rise should lead to higher inflation in the near term. However, investors may also be concerned about the negative effect on real consumer spending, which could then cause disinflationary pressures. This concern seems to be showing up in breakevens via a decline in forward inflation expectations, though, in our view, the move in CPI swaps appears more logical than that in breakevens (Figure 1). 1y forward 1y CPI swaps have dropped more than 30bp since the end of January, about the time when energy prices began rising. Since a decline in real activity might affect inflation with a small lag, this decrease in 1yfwd1y CPI makes sense to us if investors believe high energy prices might lead to a slowdown in real consumption over the coming quarters. Some forward breakevens implied by TIPS have also declined, though, oddly, the largest drop, of 20bp, has come from the 2y forward 1y rate implied by TIIApr14 and TIIApr15 (Figure 1 and Figure 3). We believe this is too long a lag to be related to the disinflationary force of oil, and think this market move presents an opportunity and is largely a sign of the cheapness of the TIIApr15s. Figure 1: Forward 1y breakevens and CPI swaps 1.6 Change in fwd 1y CPI curve from 1/31/12 1.4 Change in fwd 1y BE curve from 1/31/12 1.2 1.0 0.8 0.6 0.4 0.2 - (0.2) (0.4) (0.6) Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Source: Barclays Capital We can think of two reasons why the TIIApr15s would have cheapened so much, though neither justify the full move over the past month. First, the oil curve is much more in contango than it had been. In other words, the energy market is priced for steeper declines in energy inflation over the next several years and implied oil deflation for a period consistent with the TIIApr14/TIIApr15 forward breakeven is about 1.5% greater than it had been at the end of January (Figure 2). However, this drop should have been apparent for other forward periods as well. 9 March 2012 17 Barclays Capital | Global Rates Weekly Figure 2: Change in fwd oil curve versus change in forward 1y breakvens, oil price changes chart (RHS), FWD BE change (LHS) 0.8 Change in fwd 1y BE curve from 1/31/12 6 Change in fwd 1y crude inflation (RHS) 5 0.6 4 0.4 3 2 0.2 1 - - (1) (0.2) (2) (0.4) (3) Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Source: Barclays Capital Another factor could be that investors may be concerned about selling pressure on the TIIApr15s over the next several months. In May, the TIIApr15s will roll into the Fed’s eligibility window for TIPS sales. If it is to sell as much as it is buying ($12bn = 3% of $400bn), it will have to sell very close to all TIPS eligible for sale because it has bought about $8bn and has about $4bn left in the eligible basket (including TIIApr15s). We expect that it will fall short of $12bn in total sales because of the $4bn left, $1.3bn is in TIIJul12s, which will not be eligible after the April sale operation. Instead, we expect it to sell a total of about $11bn TIPS, though this assumes it will sell all others eligible. Even as the TIIApr15s roll into the basket, we do not believe they should come under much pressure because the Fed only owns $0.23bn of them. Figure 3: Apr14-Apr15 Fwd BE 2.80% Apr14-Apr15 Fwd BE 2.60% 2.40% 2.20% 2.00% 1.80% 1.60% 1.40% 1.20% 1.00% Apr-10 Oct-10 Apr-11 Oct-11 Source: Barclays Capital We recommend investors take advantage of this apparent curve dislocation by going long the forward breakeven implied by TIIApr14s/TIIApr15s. In addition to appearing cheap on a forward breakeven basis, the TIIApr15s stand out as cheap within the relative value framework shown in our daily Inflation Forwards Packet. One way to see its cheapness is that it has a 2.7 z-score off our real fitted curve. It is also cheap on ASW in our view. 9 March 2012 18 Barclays Capital | Global Rates Weekly Therefore, we recommend that investors not able to put on a forward breakeven position instead simply shift existing shorter end breakevens out to the TIIApr15s. Figure 4: Trade table for 10k DV01 of forward breakeven implied by TIIApr14/TIIApr15 Action Security Price Yield Duration DV01 per 10k notional Notional Sell TII 1 1/4 04/15/14 106.82 -1.89 2.09 2.384 $87,741,108 Buy T 1 7/8 04/30/14 103.27 0.34 2.10 2.164 $96,698,802 Breakeven 2.234 Buy TII 0 1/2 04/15/15 106.63 -1.56 3.09 3.442 $89,846,787 Sell T 2 1/2 04/30/15 106.29 0.48 3.02 3.208 $96,385,893 Source: Barclays Capital 9 March 2012 19 Barclays Capital | Global Rates Weekly UNITED STATES: VOLATILITY Hedge with Bermudans Piyush Goyal Rate-based hedgers looking for protection against low rates should consider long-dated +1 212 412 6793 Bermudan receivers instead of European options. Current levels are attractive because email@example.com of supply from callable zeroes, and Bermudans should resist a loss of premium if rates sell off by a small amount. A Bermudan option can be thought of as a portfolio of probability-weighted options. For example, a 1y*30y Bermudan receiver is equivalent to a portfolio of 1y*29y, 2y*28y, 3y*27y, etc European receiver swaptions. Therefore, the value in Bermudan receivers, relative to comparable Europeans, is driven by the following factors: Level of volatility – Bermudans have more optionality than European options. Therefore, they gain value when vol is high. Level of long-dated vs short-dated volatility – Bermudans have more long-dated options than comparable European options. Therefore, as long-dated vol richens to shorter expiry vol, ie, a steeper vol surface, Bermudans become more valuable. Curve shape – The flatter the curve, the less chance that Bermudan receivers will be exercised early. As longer expiry options become more probable, Bermudans gain value. Bermudan receivers gain from To verify the above, we regress the available historical data on Bermudan options with the higher vol, long vs. short-dated above factors. Figure 1 shows the actual spread between 1x30 Bermudan receivers and vol and flatter curve 1y*30y receivers for the past few years and compares it with the regression value. The regression is based on 1y*30y vol (level of vol), the 10y*30y to 1y*30y vol ratio (long-dated vs short-dated vol), and the 2y-30y swap curve (curve shape). Figure 1: 1x30 Bermudan vs European receiver is driven by vol, long vs short-dated vol, and rate curve Actual Regression Value 1,000 900 800 700 600 500 400 300 200 100 0 Mar-02 Apr-03 May-04 Jun-05 Jul-06 Aug-07 Sep-08 Oct-09 Nov-10 Dec-11 Note: Last data point as of March 1, 2012. Actual data are for October 15, 2009-March 1, 2012. We regress the actual 1x30 Bermudan vs European receiver spread (in cents) with 1y*30y vol, the 10y*30y/ 1y*30y vol ratio, and the 2y-30y swap curve for this period. The regression value is based on beta parameters generated from this regression. We use the same parameters to determine the trend for prior years. Admittedly, this makes the historical data sensitive to regression done for the October 15, 2009-March 1, 2012, period. Source: Barclays Capital. 9 March 2012 20 Barclays Capital | Global Rates Weekly The r-squared is high (= 93%), indicating that the regression is meaningful. Also, each variable is relevant to the regression, as each has a high t-statistic. Furthermore, as expected, the beta is positive for vol and long vs short-dated vol and negative for the rate curve. This confirms our hypothesis that high vol, a steeper vol surface, and a flatter curve increase the value in Bermudan receivers relative to European swaptions. Hedge with Bermudans As shown in Figure 1, Bermudan receivers have gained in value compared with European receivers over the past year. But it is still a good time to buy, for three reasons. They could gain from further One, Bermudans have richened because the rate curve has flattened 6 and short-dated vol steepening of the vol surface has come off relative to long-dated vol. 7 But the move may not be over yet. Their value will likely increase further as the vol surface steepens. This should happen because longer rates will likely remain in a range for much of 2012 as looming spending cuts and the expiration of various tax cuts hold back the market’s growth expectations. A range-bound rate environment should cause shorter expiry options such as 1y*30y to cheapen more. The JPY options market provides context: JPY 1y*30y has traded within 35-90bp/y for all of the past ten years, with an average of 55bp/y. So, the current 100bp/y for the US 1y*30y is clearly at the higher end of the range. Further, the JPY 10y*30y to 1y*30y ratio has averaged ~ 1 in the same period. If 1y*30y and 10y*30y USD vol trade as same level, ie, a ratio ~ 1, Bermudans should trade about 100cts richer than current levels. In fact, a longer history of the regression value suggests that Bermudan receivers can be more valuable than comparable European swaptions (Figure 1). Essentially, the US’s own history suggests that long-dated vol can be as rich as short-dated vol and the rate curve flatter, leading to an increase in Bermudan prices. Two, the receivers would lose value much quicker with a small rise in rates.ATM 1y*30y receivers would be worthless if 30y swap rates end 15bp higher in one year. On the other hand, Bermudan receivers would lose maybe 10% of their initial value if rates increase such small amount. In fact, longer rates would need to rise 75-100bp for Bermudans to lose half of the initial premium outlay, an amount similar to what long 1y*30y ATM receivers would lose in a small 15-20bp sell-off. Since rates are low and have been low for a while, a small rise in rates cannot be discounted. Finally, Bermudans can probably be purchased at better prices than discussed above because of the excessive supply from callable zeroes over the past few years (Figure 2). These are typically 30y notes that are non-callable only for the first year; they pay zero coupon until called or matured. Given such a structure, these notes lead to supply of high- strike 1y x 30y Bermudan receivers at the time of issuance. Generally, there is little demand for such options; therefore, dealers end up managing the risk by dynamic delta/vega hedging this option supply. Moreover, there has been a spike in issuance lately, leading to adequate inventory of long-dated Bermudan. 6 The 2y-30y swap curve has flattened about 110bp since March 2011. 