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Barclays Capital - Risk aversion takes hold again

VIEWS: 71 PAGES: 84

									INTEREST RATES RESEARCH                                                                            Global Rates Strategy | 1 June 2012




GLOBAL RATES WEEKLY                                                                             Views on a Page                                  6

Risk aversion takes hold again                                                                  Trade Recommendations                           65

                                                                                                Trade Portfolio Update                          69
     As concerns over the Spanish banking system intensify, risk aversion has taken
     hold again with front end German nominal yields briefly turning negative and               Global Traders’ Guide                           74
     yield curves bull flattening aggressively                                                  Global Economics Calendar                       74

     The weak Employment Report raises the possibility that the Fed might look to               Global Supply Calendar                          79
     offer more policy stimulus while the Bank of England is seeing slowing survey
                                                                                                Global Bond Yield Forecasts                     80
     data. We expect the ECB to leave rates unchanged at Wednesday’s meeting but
     rather to announce further liquidity measures.
                                                                                                United States
     While rates in safe-haven markets are now at record lows, a sustained sell-off is
                                                                                                Agencies:
     still not on the cards.
                                                                                                Going to extremes?                              10
     Before risk aversion lessens, investors will need clarity on several issues, such as       Money Markets:
                                                                                                Have US short-rate markets been immunized? 13
     the Greek elections, European bank recapitalization and economic growth.
                                                                                                TIPS:
     We do not expect any proposals to come out of the Eurosystem until after the               Signs of risk off, but not in the usual suspects 17
     Greek elections; until then, the safe-haven bid in rates should continue.                  Volatility:
                                                                                                Buy 10y-30y digital floors                      20
Global
Don’t fade the rally                                                                  2         Europe
Rates in safe haven markets have rallied to new lows as economic data has weakened              Money Markets:
and fears about Spain have risen. But we do not think it is time to fade this flight to         Market has brought forward expectations of
                                                                                                ECB cut                                   28
quality rally yet. We still recommend asymmetric hedges like front end spread wideners.
                                                                                                Spain:
United States                                                                                   Spain debt flows: Big challenges ahead          32
                                                                                                Sovereign Spreads:
Treasuries: Not time yet                                                           7            Spain: Taking stock                             35
We do not recommend fading the rally yet, given modest growth expectations in the               SSA:
US/ euro area with downside risks, the potential for a further worsening of the euro            Single versus multiple-guarantee structures     39
area crisis before policymakers act and possible key events that could be dovish.               Covered Bonds:
                                                                                                Relative value in spotlight: Dislocation
Euro Area                                                                                       between major issuers in Spanish and Italian
                                                                                                covered bond markets                        50
A Greece exit is not fully priced into rate markets                                        23   Scandinavia:
The impact on interest rate markets of Greece exiting the EMU is likely to be significant. We   Sweden: No recession, no rate cut?              53
would expect money markets to suffer a renewed bout of stress, with Italy and Spain             Euro Inflation-Linked:
                                                                                                BTP€is not cheap enough to be compelling 55
bonds likely selling off aggressively, despite any policy responses that would be introduced.
                                                                                                UK Inflation-Linked:
UK                                                                                              Fear trumps fundamentals                        57

The irresistible force                                                                     37
MPC members have hinted that further QE might not be appropriate for the economy.               www.barcap.com
Current valuations have not been driven by “safe haven” status but rather by position
squaring from domestics. If this continues, the beleaguered flattener will come into its own.

Japan
Assessing lifers’ capacity to buy super-long JGBs                                    62
Looking at superlong purchasing capacity at life insurers, we find the pace of portfolio
duration extension has slowed in FY 11 due to the decline in yields.

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 81
Barclays | Global Rates Weekly


GLOBAL THEMES

                                        Don’t fade the rally
                Ajay Rajadhyaksha       Rates in safe haven markets have rallied to new lows as economic data have weakened and
                 +1 212 412 7669        fears about Spain have risen. However, we do not think it is time to fade this flight to quality
 ajay.rajadhyaksha@barcap.com           rally yet. We still recommend asymmetric hedges such as front-end spread wideners.

                                        Records tumbled like dominoes in the bond markets this week as US, UK and German yields
                 Laurent Fransolet
                                        set new lows. 10-year Treasury yields in the US touched a new intra-day low of 1.44%, the
              +44 (0)20 7773 8385
                                        German 30-year fell below that of Japan, and German 2y yields went negative. Investors might
  laurent.fransolet@barcap.com
                                        be tempted to short rates at these levels, but we advise against doing so. A 10-15bp knee-jerk
                                        sell-off is possible after this strong rally, but a sustained sell-off is unlikely in the absence of
                                        clarity on several issues: the Greek election outcome, progress on various options available to
                                        the Eurosystem, answers on how the Spanish government will recapitalize its banks, prospects
                                        for US growth (after a very weak payroll report), etc. In other words, for those tempted to
                                        short the bond market, the right time is more important than the right level.

   Despite the strong rally in safe     Spain takes center stage: How big are the losses?
haven assets, a sustained sell-off      Investors seemed to stop worrying about Greece this week, mainly because they were too
                         is unlikely    busy worrying about Spain. Much of the recent furor in Spain reflects a lack of investor
                                        confidence, on two fronts.

                                        The first is the size of the hole in the banking system, which authorities have struggled to
                                        get a handle on. Consider the past few months: 1) In Q1 2012, the Spanish government
                                        announced that banks would not need new capital; 2) Roughly two months later, the
                                        Spanish government seized control of Bankia (May 9); 3) Two weeks after that, the bank’s
                                        board asked for an additional €19bn. The total bailout thus jumped from €4.5bn to €23.5bn.
                                        4) The governor of the Spanish central bank resigned abruptly, a month before his term was
                                        up, under criticism from some lawmakers about the central bank’s role in the regulation of
                                        savings banks, as well as the Bankia merger and subsequent IPO.

 Investor concerns have focused         All of this has raised questions about the true magnitude of future losses in the Spanish
on the magnitude of losses in the       banking system. Our own estimate (see European Banks: Comparing Spain to Ireland, May
 Spanish banking system, on the         17, 2012) is that in the base case, Spanish banks will take total losses of €198bn, of which
        alternatives Spain has to       €110bn is provisioned for. Subordinated debt could offset some of the rest, leaving the
   recapitalize it, and if there is a   Spanish government with €45-50bn to contribute. In our stress scenario, though, the losses
consensus among authorities on          (and the capital injection from the government) rise by €68bn. The IIF (International
                   the alternatives     Institute of Finance) recently came out with its own figures – it also estimates that an
                                        additional 50-60bn of capital injections will be needed from the government. In both cases,
                                        the amounts needed are considerably greater than the €19bn required just for Bankia.

                                        How does Spain finance a recapitalization of its banking system?
                                        The second issue relates to how Spain will finance this rescue. Until recently, the deposit
                                        guarantee fund has contributed to bank rescues, and the FROB (the state-backed bank
                                        restructuring fund) had been raising debt in the capital markets and injecting it into troubled
                                        banks. However, the FROB currently has about €5bn, less than the €19bn needed for Bankia.
                                        And with Spanish 10-year yields well above 6%, the cost of financing has risen sharply.
                                        Spanish Prime Minister Rajoy noted that Spain was “finding it very difficult to finance itself
                                        with sovereign debt risk premium so high”. In Spain debt flows: Big challenges ahead, May 30,
                                        2012, we discussed the Spanish government’s ability to issue new debt in the capital markets


1 June 2012                                                                                                                              2
Barclays | Global Rates Weekly


                                          to finance bank bail-outs. Our conclusion: if Spain decides to issue an extra €19bn of
                                          government debt in the next month, there could be a large price effect. But if the authorities
       If losses are large enough, it     can spread this issuance over a longer period, the impact on yields should be more
   would be hard for Spain to tap         manageable. If the amounts needed exceed €19bn by a lot, it would likely be very difficult for
                        the markets       Spain to tap the markets.

                                          Several other avenues have been broached by Spanish authorities to recapitalize Bankia: 1)
                                          Newly issued government debt could be injected directly into Bankia, which could then use
                                          the bonds as collateral to borrow from the ECB; 2) Economy Minister Luis de Guindos said
                                          the FROB would continue to issue debt in open markets as a means to recapitalize Bankia;
                                          3) Prime Minister Rajoy also urged the ESM (European Stability Mechanism) fund to directly
                                          recapitalize banks across the eurozone; the European Commission made a similar call.

                                          The first and second options are similar. Recapitalization bonds are issued (in the market or
                                          not) and the financing is indirectly provided by the ECB. This is similar to, but not the exact
                                          approach used in Ireland (a promissory note repo-ed via ELA but not ECB eligible) or Greece
                                          (EFSF bonds, which are repo-ed at the ECB). With FROB/Spanish government bonds eligible
                                          for repos at the ECB, this may still be the route used. The third option, using ESM/EFSF
                                          bonds to do the same, raises the issues of 1) who can access the ESM (the sovereign for its
                                          banks, or the banks directly); and 2) under which conditionality the funds can be disbursed.

                                          Germany restated that it was not in favor of direct bank recapitalization using the ESM. In
                                          terms of conditionality of ESM funds, we note that this has not been spelled out yet (although
                                          it is assumed to be similar to the relatively light conditionality of the EFSF). But the key point is
                                          that ESM loans (unlike EFSF loans) are senior to other borrowings. Hence the reluctance of
                                          Spain to access the ESM directly. Instead, there have been press reports of a possible
                                          sovereign rescue for Spain, under the auspices of the EU and the IMF. However, such a bail-
                                          out would likely come with a significant loss of sovereignty, stringent conditions, and likely
                                          loss of market access, as seen in countries such as Greece and Ireland. Consequently, the
                                          Spanish authorities have been eager to dampen speculation of any such plans.