7 The 10y*10y to 1y*10y ratio has increased from ~ 0.75 in March 2011 to ~ 0.85 now. 9 March 2012 21 Barclays Capital | Global Rates Weekly Figure 2: There has been significant issuance of callable Figure 3: …and a spike in the past two months zeroes in the past few years… 30 300 2.7 $2.6 5 $2.2 25 250 2.2 4.5 20 200 1.7 4 15 150 1.2 3.5 10 100 0.7 $0.3 3 0.2 2.5 5 50 -0.3 2 0 0 Jan-11 Feb-11 Apr-11 Mar-11 May-11 Jun-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jul-11 Jan-12 Feb-12 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Gross Issuance ($bn) Forecast ($bn) Gross Issuance ($bn,L) 30yr Swap,R 2-10 swap curve (bp) Note: As of February 29, 2012. There has been a total of $4.78bn in the first two Note: As of February 29, 2012. Source: Bloomberg months of 2012. At this pace, there could be a total of $27bn for the entire year. Source: Bloomberg Weighed down by supply Callable zero notes There has been a adequate The issuance of callable zeroes has increased notably in the new year (Figure 3). After supply of 1x30 Bermudan plummeting to ~ $1bn/month on average in second half of last year, probably because of receivers from callable zeroes in investor concerns about issuer credit risk, the issuance of zeroes totalled $2.2bn and $2.6bn the past two months in January and February this year. Because of higher issuance, there was a $17mn log vega supply from callable zeroes in February, higher than $15mn in January and the average $6mn/month in H2 2011. More important, because of the increase in issuance, dealer desks have an adequate supply of high-strike 1x30 Bermudan receivers. So investors may be able to buy these structures at attractive prices. FHLB callable notes The other source of Bermudans is agency issued callable notes. There was a conspicuous increase in callable note issuance by the Federal Home Loan Banks last month (Figure 4). Roughly $32bn was issued by the FHLBs, considerably more than the $12bn and $6bn in the previous two months. Because of this increase, the log vega delivered to option market was much higher than in any of the previous six months. A total of $12.3mn was dealt to the market, more than the $7mn+ and $2mn- in January and December, respectively. However, the general structure of the note is 2-5y term non-callable for the first three or six months. So the supply is felt in the form of 3m*5y high-strike Bermudan options, essentially the top left. 9 March 2012 22 Barclays Capital | Global Rates Weekly Figure 4: Massive pick-up in FHLB callable notes Figure 5: The effects of supply felt by long-dated skew 90 1.8 100 20 80 1.6 90 15 70 1.4 80 60 1.2 70 10 50 1 60 5 40 $32 0.8 50 30 $6 0.6 0 40 20 0.4 30 -5 10 0.2 $12 20 0 0 -10 Q1 Q3 Q1 Q3 Q1 Q3 Q1 10 2009 2009 2010 2010 2011 2011 2012 0 -15 Mnth 1 Mnth 2 Mnth 3 6m10y 1y10y 3y10y 5y10y 10y10y FHLB ($bn,L) Forecast ($bn) 2y rate, R Change (USD) Change (EUR) EUR USD Source: Bloomberg Note: Chart shows the cost of 100bp high-strike payers versus 100bp low-strike receivers in cents for various expiry swaptions on 10y tails in US and EUR. The change shows the change in the cost between December 30, 2011, and February 29, 2012. Source: Barclays Capital The effect of supply is visible in Put together, there was more vega supply in February than in January ($29mn versus the long-dated skew $23mn) because of the increase in both callable zeroes and FHLB-issued callable notes. The effect is noticeable in long-dated payer skew. Figure 5 shows the payer skew for various option expiries in both US and EUR. The two lines correspond to the level of the skew in US and EUR as of February 29, 2012. Two takeaways: One, 10y*10y skew is about as expensive in US as in EUR, even though shorter expiries such as 3y*10y are visibly expensive in US. This highlights the effect of the overall large supply of callable zeroes over the past three years (Figure 2). Two, the US 10y*10y skew cheapened between end-2011 and end-February, even as shorter expiry skew in US richened/EUR long-dated skew did not cheapen. This highlights the effect of the increase in issuance of callable zeroes in the past two months compared with H2 2011. Conclusion Buy Bermudan receivers to Because of the increase in callable zero issuance in the past two months and over the past hedge low-rates-for-long three years, there is adequate inventory of 1y*30y Bermudan receivers. Hedgers looking for protection against low rates should be able to buy Bermudan receivers cheaply. We think they are preferable to comparable receiver swaptions because they would benefit from a steeper vol surface, which is likely in the current range-bound rate environment. Also, if rates rise temporarily, receiver swaptions would expire worthless, but the Bermudans would resist a loss of premium. 9 March 2012 23 Barclays Capital | Global Rates Weekly EURO AREA: RATES STRATEGY Greek PSI: almost done, with success Laurent Fransolet Greek PSI deal to go ahead: 95.7% participation reached after use of CACs on domestic +44 (0)20 7773 8385 law bonds. Headline risk now lower. firstname.lastname@example.org Greek PSI news Huw Worthington The Greek Ministry of Finance has indicated in a press release that the PSI has succeeded +44 (0)20 7773 1307 and the bond exchange will go ahead as the participation rate has exceeded 75%. A few email@example.com important points are worth noting: 1) The participation rate on domestic law bonds was 85.8% (€152bn of €177bn), high enough to legitimise the use of CACs on hold-outs. The government has stated that it intends to activate CACs to include all domestic law bonds in the exchange. It appears that domestic law bond holders that have not tendered will receive the same deal as to those bondholders that have tendered. 2) The addition and trigger of CACs on the domestic law bonds, which will force the same deal on holdouts, will very likely constitute a CDS credit event, in our view. This is, however, to be established by the ISDA Determination Committee (DC). ISDA issued a press release early this morning stating that it had received a question regarding a potential credit event on the Hellenic Republic and that the DC will meet at 1pm GMT on Friday 9 March to address this question. Figure 1: Estimated Greek debt ownership before and post PSI at the end of 2012 (€bn) Before PSI Post PSI end of 2012 IMF loans 20 28 EU loan package 1 53 74 EU loan package 2 0 88 ECB SMP + Investment portfolio 55 46 T-bills 15 15 Sub total 1 143 251 Banks 70 0 Insurance 10 0 Central banks/official institutions 38 0 Other investors (real money, etc) 70 0 Greek Social Security fund 18 0 Sub total 2 206 0 New exchange bonds from PSI 0 65 Total Greek debt 349 316 Source: Bank of Greece, Troika Greece reports, Reuters, Barclays Capital. Assumes full participation on the total €206bn of debt subject to the PSI. 3) A total of €20bn of bondholders of foreign law bonds and bonds issued by state-owned enterprises (SOE) and guaranteed by the state have tendered. According to Bloomberg, of the €18bn of foreign law bonds, it seems that €12bn have tendered. The latter appears to correspond to the FRNs issued to Greek banks, which the market had expected to tender. Overall, combining all bonds, the participation rate would reach 95.6%, a bit higher than assumed in the 'Troika' DSA. We think that the remaining €6bn of foreign law bonds may well holdout. The MoF statement also indicated that invitations to offer exchange and submit 9 March 2012 24 Barclays Capital | Global Rates Weekly consents for these bonds and guaranteed bonds will remain open until 23 March 2012, after which there will be no further opportunity for creditors to benefit from the package of EFSF notes, co-financing and GDP linked securities. A question therefore remains open on what will Greece do after 23 March 2012 to those foreign law bonds holders who do not participate. As we have indicated in previous research reports, we do not expect that the activation of the CACs and the likely CDS trigger will be of systemic importance. While we cannot rule out potential unforeseen problems through the settlement process of CDS or the potential inability of a counterparty to meet its commitments, we think that the relatively small amount of net notional exposure (c $3bn), and improvements in counterparty risk management over the last three years mean that the process is likely to be relatively uneventful. What next for Greece? Even if the PSI deal is done, the actual debt reduction for Greece will be limited, and it still requires optimistic assumptions for the debt/GDP ratio to reach 120% in 2020, as per the Troika DSA. In our view, the debt would still be barely sustainable, and it is likely that some kind of official debt relief will have to follow (see Greece post PSI 2: Financing, debt sustainability and a road map, 2 March 2012). What the PSI achieves definitely is that it reduces massively the near-term cash needs of Greece, and pushes back the prospect of a hard default. The headline risk will likely lessen, and the importance of the elections (due end April) is likely to decline in respect of the debt burden at least. Still, elections would remain a major risk factor: the traditional parties have lost a lot of support, and the formation of a coalition government seems arduous at this stage. Note that it is not in the interests of either Greece or the euro area for Greece to leave the euro area. It is not our base case either, but clearly, the risks of that happening are not trivial anymore. What next for the rest of the periphery? In the periphery, the performance YTD of Italy vs Spain has seen 10y spreads tighten c. 190bp leaving Italy trading c.15-20bp richer than Spain in the 10-15y area. Earlier in the crisis, Italy trade in a range from 20bp and up to 80bp richer than Spain. A return to these sorts of valuations seems unlikely given the similar fiscal consolidation challenges facing both countries. Similarly, we have seen how Italy can cheapen should the focus move back to more generalised contagion, when large outstandings of debt held in particular by foreigners, can work against BTPs. Indeed, in the short term, any moves in Italian vs. Spanish spreads may be more focused on the very rich 5-7 area in Spain, which still trade flat to BTPs and which may be more vulnerable especially ahead of Spanish bond auctions next week. Over the past few months, there has been a lot of focus on Portugal. In a recent note (Greece post PSI 2: Financing, debt sustainability and a road map, 2 March 2012), we assess the risk of a PSI on Portuguese bonds. The large stock of public debt, lack of growth and unresolved macroeconomic imbalances cast doubts over the sovereign’s solvency and the viability of its adjustment programme. Also, regaining competitiveness through a process of internal devaluation looks to be a daunting task, especially as the public and private sectors are deleveraging. At the same time, we strongly believe the euro area’s “strong rhetoric” in support of Portugal (eg, “Greece is unique and PSI won’t be replicated in Portugal or any other euro area countries”), and concern about potential contagion to other peripherals, considerably reduce the likelihood of a Portugal PSI in 2012. 9 March 2012 25 Barclays Capital | Global Rates Weekly EUROPE MONEY MARKETS Money markets: low rates, and more stability Laurent Fransolet The ECB signalled that currently it does not plan to lower interest rates further. With +44 (0)20 7773 8385 liquidity expected to remain abundant for a long period, euro money markets appear to firstname.lastname@example.org have entered a period of stability characterized by low and stable rates, but with EONIA, if anything, still looking too high. Giuseppe Maraffino +44 (0)20 3134 9938 ECB: No further rate cuts email@example.com As expected, no monetary policy decisions were announced at the ECB’s March meeting. However, by referring to "upside risks prevailing" for the inflation outlook, President Draghi clearly signalled that the Governing Council currently does not plan to lower interest rates further. This comment accompanied an upward revision to the ECB staff's midpoint projection for HICP inflation, from 2.0% to 2.4% for 2012, and from 1.5% to 1.6% for 2013. Consequently, our economists no longer expect a 50bp refi rate cut in Q2 2012, and forecast the refi rate to be unchanged at 1% (with the deposit facility at 0.25%) until the end of 2013. This has not changed our expectations on EONIA (which is related to the level of the deposit facility), which should remain broadly stable at around 35bp in the next reserve periods, with risks to the downside. For the 3m Euribor we continue to see room for a further decline, probably to around 70bp by mid-June, with the bottom likely at 65bp by mid-summer. This would imply a slowdown in the recent pace of decline. In general, following the big take-up at the two 3y LTROs, we appear to have entered into a new period of stability for the euro money markets, similar to that observed in H2 2009 (after the flood of liquidity following the first 1y LTRO), characterized by more abundant and longer-term liquidity. All rates have already started moving down, or are already at their lowest levels. The exception is the EONIA fixing, where continued frictions seem to be preventing it from moving lower, closer to the deposit facility, as the current level of the EURONIA fixing would suggest. However, before analysing the EONIA’s dynamics, we highlight a few facts linked to the 3y LTROs that President Draghi mentioned during the press conference. A bit more information on the 3y LTROs First, he said that there were apparently 460-odd