                                          In other words, worried investors might conclude that: 1) there could be more losses hiding
                                          on bank balance sheets; 2) Spain might not be able to raise the debt to recapitalize its banks
                                          without pushing yields even higher; and 3) there is no agreement among eurozone
                                          authorities on how to help Spain with recapitalization. These worries have been reflected in


Figure 1: Sharp drop in Spanish asset prices                              Figure 2: Inter-bank spreads have not widened much

 600                                                          9,500           0                                                            80

 550                                                          9,000        -10                                                             70
                                                              8,500                                                                        60
 500                                                                       -20
                                                              8,000                                                                        50
 450                                                          7,500        -30
                                                                                                                                           40
 400                                                          7,000        -40
                                                                                                                                           30
                                                              6,500        -50
 350                                                                                                                                       20
                                                              6,000
 300                                                                       -60                                                             10
                                                              5,500
 250                                                         5,000         -70                                                             0
  Mar-12               Apr-12           May-12          Jun-12               Sep-11        Nov-11        Jan-12   Mar-12       May-12

                      Spain-Germany 10y yld spd (bp, LHS)                                  5y EUR-USD cross currency basis (bp, LHS)
                      IBEX Equity Index (RHS)                                              Sep 12 FRA-OIS spreads (bp, RHS)
Source: Bloomberg, Barclays Research                                      Source: Bloomberg, Barclays Research


1 June 2012                                                                                                                                    3
Barclays | Global Rates Weekly


                                      markets this week, with Spanish stocks at multi-year lows and the spread between Spanish
                                      and German sovereign debt (10-year sector) widening by more than 500bp (Figure 1).

                                      No quick solutions
 Potential solutions are political,   Based on their public statements, eurozone policy makers have discussed three prospective
   and hence may take time. We        solutions. One is some form of Eurobonds, with pooled debt issuance for the sovereigns.
  don’t expect a game-changing        The second is using the EFSF and ESM to recapitalize European banks directly, to ‘sever the
       proposal in the near term      links between banks and the sovereigns’, according to the European Commission. The third
                                      is a eurozone-wide deposit guarantee for European banking systems. Northern European
                                      countries, especially Germany, have stated their strong opposition to the first and second
                                      options. And, as we noted in last week’s Global Themes, we do not believe a euro area
                                      guarantee would be effective because it would not protect against devaluation.

                                      These three solutions are essentially political decisions. They all need a big leap forward into
                                      mutualisation of the debts (a process started already with the EFSF) and legislative
                                      ratification – both will take time. Consequently, none of these solutions are likely to restore
                                      market confidence in the immediate future, even if they provide a necessary roadmap for
                                      the eurozone. In the meantime, the ECB is probably the only institution which can provide
                                      some form of stop-gap – but it and the markets know that these are only stop gaps. The
                                      ECB’s role is to provide emergency liquidity and be a lender of last resort. While it will leave
                                      all doors open at its June 6 meeting, the ECB is unlikely to provide much relief to the markets
                                      just yet, except maybe in the form of further very long LTROs (see the Money market
                                      article), and, under pressure, a restart of the SMP.

 10y rates at 1.5% are defensible     In any case, it seems likely that European policymakers will wait until after June 17 before
    given weaker growth outlook       making any decisions, instead of first reacting to Spain and then to Greece. That is a big part
         and rise in risk aversion    of why we do not expect a sudden, sharp sell-off in rates, even from record lows. In ‘Not
                                      time yet’ on page 7’, we note that based on fair value alone, rates in the US are now
                                      overbought. But once we add in a compensating factor for risk aversion, 10y rates at 1.5%
                                      seem defensible. Moreover, the weak US payroll report suddenly raises worries about US
                                      growth as well. Until at least some of these questions are answered, risk aversion is unlikely
                                      to fade and rates are unlikely to rise much.

                                      Finally, there are several key dates coming up. June 17 is clearly important not just because
                                      of the Greek elections but also because the French parliamentary elections are on June 10
                                      and June 17. A Parliamentary majority (which we believe to be likely) could affect the
                                      approach President Francois Hollande takes over the next few months. Hollande, Germany’s
                                      Angela Merkel, Spain’s Rajoy and Italy’s Mario Monti are set to meet in Rome on June 22,
                                      with a full EU summit on June 28-29. The fact that no meetings are scheduled before June
                                      17 supports the theory that there is no imminent solution coming.

                                      Still time
                                      So what do investors do as they wait for June 17? One of the surprises in this week’s flight
                                      to quality has been that it has not been uniform. For example, the 5y cross-currency basis is
                                      now close to last November’s levels, and Spanish sovereign CDS are 100bp wider than the
                                      wides of Q4 2011. But the US stock market is still well above Q4 2011 levels, while
                                      mortgage credit products in the US (both RMBS and CMBS) have held up well.

                                      Inter-bank spreads fall into this second category; front-end spreads are still tighter than the
                                      levels of mid-May (Figure 2). At one level, this is understandable. European banks might
                                      have capital issues, but the bigger banks are well protected from a drying up of wholesale
                                      funding, thanks to the 3-year LTROs. But if sovereigns like Spain have increased trouble
                                      funding themselves, the banking system will at some point be pulled in. For example, one of
1 June 2012                                                                                                                        4
Barclays | Global Rates Weekly


                                    the fears associated with a Greek exit is of deposit runs in Southern European countries,
                                    causing funding problems for their banking systems. Front-end spreads might not widen on
                                    nervousness alone, but if there is an actual credit event, they would not be immune.

     We continue to recommend       That is why, at the risk of sounding like a broken record, we recommend yet again that
  front-end spread wideners as a    investors searching for cheap protection find it in front-end spread wideners. If there is an
                 protection trade   event, bank funding levels should be affected. Consequently, for investors who want to
                                    hedge against this, front-end wideners look to be an attractive tail hedge.




1 June 2012                                                                                                                    5
Barclays | Global Rates Weekly


VIEWS ON A PAGE
               US                                                               EUROPE                                                          JAPAN
 Direction       US yields have rallied sharply, though in the global context    Extreme risk aversion now dominates, with front-end             Market developments stemming from the extreme
                 they do not look artificially low.                              German yields now negative. The ECB is not likely to cut the    movement in eurozone bond markets could ease as
                 Downside risks to growth expectations, along with               refi rate at this Wednesday’s meeting, but rather announce      early as mid-June.
                 heightened risk aversion, do not justify higher yields          further liquidity measures. We hold onto long EUR               There may also be a brief acceleration in the bull
                 Remain neutral on duration.                                     2s/5s/10s 1y fwd and also recommend money market                flattening trend.
                                                                                 flatteners in EUR vs GBP.                                       We see continued attraction in a position based on a
                                                                                 UK: Domestic investor reduction of short positions, rather      10y-20y bull flattening over a 1-2 week span. There
                                                                                 than overseas investors, have largely driven the rally.         should subsequently be a need for short positioning,
                                                                                                                                                 depending on market developments.
 Curve/          Remain neutral on 10s30s Treasury curve steepeners, as          Hold onto long EUR 2s/5s/10s 1y fwd.                            JGB 20-30 steepener.
 curvature       the potential for risk aversion to rise remains significant.    For long-end steepening, receive EUR 5y5y fwd/5y10y
                                                                                 fwd/5y15y fwd and long EUR 5s/10s/30s.
                                                                                 UK Gilt 10/30s looks too steep for post-QE world. We
                                                                                 recommend 10/30s flatteners over Q3 12.
                                                                                 Change in MPC rhetoric should see bearish resteepening of
                                                                                 the GBP forward curve. 2-3y sector looks too flat in RV. Pay
                                                                                 fwd OIS rates out of 2013 MPC dates
 Swap            Mar 13 FRA-OIS spread as a protection trade.                    EUR: Near-term EUR ASWs are likely to range trade.              20y ASW long vs 3m.
 spreads         30y spread tighteners for asymmetric tightening risk.           GBP: 10y10y fwd ASW is cheap relative to other parts of the     Long 9y & 10y ASW.
                                                                                 ASW curve. Long 20y ASW vs 10y ASW.
Other            With few discernible near-term catalysts to reduce risk         SEK: Hold SEK/EUR 1y6mth fwd spread tighteners, but take        20y 3v6 tightener.
spread           aversion from euro sovereign concerns, we advise caution        profit on SEK/EUR 2y2y/5y5y fwd steepeners. Hold                Pay 6myx1y USD/JPY Xccy basis.
sectors          in fading the recent widening of agency-Treasury                medium-term 5y SGB (1050) ASW tighteners.                       Receive USD/JPY 20x10 Xccy basis.
                 spreads. In the medium term, we recommend fading the            NOK: Hold cross-market tighteners in 5y5yfwd versus EUR.
                 spread curve flattening by owning 3-5y agencies versus          Short Schatz and Bund contract rolls
                 Treasuries.                                                     UK: Long 30y gilts vs core EGB markets; Gilt 10/30s
                 We remain constructive on Canadian covered bonds,               flatteners vs EGB 10/30s steepeners (Netherlands/Bunds).
                 given their relative isolation from Europe and continued
                 significant spread pickup to agencies.
Inflation        Neutral on breakevens outside the very front end.               5y euro swaps are cheap and should be less directional than     Take profit on long BEI.
                 Long 10y10y versus 5y5y BEs, as longer forwards trade           bond breakevens, receive sub 1.4% 5y inflation.
                 significantly below 5y5y forwards.                              Buy IL20 versus paying maturity-matched nominal swap as
                 Long Apr17s versus Jan17s, as the floor premium on new          a less volatile way to fade economically cheap breakevens.
                 5s could rise with risk aversion.
 Volatility      Neutral gamma. Levels are not high enough to sell amid          Buy EUR gamma, as the risk of an event lingers.                 Short 1mx20y receiver spread
                 the eurozone uncertainty.                                       Initiate 2y*5y - 2y*30y bear steepeners capped with SL
                 Short 2y*10y. A large sell-off in rates is still unlikely.      curve caps.
                 Further, implied vol is at significant premium to realized      Buy 6m*2y payer vs. GBP 6m*2y payer as a tactical trade.
                 vol, and vega is richer than gamma.
Source: Barclays Research




1 June 2012                                                                                                                                                                                        6
Barclays | Global Rates Weekly


UNITED STATES: TREASURIES

                                        Not time yet
                   Anshul Pradhan       We do not recommend fading the rally yet, given modest growth expectations in the US/
                  +1 212 412 3681       euro area with downside risks, the potential for a further worsening of the euro area
   anshul.pradhan@barcap.com            crisis before policymakers act and key events that could push yields lower still ahead.