German banks who participated in the February 3y LTRO. This, along with the likely high number of Italian banks who participated (230 Italian banks issued government guaranteed bonds, for a total of less than €20bn, in the past few months), helps to explain the large increase in the number of banks, to 800 at the February 3y LTRO (from 523 in December). These small, typically very local, banks probably did not borrow that much in aggregate, but, currently, there is very limited information on which banking system, or individual banks, borrowed. As these are local banks, with typically very simple balance sheets, their borrowing will probably flow more directly to the 'real economy'. While a lot of small banks borrowed, it is likely that overall, the borrowing has remained quite concentrated: the c.25 banks that reported their borrowings at a bit less than €200bn out of €529bn (and in the December 3y LTRO, we estimate that the top 70 banks borrowed about €300bn out of €489bn). Second, it appears that around €53bn of borrowing was on the back of the new 'enlarged' credit claims criteria, of which the bulk (€40bn) was apparently by French banks, with only €3bn by Italian banks (and the rest being split between the remaining 5 banking systems which opted for 9 March 2012 26 Barclays Capital | Global Rates Weekly this enlarged collateral). It appears that the validation of the new credit claims was not fully ready in some countries in time for banks to use this newly created eligible collateral. In our view, this was particularly the case in Italy (apparently €70bn worth of such collateral was potentially available in Italy, but only €3bn were used for the 3y LTRO): this may be why Italian banks have been buying Italian government bonds and T-bills in advance of the LTRO2. Once the new collateral is accepted, the banks will be able to swap out their more ‘liquid' collateral and replace it with the least liquid one, potentially reducing their overall holding of government bonds, and probably not adding further to their holdings. The EONIA’s conundrum An important feature of the euro money markets is currently the spread between EONIA (36bp) and EURONIA (18bp), which, despite the recent tightening, is still wide given the current situation of abundant liquidity. It is important to recall that EURONIA is calculated (by WMBA) on the transactions via brokers, while the calculation of EONIA (by EBF) considers also bilateral transactions among banks, which are charged higher rates when they involve small (and, to some extent, riskier) banks. Therefore, the spread between the two fixings can be considered something of a proxy of the credit risk embedded in the unsecured overnight liquidity market. Figure 1 shows that the Euronia/Eonia spread is much higher (about 10bp) than the level reached towards the end of 2009 (following the flood of liquidity after the first 1y LTRO). Interestingly, it reflects a more pronounced decline of the EURONIA, which is now below the level hit in the second part of 2009, indeed EONIA is now stable at around 35bp, as in H2 2009. Also, the breakdown of the transactions by band rate (available for EURONIA but not for EONIA) shows a gradual decline in the min vs max rate charged since the first 3y LTRO to the current level of 20bp, after having increased to 80bp in mid-December. This suggests less differentiation among banks, with a large number of transactions closed at rates below the deposit facility. Ultimately, we would expect the spread to track down to 10b, its H209. level. Considering the rates in the breakdown of EURONIA as a subset of the rates in the calculation of EONIA, it is very likely that some small banks are being charged rates at around 40/50bp or even higher. This is quite puzzling due to the recent sharp reduction in the refinancing risks and the abundance of liquidity; we believe that these could be very small banks that have no access to the ECB’s liquidity, or to the interbank market. Figure 1: EONIA vs EURONIA (bp) Figure 2: O/n (unsecured) liquidity market: volume 50 Spread, bp (LHS) 5.0 70 (10d mov av, €bn) EURONIA EONIA 40 EUREONIA (RHS) 4.5 60 EONIA (RHS) 4.0 30 3.5 50 20 3.0 40 10 2.5 30 0 2.0 1.5 20 -10 1.0 -20 10 0.5 -30 0.0 0 Jan-07 Jan-08 Jan-09 Feb-10 Feb-11 Mar-12 Sep-08 Nov-09 Jan-11 Mar-12 Source: ECB, Barclays Capital Source: EBF, WMBA, Barclays Capital 9 March 2012 27 Barclays Capital | Global Rates Weekly Another important aspect to consider is the dynamics of the volumes. Figure 2 shows the evolution of the volume in the overnight unsecured market for EONIA and EURONIA (we show the 10 days moving average). While for the EURONIA market the volume has declined sharply since the allotment of the 3y LTRO in December (probably reflecting the big take-up by big banks at the December 3y LTRO), for EONIA, market volumes have been stable in January and increased before the 3y LTRO in February, probably reflecting that some small banks continued to use the overnight unsecured market for funding before moving to the ECB’s 3y operations. Indeed a gradual decline in the EONIA market volumes occurred after the 3y LTRO in February (to around €22bn, the lowest level since the beginning of the year). However, a number of small banks are probably still in the market and the fact that they are being charged higher prices creates a distortion in the calculation of EONIA, thus preventing the fixing declining further. The spread EONIA vs EURONIA averaged 9bp during the life of the first 1y LTRO. If we assume the same spread should now prevail, this would correspond to a fair value of EONIA around 27bp, based on the current value of EURONIA of 18bp. As long as some price differentiation remains in the market it will be difficult for EONIA to drop below 30bp, but over time, the abundance of liquidity is likely to eventually push this rate lower. This suggests some further downside for Euribor fixings, regardless of the evolution of the FRA-OIS spread. 9 March 2012 28 Barclays Capital | Global Rates Weekly EUROPE: SOVEREIGN SPREADS Spain vs Italy Huw Worthington Earlier in the crisis Italy traded in a range 20-80bp richer than Spain in 5-15y bonds. A +44 (0)20 7773 1307 return to this level will likely be challenging, given the similar fiscal consolidations firstname.lastname@example.org challenges and the relative supply/ demand pictures facing both countries. EGB spreads vs bunds over the past week were mixed in terms of performance. Belgian Cagdas Aksu bonds led the way outperforming 10y bunds by 6bp, while France and Austria continued +44 (0)20 7773 5788 their recent tightening too, contracting 2bp on the week on the same basis; Dutch and email@example.com Finnish bonds were broadly unchanged on the week. In the periphery Italy also maintained recent moves, coming in a further 20bp on the week. The move was particularly notable vs. Spain, whose recent performance has been somewhat lacklustre compared with a widening of 7bp on the week. This move means that YTD, as Figure 1 below shows, Italy has now outperformed Spain from the spread wides seen at 2011 year-end by c.190bp, such that in the 10y area Italy now trades c.20bp tighter than Spain. We would contend that the reasons for the outperformance are related mainly to a refocusing of market concerns away from that of debt burden, and in particular the ownership structure of peripheral debt, back to the levels of fiscal consolidation required to bring debt back to sustainable levels, while being consistent with growth forecasts. In this regard, in Spain, it was announced this week that the fiscal slippage in 2011 was even larger than the c.8% initially reported in January at c.8.5% of GDP vs. a 6% official target. Notably, the majority of the shortfall has been in the Spanish regions and as such this week’s rejection of the budget by the third largest region, Andalucía, seems to have highlighted the challenge facing the Spanish government. However, we think that this is more likely a short-term political issue, with elections set for March 25 and polls indicating the Partido Popular may take the region for the first time. A full Spanish budget is likely in Spain soon after that date. Concerns over fiscal slippage have also been compounded by Spain revising its 2012 fiscal target to 6%, without EC involvement, thus somewhat damaging the credibility of the new fiscal compact and possibly, using up political capital with other eurozone states. Figure 1: Italy vs Spain 10y Yield Spread Figure 2: Italy and Spain ASW Structure 200 10y Yield Spread Italy vs Spain Spain 302.4 150 BTPS 100 252.4 50 202.4 0 152.4 -50 -100 102.4 Jan10 May10 Sep10 Jan11 May11 Sep11 Jan12 Nov 13 Jul 16 Apr 19 Jan 22 Oct 24 Source: Barclays Capital Source: Barclays Capital 9 March 2012 29 Barclays Capital | Global Rates Weekly The Italian government, for the most, part appears to be delivering on its reform programme, although challenges lie ahead and labour market reform and privatization news both have the potential to affect sentiment. In deficit terms, we look for Italy to hit just 2.2% in 2012 from 3.9% last year, although we would note that in cash terms at least requirements in Jan and Feb have been some €0.5bn higher Y/Y. Thus, the €24bn official cash deficit on which borrowing assumptions are predicated may prove challenging (the cash deficit was €61bn in cash terms in 2011). At the same time, we expect growth to be negative in both countries in 2012, at -2% in Spain and -1.5% in Italy: any attempt to hit the original 2012 deficit target of 4.4% in Spain could make this challenging, as further fiscal consolidations would likely hit near-term growth prospects. Figure 3: EZ Deficit and Debt burden forecasts Fiscal balance ( % GDP) Gross debt (% GDP) 2008 2009 2010 2011 2012 2013 2008 2009 2010 2011 2012 2013 Austria -0.9 -4.1 -4.4 -3.0 -2.7 -2.1 64 70 72 71 72 72 Belgium -1.3 -5.8 -4.1 -4.2 -3.0 -2.1 89 96 96 97 97 96 Finland 4.3 -2.5 -2.5 -0.9 -0.4 0.3 34 43 48 46 46 45 France -3.3 -7.5 -7.1 -5.5 -4.5 -3.0 68 79 82 84 86 85 Germany -0.1 -3.2 -4.3 -1.0 -1.0 -0.9 67 74 83 81 80 79 Greece (1) -9.8 -15.8 -10.6 -9.1 -6.5 -5.3 113 129 145 167 186 192 Ireland -7.3 -14.2 -31.3 -10.5 -9.1 -7.4 44 65 93 106 114 117 Italy -2.7 -5.4 -4.6 -3.9 -2.2 -0.7 106 116 118 121 122 120 Netherlands 0.5 -5.6 -5.1 -4.3 -3.7 -3.3 59 61 63 66 68 69 Portugal -3.6 -10.1 -9.8 -6.0 -5.6 -5.3 72 83 93 110 123 130 Spain -4.5 -11.2 -9.3 -8.5 -6.0 -3.9 40 54 61 68 79 84 Total euro -2.1 -6.4 -6.2 -4.2 -3.2 -2.2 70 80 85 88 91 91 Source: Barclays Capital. In terms of flow dynamics, thus far Spain has completed c.41% of its official €86bn target for 2012. Even allowing for the fiscal slippage and a more realistic target, Spain would still be one-third funded here. Cash balances are also at 2y highs and provide a substantial buffer going forward. Italian issuance, on the other hand, is running at around 17% of requirements, slightly below last year’s run rate, while cash balances do not provide the level of comfort seen in Spain and issuance volumes will have to stay constant. Moreover, in terms of demand, we believe much of the buying ahead of the 3y LTROs is likely over now. Notably, the move between Italy and Spain has not been consistent across both curves and as Figure 2 illustrates, the 8-15y sector in Italy trades 15-20bp richer, while shorter bonds are still more or less flat to one another. Earlier in the crisis Italy traded in a range of 20-80bp richer than Spain in 5-15y bonds, a return to these sorts of valuations seem likely to be more challenging, given the similar fiscal consolidations challenges facing both countries. Similarly, the experience of how Italy can cheapen should the focus move back to more generalised contagion when the simple large outstandings of debt held, in particular by foreigners, could work against BTPs. Indeed, in the short term, any moves in Italian vs. Spanish spreads may be more focused on the very rich 5-7y area in Spain, which still trade flat to BTPs and