                                        The Treasury market rallied sharply this week, led by the long end amid a further worsening
                                        of the situation in Europe, which was exacerbated by weaker US economic data. 10y and
                                        30y yields have rallied ~30bp, since the beginning of the week.

Risk aversion spiked in Europe as       With the potential for a Greek exit from the euro more or less on the backburner until the
  investors focused on the health       second round of elections on June 17, investors focused their attention on the health of the
   of the Spanish banking system        Spanish banking system. The possibility of the Spanish government having to foot the bill
                                        for recapitalizing its banks has led to a sharp rise in government bond yields. The European
                                        commission’s proposal to use ESM funds to inject capital into banks has been met with
                                        scepticism in Germany.

        In the US, economic data,       In the US, economic data also weakened, with personal consumption, consumer confidence,
     especially the payroll report,     housing, initial claims and finally the payroll report all surprising to the downside; Q1 12
           surprised sharply to the     GDP growth was revised lower to 1.9%, from 2.2% in the advance release. The payroll
                           downside     report was weaker on all fronts: low payroll growth with downward revisions to the prior
                                        month, a higher unemployment rate and a deceleration in hourly earnings.

        While US yields are below       With 10y yields at historical lows, the question is whether the move has been overdone, even
      what can be justified purely      in the context of heightened risk aversion. We believe that given modest growth expectations
              by fundamentals, risk     in the US and euro area with downside risk; the potential for a further worsening of the euro
              of lower yields remain    area crisis before policymakers act; and key events, such as the Greek election, the Fed
                                        Chairman’s testimony, and the June FOMC meeting, still ahead, the move should not be faded.
                                        While yields may look too low in a historical context, a worsening of sentiment could push
                                        them even lower. Indeed, US yields do not look out of line in a global context. 10y yields in UK
                                        are trading at 1.53% and in Germany at 1.17%.


Figure 1: Risk aversion has spiked in a modest growth                 Figure 2: 10y yields at 1.5% reflect not only high risk
environment, pushing yields to historical lows                        aversion but a weak economic outlook as well

  4.5                                                                   4.5
  4.0
                                                                        4.0
  3.5
  3.0                                                                   3.5
  2.5
  2.0                                                                   3.0
  1.5                                                                   2.5
  1.0
  0.5                                                                   2.0                                                         1.8
  0.0
                                                                        1.5
 -0.5                                                                                                                               1.5
    Jan-10      Jun-10    Nov-10 Apr-11 Sep-11 Feb-12                   1.0
                         10y yields, %                                    Jan-10     Jun-10      Dec-10      May-11   Nov-11   May-12
                         1y ahead US growth expectations
                         European Financial Spreads, %                                            Actual        Estimate
Source: Bloomberg, Barclays Research                                  Source: Bloomberg, Barclays Research


1 June 2012                                                                                                                               7
Barclays | Global Rates Weekly


 10y yields are typically driven by      Figure 1 shows that 10y yields have typically been driven by expectations of future growth.
        underlying fundamentals,         More recently, however the key driver has been a spike in risk aversion even as economic
   growth and inflation; however,        data have surprised somewhat to the downside. Over the past month, European financial
         risk aversion has recently      spreads have widened ~50bp, though still below the peak reached in November 2011. A
                been the key driver      simple regression based on 1y ahead consensus economists’ growth expectations (in the US
                                         and euro area), 1y1y inflation expectations in the US, and risk aversion (as proxied by
                                         European financial spreads) shows that 10y yields should trade at 1.8%, ~30bp above
                                         where they are now. We believe this estimate overstates the level of yields in the current
                                         environment and remain wary of fading the rally for a few reasons.

   Market’s growth expectations          The market’s growth expectations are likely to remain shy of consensus expectations. US
 are likely to be below consensus        growth has surprised to the downside of late: Q1 12 growth printed at 1.9%, versus the
        expectations, given recent       advance release at 2.2%. Over the past year, real GDP growth has been ~2%, and looking
                 negative surprises      downside risks associated with the fiscal cliff persist. Similarly, in the euro area, the market is
                                         likely to doubt the sharp recovery expected by economists, given strains in the financial market

Figure 3: Market’s growth expectations likely below                     Figure 4: Market may doubt the sharp reversal expected in
consensus econ expectations, given recent misses                        the euro area

  4.0                                                                       1.2
                                                                                                                                        1.0
  3.5                                                                       1.0
  3.0                                                                       0.8     0.7
                                                                  2.4
  2.5                                                                       0.6                                             0.4
  2.0                                                             2.0       0.4
  1.5                                                                       0.2                 0.0
  1.0                                                                       0.0
  0.5                                                                      -0.2
  0.0                                                                      -0.4                                   -0.2
 -0.5                                                                      -0.6
 -1.0                                                                      -0.8                           -0.6
    Jan-10       Jul-10     Jan-11     Jul-11     Jan-12                           Q112       Q212       Q312    Q412     Q113      Q213
                     1y ahead growth expectations
                     Realized Growth over the past 1 year, %                                    Euro Area Growth expectations, %
Source: Bloomberg, Barclays Research                                    Source: Bloomberg, Barclays Research




Figure 5: Sovereign spreads in Italy and Spain have moved               Figure 6: Measures of financial stress have not risen as
out to last year’s wides                                                much, thanks to the liquidity provided by the ECB

  Spreads of 10y Govt bonds vs Germany, %                                 375                                                                 80
 6.0
                                                                                                                                              70
 5.5                                                                      325
 5.0                                                                                                                                          60
 4.5                                                                      275                                                                 50
 4.0
                                                                          225                                                                 40
 3.5
 3.0                                                                                                                                          30
                                                                          175
 2.5                                                                                                                                          20
 2.0
                                                                          125                                                                 10
 1.5
                                                                           May-11 Jul-11       Sep-11 Nov-11 Jan-12 Mar-12 May-12
 1.0
                                                                                          European financials,5y CDS spreads, LHS, bp
   Jun-11       Sep-11       Dec-11      Mar-12                Jun-12
                                                                                          1y fwd 3M LOIS Expectations, bp, RHS
                                 Spain       Italy                                        3M LOIS, bp, RHS
Source: Bloomberg, Barclays Research                                    Source: Bloomberg, Barclays Research


1 June 2012                                                                                                                                    8
Barclays | Global Rates Weekly


                                     (Figure 3 and 4). Risk aversion, coupled with 2% growth expectations in the US and a stagnant
                                     real GDP in the euro area, would justify 1.6% 10y yields – not much higher than current levels.
                                     Hence, one does not need to make excessively pessimistic growth assumptions to justify the
                                     current level of yields.

 Financial stress has more room      Financial stress still has room to worsen. While sovereign yields in Italy and Spain are trading
 to rise before it catches up with   close to the highs reached late last year, financial spreads are not (Figure 5). For instance,
        the underlying sovereign     spot 3m USD Libor-OIS has not even budged and 1y fwd expectations at 45bp are well
                        concerns     below the 75bp peak of November 2011. While CDS spreads on European financial debt
                                     have widened, they are also below their peak (Figures 6). Liquidity actions taken by the ECB
                                     have certainly helped, but if underlying sovereign concerns remain elevated, financial
                                     conditions could continue to worsen, pushing yields even lower across safe havens. A 50bp
                                     widening in European financial spreads, ie, levels rising close to the peak observed late last
                                     year, could push our estimate of 10y yield lower by ~20bp.

      Key events that could push     Finally, key events that could push yields lower lie ahead. Chairman Bernanke is scheduled
      yields lower are still ahead   to testify on the economic outlook on June 7. The FOMC meeting and the press conference
                                     are on June 20. He will have ample opportunity over the coming weeks to lay out any
                                     potential actions the Fed may take. And the outcome of the Greek election on June 17
                                     hangs in the balance. With no meetings scheduled before June 17, any solution to the
                                     banking crisis unlikely to materialize before then as well.

   Hence, while US yields remain     Hence, while US yields are below what can be justified purely by US fundamentals, we do
  below what can be justified by     not recommend fading the move yet. Were risk aversion to subside, US 10y yields could rise
        fundamentals, we do not      to 1.75-2%. However, if more austerity is the price Europe pays for a stable banking system,
recommend fading the move yet        the sell-off could be limited. Growth expectations, which are unspectacular to begin with,
                                     could themselves shift lower, putting a cap on how much US yields can rise.




1 June 2012                                                                                                                         9
Barclays | Global Rates Weekly


UNITED STATES: AGENCIES

                                            Going to extremes?
                            James Ma        Agency-Treasury spreads face should further widening pressure as risk aversion
                  +1 212 412 2563           continues. We see value in the 3-5y sector in the medium term as relative spreads are high,
          james.ma@barcap.com               the supply technical remains positive, and GSE credit concerns should not be a factor.

                            Rajiv Setia
                                            Whither agency spreads?
                  +1 212 412 5507           There is ample evidence that the latest euro zone-related risk aversion episode will end up
            rajiv.setia@barcap.com          comparable in severity to that of late 2011, but there is less indication that agencies have
                                            become as dislocated. Agency-Treasury spreads have widened to T+18bp in 3s and T+30bp in
                                            5s, which compares well to absolute Treasury yield levels (0.35% and 0.65%, respectively).