which may be more vulnerable, especially ahead of Spanish auctions next week. 9 March 2012 30 Barclays Capital | Global Rates Weekly Next week’s cash flows Tuesday will see Holland auction its 3y bonds for €2.5-3.5bn, while the following day Italy will conduct BTP auctions. The following day France will tap 2y, 4y and 5y bonds alongside 7y, 10y and 15y linkers. Spain will also auction 3y,4y and 6y bonds on the same day. Support for the market will come primarily in the form of redemptions in Germany. Figure 4: Barclays Capital’s cash flow expectations for week beginning 12 March 2012 Beginning Auction Date Issuance Redemptions Coupons Net Cash Flow 27-Feb -20.10 Germany 0.00 19.00 0.46 -19.46 Weekly 05-Mar 2.20 France 10.20 0.00 0.00 10.20 Net 12-Mar 1.33 Italy 6.50 0.00 1.55 4.95 Cash flow 19-Mar -11.04 Spain 4.50 0.00 0.01 4.49 26-Mar -1.51 Belgium 0.00 0.00 0.00 0.00 Greece 0.00 0.00 0.01 -0.01 Net Cash Flow is issuance minus redemptions minus Finland 0.00 0.00 0.00 0.00 coupons. Negative number implies cash returned to Ireland 0.00 0.00 0.45 -0.45 the market. Holland 3.00 0.00 0.00 3.00 Austria 0.00 0.00 1.39 -1.39 Total issuance 24.20 Portugal 0.00 0.00 0.00 0.00 Total redemptions 19.00 Total 24.20 19.00 3.872 1.33 Total coupons 3.87 Net cash flow 1.33 Source: Barclays Capital 9 March 2012 31 Barclays Capital | Global Rates Weekly UNITED KINGDOM: RATES STRATEGY Tangled up in red Moyeen Islam The public finance projections in the Budget on 21 March are likely to be broadly akin to +44 (0)20 7773 4675 those published in November 2011. We retain our current view for gilt issuance of firstname.lastname@example.org £185bn. The risk to this number lies towards a lower number given uncertainties over the timing of cash measures. Henry Skeoch The Office of Budget Responsibility (OBR) publishes its latest set off fiscal forecasts on +44 (0)20 7773 7917 21 March and this will also see the publishing of the new financing remit from the DMO on email@example.com the same day. The new remit will be published after the Chancellor completes his Budget speech in the House of Commons. Given the relatively late timing of the OBR’s November forecast (published on 29 November 2011), there has been little in the way of economic news other than the ebb and flow of economic data. Figure 1 shows the OBR’s November growth forecast versus our own forecasts, the BOE February 2012 Inflation Report forecast and the latest long-term forecasts from the Treasury’s own “Forecasts for the UK economy” monthly publication where it compiles independent forecast for the economy. The OBR forecasts are notably higher than either our own or the average of independent forecasts. However, we see little reason to suppose that the OBR will materially revise lower its growth forecasts. The latest PMI surveys are consistent broadly with our expectations for fairly weak growth in Q112, although overall we see growth bottoming out in Q212. This relatively soft growth backdrop means that the Chancellor has relatively little, if any, room at all for discretionary fiscal measures to support the economy With the debt profile published in November worse than those published in Budget 2010, the Treasury will be acutely aware of the fact that a material worsening of the debt metrics will probably leave the UK vulnerable to further rating action from the sovereign ratings agencies. Moody’s already has the sovereign’s AAA credit rating on negative outlook as it felt that the pace of fiscal consolidation could be affected by weak growth prospects and the close ties with the eurozone would also lee it exposed to a material slowdown there. Given the political capital that has been attached to the preservation of the rating, we judge it unlikely that the Chancellor would want to let it slip easily so we would not expect the Treasury to be looking at any fiscal loosening that might materially effect key debt ratios. Figure 1: Comparative economic forecasts (%) Figure 2: Path of the CGNCR FY11/12 vs FY10/11 (£mn) 4.0 OBR Nov 2011 160,000 2011/12 HMT Survey 2010/11 3.5 Barcap 140,000 BOE Feb 2012 IR (Q4 y/y) Budget 2011 3.0 120,000 2.5 100,000 80,000 2.0 60,000 1.5 40,000 1.0 20,000 0.5 0 0.0 Apr May Jun Jul Aug Sept Oct Nov Dec Jan Feb Mar 2012 2013 2014 2015 2016 Source: OBR, Bank of England, HM Treasury and Barclays Capital Source: National Statistics and Haver Analytics 9 March 2012 32 Barclays Capital | Global Rates Weekly Figure 3: Total receipts have remained resilient (£mn) Figure 4: 12 month rolling CGNCR (£mn) 65,000 2009/10 2010/11 2011/12 225,000 200,000 60,000 175,000 55,000 150,000 50,000 125,000 100,000 45,000 75,000 40,000 50,000 25,000 rolling 12m CGNCR 35,000 0 30,000 -25,000 25,000 -50,000 April July October January Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: National Statistics and Haver Analytics Source: National Statistics, Haver Analytics and Barclays Capital Figure 2 shows the evolution of the central government net cash requirement (CGNCR) over the course of the current fiscal year when compared with the last fiscal year. This has seen a relative richness in receipts as the net cash position has been running better than had been expected despite the relative weakness in growth. Figure 3 shows the patterns of monthly tax receipts. The strength in the current fiscal year has been attributed in part to the rise in the VAT rate in January 2011. On average, we estimate that the monthly cash position has been £11.6bn better than the comparable month in FY2010/11 for the first ten month of the fiscal year. Of this, some £1.4bn per month has been due to higher VAT receipts. So while VAT has been an important factor, it has not been the main explanatory factor. Given the relative weakness of domestic demand, this receipts performance is all the more impressive. Should this mean that we should expect a big undershoot in the CGNCR in the Budget and hence a sizeable “overfund” (ie, “too much” cash has been raised in FY11/21) that is set against FY2012/13’s requirements? Our preferred measure of the cash deficit, the 12 month rolling CGNCR, currently is at £119bn compared to the OBR forecast of £135bn so seems to imply a degree of improvement. But in its monthly commentary on the January public finance data, the OBR noted that growth in receipts for the remaining two months of the fiscal year was likely to be lower given low growth in both VAT receipts and tax revenues from financial sector bonuses and that expenditure growth may well pick up as departmental expenditure is typically back loaded. Additionally, there is considerable uncertainly still over intra-public sector financial transactions that could produce a material change in the CGNCR. New legislation means that there are technical changes in the payments between central and local government. These arise from the financing of social housing and will see local authorities transfer £13.7bn to central government while central government would reduce local authority borrowing by £5.2bn. All told, this would potentially reduce the CGNCR by £8.5bn. However, if local authorities were to replace the £13.7bn of financing via borrowing from the Public Works Loan Board then net, the CGNCR would increase by £5.2bn. These transactions are due to take place in March 2012 so would ultimately might be caught in the April restatement of the remit but the OBR may well factor these changes into its CGNCR forecasts if they are know to be occurring. The Royal Mail Pension Scheme transfer will also have an effect on the CGNCR. Essentially, the government is taking on a funded pension scheme and taking on the share of the assets and all liabilities accruing prior to March 2012. This is estimated to be £25bn of assets 9 March 2012 33 Barclays Capital | Global Rates Weekly versus £35bn of liabilities. The assets would be transferred to the government immediately whereas the liabilities would fall due over time. The overall impact on the CGNCR will be dependent on the timing of any planned asset disposal. The OBR estimate that the immediate impact would be a £2bn improvement in the CGNCR reflecting the cash held in the scheme. While the broader headline measure would also improve, the longer-term benefits to the public sector are more questionable sine the current present value of the liabilities is in excess of that of the assets and even after the programme of asset sales would be executed, we could well find that the liabilities continue to accrue. So we think that, overall, the revisions to the headline public finances are likely to be relatively small but there remains considerable uncertainty over the cash deficit measures which will only be resolved by clarity over policy actions. If the OBR feels that there is “reasonable certainty” over a specific policy action then this will be reflected in their forecasts. But as we have no real clarity beyond what has been discussed, at this stage, we retain our working assumption for gilt issuance in FY2012/13 of £185bn. We outlined our expectations in the 2012 Supply Outlook published on 12 December 2011. Here, we outlined an expectation that the DMO will retain the current split of issuance of around 20% in inflation-linked issuance and 80% in nominals. This is historically very close to the split that the DMO has presided over since it took over the issuance of gilts from the BOE in 1998. In terms of the split between conventional issuance across maturity bands, we think that the split will remain broadly as has been seen over the past few years, with a slight bias to shorter dated issuance, again closer to what has been the average for the most recent programmes. All told, we expect the conventional-linker split to be £144bn versus £41bn. Our working assumption for conventional issuance split is £60bn short, £42bn medium and £42bn of long maturity paper. But given the uncertainties, we would see the risks to this number as lying towards a lower rather than higher issuance number. Figure 5: Net linker issuance set to increase sharply 50 Gross Linker Issuance (£bn) 35% 45 Net Linker Issuance (£bn) Forecast 40 Linkers as % total cash sales (RHS) 30% 35 30 25% 25 20 20% 15 10 15% 5 0 10% FY01/02 FY03/04 FY05/06 FY07/08 FY09/10 FY11/12 Source: Barclays Capital, Note: FY11/12 numbers BarCap estimates, FY12/13 numbers BarCap forecasts We expect the DMO to issue £41bn cash value of index-linked gilts in FY12/13, up from £39bn in FY11/12. Our projections imply linkers will comprise 22% of total cash gilt sales in the forthcoming fiscal year, a similar proportion to the past two fiscal years. While the gross issuance figure we project is not significantly larger than last year, there are no linker redemptions until August 2013, meaning that net linker issuance is set to increase almost 40%. Long linker real yields are near zero, having been pushed negative in the final quarter in 2011 as the MPC electing to resume QE pushed nominal gilts sharply richer. Initially, this also resulted in 9 March 2012 34 Barclays Capital | Global Rates Weekly breakevens falling until 3% breakeven levels encouraged structural allocation flows away from nominal gilts into linkers. The historically low level of breakevens make linkers attractive value versus nominals for investors, even with real yields low, but for the DMO there would be a compelling argument to reduce linker issuance on cost grounds. On the flip side, the DMO has in the past stated its commitment to the linker market, and in recent years has generally maintained linker issuance in line with the proportion of the gilt market they constitute, close to 20%. The annual DMO consultation meetings between investors also highlighted continue demand from the pension sector for long index-linked gilts, while there have also been widespread calls from dealers and investors for an increase in linker auction sizes. For supplementary issuance, we expect one linker syndication per quarter in FY12/13 including one to coincide with the multiple index drops occurring in late November. On CPI linkers, the Government decided against issuance in the near term in November 2011 after a DMO consultation with the market on the subject. A potential obstacle to any future CPI- linked issuance is the possibility of market fragmentation given the split in the market between “old-style” 8m lag linkers and “new-style” Canadian model 3m lag issues. The DMO may choose at some point to consult on retiring old-style issues, which presently comprise 39% of linkers outstanding by market capitalisation. This could be undertaken by conversions, but would pose operational difficulties given that a reasonable proportion of old-style linkers were generally purchased by longer-term investors, and an unsuccessful conversion would arguably heighten market distortions. We think that the Budget will have a muted impact on gilt asset swap spreads. With the Bank of England still actively pursuing a QE policy, 10yr spreads trade slight more rich than cheap but 10yr spreads vs OIS at around +15bp are slightly rich but within the errors of our fair value model. However, we would see better value in exploiting the relative cheapness of 20yr spreads relative to 10yr and 5yr spreads. Overall, the forthcoming Budget is likely to tell us far more about how much the Treasury cannot do in terms of fiscal action and will outline further the long path toward fiscal consolidation. Figure 6: Real yields rallied sharply in FY11/12 Figure 7: Breakevens not far from multi-year lows 2.5 IL22 real yield 4.5 IL22 breakeven IL37 real yield IL37 breakeven 2.0 4.0 IL55 real yield IL55 breakeven 1.5 3.5 1.0 3.0 0.5 2.5 0.0 -0.5 2.0 -1.0 1.5 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Source: Barclays Capital Source: Barclays Capital 9 March 2012 35 Barclays Capital | Global Rates Weekly Figure 8: Asset swaps are broadly in line with the deficit Figure 9: 20yr spreads looks cheap (bp) 0 Rolling 1yr ahead deficit -50 80 Gilt/OIS 5y5y/10y10y/15y15y -20 Gilt/OIS 5y5yfwd ASW (RHS) 60 -25 -40 40 -60 0 20 -80 25 0 -100 -20 -120 50 -40 -140 75 -60 -160 100 -80 -180 -100 -200 125 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Consensus Economics and Barclays Capital Source: Barclays Capital 9 March 2012 36 Barclays Capital | Global Rates Weekly EURO INFLATION-LINKED MARKETS Bracing for a Q2 supply bonanza Khrishnamoorthy Sooben We expect European linker issuance to pick-up significantly in Q2, especially in the 5y to +44 (0)20 7773 7514 10y sector. This leaves shorter-dated breakevens as likely to outperform on the curve. khrishnamoorthy.sooben@ The European sovereign linker market has seen no issuance of new lines so far this year. barcap.com This contrasts sharply with 2011 when the first quarter saw a flurry of new benchmarks, with two new bonds from France and one from Italy. Our current forecasts indicate that Q1 2012 is likely to see the lowest first-quarter issuance since 2009, when the market was still recovering from the volatility of late 2008 and distressed conditions. First and second quarters generally see a high concentration of a calendar year’s issuance, indeed due to the launch of new benchmarks, with the initial supply in the latter typically conducted in sizes that are well above reopenings. However, in our view, the low pace of issuance so far in 2012 has not been a surprise to market participants. Given the general uncertainty in European markets maintained by the peripheral-debt crisis, it seemed obvious that issuers would not resort to the usual front-loading of linker issuance. More importantly, perhaps, the first quarter was foreseen to carry significant uncertainty specific to the European linker market, namely in terms of the possibility for BTP€is to be excluded from Barclays’ indices after ratings downgrades. The response of issuers to low investor demand and probably a reduced willingness from dealers to warehouse risk has therefore been welcome. This leaves the second quarter as most likely to see a catch-up in terms of issuance activity. In particular, we note that the index-related risk for BTP€is is probably no longer a short- or even medium-term concern, and as for the treatment of linkers within the Greek PSI, there is little or no uncertainty anymore. Furthermore, the ECB’s 3y LTROs have contributed to a reigniting of outright, breakeven and asset swap demand for BTP€is, and alongside negligible SMP purchases over the past months, have played a role in the significant normalisation in their valuations versus German and French linkers. This is not to say that distressed BTP€i breakevens were an overwhelming factor limiting the issuance ambitions of France of Germany, but are likely to have contributed to sentiment that the market was not fully functional and therefore not in a position to accommodate the usual magnitude of issuance seen in the first few months of previous years. Figure 1: 2012 could see highest Q2 issuance ever Figure 2: Q2 2012 issuance to be concentrated in 5-10y 20000 Quarterly issuance (€mn) Forecast 5.0 2012 european linker issuance projections by maturity bucket (€bn) 18000 4.5 16000 4.0 14000 3.5 5 10 15 30 12000 3.0 10000 2.5 8000 2.0 6000 1.5 4000 1.0 2000 0.5 0 0.0 Q1 06 Q1 07 Q1 08 Q1 09 Q1 10 Q1 11 Q1 12 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Note: These forecasts do not include BTP Italia. Source: Barclays Capital Note: These forecasts do not include BTP Italia. Source: Barclays Capital 9 March 2012 37 Barclays Capital | Global Rates Weekly With France announcing that March’s supply will consist of a €1.2bn to €1.7bn split between the OATi19, OAT€i22 and OAT€i27, we see Q1 as likely to end without a new benchmark being launched. Italy has demonstrated a willingness to continue issuing BTP€is and at current valuations, we expect that willingness to be reinforced. However, for the time being, and perhaps for the rest of this year, a new BTP€i does not seem to be on the agenda. That said, Italy has announced the creation of a new class of inflation-linked BTPs that would be linked to the domestic FOI ex-tobacco index, starting with a 4y issue being issued in late March. While these bonds are primarily aimed at retail investors, we see no strong reason why they may not appeal to domestic institutional investors too. This means that in the medium- to long-term, issuance in the so-called “BTP Italia” could also be directed towards the institutional investor base. Dealers may also see an interest in this new class of securities to their hedge exposure in FOIx swaps, although the structure of the new bonds is very different to the usual back-ended accreting formula applied to current European sovereign linkers. BTP Italia will pay out principal inflation accretion alongside their semi- annual coupons, which does not make them an ideal hedge for Italian swap exposures. In our view, new benchmark issuance this year is likely to come first from Germany. We highlight that Germany has not issued so far this year and we see a new 10y benchmark as most likely in April, ahead of the OBL€i13 dropping out of bond indices at the end of the month. Admittedly, there is still significant room to increase the size of the OBL€i18 but at the same time, with the Bund€i20 almost an 8y bond, we believe there is a strong rationale for Germany to bring a new 10y Bund€i to the market to maintain a benchmark status in the traditionally most liquid point for the market. Assuming a new 10y German benchmark, we would expect the next new bond from France to be shorter on the curve. In particular, we see the possibility for an OAT€i 2018, which would fill a gap in the French €i curve. We would expect such a new bond from France in Q2 also, probably in May. We also see the potential for an inaugural Belgian linker, possibly by the end of Q2. We do not discard the possibility that Belgium also opts for a retail-targeted programmed if the “BTP Italia” launch is a success, but if they opt for €i supply and given the scope for Spain to issue in the second half of the year if spread conditions become more benign we would not be surprised to see Belgium issue in June. Overall, assuming €4bn each in new bonds from Germany and France, alongside typical French and Italian tap auctions, Q2 2012 could see the highest second-quarter issuance ever in the European linker market and close to an all-time record if Belgium issues too. Our current forecasts suggest that sub-5y issuance in Q2 is likely to be negligible. With longer-dated issuance likely to be particularly heavy, at least based on our expectations, short end breakevens curve may outperform on the curve. The very positive seasonal carry in Q2 could be a further supportive factor for the short end, especially if energy prices continue to increase. We would note also that while a resumption of a more normal issuance pattern would be an indication of a healthy market, breakeven valuations in the 5y and longer maturities may cheapen unless real yields back up enough to entice sufficient real money interest. 9 March 2012 38 Barclays Capital | Global Rates Weekly EUROPE: VOLATILITY EUR 5y tails: Too high to buy Piyush Goyal Intermediate-expiry 5y tails are rich compared to rest of the surface and could cheapen +1 212 412 6793 as ECB-on-hold expectations spread further out. We recommend selling 2y*5y vol firstname.lastname@example.org through 2y*5y-2y*30y capped bear steepeners, which also carry favourably. The 2y*2y-2y*5y-2y*10y volatility fly in EUR is at its richest level in the past ten years (Figure 1). Hitendra Rohra Broadly, the higher volatility for the belly is justified when intermediate rates lead the yield curve +44 (0)20 7773 4817 in a rally or a sell-off. An investor can buy a 2y*5y payer funded with 2y*2y and 2y*10y payer email@example.com and gain if rates sell off a large amount. Conversely, a 2y*2y-2y*5y-2y*10y receiver fly could deliver gains in a rate rally. So, 5y tails are richer than 2y and 10y tails. However, as Figure 2 shows, the 2y5y rate and the 2y forward 2s5s10s rate fly have broadly moved in opposite directions in the recent past. In other words, the 2y5y rate has lagged the 2y2y and the 2y10y rate during rallies and sell-offs. So the richness of the vol fly is not justified by the relative yield curve move. Why so rich? The US vol surface provides a context. Until recently, 5y and 10y tails in the US had benefitted from demand from mortgage hedgers. And while this support has fallen off in the past couple of years, the Fed’s endeavour to push hike expectations further out (such as at the August and January FOMC meetings) has pummelled 2y tails. Together, this has caused the fly to trade at an average of 1.02 for the past ten years. Currently, it is trading at ~1.04, mostly due to Fed-on-hold expectations. The EUR 5y and 10y tails never benefitted in the manner US intermediate tails did from the mortgage prepay convexity. As a result, the fly traded below 1.04 for most of the past decade. However, it has now richened to record levels, for two reasons. One, ECB-on-hold expectations are taking deeper roots. As a result, the 2y*2y has fallen more than 2y*5y or 2y*10y over the past few months. Two, there has been a dearth of new issuance of CMS notes in the past few months (Figure 3). Typically, such issuance leads to supply of intermediate expiry 5y tails, so the absence of it has benefitted 5y tails. Going forward, a renormalisation of the fly could happen; at a minimum, it may not richen Figure 1: 2y*5y is rich on the fly… Figure 2: … even as the 2y5y rate has lagged the curve 1. 06 14 4.5 12 1. 04 4 10 1. 02 3.5 8 1. 00 6 3 0. 98 4 2.5 2 0. 96 0 2 0. 