  Agency-Treasury spreads have              However, the same sectors reached T+35-40bp in late 2011 at a similar level of Treasury
  widened, but have not reached             yields (Figure 1). Therefore, we believe caution is warranted in the near term, though
   late-2011 levels of dislocation          investors committed to the asset class in the medium term should be able to find value,
                                            especially in the intermediate part of the curve.

                                            The case for further near-term widening
Several factors, including further          As with other spread products, agencies tend to underperform Treasuries in a flight to
risk aversion, could maintain the           quality; in November 2011, the agency-Treasury spread widening persisted for months, only
                 widening pressure          compressing once Treasury yields pushed higher. Similarly, several near-term factors could
                                            widen agency-Treasury spreads:

                                               Of course, a continued flight to quality would push all spread products, including
                                               agencies, wider to Treasuries. While agencies typically outperform swaps in a risk flare,
                                               surprisingly even this axiom has not held true thus far; consider that agency asset swaps
                                               have widened 5bp in the past two weeks, despite just $1bn in issuance activity between
                                               May 21 and the next window on June 5).




Figure 1: Agency-Treasury spreads, rates diverge                         Figure 2: Dealer inventories of agencies are building

    %                                                                      70     $ bn
 1.8                                                                       60
 1.6
                                                                           50
 1.4
 1.2                                                                       40
 1.0                                                                       30
 0.8
                                                                           20
 0.6
 0.4                                                                       10
 0.2                                                                       0
 0.0                                                                       Jan-11      Apr-11        Jul-11   Oct-11   Jan-12     Apr-12
   Jan-11        May-11           Sep-11      Jan-12      May-12
                                                                                                <3y Coupons        3-6y Coupons
                        3y Treasury yield        3y OTR agency yield                            6-11y Coupons      11+y Coupons
Source: Barclays Research                                                Source: Barclays Research

1 June 2012                                                                                                                                10
Barclays | Global Rates Weekly


                                                     Front-end Treasury yields could also fall with the scheduled end of MEP-related sales at
                                                     end-June. In addition, the deterioration in economic conditions leaves open the
                                                     possibility that further QE may be unsterilized, which we believe the market is clearly not
                                                     pricing in appropriately.

                                                     Dealer inventories are building back to levels last seen in the previous eurozone-related
                                                     risk-aversion episode of late 2011 (Figure 2).

                                                     Similarly, eurozone funding stress indicators also appear to be headed for their late-
                                                     2011 extremes. At -70bp in 2-3y, the EUR/USD cross-currency basis is 10bp away from
                                                     the peak, which may reflect the LTRO’s effect on funding, but the 5y at -65bp is already
                                                     in line with the late 2011 extreme (Figure 3).

    There appears to be no near-              We believe the immediate catalysts for a reversal in risk-averse sentiment are still weeks
    term catalyst for a reversal in           away; the next key date seems to be the June 17 Greek elections. Before then, we would not
              risk-averse sentiment           expect yields to stabilize and provide agency-Treasury spreads with an environment
                                              conducive to tightening. However, we think the case for outperformance remains strong in
                                              the medium term.

                                              The case for medium-term agency outperformance
   Several factors favor medium-              Even with the potential for worsening risk aversion near-term, we have long argued that GSE
 term outperformance, including               credit and Treasury credit are fundamentally similar. 1 As such, current valuations begin to
 GSE credit and supply technicals             represent value for investors committed to the asset class over the medium term: consider
                                              that at T+18bp, owning 3y agencies is the same as extending a year out the Treasury curve;
                                              5y agencies at T+30bp yield the same as 7y Treasuries. Put another way, bull flattening of the
                                              rate curves has pushed agency-Treasury spreads in these sectors to all-time highs on a
                                              percentage basis (Figure 4), with agencies yielding 50% more than Treasuries in 3s and 5s,
                                              mainly because Treasury yield levels have never before been this low.

                                              Furthermore, the following background factors remain the same regardless of the degree of
                                              eurozone-related risk aversion priced into the market:

                                                     From a supply standpoint, the GSEs are shrinking their balance sheets and long-term
                                                     debt outstanding at a similar pace to 2011; term debt shrinkage has been -$75bn
                                                     (Figure 5). Furthermore, FNM has already shrunk halfway to its YE12 portfolio target

Figure 3: EUR-USD cross currency basis swap                                          Figure 4: Agency-Treasury spreads as % of Treasury yields

   bp                                                                                  120%
    20
                                                                                       100%
     0
                                                                                        80%
   -20
                                                                                        60%
   -40
                                                                                        40%
   -60
                                                                                        20%
   -80

 -100                                                                                     0%
    Jan-07      Jan-08      Jan-09        Jan-10        Jan-11        Jan-12               Jan-10       Jul-10        Jan-11    Jul-11   Jan-12

                                     2y            3y            5y                                              2y        3y      5y     10y

Source: Barclays Research                                                            Source: Barclays Research

                                              1
                                                  “Back in black”, Global Rates Weekly, 11 May 2012.

1 June 2012                                                                                                                                       11
Barclays | Global Rates Weekly


                                               ($25bn) over the first four months of the year, while FRE has shrunk $52bn in the same
                                               period, despite already being $55bn below the limit.

                                               From a demand standpoint, regulatory guidelines for liquidity and capital continue to
                                               motivate banks to hold agency debt/MBS, thus making bank portfolios a potential
                                               source of captive demand for the asset class. Furthermore, NIM compression makes
                                               high-quality Treasury surrogates even more attractive to bank portfolios.

                                               Our base-case view remains that European policymakers will take substantive steps,
                                               potentially as soon as Greek elections conclude, to support the eurozone and calm
                                               markets. Should this occur, we would expect an environment more conducive to spread
                                               tightening.

     Medium term, we retain our             In summary, we believe that these factors all argue for tighter agency-Treasury spreads in
 tightening view on intermediate            the medium term, especially with 3y agencies approaching T+20bp and 5y approaching
          agency-Treasury spreads           T+30bp on a matched-date basis. Thus, investors seeking excess return in a high-quality
                                            Treasury surrogate might be well served by owning agencies instead, although we advise
                                            near-term caution as we acknowledge no lack of headwinds for all spread asset classes.

                                            Notably, while agencies have cheapened by about 5bp to swaps over the past two weeks,
                                            most USD covered bond names have cheapened by closer to 10bp (Figure 6). While we still
                                            believe Canadian and Australian covered bonds represent solid relative value to agencies at
                                            almost L+30bp and L+75bp in 5s, respectively, risk aversion and strains in market liquidity
                                            will almost assuredly affect valuations in this asset class as well.




Figure 5: YTD GSE debt shrinkage has been dramatic                       Figure 6: Covered bonds underperform
  Net issuance, $bn                                                       L Spd, bp
  YTD 2012                  ST     Bullet       Callable     Total         150
  FNM                       -65     -8             -9        -82           135
                                                                           120
  FRE                       -35     -15           -29        -78           105
  FHLB                       -9      4            -27        -32            90
                                                                            75
  Total                     -109    -19           -65        -193           60
  20 11                     ST     Bullet       Callable     Total          45
                                                                            30
  FNM                        -5     -15           -32        -52            15
  FRE                       -34      3            -20        -51
                                                                             0
                                                                           -15
  FHLB                       -4     -71           -29        -105          29-Feb-12 21-Mar-12 11-Apr-12     2-May-12 23-May-12
  Total                     -43     -83           -82        -208
                                                                                              ANZ      TD           NBHSS
                                                                                              BNP      FRE          EIB
Source: Barclays Research                                                Source: Barclays Research


1 June 2012                                                                                                                          12
Barclays | Global Rates Weekly


UNITED STATES: MONEY MARKETS

                                       Have US short-rate markets been immunized?
                       Joseph Abate    Despite considerable anxiety in Europe about the loop linking sovereign credit to bank
                    +1 212 412 6810    funding, there are few signs of stress in US short-rate markets. Have these markets been
      joseph.abate@barcap.com          inoculated by past crises?

                                          Interest rates, deposit flows and the usage of the Fed’s central bank liquidity facility are
                                          little changed in recent weeks, despite the flare-up in worries about European bank and
                                          sovereign risk.

                                          Since last year, money funds have sharply reduced their European bank exposures while
                                          shortening the tenors of this paper.

                                          Institutional prime fund balances are little changed. The most risk-averse investors
                                          appear to have left these accounts for bank deposits with unlimited insurance.

                                          However, there is some sign of emerging stress in unsecured funding markets – financial
                                          CP issuance tenors are shortening due to the European situation and the impending
                                          Moody’s credit ratings announcement.

                                          Amid rigorous regulatory scrutiny, fund managers have a strong incentive to keep
                                          WAMs short and trim exposures to distressed or downgraded banks to forestall an
                                          attention-grabbing surge in redemptions.

                                       However, we do not believe the lack of current strains implies that short-rate markets are
                                       immunized from European distress. Instead, they may be in a holding pattern, and, similar to past
                                       financial shocks, we expect money fund redemptions to pick up, bill rates to fall, and unsecured
                                       funding markets to become more difficult for some borrowers – perhaps as soon as this month.