94 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Nov-02 Nov-04 Nov-06 Nov-08 Nov-10 2yf 2y-5y-10y Vol Fly 2yf 2s5s10s fly 2y5y rate Source: Barclays Capital Source: Barclays Capital 9 March 2012 39 Barclays Capital | Global Rates Weekly anymore. This is because while the recent drop in 2y*2y was warranted, further declines may be harder to come by. The cheapening in 2y tails was reasonable because ECB-on-hold expectations have spread further out, as reflected by lower forward short rates. Eventually, the EUR top left should resemble the US top left. But longer than 2y expiry options, including 2y*2y, have already become as cheap as or cheaper than comparable vol in the US and may not fall more. However, 5y tails could come under pressure if a longer dovish ECB is priced in. Further, structured note issuance can only, it would seem, pick up, putting downward pressure on 2y*5y. Capped steepener Instead of selling the vol fly, we recommend fading the richness of the 5y tails via a capped bear steepener. The trade involves a vanilla 5s-30s bear steepener and capping the upside by shorting a 5s-30s single look curve cap. The high level of the 2y*5y vol means that the steepener can be struck at an attractive point, while a fall in the 5y vol would help improve the MTM characteristics. Sell EUR 450mn 2y*5y payer @ 2.2% Buy EUR 100mn 2y*30y payer @ 2.65% Sell EUR 2.1bn 2y SL 5y-30y curve cap @ 75bp Essentially, this is a steepener struck at significantly better than 45bp when the forward is 43bp and the spot curve is 100bp. In the base case, rates largely remain range-bound as the resolution of the eurozone issues take time. So the trade would benefit from positive carry: 110cts in six months and 200cts in one year. On the other hand, if the outlook in the eurozone takes a turn for the worse, the curve will likely bull flatten due to the CVA hedging. In this case, all options (including the curve cap) would likely expire worthless and the trade would retain the initial premium. Least likely, but still possible, if the conditions in the eurozone improve considerably and rates sell off, the 5s-30s curve will likely bear steepen and the trade make a profit. The curve option would cap the upside at 75bp, but would have still generated 50bp of curve dv01 (= ~1000cts = 50bp * 20cts). The major risk to this trade is bull steepening. However, with rates already low, there is not much scope for this. Besides, the premium intake from the curve cap provides a decent cushion against the steepening Figure 3: Structured note issuance has picked up recently 35 30 25 20 15 10 5 0 Q1 2009 Q3 2009 Q1 2010 Q3 2010 Q1 2011 Q3 2011 Q1 2012 Fixed Callable Fixed Step Cpn Capped Floaters CMS Notes Forecast Source: Barclays Capital 9 March 2012 40 Barclays Capital | Global Rates Weekly AUSTRALIA: RATES STRATEGY Model update: AU curve still too flat, despite recent steepening Gavin Stacey This article was originally published on 8 March 2012. +61 2 9334 6128 Earlier this week, we recommended an AU 3s10s curve steepener at 37bp (Australia: firstname.lastname@example.org Curve flattener has gone too far; recommend a tactical steepener, 6 March 2012). Despite our view that troughs in global manufacturing PMIs – the recent bottom appears to have been reached in November 2011 – tend to be associated with higher short-end rates and a flatter curve, we thought "risk on" fatigue would likely deliver a partial retracement of trends seen in both over the past month. An AU 3s10s steepener provided an attractive risk/return tactical trade, in our opinion. We saw scope for the market to partially unwind the 25bp of monotonic flattening in the AU 3s10s bond curve over the past month. With less than two 25bp rate cuts priced in by October, there appeared ample opportunity for the AU market to scale up easing expectations in the event that upcoming China data undershoot expectations. Our confidence in the trade was strengthened by the fact that our model for the AU curve suggested fair value was around 59bp versus its level at the time of 37bp (see Figure 1 and 2). Fair value in the model utilises a range of domestic and offshore economic and market variables, including US 10y yields, AU 3y yields and BarCap's global PMI. The global PMI was introduced to capture emerging macroeconomic developments that have been historically important drivers of AU short-end rates. A lagged dependent variable was also included to correct for serial correlation. With the AU 3s10s bond curve currently around 43bp we believe there is still scope for further steepening. It is worth positioning for, in our opinion. Figure 1: AU 3s10s bond curve vs fair value Figure 2: AU 3s10s bond curve model residual 1.6 0.40 1.4 1.2 0.30 1.0 0.20 0.8 0.6 0.10 0.4 0.00 0.2 0.0 -0.10 -0.2 -0.4 -0.20 -0.6 -0.30 Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- -0.40 00 01 03 04 06 07 09 10 12 Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Actual Fitted 00 01 03 04 06 07 09 10 12 Source: RBA, Bloomberg, Barclays Capital Source: RBA, Bloomberg, Barclays Capital 9 March 2012 41 Barclays Capital | Global Rates Weekly JAPAN: RATES STRATEGY Market’s response function to investor sentiment Chotaro Morita JGB market sentiment peaked last December, but we have not seen the usual pattern, in +81 3 4530 1717 which a peak is followed immediately by a bearish market. We attribute this largely to email@example.com the impact of the BoJ’s latest easing. However, we should also recall the case of 2003, when sentiment eventually began to weaken with a significant lag after hitting its peak. Reiko Tokukatsu, CFA We think the recent diversion of EUR/USD OIS/OIS basis in a more negative direction does +81 3 4530 1532 not mean more negative JPY/USD basis. We also add a short JGB 2-5-10y position. firstname.lastname@example.org We noted last week that although the expansion in the loan-deposit gap at Japanese banks Noriatsu Tanji halted last autumn, they have continued to boost their JGB holdings at a consistent pace. +81 3 4530 1346 Deposit and loan data for February, released this week, show continued flat growth in the email@example.com loan-deposit gap. That is, banks are accumulating JGBs at a faster pace than the growth in their surplus cash. Bank data is about the only balance sheet information available on a timely basis, but more general information on investor positions, gleaned from investor surveys, indicates that the overall bullish phase in the markets reached a peak in December. The domestic bond weighting in the QUICK survey serves as one indicator of market sentiment (Figure 1). We also look at US Treasury sentiment as reported in a JP Morgan survey. We note that the overall trend in both markets tends to move in the same direction, but fluctuations in sentiment differ in some cases and occasionally veer in completely different directions. Last December, while UST investor sentiment was rather weak, Japanese sentiment was hitting a peak. Japanese bond investor sentiment was at bullish levels in December, but as with the two previous occasions, suffered a relatively large correction immediately after it reached its high. In December 2008, when sentiment similarly peaked, yields touched their low point at the end of the month, followed by a bearish market through the following June. During another sentiment peak in October 2010, yields bottomed early in the month, and the markets then rose though April. At least in these two cases, market sentiment data functioned as a contrarian indicator. Figure 1: UST and JGB positions Figure 2: Oil prices and 3m-1y1y JGB (bp) 60 Dec-08 40 70 y = 0.9765x - 116.19 2 60 R = 0.7198 Dec-11 30 y = 0.5444x - 25.724 55 Oct-10 20 50 2 Apr-03 R = 0.6591 y = 0.1165x + 9.0461 40 10 2 R = 0.0418 30 50 0 20 -10 10 45 -20 0 Bullish -30 -10 40 -40 -20 -50 -30 Bearish 60 80 100 120 140 160 180 35 -60 03 04 05 06 07 08 09 10 11 12 Jan-Oct 08 Oct-Dec 08 Dec 08-Jun 10 JGB positions (LHS) UST net long (RHS) Jun 10-Oct 11 Oct 11-present Present Source: QSS, JP Morgan Chase Source: Bloomberg, Barclays Capital 9 March 2012 42 Barclays Capital | Global Rates Weekly This time, however, despite the fact that sentiment peaked in December, there has been no shift to a bearish market in the subsequent months. One factor is the unusually strong effect of monetary policy. In particular, we believe the low sensitivity of yields to the rise in commodity prices represents the growing impact of the BoJ’s easing. One element in common during the bear markets of December 2008-June 2009 and October 2010-April 2011 was the uptrend in oil prices. JGB markets are affected to a significant extent by commodity price rises, including an indirect impact via US and European bond markets. Figure 2 shows the strong correlation between oil prices and the short end of the JGB yield curve in January 2008-October 2008 and December 2008-June 2009. The relation diminished markedly from June 2010. In contrast, UST yields and oil prices were clearly linked during June 2010-November 2011, but since then the correlation has weakened. However, from the standpoint of the impact of monetary easing, we should also recall the case of April 2003, another peak in sentiment point indicated in Figure 1. This represents the initial launch of the BoJ’s quantitative easing policy and policy duration effect, precisely the strategies the bank is pursuing at present. At that time, it took two months from the peak in sentiment until we entered a bear market. This is an example of how the widening impact of monetary policy measures does not necessarily guarantee a prolonged bullish bond market. Impact of the more negative EUR/USD basis on JPY/USD basis, rich 5y JGB Historically EUR/USD and JPY/USD cross-currency basis used to move in line when compared as OIS/OIS basis, given that OIS is much closer to actual funding rates. However, recently, EUR/USD OIS/OIS diverged significantly in the negative direction (Figure 3). We attribute this trend to ECB’s 3y LTROs, which supplied EUR529bn. This means that for cash-rich USD investors, it may be more attractive to invest in EUR instead of JPY. Since 2010, US banks have increased excess reserves at the BoJ to capture the spread between the effective JPY funding rate and IOER. However, as the JPY/USD basis returned to near flat, the spread has compressed and excess reserves were withdrawn (Figure 4). If such investors shift investment from the BoJ to the ECB, the JPY/USD basis may follow the negative move by EUR/USD. Figure 3: Spot 3m OIS/OIS basis (bp) Figure 4: Foreign banks’ excess reserves at BoJ (JPY trn) and implied JPY funding rate when USD is funded at OIS (%) -20 Jan-09 Jan-10 Jan-11 Jan-12 -30 0 0.2 -40 1 0.1 -50 2 0.0 spread -60 -0.1 3 JPY tn -0.2 -70 4 -0.3 -80 5 -0.4 -90 6 -0.5 -100 7 -0.6 -110 Excess reserve by foreign banks (LHS) 8 -0.7 Aug-11 Oct-11 Dec-11 Feb-12 implied JPY funding rate (RHS) EUR/USD JPY/USD IOER (RHS) Source: Barclays Capital Source: Barclays Capital 9 March 2012 43 Barclays Capital | Global Rates Weekly Figure 5: Margin comparison at BoJ vs ECB (bp) Figure 6: 25% risk reversal in EUR/USD, % 120 0.0 Vol low 100 -0.5 for Euro put 80 -1.0 60 -1.5 40 -2.0 20 -2.5 0 -3.0 -20 Vol high -3.5 -40 for Euro put -4.0 -60 -4.5 -80 -5.0 Aug-11 Oct-11 Dec-11 Feb-12 Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Margin via BoJ Margin via ECB 25%RR Source: Barclays Capital, assuming investor can fund USD at OIS and either Source: Barclays Capital, difference of implied volatility between EUR call and put deposit at ECB or BoJ via reserve account options of 25% delta. However, current pricing does not suggest that there is a compelling incentive to shift. Figure 5 shows that while the JPY’s advantage has been reduced relative to the EUR, both investments still earn a similar spread. Therefore, at this stage, we are comfortable with paying 1y1y JPY/USD cross-currency basis as a carry position. This week, the 5y JGB richened further, as there has been some speculation that the BoJ may ease again at next week’s MPM. First, we the fresh 5y positions face disappointment if easing does not materialize. In addition, during the past two years, we have seen 5y richness ahead of easing had retraced – even when the easing took place. Therefore, we recommend positions that are short 5y JGBs and add 2s5s10s short butterfly. Figure 7: Recommendation updates (bp) Year end/ Current Weekly Risk Target Entry Entry (incl P&L (DV01, (incl date level carry) (JPY mn) JPY mn) carry) Stop Horizon Action JGB 10-30y flattener New (per 30y auction JGB 06-Mar 97.0 96.8 2.0 10 93.0 101.0 medium (JB321/JX36) preview on Mar 5) JGB 2s5s10s short 20 short- 09-Mar -55.0 -55.5 -5.0 -50.0 -60.0 New (JN314-JS100-JB321) (body) medium by March Swap Tibor/Libor 5-10y steepener 09-Dec -2.0 -1.2 0.0 10 2.0 -4.0 Hold end 10Y ASW (JB318) 25-Nov 0.1 -3.0 15.0 10 -5.0 8.0 long Hold Swap 20Y ASW vs. 3month(JL129) 28-Oct 36.0 30.4 15.0 10 25.0 42.0 long Hold spread Increase position by 5Y ASW short (JS100) 02-Mar -15.7 -16.0 -5.0 15 -13.0 -18.0 medium JPY 5mm Hold (CM=-63.5bp, the Pay 1y1y 02-Dec -92.0 -59.0 10.0 10 -50.0 -100.0 medium difference owes Xccy basis rolldown) swap medium- Rec 20yx10y 27-Jan 38.0 41.5 -4.8 3 20.0 45.0 Hold long Hold with view to 3mx10Y swaption long JPY10b 20-Jan 43.0 20.5 1.9 90.0 20.0 till expiry possible sell-off in early (K=1.12% ) n face April Swaption JPY10b 1mx10y-20y conditional bull 15-Feb -5.0 4.7 -1.7 n face 35.0 -5.0 1 month Hold steepener for 10Y Weekly P/L = 11.0; Total P/L since 2012: 537; Balance sheet 162.1; 1 day VaR (x2.33 std) 64.0. Note: Current levels based on the absolute maturity to capture rolldown correctly; therefore, it is different from the constant-maturity spread. Source: Barclays Capital 9 March 2012 44 Barclays Capital | Global Rates Weekly GLOBAL TRADERS’ GUIDE Key data and events US We do not anticipate any major changes to the monetary policy stance at the next FOMC meeting (Tues). Although labor market conditions have improved, some data on activity have been mixed – factors that are likely to be reflected in the assessment of economic conditions. We look for a 0.5% m/m increase in the February CPI (Fri; consensus: 0.4%, last: 0.2%), driven by higher gasoline prices, and a 0.2% m/m increase in core CPI (consensus/ last: 0.2%), reflecting our view that gains in core service prices are likely to persist. We and the consensus look for a 0.5% m/m increase in the February PPI (Thurs; last: 0.1%) and a 0.2% m/m increase in core PPI (last: 0.4%). February retail sales are expected to have increased 1.2% m/m (Tues; consensus: 1.0%, last: 0.4%). We and the consensus are looking for a 0.4% m/m increase in industrial production (Fri; last: 0.0%). We expect the current account deficit to have widened modestly to $113.0bn in Q4 from $110.3bn in Q3 (Wed; consensus: $114.2bn). Europe The Eurogroup (Mon)/Ecofin (Tues) meetings are expected to review progress made on the proposal of a Financial Transaction tax, adopt conclusions on the Alert Mechanism Report and debrief the main outcomes of the G20 summit at the end of February. We and the consensus expect euro area final HICP inflation rate to be confirmed at 2.7% y/y (Wed; last: 2.6%), while we are below-consensus in forecasting an unchanged reading for core inflation (+1.5% y/y; consensus: 1.6%). We also look for the euro area HICPx index to have increased to 113.53 (last: 112.96). We expect E17 January industrial production to climb by 0.2% m/m, offsetting last month’s 1.2% m/m decline (Wed; consensus: 0.6%). We look for E17 employment to fall by 0.3% q/q in Q4 11 after -0.1% q/q in Q3 11 (Thurs). We expect the January E17 trade balance to remain in positive territory with a €6.5bn surplus (Fri; last: €7.5bn). We and the consensus expect the Norges Bank to keep the policy rate unchanged at 1.75% (Wed). In the UK, we expect the February RICS house price balance to fall to -17 from -16 (Tues; consensus: -14), the January goods trade balance to improve to -£7.0bn from -£7.1bn (Tues; consensus: -£7.9bn), average weakly earnings (January) to grow by 1.9% 3m/y (Wed; consensus 1.9%; last: 2.0%) core earnings growth of 2.0% 3m/y (consensus 1.9%; last: 2.0%), ILO unemployment to remain at 8.4% (consensus: 8.4%) and claimant count unemployment (February) to grow by 4.9k (consensus: 4.9k; last: 6.9k). Japan We estimate that January core machinery orders increased 2.0% m/m (Sun; consensus: 2.3%, last:-7.1%). Using our estimate and assuming flat m/m readings in February and March, orders will be up 1.6% q/q. For BoJ’s MPM (Tues), we do not expect any change to policy rates or the asset purchase program (APP). 9 March 2012 45 Barclays Capital | Global Rates Weekly GLOBAL WEEKLY CALENDAR Saturday 10 March Period Prev 2 Prev 1 Latest Forecast Consensus - Slovakia: Parliamentary elections 11:30 E17: EU President Rompuy speaks at "European strategy forum" in Dubrovnik - China: Exports, % y/y Feb 13.8 13.4 -0.5 - 31.1 - China: Imports, % y/y Feb 22.1 11.8 -15.3 - 31.8 - Egypt: CPI, % y/y Feb 9.1 9.6 8.6 9.7 - Sunday 11 March Period Prev 2 Prev 1 Latest Forecast Consensus - Russia: Overnight deposit rate, % (to 15/03) Mar 4.00 4.00 4.00 4.00 4.00 - Russia: Refinancing rate, % (to 15/03) Mar 8.00 8.00 8.00 8.00 8.00 23:50 Japan: Core machinery order, % m/m Jan -6.9 14.8 -7.1 2.0 2.3 23:50 Japan: Corporate goods price index, % y/y Feb 1.6 1.2 0.5 0.6 0.6 Monday 12 March Period Prev 2 Prev 1 Latest Forecast Consensus - Greece: Private creditors' swap transactions 11:45 Belgium: CB Governor Coene speaks on Belgium financial administration in Brussels 16:00 E17: Eurogroup meeting - Serbia: HICP, % y/y Feb 8.1 7.0 5.6 4.5 - 08:00 Romania: CPI, % y/y Feb 3.4 3.1 2.7 2.8 2.4 09:00 Bulgaria: CPI, % y/y Feb 3.1 2.8 2.3 - - 09:00 Italy: Final GDP release, % q/q Q4 0.3 -0.2 -0.7 P -0.7 -0.7 10:00 Portugal: HICP, % m/m (y/y) Feb -0.1 (3.8) 0.1 (3.5) 0.3 (3.4) -0.3 (3.1) - 18:00 US: Treasury budget balance, $ bn Feb -193.9 ('09) -220.9 ('10) -222.5 ('11) -229.0 -229.4 23:50 Japan: Index of tertiary industry activity, % m/m Jan 0.8 -0.6 1.4 1.5 0.2 02:30 Korea: 5y Bonds Auction KRW 2300 bn 04:00 Malaysia: 128d/154d/210d Notes Auction MYR 5.5 bn 10:30 Germany: New 6m Bubill 12Sep 2012 € 4 bn 13:50 France: BTF auction € 7.5 bn 14:45 UK: 3-7y Reverse Gilt Auctions £ 1.5 bn 18:00 US: 3y Note Auction $ 32 bn Tuesday 13 March Period Prev 2 Prev 1 Latest Forecast Consensus - Japan: BoJ Target rate, % Mar 0.10 0.10 0.10 0.10 0.10 08:00 E27: ECOFIN meeting 10:45 Finland: PM Katainen and former ECB President Trichet speaks at a seminar on the "Future of Europe" 11:30 E17: EU President Rompuy and EC Barroso speaks to the European Parliament about the last EU summit 11:30 E17: ECB President Draghi speaks on "The challenges of competitiveness" in Paris 14:00 Global: WTO Committee on budget, finance and administration 15:00 Italy: PM Monti and German Chancellor Merkel to discuss latest developments in the eurozone debt crisis in Rome 16:30 France: FM Baroin and German FM Schaeuble discuss on "How to exit the crisis & restore growth" in Paris 18:15 US: FOMC rate decision Mar 0.25 0.25 0.25 0.25 0.25 00:01 UK: RICS house price balance Feb -17.0 -16.0 -16.0 -17.0 -14.0 06:30 France: HICP, % m/m (y/y) Feb 0.3 (2.7) 0.4 (2.7) -0.4 (2.6) 0.5 (2.6) 0.5 (2.6) 06:30 France: CPI, % m/m (y/y) Feb 0.3 (2.5) 0.4 (2.5) -0.4 (2.3) 0.5 (2.4) 0.4 (2.3) 06:30 France: CPI ex tobacco index Feb 123.00 123.51 123.06 123.67 123.67 08:00 Hungary: CPI, % y/y Feb 4.3 4.1 5.5 5.5 5.5 08:00 Spain: Final HICP, % m/m (y/y) Feb 0.0 (2.4) -1.7 (2.0) ...(1.9) P 0.0 (1.9) 0.1 (1.9) 08:30 Sweden: CPI Level, Feb 314.16 314.78 311.85 314.05 313.67 08:30 Sweden: CPIF, % m/m (y/y) Feb 0.2 (1.1) 0.0 (0.5) -0.7 (0.9) 0.7 (1.1) 0.6 (1.0) 08:30 Sweden: CPI Headline, % m/m (y/y) Feb 0.2 (2.8) 0.2 (2.3) -0.9 (1.9) 0.5 (2.0) 0.4 (1.7) 09:00 Italy: Final HICP, % m/m (y/y) Feb 0.3 (3.7) -1.8 (3.4) 0.2 (3.4) P 0.2 (3.4) 0.2 (3.4) 09:00 Italy: Final CPI, % m/m (y/y) Feb 0.4 (3.3) 0.3 (3.2) 0.4 (3.3) P 0.4 (3.3) 0.4 (3.3) Note: All times reported in GMT. Some data or events are boxed to indicate their importance to financial markets. Market events are highlighted in light blue. 9 March 2012 46 Barclays Capital | Global Rates Weekly Tuesday 13 March Period Prev 2 Prev 1 Latest Forecast Consensus 09:30 UK: Visible trade balance, £bn Jan -8.1 -8.9 -7.1 -7.0 -7.9 10:00 Germany: ZEW economic expectations index Mar -53.8 -21.6 5.4 - 10.0 10:00 E17: ZEW economic sentiment index Mar -54.1 -32.5 -8.1 - - 12:30 US: Retail sales, % m/m Feb 0.3 0.0 0.4 1.2 1.0 12:30 US: Retail sales ex autos, % m/m Feb 0.2 -0.5 0.7 0.8 0.7 12:30 US: Core retail sales, % m/m Feb 0.3 -0.7 0.8 0.4 - 13:00 Poland: CPI, % y/y Feb 4.8 4.6 4.1 4.1 4.2 14:00 US: Business inventories, % m/m Jan 0.8 0.3 0.4 0.5 0.6 19:00 Argentina: CPI, % m/m Feb 0.60 0.80 0.90 0.8 - 09:00 Holland: 3y DSL Auction € 4 bn 09:00 Indonesia: 5y/25y Sukuk Auction - 09:00 Indonesia: 6m Bills Auction - 10:00 Italy: 12M & 3M BOT's (14 Mar13) € 8.5+3.5 bn 10:30 Belgium: TC 14Jun12 & 14Mar13 € 5 bn 14:45 UK: 15y+ Reverse Gilt Auctions £ 1.5 bn 18:00 US: 10y Note Auction $ 21 bn Wednesday 14 March Period Prev 2 Prev 1 Latest Forecast Consensus 09:30 Portugal: FM Gaspar speaks on the third review of Portugal's financial aid program at Parliamentary Commission 12:00 E17: ECB Executive board member Praet speaks at the “Collateral Solutions Conference” in Paris 13:00 Norway: Interest rate announcement, % Mar 1.75 1.75 1.75 1.75 1.75 13:00 US: Fed President Bernanke (FOMC voter) speaks in Nashville 17:00 Germany: Chancellor Merkel speaks on "German Economy" in Heidelberg 07:00 Finland: HICP, % m/m (y/y) Feb 0.2 (3.2) 0.0 (2.6) 0.8 (3.0) 0.9 (3.1) - 08:00 Slovakia: HICP, % m/m ( y/y) Feb 0.5 (4.8) 0.1 (4.6) 1.5 (4.1) 0.0 (3.7) (3.9) 09:00 Austria: HICP, % m/m (y/y) Feb 0.1 (3.9) 0.2 (3.4) -0.5 (2.9) 0.5 (2.6) - 09:00 Sweden: Unemployment rate (PES), % Feb 4.4 4.7 4.8 4.8 - 09:30 UK: Average weekly earnings, % 3m/y Jan 2.1 2.0 2.0 1.9 1.9 09:30 UK: Core average earnings, % 3m/y Jan 1.8 1.9 2.0 2.0 1.9 09:30 UK: ILO unemployment rate, % Jan 8.3 8.4 8.4 8.4 8.4 09:30 UK: Claimant count unemployment, k Feb 0.2 1.9 6.9 4.9 5.0 10:00 Croatia: CPI, % y/y Feb 2.6 2.1 1.2 - - 10:00 E17: Final HICP, % m/m (y/y) Feb 0.3 (2.7) -0.8 (2.6) ...(2.7) P 0.5 (2.7) 0.5 (2.7) 10:00 E17: HICP ex tobacco, index (2005 = 100) Feb 113.58 113.91 112.96 113.53 - 10:00 E17: 'Eurostat' core (HICP x fd, alc, tob, ene), % m/mFeb -0.1 (1.6) 0.4 (1.6) -1.7 (1.5) 0.4 (1.5) (1.6) 10:00 E17: Industrial production, % m/m (y/y) Jan 0.2 (1.0) -0.3 (0.1) -1.2 (-2.0) 0.2 (-1.0) 0.6 (-0.8) 12:30 US: Import prices, % m/m (y/y) Feb 0.7 (10.1) -0.1 (8.5) 0.3 (7.1) 0.4 (5.7) 0.6 (5.6) 12:30 US: Nonpetroleum import prices, % m/m (y/y) Feb -0.3 (3.3) 0.1 (2.5) 0.0 (1.7) 0.1 (1.9) - 12:30 US: Current account balance, $ bn Q4 -119.6 -124.7 -110.3 -113.0 -114.2 14:30 Brazil: Economic activity index, % y/y Feb 0.69 0.79 1.47 - - 04:00 Malaysia: 15y Bonds Auction MYR 3 bn 04:00 Malaysia: 126d/208d/306d Notes Auction MYR 4 bn 10:00 Italy: BTP Auction € 6.5 bn 14:45 UK: 7-15y Reverse Gilt Auctions £ 1.5 bn 18:00 US: 30y Bond Auction $ 13 bn Thursday 15 March Period Prev 2 Prev 1 Latest Forecast Consensus - Global: G20 Sherpas Meeting (to 16/03) 06:30 India: RBI repo rate, % Mar 8.50 8.50 8.50 8.50 8.50 06:30 India: RBI reverse repo rate, % Mar 7.50 7.50 7.50 7.50 7.50 08:00 E17: Euromoney conference in Luxembourg 08:30 Swi: Interest rate announcement, % Mar 0.00-0.25 0.00-0.25 0.00-0.25 0.00-0.25 0.00-0.25 08:45 E17: ECB publishes monthly bulletin Mar 09:00 Finland: CB Governor Liikanen speaks on monetary policy and global economy in Helsinki 13:00 Neth: CB Governor Knot speaks at VU Amsterdam university in Amsterdam 18:30 Austria: CB Governor Nowotny speaks in Vienna 22:00 Chile: Overnight rate target, % Mar 5.25 5.00 5.00 5.00 5.00 Note: All times reported in GMT. Some data or events are boxed to indicate their importance to financial markets. Market events are highlighted in light blue. 9 March 2012 47 Barclays Capital | Global Rates Weekly Thursday 15 March Period Prev 2 Prev 1 Latest Forecast Consensus - Peru: Economic activity index, % y/y Jan 5.3 5.1 6.0 5.65 - 00:00 Australia: Inflation gauge , % m/m Mar 2.4 2.8 2.5 - - 07:00 EU 27: New car registrations, % y/y Feb -3.5 -6.4 -7.1 - - 08:30 Sweden: Unemployment