                                       Where is the stress?
  There are few signs of stress in     Despite growing anxiety about Greece’s future in the euro, loan losses at Spanish banks, and
               short-rate markets      sovereign debt auctions in Europe, US money markets are little changed since March.
                                       Collateral and bill rates have been hovering around current levels for weeks. These have


Figure 1: 3m LOIS (bp)                                                Figure 2: Taxable money fund regional exposures (% total
                                                                      assets)

 65                                                                      20
                                                                         18
 60
                                                                         16
 55                                    1y forward                        14
 50                                                                      12
                                                                         10
 45
                                                                           8
 40                                                                        6
                                           Spot                            4
 35
                                                                           2
 30                                                                        0
 25                                                                              May-11        Jan-12       Feb-12       Mar-12        Apr-12
  Jan-12       Feb-12       Mar-12    Apr-12      May-12                                                Fr & Ger   Non-Eur

Source: Bloomberg                                                     Note: Non-Europe includes Canada, Australia and Japan. Source: imoney.net,
                                                                      Barclays Research

1 June 2012                                                                                                                                        13
Barclays | Global Rates Weekly


                                             traded heavy as supply distortions from the Fed’s Operation Twist asset sales caused funding
                                             congestion on dealer balance sheets. Spot Libor and LOIS are unchanged – 3m Libor has
                                             hardly moved since mid-April and LOIS has lingered around 31bp for weeks (Figure 1).
                                             Interestingly, as a measure of bank credit stress, forward LOIS suggests that the markets are
                                             looking for strains to pick up in the future – but not within the next three months. 2

                                             Likewise, money fund balances are unchanged. Flight-prone institutional investors have
                                             been content to stay in prime funds, and there has not been a “flight-to-quality” driven
                                             surge in super-safe government-only money fund balances. Moreover, usage of the Fed’s
                                             central bank liquidity swap program remains light: as of last week, less than $30bn was
                                             outstanding in this program, where, for instance, a European bank can pledge €-
                                             denominated collateral at the ECB and receive dollars in return. Last year’s crisis pushed
                                             usage of this facility to over $100bn. 3

                                             Beyond the widening in forward LOIS and the increase in the cross currency dollar swap,
                                             short-rate traders might be forgiven for wondering if this year’s financial crisis is different
                                             from those in 2010 and 2011.

                                             The case for immunity
                                             Indeed, the absence of a sharper reaction in short-rate markets might suggest that past euro
                                             risk flare-ups have changed investor behavior and inoculated short-rate markets, rendering
                                             them immune to the current turbulence.

       The regional distribution of          Money market funds have sharply reduced their European bank exposures while shortening
               money fund assets             the tenors of this paper. According to a recent Fitch study, European exposures in the
                      has changed            largest prime money funds have shrunk from 50% of assets in May 2011 to just 30% at the
                                             end of April 2011. 4 When this is extrapolated to the overall size of prime funds, European
                                             exposures fell from $825bn in May 2011 to $430bn in April 2012. Although money fund
                                             holdings continue to be heavily skewed toward non-US assets, most of their non-US
                                             exposure is to a handful of countries outside the eurozone such as Canada, Australia, and
                                             Japan (Figure 2). These exposures have grown rapidly since May 2011, rising from $274bn
                                             and 11.7% of overall taxable money fund assets to $430bn and 18.8% in April 2012. By
                                             contrast, money funds have sharply trimmed their exposures to French banks, which were
Figure 3: Institutional money fund balances (Dec 2010 =100)                          Figure 4: Daily CP issuance (% longer than 80d, 15d mave)


 120                                                                                      90

 115                              Gov-only                                                80

 110                                                                                      70
                                                                                          60
 105
                                                                                          50
 100
                                                                                          40
  95
                                             Prime                                        30
  90
                                                                                          20
  85
                                                                                          10
  80
                                                                                           0
   Dec-10 Mar-11        Jun-11    Sep-11 Dec-11 Mar-12
                                                                                           Jan-10         Jul-10        Jan-11        Jul-11         Jan-12

Source: imoney.net, Barclays Research                                                Source: Federal Reserve, Barclays Research

                                             2
                                               For more on this phenomenon, please see “Will the tail wag the dog?” Market Strategy Americas, May 25, 2012.
                                             3
                                               Usage of the facility is limited by the amount of available collateral that banks can pledge. Thus, with nearly €1trn already
                                             pledged to the ECB backing the 3y LTROs, European banks may not have much left over to access the dollar swap.
                                             4
                                               See Money Fund Exposure and European Banks: Holding Pattern, Fitch Ratings, May 23, 2012.

1 June 2012                                                                                                                                                              14
Barclays | Global Rates Weekly


                                     at the center of last year’s financial crisis. Over May 2011 to April 2012, taxable money fund
                                     holdings of French bank paper fell from $233bn (with a 43d weighted average maturity) to
                                     $118bn (with a 5d WAM). Most of this exposure (70%) is secured against government,
                                     agency or MBS collateral in the repo market. Money funds abandoned their exposure to
                                     Spanish and Italian institutions in early 2010, and German exposures are largely unchanged
                                     in the past year. Indeed, across the industry’s five largest exposures, two are Canadian
                                     banks, and the rest are UK, Australian, and Swiss banks.

                                     Thus, to the extent that the risk flare-up remains a euro-specific issue, money fund
                                     diversification away from core Europe could provide some degree of immunity.

                                     Nervous Nellies?
           The most risk-averse      The recent stability in money fund balances – particularly institutional balances – may reflect
              investors may have     a change in the risk tolerances of investors. Last year’s credit flare-up prompted institutional
       already left money funds      investors in prime funds to redeem shares. Institutional balances fell nearly 20% (over
                                     $200bn) by the end of the year (Figure 3). Some of these moved into super-conservative
                                     government-only money funds, but given the availability of unlimited FDIC deposit insurance
                                     on non-interest bearing transactions accounts, we suspect that some moved into US bank
                                     deposits. But as Figure 3 illustrates, even with the return of “risk on” sentiment and a decline
                                     in funding market anxiety, while government-only money fund balances shrank, institutional
                                     money did not return to prime funds. Instead, despite a few ups and downs, institutional
                                     prime fund balances are largely unchanged since January.

                                     It is possible that the most nervous investors have already left the sector, leaving behind
                                     more risk-tolerant ones in prime funds. These remaining investors may be less sensitive to
                                     the headlines from Europe and, therefore, less flight prone. In turn, money fund managers
                                     may be feeling a little more confident about their European exposures, as they are not
                                     petrified that a wave of investors was gearing up to redeem from one day to the next.

                                     Of course, while risk tolerances among money fund investors may have increased somewhat
                                     since last summer, it is unlikely that these institutions – whose dominant concerns are
                                     principal protection and liquidity – are oblivious to developments abroad.

                                     Calm before the storm
         Short-rate markets are      The departure of “nervous nellies” from prime funds and the diversification of money fund
              in a holding pattern   assets away from core European banks may have reduced the sensitivity of short-rate
                                     markets to the current strains in the eurozone, but it has not entirely “immunized” the
                                     sector. Instead, we suspect money markets and short-term investors are in a holding
                                     pattern, waiting for additional information – particularly the outcome of the Greek elections
                                     and the Moody’s ratings review of banks with global capital market businesses in mid-
                                     June. 5 In light of recent news about bank losses related to poorly executed hedges, we
                                     expect the downgrades to be similar in scale to what Moody’s outlined back in February –
                                     that is, there seems to be less chance the rating agency will be forgiving and either pass
                                     over or lightly downgrade the 17 banks on review.

      Funds are unwilling to roll    That said, there are some signs of stress in unsecured markets. Significantly, the percentage
               unsecured funding     of daily financial issuance with a tenor longer than 80 days has fallen from 70% in mid-April
                   past mid-June     to less than 35% in late May (Figure 4). Although overall money fund WAMs are unchanged
                                     (as are their 7d liquidity buffers), there is evidence that funds are keeping a tight leash on



                                     5
                                      See Money Markets: Short-term ratings implications, February 21, 2012, and “Moody’s downgrade and money fund
                                     behavior,” Market Strategy Americas, April 26, 2012.

1 June 2012                                                                                                                                      15
Barclays | Global Rates Weekly


                                     their unsecured exposures and have become increasingly unwilling to roll paper beyond
                                     mid-June.

                                     Increased scrutiny
              Funds seek to avoid    At the same time, we suspect that regulatory scrutiny may increase the propensity for money
              regulatory attention   fund managers to “pull funding and ask questions later” to forestall investor redemptions.
                                     Although the SEC’s proposed reforms seem stalled in political limbo, regulators at the Federal
                                     Reserve in particular remain concerned about the propensity of institutional investors to flee
                                     funds perceived to have too much principal (or liquidity) risk. As a result, money fund
                                     managers are especially sensitive about avoiding any attention-grabbing destabilizing surge
                                     in investor redemptions. They may not feel that the extra few basis points (over overnight
                                     repo) are worth the risk of increased regulatory scrutiny and potentially significant industry-
                                     wide reforms. Thus, in an effort to stay below the regulatory radar screen, fund managers
                                     have a strong incentive to let their bank credit exposures run down, replacing them with
                                     secured repo (or AB-CP) or shortening the tenor to a few days at most in an effort to keep
                                     redemptions light. From the perspective of regulators – including those at FSOC – the issue is
                                     less that the money fund industry has “survived” successive financial market stresses in 2010
                                     and 2011 without government intervention, but instead the fact that the industry is
                                     constantly being tested by flight-prone investors with extremely low risk tolerances.

                                     Déjà vu?
                                     We believe the stress in European markets will eventually spill over into US short-rate
                                     markets. Like the crises in 2010 and 2011, we expect bill and repo rates to richen (decline)
                                     and credit spreads (CP and bank deposits) to widen alongside LOIS and Libor, given an
                                     increase in money fund redemptions. Depending on how nervous the credit ratings news and
                                     European credit market developments make money funds investors, bill and repo rates could
                                     rally 5-10bp. At the same time, unsecured funding will likely become more strained for
                                     certain eurozone banks and money funds will shift more of their already declining eurozone
                                     counterparty exposures to Australian, Canadian, Japanese, Scandinavian and UK banks. Like
                                     last fall, their short-term unsecured funding rates could trade 25bp under Libor.

         A rally in bills and repo   However, any rally in bill and repo rates could be short-circuited by the Fed via sterilized QE
        could be short-circuited     operations. Our economists do not believe that sterilized QE is likely. But the market
              by Fed-sterilized QE   continues to look for some QE from the Fed, and this is a reason why Treasury 2y notes are
                                     trading near 30bp. Stimulus expectations now seem centered on developments in Europe
                                     and the fear that US financial markets (mainly equities) could suffer from contagion effects
                                     that hurt domestic growth and exports. Of course, the latter argument ignores the fact that
                                     the Fed has a more direct tool for addressing the bank funding – the central bank liquidity
                                     facility – and, at least for the moment, stock prices are up on the year. But to the extent that
                                     the market prices in some probability of sterilized QE, repo and bill rates should remain
                                     biased higher – to 20-25bp (in the absence of any significant flight-to-quality bid).