rate, % Feb 6.7 7.1 8.0 - 7.9 10:00 E17: Eurozone employment, % q/q (y/y) Q4 0.1 (0.3) 0.2 (0.4) -0.1 (0.3) -0.3 (0.0) - 10:00 E17: Labor cost, % y/y Q4 2.5 3.3 2.7 - 2.3 11:00 Ireland: HICP, % m/m (y/y) Feb 0.0 (1.7) -0.1 (1.4) -0.4 (1.3) 0.7 (1.1) - 11:00 Brazil: IGP-10 inflation, % m/m Mar 0.19 0.08 0.04 - 0.14 12:30 US: PPI, % m/m (y/y) Feb 0.2 (5.7) -0.1 (4.8) 0.1 (4.1) 0.5 (3.3) 0.5 (3.1) 12:30 US: Core PPI, % m/m (y/y) Feb 0.1 (2.9) 0.3 (3.0) 0.4 (3.0) 0.2 (3.9) 0.2 (2.9) 12:30 US: Initial jobless claims, k (4wma) 10-Mar 353 (360) 354 (355) 362 (355) 365 (359) 355 12:30 US: Empire State mfg, index Mar 8.19 13.48 19.53 22.0 17.4 13:00 US: Net long-term TIC flows, $ bn Jan 8.1 61.3 17.9 - - 14:00 US: Philadelphia Fed mfg, index Mar 6.8 7.3 10.2 11.5 11.0 16:30 Israel: CPI, % y/y Feb 2.6 2.2 2.0 1.9 1.7 03:00 Japan: 20y JGB Auction ¥ 1100 bn 04:00 Malaysia: 182d Notes Auction MYR 1 bn 09:30 Spain: 3y, 4y & 6y SPGB Auction € 4.5 bn 09:50 France: 2y & 4y BTAN Auction € 8.5 bn 10:30 UK: 2042 Gilt Auction £ 2.25 bn 10:50 France: 7y OATi Auction € 0.6 bn 10:50 France: 10y & 15y OATei Auction € 1.6 bn Friday 16 March Period Prev 2 Prev 1 Latest Forecast Consensus - Peru: Central bank inflation report (to 23/03) Q1 - UK: BoE interim FPC Meeting Q4 10:00 E17: ECB Executive board member González-Páramo speaks at "Finance meeting" in Spain 11:30 Germany: Chancellor Merkel speaks at a conference with German Industry Associations in Munich 12:00 Finland: CB Governor Liikanen speaks on European integration in Helsinki 15:00 France: CB Governor Noyer speaks at a central banking conference in Paris 15:00 Mexico: Overnight rate, % Mar 4.50 4.50 4.50 4.50 4.50 - Uruguay: GDP, % y/y Q4 6.7 4.7 7.5 6.8 6.5 10:00 E17: Trade balance, € bn (sa) Jan 0.5 6.1 7.5 7.1 - 12:30 US: CPI, % m/m (y/y) Feb 0.1 (3.4) 0.0 (3.0) 0.2 (2.9) 0.5 (3.0) 0.4 (2.9) 12:30 US: Core CPI, % m/m (y/y) Feb 0.2 (2.2) 0.2 (2.2) 0.2 (2.3) 0.2 (2.3) 0.2 (2.2) 12:30 US: CPI, NSA index Feb 226.230 225.672 226.665 228.0 - 13:15 US: Industrial production, % m/m Feb 0.0 1.0 0.0 0.4 0.4 13:15 US: Capacity utilization, % Feb 77.9 78.6 78.6 78.9 78.8 13:55 US: Michigan consumer sentiment- p, index Mar 69.9 75.0 75.3 74.0 75.6 Note: All times reported in GMT. Some data or events are boxed to indicate their importance to financial markets. Market events are highlighted in light blue. 9 March 2012 48 Barclays Capital | Global Rates Weekly GLOBAL KEY EVENTS Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Forthcoming central bank announcement dates North America FOMC meeting 13 24-25 - 19-20 31 - 12 23-24 - 11 n/a n/a FOMC minutes - 2 16 - 11 21 - 3 14 - n/a n/a Congressional testimony - - - - Jul - - - - - n/a n/a Fed's Beige Book - 11 - 6 18 30 - 10 28 - n/a n/a Bank of Canada 8 17 - 5 17 - 5 23 - 4 n/a n/a Europe ECB "policy" meeting 8 4 3 6 5 2 6 4 8 6 10 7 ECB monthly bulletin 15 11 10 13 12 9 13 11 15 13 17 14 ECB "non-policy" meeting 22 19 16 21 19 - 20 18 22 20 24 21 Bank of England 7-8 4-5 9-10 6-7 4-5 1-2 5-6 3-4 7-8 5-6 11-12 8-9 BoE Inflation Report - - 16 - - 8 - - 14 - - 15 BoE minutes 21 18 23 20 18 15 19 17 21 19 25 22 Riksbank - 19 30 - 4 - 6 25 29 18 n/a n/a SNB 15 - - 14 - - 13 - - 13 n/a n/a Norges Bank 14 - 10 20 - 29 - 31 - 19 n/a n/a Asia/RoW Bank of Japan 12-13 9-10,27 22-23 14-15 11-12 8-9 18-19 4-5, 30 19-20 19-20 n/a n/a BoJ minutes 16 13 7, 28 20 18 14 24 11 2,28 26 n/a n/a Reserve Bank of Australia 6 3 1 5 3 7 4 2 6 4 n/a n/a RBNZ 8 - - 14 - - 13 - - 6 - - Key international meetings ECOFIN 13,31 - 15 22 n/a n/a n/a n/a n/a n/a n/a n/a G20 15-16 19-20 10-11 15-17 - - 13-14 n/a n/a n/a n/a n/a Elections Finland (Presidential) - - - - - - - - - - - - Russia (Presidential) 4 - - - - - - - - - - - Greece (Parliamentary) - Apr - - - - - - - - - - France (Presidential) - 22 6 - - - - - - - - - France (Legislative) - - - 10-17 - - - - - - - - India (Presidential) - - - - Jul - - - - - - - Mexico (Presidential/Legislative - - - - 1 - - - - - - - Hong-Kong (Legislative) - - - - - - Sep - - - - - US (Presidential/Legislative) - - - - - - - - 6 - - - Source: Central banks, IMF, European Commission, Reuters, Bloomberg, Market News, Barclays Capital 9 March 2012 49 Barclays Capital | Global Rates Weekly GLOBAL SUPPLY CALENDAR Spread to 3 mth Z 3 mth Z German Score to Spread to Score to Country Bond Coupon Maturity Size - bn Spline Germany Swaps Swaps Euro Area Mar-12 Belgium New 5y OBL Auction 5.00 500.00 500.00 13-Mar-12 Holland 3y DSL Auction 15-Apr-15 4.00 500.00 500.00 14-Mar-12 Italy New 3yr BTP Auction 01-Mar-15 4.00 500.00 500.00 14-Mar-12 Italy 2yr BTP Auction 4.00% 01-Apr-14 1.00 197.9 -1.65 102.6 -1.77 14-Mar-12 Italy 15yr BTP Auction 4.50% 01-Mar-26 1.50 296.0 -1.67 245.7 -1.74 14-Mar-12 Finland 5y RFGB Auction 1.875% 15-Apr-17 1.50 500.00 500.00 15-Mar-12 Spain 6y SPGB Auction 4.10% 30-Jul-18 1.50 297.6 -0.76 217.6 -0.82 15-Mar-12 Spain 7y SPGB Auction 4.30% 30-Oct-19 1.50 304.9 -0.49 229.7 -0.55 15-Mar-12 Spain 10y SPGB Auction 5.85% 31-Jan-22 1.50 330.2 -0.71 278.7 -0.76 15-Mar-12 France 2yr BTAN (range €7.5-8.5bn) 4.00% 25-Apr-14 1.50 48.3 -1.18 -39.3 -1.83 15-Mar-12 France 2yr BTAN (range €7.5-8.5bn) 4.00% 25-Oct-14 1.50 54.0 -1.34 -28.4 -1.98 15-Mar-12 France 5yr BTAN (range €7.5-8.5bn) 2.25% 25-Feb-16 2.00 77.6 -1.40 -0.7 -1.71 15-Mar-12 France 5yr BTAN (range €7.5-8.5bn) 1.75% 25-Feb-17 3.50 91.2 -0.68 16.1 -1.14 15-Mar-12 France 7y OATi Auction (range €1.2-1.7bn) 0.60 15-Mar-12 France 10y OATei Auction (range €1.2-1.7bn) 0.60 15-Mar-12 France 15y OATei Auction (range €1.2-1.7bn) 0.50 500.00 500.00 21-Mar-12 Germany 2y Schatz Auction 0.25% 14-Mar-14 5.00 500.00 500.00 26-Mar-12 Belgium Auctions Cancelled ? 0.00 500.00 500.00 27-Mar-12 Italy CTZ Auction 0.00% 31-Jan-14 2.50 500.00 500.00 27-Mar-12 Italy BTPei Linker Auction 1.00 500.00 500.00 29-Mar-12 Italy CCT Auction Cancelled 0.00 500.00 500.00 29-Mar-12 Italy 5y BTP Auction 4.75% 01-May-17 2.50 299.6 -1.26 223.4 -1.32 29-Mar-12 Italy 9y BTP Auction 3.75% 01-Mar-21 1.50 288.4 -1.83 215.7 -1.94 29-Mar-12 Italy 10y BTP Auction 5.50% 01-Sep-22 2.50 500.00 500.00 Japan 15-Mar-12 Japan 20y JGB Auction 1100 22-Mar-12 Japan Liquidity Enhancement Auction 300 27-Mar-12 Japan Liquidity Enhancement Auction 300 29-Mar-12 Japan 2y JGB Auction 2700 UK 12-Mar-12 UK 3-7y Reverse Gilt Auctions 1.50 13-Mar-12 UK 15y+ Reverse Gilt Auctions 1.50 14-Mar-12 UK 7-15y Reverse Gilt Auctions 1.50 15-Mar-12 UK 2042 Gilt Auction 4.50% 07-Dec-42 2.25 19-Mar-12 UK 3-7y Reverse Gilt Auctions 1.50 20-Mar-12 UK 15y+ Reverse Gilt Auctions 1.50 21-Mar-12 UK 7-15y Reverse Gilt Auctions 1.50 22-Mar-12 UK 2042 Linker Auction 0.625% 22-Nov-42 0.90 26-Mar-12 UK 3-7y Reverse Gilt Auctions 1.50 27-Mar-12 UK 15y+ Reverse Gilt Auctions 1.50 28-Mar-12 UK 7-15y Reverse Gilt Auctions 1.50 US 12-Mar-12 US 3y Note Auction 32 13-Mar-12 US 10y Note Auction 21 14-Mar-12 US 30y Bond Auction 13 22-Mar-12 US 10y TIPs Auction 13 27-Mar-12 US 2y Note Auction 35 28-Mar-12 US 5y Note Auction 35 29-Mar-12 US 7y Note Auction 29 Unconfirmed Barclays Capital Estimate Rich Cheap Source: Barclays Capital 9 March 2012 50 Barclays Capital | Global Rates Weekly GLOBAL BOND YIELD FORECASTS US Treasuries US swap spreads Fed funds 3m Libor 2y 5y 10y 30y 10y RY 2y 5y 10y 30y Q1 12 0.00-0.25 0.65 0.25 1.00 2.25 3.25 0.00 Q1 12 50 45 15 -20 Q2 12 0.00-0.25 0.65 0.25 0.75 2.00 3.25 -0.40 Q2 12 50 40 15 -30 Q3 12 0.00-0.25 0.60 0.25 0.75 2.00 3.25 -0.25 Q3 12 40 30 10 -35 Q4 12 0.00-0.25 0.40 0.25 0.75 2.00 3.40 -0.10 Q4 12 40 25 5 -40 Euro government Euro area swap spreads Refi rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y Q1 12 0.5 0.90 0.35 1.00 2.00 2.70 0.05 Q1 12 70 60 45 0 Q2 12 0.5 0.70 0.40 1.10 2.10 2.70 0.15 Q2 12 65 55 40 0 Q3 12 0.5 0.70 0.45 1.20 2.20 2.80 0.15 Q3 12 60 50 35 -5 Q4 12 0.5 0.70 0.50 1.25 2.25 2.90 0.20 Q4 12 60 50 35 -5 UK government UK swap spreads Bank rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y Q1 12 0.5 1.00 0.40 1.15 2.40 3.30 -0.40 Q1 12 100 55 15 -15 Q2 12 0.5 1.00 0.50 1.30 2.50 3.35 -0.60 Q2 12 100 55 15 -10 Q3 12 0.5 1.00 0.60 1.60 2.75 3.45 -0.35 Q3 12 95 50 10 -5 Q4 12 0.5 1.00 0.70 1.80 3.00 3.50 -0.10 Q4 12 90 45 10 -5 Japan government Japan swap spreads Official rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y Q1 12 0.10 0. 20 0.10 0.35 1.15 2.05 0.95 Q1 12 15 15 5 0 Q2 12 0.10 0. 20 0.10 0.40 1.20 2.10 0.85 Q2 12 15 15 10 0 Q3 12 0.10 0. 20 0.10 0.35 1.15 2.05 0.85 Q3 12 15 15 10 0 Q4 12 0.10 0. 20 0.10 0.35 1.10 2.00 0.85 Q4 12 15 15 10 0 Q1 13 0.10 0. 20 0.10 0.35 1.00 2.00 0.85 Q1 13 15 15 10 0 Australia government Official Rate 3y 5y 10y AU-US 10y Q1 12 4.25 3.85 4.05 4.25 2.00 Q2 12 3.75 3.95 4.05 4.15 2.15 Q3 12 3.75 4.15 4.20 4.25 2.25 Q4 12 3.75 3.95 4.05 4.15 2.15 Source: Barclays Capital 9 March 2012 51 Barclays Capital | Global Rates Weekly GLOBAL RATES RESEARCH US Ajay Rajadhyaksha Joseph Abate Piyush Goyal James Ma Head of US Fixed Income and Fixed Income Strategy Fixed Income Strategy Fixed Income Strategy Securitised Products Strategy +1 212 412 6810 +1 212 412 6793 +1 212 412 2563 +1 212 412 7669 firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com Chirag Mirani Amrut Nashikkar Michael Pond Anshul Pradhan Fixed Income Strategy Fixed Income Strategy Treasury and Inflation-linked Treasury and Inflation-linked +1 212 412 6819 +1 212 412 1848 Strategy Strategy firstname.lastname@example.org email@example.com +1 212 412 5051 +1 212 412 3681 firstname.lastname@example.org email@example.com Rajiv Setia Vivek Shukla Igor Zoubarev Fixed Income Strategy Fixed Income Strategy Fixed Income Strategy +1 212 412 5507 +1 212 412 2532 +1 212 526 5518 firstname.lastname@example.org email@example.com igor.zoubarev @barcap.com Europe Laurent Fransolet Alan James Cagdas Aksu Fritz Engelhard Head of European Fixed Income Global Inflation-Linked Strategy European Strategy German Head of Strategy Strategy +44 (0)20 7773 2238 +44 (0)20 7773 5788 +49 69-7161 1725 +44 (0)20 7773 8385 firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com Jussi Harju Moyeen Islam Sreekala Kochugovindan Giuseppe Maraffino European Strategy Fixed Income Strategy Asset Allocation Strategy Fixed Income Strategy +49 69 7161 1781 +44 (0)20 777 34675 +44 (0)20 7773 2234 +44 (0)20 313 49938 firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com m Mikael Nilsson Hitendra Rohra Michaela Seimen Henry Skeoch Fixed Income Strategy Fixed Income Strategy SSA & Covered Bond Strategy Inflation-Linked Strategy +44 (0)20 7773 6057 +44 (0)20 7773 4817 +44 (0) 20 3134 0134 +44 (0)20 777 37917 firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com Khrishnamoorthy Sooben Stuart Urquhart Marcus Widen Huw Worthington Inflation-Linked Strategy European Strategy Fixed Income Strategy European Strategy +44 (0)20 7773 7514 +44 (0)20 7773 8410 +44 (0)20 3134 5632 +44 (0)20 7773 1307 khrishnamoorthy.sooben@ firstname.lastname@example.org email@example.com firstname.lastname@example.org barcap.com Asia Pacific Chotaro Morita Reiko Tokukatsu Rohit Arora Kumar Rachapudi Head of Fixed Income Strategy Senior Fixed Income Strategist, Fixed Income Strategist, Fixed Income Strategist, Research, Japan Japan Emerging Asia Emerging Asia +81 3 4530 1717 +81 3 4530 1532 +65 6308 2092 +65 6308 3383 email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org Ju Wang Gavin Stacey Fixed Income Strategist, Fixed Income Strategist, Emerging Asia Australia and New Zealand +65 6308 2801 +61 2 933 46128 email@example.com firstname.lastname@example.org 9 March 2012 52 Analyst Certification(s) We, Vivek Shukla, Anshul Pradhan, James Ma, Rajiv Setia, Amrut Nashikkar, Joseph Abate, Chirag Mirani, Michael Pond, Piyush Goyal, Laurent Fransolet, Huw Worthington, Giuseppe Maraffino, Cagdas Aksu, Moyeen Islam, Henry Skeoch, Khrishnamoorthy Sooben, Hitendra Rohra, Gavin Stacey, Chotaro Morita, Noriatsu Tanji, Reiko Tokukatsu, CFA and Marion Laboure, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this 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