1 June 2012                                                                                                                       16
Barclays | Global Rates Weekly


UNITED STATES: INFLATION-LINKED MARKETS

                                              Signs of risk off, but not in the usual suspects
                      Michael Pond            Over the past month, 5y5y breakevens, floor values, and 10y relative ASWs have not
                  +1 212 412 5051             shown elevated signs of stress, while other inflation market measures, such as the 30y
      michael.pond@barcap.com                 relative ASWs, have. We recommend selling 5y5y versus 10y10y forward breakevens.

                                              Markets have been in risk-off mode over the past several weeks and breakevens, particularly
                      Chirag Mirani
                                              at the front end, have fallen as a result. We continue to believe that although breakevens are
                  +1 212 412 6819
                                              cheap to fundamentals, we would not recommend longs at this point because of downside
      chirag.mirani@barcap.com
                                              risks and uncertainty. The past several days, where 10y breakevens have fallen by 15bp
                                              over a few days, illustrate why we are of this view. Real yields have also fallen, suggesting a
                                              flight to safety and concerns about growth in a world with a small global pool of safe assets.
                                              Spot real yields are negative out to the TIApr29s and, importantly, forward real yields have
                                              declined sharply and the 5y5y real yield has gone negative for the first time (Figure 1).

    5y5y forward real yields have             In past risk-off environments, we have also seen moves in other sectors of the inflation
          now gone negative, with             market. In late summer of 2010 and fall of 2011, the 5y5y forward breakeven fell below 2%
    increased risk aversion and a             - it now stands at 2.41% and is up 8bp since mid-May. Similarly, when investors are flocking
  small global pool of safe assets            to nominals in a flight to liquidity TIPS tend to underperform nominals on an ASW basis and
                                              relative ASWs tend to widen as they did in mid-2010 and Q3 2011 (Figure 2). Instead the
                                              10y relative ASW has declined recently. Another response in past risk off episodes has been
                                              an increase in deflation floor values as inflation expectations declined and the desire for
                                              downside protection increased. Defying this historical reaction function, 5y and 10y floor
                                              premiums have increased only slightly recently (Figure 3).

                                              We believe these three measures have not reacted as they have historically because of market
                                              sentiment on the Fed and post auction flows at the 10y point. Regarding deflation floors, it is
                                              likely that the Fed gained credibility as a deflation fighter because of its sharp reaction to
                                              deflation pressures over the past several years. This does not mean the market will necessarily
                                              stay less concerned about deflation, but perhaps the bar is higher because of the Fed’s response
                                              function to below desired inflation. We expect that if risk aversion continues, deflation floor
                                              values would rise and we continue to recommend TIIApr17s versus TIIJan17s and TIIJul17s.


Figure 1: 5y5y real and breakeven rates                                     Figure 2: 10y relative ASWs

 3.5%                                                                         70

 3.0%                                                                         60
 2.5%                                                                         50
 2.0%
                                                                              40
 1.5%
                                                                              30
 1.0%
                                                                              20
 0.5%
                                                                              10
 0.0%
    Mar-10         Sep-10        Mar-11        Sep-11       Mar-12            0
                                                                              Mar-10         Sep-10     Mar-11      Sep-11     Mar-12

                            5y5y real yield       5y5y BE                                               10y Relative ASWs
Source: Barclays Research                                                   Source: Barclays Research


1 June 2012                                                                                                                                17
Barclays | Global Rates Weekly



                                            Figure 3: 5y, and 10y deflation floor premiums (% of notional)

                                              1.8%
                                              1.6%
                                              1.4%
                                              1.2%
                                              1.0%
                                              0.8%
                                              0.6%
                                              0.4%
                                              0.2%
                                              0.0%
                                                 Mar-10                 Sep-10                Mar-11                Sep-11           Mar-12

                                                                                             5y         10y
                                            Source: Barclays Research


Increased risk aversion will likely         While 10y ASWs have fallen recently, most relative ASWs are much wider than they had
       mean an increase in Apr17            been a month ago. This could be because investors within the TIPS market are moving
     floors; we recommend being             toward the more liquid points. Market participants who missed in the strong 10y TIPS
           long Apr17-versus Jan17s         reopening in May have been buying the 10y point since and this is richening up the 10y
                                            point. We had recommended holding 10y TIPS versus nominals on ASW – we now
                                            recommend exiting this trade because of expectations that the 10y point will follow the rest
                                            of the curve unless risk sentiment improves quickly.

 The -21bp spread between 5y5y              This richening of the 10y sector can also be seen in spreads of forward breakevens. One
and 10y10y breakevens does not              could argue that the Fed has gained credibility as an inflation targeter and thus forward
  make fundamental sense to us              breakevens should not fall in risk-off episodes as they have in the past. But if this is correct,
           at these breakeven levels        longer forwards should move even less. While 5y5y breakevens remain above 2.40%, the
                                            10y10y breakeven fell to near 2011 lows and hit an all-time low relative to the 5y5y this
                                            Thursday. The -21bp spread between 5y5y and 10y10y breakevens does not make
                                            fundamental sense to us at these breakeven levels. Instead we believe the decline in the
                                            spread has been driven by post-auction/month-end flows that are likely to reverse in the
                                            coming months. For example, the spread between 10y10y and 5y5y CPI swaps has

Figure 4: TIPS relative ASWs                                                     Figure 5: 5y5y versus 10y10y and 10yf20y breakevens

  40                                                                                60
                                                                                    50
  35
                                                                                    40
  30                                                                                30
                                                                                    20
  25                                                                                10
                                                                                     0
  20
                                                                                   -10
  15                                                                               -20
                                                                                   -30
  10                                                                               -40
       0          5         10         15        20         25          30         19-Apr-10       19-Oct-10   19-Apr-11     19-Oct-11   19-Apr-12
               May 30 Rel ASWs curve        Apr30 Rel ASWs curve                                  10y20yBE-5y5yBE            10y10yBE-5y5y BE
Source: Barclays Research                                                        Source: Barclays Research


1 June 2012                                                                                                                                          18
Barclays | Global Rates Weekly


   We believe the decline 10y10y      narrowed only 10bp over the past month while, the 10y10y and 5y5y cash BE spread has
     versus 5y5y BE is technical in   narrowed about 30bp, which suggests that up to 20bp of the recent spread narrowing in
nature and recommend fading it        the 10y10y-5y5y BEs could be bond sector liquidity/supply related. Therefore, we
                                      recommend fading the recent drop by going long 10y10y breakevens versus 5y5y
                                      breakevens with an expected holding period of 3m. We use an entry level of -20bp (to
                                      account for bid/offer) with a target of 0bp and stop of -35bp. Please see Figure 6 for a 25K
                                      DV01 trade setup.

Figure 6: Recommendation – Short 5y5y versus long10y10y breakeven trade details, as of June 1 , 2012 (10:00am levels)
Long10y10y versus
Short 5y5y 25K DV01                    TIPS Notional    Nominal Notional      DV01           TIPS Security      Nominal Security

Long 20y BE                            $23,705,437        -$29,076,145        50871       TII 2 1/2 01/15/29   T 5 1/4 02/15/29
Short 10y BE                           -$65,123,601       $73,335,878        -67420       TII 0 1/8 01/15/22     T 2 02/15/22
Long 5y BE                             $39,139,968        -$41,401,206        16549       TII 0 1/8 04/15/16     T 2 04/30/16
Long 10y10y BE                             2.21
Short 5y5y BE                              2.41
Long 10y10y BE Short 5y5y BE Spread        -20
Source: Barclays Research




1 June 2012                                                                                                                        19
Barclays | Global Rates Weekly


UNITED STATES: VOLATILITY

                                                      Buy 10y-30y digital floors
                                      Piyush Goyal    We discuss a few strategies to protect against a worsening of the Eurozone crisis. In our
                                 +1 (212) 412 6793    view, 1y digital floor on 10y-30y curve @ 25bp offers attractive risk reward for those
                    piyush.goyal@barcap.com           who believe the curve can flatten dramatically alongside lower yields in a crisis.

                                                      Receiver spreads on 30y swaps
                                                      This is an obvious choice, in our view, as Treasuries will likely gain from a flight-to-quality
                                                      bid if the European situation worsens. However, yields are already very low and short-dated
                                                      volatility quite high to benefit from receiver spread.

                        CMS floor spread is better    As an example, a 1y*30y ATM versus 50bp receiver spread has a risk reward of only ~1:2.3,
                             than receiver spread     which is not attractive enough. CMS floor spreads improve the risk reward marginally, but
                                                      not by an adequate amount. For example, 1y SL 30y CMS floor spread has a risk-reward of ~
                                                      1:2.7 (Figure 3).

                                                      10y-30y curve floor spread
                                                      While yields have fallen, the long-end curve has held on to lofty levels. A further
                                                      conspicuous decline in yields, presumably due to a Eurozone crisis, would likely be led by
                                                      the long end, ie, a richer and flatter curve.

                                                      In fact, that is how the volatility market is positioned. 3m*30y swaptions are priced at about
                                                      a 24% premium to 3m*10y swaptions. This means that long-end swaps are expected to
                                                      move 24% more than 10y swaps in the near term. And, if the Japanese experience is any
                                                      guide, the 10y-30y curve can be a lot flatter for a further large decline in yields (Figure 1). As
                                                      a result, owning floors on 10y-30y curve could be profitable in a crisis, in our view.




Figure 1: JPY 10y-30y curve tends to flatten with lower rates                        Figure 2: The curve is flatter in forward swaps

                    140                                                                                          70
                                                                                                                          64
                    120                                                                                          60
                                                                                       10y-30y swap curve (bp)




                                                                                                                                         50
                    100                                                                                          50
  JGB 10-30y (bp)




                    80                                                                                           40

                    60                                                                                           30

                    40                                                                                           20

                    20                                                                                           10

                    -                                                                                            0
                          0.50       1.00     1.50     2.00      2.50      3.00                                       0        0.5   1        1.5      2   2.5   3
                                                 JGB 30y                                                                             forward start (yrs)

Note: Data period: January 1, 2011 to May 30, 2012. The chart plots the 10y-30y      Note: As of May 31 2012. Source: Barclays Research
Treasury curve in Japan versus the level of 30y Treasury yields. This chart
suggests that at c. 2.5% on 30y yields, which is approximately the current levels
of US bonds, the 10y-30y curve has been 40-110bp. Source: Barclays Research


1 June 2012                                                                                                                                                      20
Barclays | Global Rates Weekly



                                              10y-30y digital curve floor
              Digital 10y-30y curve           One problem with any curve flattener is the curve is already flatter in the forward space
                floors are good too           (Figure 2). For example, the 1y forward 10y-30y curve is 50bp, even as the spot curve is
                                              64bp. So, a curve floor would have to beat the expectations in addition to the cost of the
                                              floor/floor spread to garner any gains.

                                              A digital floor can improve the risk reward. For example, a 1y*(10y-30y) 50 versus a 25bp
                                              curve floor spread costs 6 cts and has a maximum gain of 25 cts, implying a risk reward of
                                              1:4+. However, the 1y*(10y-30y) 25bp digital curve floor has a risk reward of ~1:6.
                                              Essentially, in exchange of the strike risk, the digital floor improves the risk reward by a
                                              significant amount.

                                              Figure 3 lays out the structure, cost, and risk reward for each of the above-mentioned
                                              strategies. However, there are a few other considerations for each strategy.

Figure 3: The digital curve floor has the best risk reward, though has strike risk
                                             Notional spot         fwd       strike 1    Strike 2 cost (cts)       cost (bp)    max gain (bp)       risk-reward

1y*30y receiver spread                       $100mn      2.30%     2.39%      2.39%       1.89%          465           21.5            50.0             1:2.34
1y SL 30y CMS floor spread                    $100mn     2.30%     2.39%      2.39%       1.89%           19           18.5            50.0              1:2.7
1y SL 10y-30y curve floor spread              $100mn       64         50         50         25            6             6              25.0              1:4.2
1y SL 10y-30y digital curve floor             $100mn       64        48.4       25.0                      2            1.6             10.0              1:6.1
Note: As of June 1 2012. Source: Barclays Research


                                              CMS Floor spread is better
Investors who are not convinced               Despite the higher risk reward, the curve floor is not appropriate for investors who do not
   of curve flattening should stick           believe in meaningful curve flattening, even in a crisis. Figure 3 suggests that 10y-30y swaps
             with CMS floor spread            need to flatten 1bp for every 2bp decline in 30y swaps to be neutral between a receiver
                                              spread and a curve floor spread 6 . While possible, as the past episodes of crisis suggest given
                                              the Fed’s efforts to fight deflation and fiscal risk premium, the curve may resist flattening.
                                              Investors not convinced of flattening even in much lower rates should therefore limit their
                                              choices to a receiver spread and a CMS floor spread. We suggest the latter, as it has a
                                              slightly better risk-reward: 1:2.34 versus 1.27.

                                              However, it is pertinent to understand the source of the better risk-reward. The CMS floor
                                              spread is cheaper than the swaption receiver spread (and therefore has better risk-reward)
                                              because CMS swap rates are higher than vanilla swap rates, due to positive convexity in
                                              swaps. For example, the 1y30y swap rate was ~2.47% as of May 31, 2012, while the 1y 30y
                                              CMS rate was 2.61%; the difference, called convexity adjustment, is 14bp. The convexity
                                              adjustment is a function of volatility – higher volatility means higher adjustment. Currently,
                                              volatility is high, so the adjustment is as well (Figure 4).

                                              From the perspective of an investor in CMS floor spread, this convexity adjustment
                                              cheapens the cost of the hedge. So, the 1y SL CMS floor spread costs lesser than 1y*30y
                                              receiver spread for the same strikes (1y*30y 2.39 versus 1.89 receiver spread costs 465 cts,
                                              while the dv01-weighted 1y SL 30y 2.39 versus 1.89 floor spread costs only 400 cts.). This
                                              means a better risk reward.



                                              6
                                                1y30y receiver spread would generate the maximum gains of 30y swap rate declines by ~40bp. 1y 10y-30y curve
                                              floor spread would generate the maximum gains if 10y-30y curve flattens by ~ 40bp. However, the latter has almost
                                              twice the risk reward. So, 1bp flattening for 2bp decline in rates makes an investor neutral between the curve floor
                                              spread and receiver spread.

1 June 2012                                                                                                                                                          21
Barclays | Global Rates Weekly



Figure 4: CMS adjustment in 1y30y swaps is high, due to vol                 Figure 5: 10y-30y swap curve is historically steep

   40                                                                         120
   35                                                                         100

   30                                                                          80
                                                                               60
   25
                                                                               40
   20
                                                                               20
   15
                                                                                0
   10
                                                                              (20)
      5                                                                       (40)
  -                                                                             May-94        May-98        May-02        May-06         May-10
      Jan-04        Jan-06          Jan-08         Jan-10       Jan-12                                   10y-30y swaps
                                                                                                         avg since '94 = 40bp
                           Actual            Regression Value                                            avg during 2008 crisis = -1bp

Note: Data period: January 2004 to May 2012. The chart shows the actual     Note: Data period: May 1994 to May 2012. Source: Barclays Research
convexity adjustment in 1y30y CMS swaps and the value determined by 1y
rolling regression with 1y*30y vol. Source: Barclays Research



                                              Digital curve floor is the best
                                              However, investors who, like us, believe the curve could be flatter if rates rally a large
                                              amount, a digital curve floor is the best. The risk reward is conspicuously higher, though it is
                                              vulnerable to the curve level on expiry.

 For those who, like us, think the            We feel comfortable with 25bp for the curve, as it was in the negative territory during the
 curve could flatten, digital curve           last crisis (Q4 08). However, a repeat of an inverted 10y-30y curve may not happen this
                 floors are the best          time, as 10y-30y exotic note hedging, which was a factor at the time, is no longer a driver.
                                              Further, the digital curve floor would gain on a mark-to-market basis in a similar manner to
                                              a curve floor spread until the curve flattens through the strike. The average curve levels over
                                              the past 15 plus years has been 40bp, which means the digital floor would most likely be
                                              away from the strike under "average" circumstances and be able to gain from subsequent
                                              curve flattening.




1 June 2012                                                                                                                                       22
Barclays | Global Rates Weekly


EURO AREA: RATES STRATEGY

                                               A Greece exit is not fully priced into rate markets
                  Laurent Fransolet            This article was previously published in Euro Themes: Risks and repercussions of a Greek exit, 31
              +44 (0)20 7773 8385              May 2012
   laurent.fransolet@barcap.com
                                               The impact on interest rate markets of Greece exiting the EMU is likely to be significant. We
                                               would expect money markets to suffer a renewed bout of stress, with Italy and Spain bonds
                                               likely selling off aggressively, despite any policy responses that would be introduced.

                                               In our view, it is clear that a Greece exit is currently not fully priced into rate markets. Should
                                               it become clearer that this is going to happen, we would expect large knee-jerk reactions in
                                               money markets and EGB markets. The breadth and forcefulness of policy reaction would
                                               define how much and how fast these reactions last.

                                               Money markets: ECB to increase intermediation role further
        Money markets would re-                Since 2007, euro money markets have experienced sea changes in their functioning, with a sharp
   segment even more than now                  reversal of cross-border flows, an increased focus on credit and counterparty risks, lower
                                               volumes and a very large domestic re-segmentation of these markets. Two factors have helped
                                               keep some money markets from disappearing completely: the move towards repos, in particular
                                               those settled at central clearing counterparties (CCPs), and the massive re-intermediation
                                               provided by the ECB, on demand, against an ever broader set of collateral and for ever longer
                                               maturities. At this stage, it is fair to say that the vast majority of peripheral banks’ money market
                                               funding comes from the ECB (€315bn for Spain, €270bn for Italy), with only the top-tier banks
                                               retaining access to small amounts of market-based CCP repo funding (€60bn at most for Spain,
                                               €90bn for Italy as at end April), at typical maturities of up to one month.

    The ECB would have to be the               A Greece exit, triggering rating downgrades for other peripheral countries (and thus their
main wholesale liquidity provider              banking systems), would likely make the remaining short and long wholesale funding for
         to the banking systems in             peripheral banks disappear, and leave the ECB as the single funding source for the vast
              peripheral markets…              majority, if not all, of these banks. This would be exacerbated further should deposits
                                               decline at an increased rate on the back of redenomination risk: these would have to be
                                               compensated by increased ECB reliance as well, and probably in much larger amounts,
                                               given the current size of deposit bases in peripheral markets (around €4trn).

Figure 1: The ECB has been intermediating money markets                        Figure 2: Money markets have been less subject to volatility
(gross ECB borrowing by banking system, EUR bn)                                recently

 600                               AT, BE, NE, LUX, FI, Others                  300                             3m EUR/USD basis, inverted,(bp)
                                   Germany
                                   Ireland                                      250                             3m FRA/OIS (bp)
 500
                                   France
                                   Spain                                        200                             1m Italy GC vs eonia (bp)
 400                               Italy
                                   Greece                                       150
 300                               Portugal
                                                                                100
 200
                                                                                  50

 100                                                                               0

    0                                                                            -50
    Jan-08    Oct-08     Jun-09     Mar-10 Nov-10         Jul-11   Apr-12          Jan-08      Nov-08      Oct-09   Aug-10      Jul-11      May-12

Source: Barclays Research, national central banks                              Source: Barclays Research


1 June 2012                                                                                                                                          23
Barclays | Global Rates Weekly


                   … but even in    In our view, banks that currently retain some access to euro area money markets (eg,
         non-peripheral markets     French banks via their CD programmes) would also likely be significantly affected by rating
                                    downgrades, increased counterparty defiance (reduced volumes, higher cost and haircuts),
                                    and reduced funding availability. Our expectation would be for further large declines in
                                    wholesale money market liquidity and availability.

  The ECB would have to provide     The ECB would, of course, stand ready to compensate this lost funding via additional LTROs
                 policy responses   at full allotment, but with the same drawbacks likely, as have occurred in peripheral markets
                                    in recent years. While money markets have stabilised (their reaction to the most recent
                                    volatility has been muted), it is essentially because the ECB has injected a lot of surplus
                                    liquidity and is providing a central intermediation role: the current market levels are
                                    representative of marginal trades with ‘good’ counterparties, and are not representative of a
                                    broader wholesale market, which in fact no longer exists.

                                    This process of ECB intermediation will, of course, also have the side effect of raising
                                    concerns about the ECB balance sheet (collateral, Target 2 exposures, addicted banks, etc).

  We would expect the following     In a Greek exit scenario, we would expect the ECB to cut all rates and inject a lot more
        moves in money markets      liquidity. In terms of market variables, we would expect the following:

                                       Eonia should move further down (and the Eonia curve flatten out for a longer period of
                                       time; maybe five years);

                                       GC repo spreads would likely widen for peripherals (1 month GC for Italy and Spain
                                       currently trade around 35bp), while the core GC will likely continue to trade well below
                                       Eonia (Germany is at 10-15bp). The widening might be limited because it would be on
                                       the back of less active markets, since a lot of the ‘risky’ repo funding would now be done
                                       at the ECB, rather than be market based.

                                       FRA-OIS (and other bases) spreads would likely widen back to around 60bp in 1y1y fwd
                                       maturities (their previous highs in 2008 and 2011), even if spot FRA-OIS might be kept
                                       tight by the absence of any kind of market.

                                       Cross currency bases would likely widen by a further 20bp or so, as they typically do
                                       when credit risk rises, even if the actual cross currency funding needs of a lot of
                                       European banks have been dramatically reduced in recent years (as evidenced by the
                                       limited take-up in USD ECB operations).

                                    Trade recommendations to manage risks of a Greece exit
                                    Our current preferred trade recommendations in the short end are still to keep FRA-OIS
                                    wideners (in Europe and the US) in 1y1y fwd. We would also recommend being short GC
                                    repos in Italy and Spain (currently round 35bp), as it is fairly asymmetric (it will likely not
                                    rally much, but if a Greece exit materialises, these rates would at least initially shoot up). As
                                    a hedge, we believe receiving short-term rates (say 2 or even 3-4y OIS) may also be
                                    profitable, although the profile of such a trade is less asymmetric than for the others, given
                                    the easing that is already priced in (1 year 3y fwd OIS is at 1%).

                                    EGB markets: Greece exit likely to trigger additional liquidation flows
                                    Peripheral markets
     The re-domestication trend     The European government bonds markets (EGBs) have already experienced massive
        would likely pick up pace   changes in the past few years, in terms of ownership (a clear re-domestication, across the
                                    board, with declines of foreign ownership of between 10-20pp in all peripheral countries
                                    over the past two years) and in terms of liquidity (a clear deterioration, or complete


1 June 2012                                                                                                                       24
Barclays | Global Rates Weekly


                                       shutdown in the case of the three smaller peripherals). In our view, a Greece exit would only
                                       push these trends to more extreme levels.

Smaller EGB markets will remain        It seems highly probable that in the case of a Greece exit, EGB markets in Portugal and
              virtually non existent   Ireland will remain virtually non existent, and that market access by these treasuries at
                                       longer maturities will be at best pushed back a few years, during which new financing will
                                       have to come from official sources. At worst, markets will start to discount more fully
                                       restructuring of these debts in the near term, or start to price the possibility of re-
                                       denomination, which would have a very large further impact on prices/yields.

            … and Spain and Italy      Spain and Italy would be the two main casualties: while yields in long maturities have
                        would suffer   already moved back up towards or above the 6% level, those at the short end have stayed at
                                       much lower levels, helped by the ECB LTROs. While further LTROs and SMP would be likely,
                                       they are unlikely to be keep yields down on a longer-term basis.

     The recent widening has not       Over the past few months, the moves in peripheral debt have occurred amid low liquidity
               really been driven by   and are no longer on the back of large liquidations by foreign investors in these markets.
              liquidations; any such   Given the poor liquidity and risk absorption of the markets currently, it is likely that any kind
   liquidations would push yields      of liquidations post a Greece exit announcement would have very large price effects (the
                       much higher     whole BTPs/SPGB curve moving way above 6.5%), even if the ECB intervenes. While the
                                       liquidation flows might be smaller than in H2 11 (positions are less overweight in Italy, and
                                       the foreign ownership has already declined significantly), the ECB interventions will also be
                                       less effective due to the implicit seniority of the ECB on these purchases since the Greek PSI.
                                       It is also worth noting that Italy, with around 40% of bonds still held by non residents, might
                                       be as much at risk as Spain, with only around 20% of non resident ownership, despite
                                       having fewer implementation risks on the banking/fiscal side.

                                       In our view, a Greek exit would raise the probability of Spain and Italy needing to get some
                                       official help, especially if current firewalls are not raised in the meantime.




Figure 3: Foreign ownership (ex ECB) of EGB markets has               Figure 4: Liquidations have been more limited recently: any
declined heavily recently, but liquidations have been limited         selling is likely to push yields much higher
recently

  90%                                              Greece               250     Yields            Spain 5y (5 days chg, bp) Net selling
                                                   Portugal             200     higher
                                                                                                  Flows+supply (RHS)
  80%                                              Ireland                       (bp)
                                                                        150
                                                   Italy
  70%                                                                   100
                                                   Spain
                                                                          50
  60%
                                                                           0
  50%                                                                    -50
  40%                                                                  -100
                                                                       -150     Yields
  30%                                                                           lower
                                                                       -200
                                                                                 (bp)                   3y LTRO (ann+all) Net buying
  20%                                                                  -250
     Sep-07       Sep-08      Sep-09   Sep-10     Sep-11                  May-11 Jul-11 Aug-11 Oct-11 Dec-11 Mar-12 May-12

Source: Barclays Research                                             Source: Barclays Research


1 June 2012                                                                                                                               25
Barclays | Global Rates Weekly


                                      Core countries
Core markets are unlikely to hold     As has been the case over the past few quarters, countries such as Belgium, France and
    up if Spain and Italy sell off…   Austria would also suffer to a certain extent: the relationship between spreads in these
                                      markets and peripheral spreads has not been constant over time, but it has been sufficiently
                                      present to likely have an effect going forward. Without direct ECB SMP support, and still
                                      high foreign ownership, these markets would likely be impacted strongly as well by non-
                                      euro area resident selling, and underperform versus Germany, probably by 100bp or more
                                      across maturities, in our view. While some of these markets have been popular shorts (eg,
                                      France), we believe the recent retightening to the past nine months’ tights provides
                                      attractive entry points for hedging against a Greece exit.

    CDS markets will move more        We believe CDS markets are likely to move broadly in line with bond markets, despite their
   quickly, as the investor base is   different supply/demand dynamics. Indeed, the CDS market shows a much higher
          more oriented towards       proportion of ‘fast money’ and ‘price takers’ (eg, banks CVA desks), while the bond market
                      ‘fast money’    has a higher proportion of long-term, less-active, holders.

          Germany would initially     A Greek exit would initially likely trigger a big flight to quality, and thus lead to an
  outperform, but not for long, in    outperformance of Germany, especially in bonds (ie, asset swap spreads would widen,
                         our view     yields would rally further). But this would likely be fairly short lived, as we would expect it be
                                      followed by subsequent moves towards mutualisation of the debt (or expectations thereof).
                                      Positioning for a cheapening of Germany in CDS allows one to be less exposed to the flight–
                                      to-quality risks, while benefiting from the latter concerns. Hence, we like buying protection
                                      on Germany in CDS.

                                      Eurobonds/Euro T-bills: a move towards debt redemptions plans likely
         Some progress towards        Talks about a Eurobond/euro T-bills are likely to accelerate in the coming quarters,
     mutualisation of debt would      especially if Greece leaves the EMU, as substantial firewalls, or mechanisms to help Italy and
                          be likely   Spain in particular would be needed. In our view, Eurobonds still face important (political)
                                      challenges before being introduced. In contrast, we believe a more limited scheme like the
                                      German-proposed debt redemption fund, or an alternative to it in the form of the T-bill
                                      redemption fund could be developed relatively quickly (the initial ERF proposal envisioned a
                                      a set-up period of less than six months), without probably necessitating a lot of the legal
                                      changes that fully fledged Eurobonds would require.

                                      Rates: already very low, but…
  Rates would likely rally, maybe     There is no doubt that a Greek exit would have a very significant knock-on effect on the
                    by up to 50bp     euro area economy and thus drive a very accommodative policy from the ECB for a very
                                      long period of time. All OIS/swap rates would likely rally further in such an environment,
                                      maybe by up to 50bp. But given the current levels of yields (around 50-90bp above
                                      Japanese swap rates), being long rates is far from being an asymmetric trade. There would
                                      also likely be some expectations that inflation will be allowed to run slightly higher than
                                      hitherto, which may have a negative impact on post-five year rates once the initial flight-to-
                                      quality rally has taken place.

 Rather than being outright long,     Currently, the market is pricing in roughly a 50% chance of an ECB rate cut in H2 12, and
    we prefer being long 5s vs 2s     then rates on hold until end 2013, with the curve starting to steepen (and reflect chances of
                  and 10s, 1y fwd     rate hikes, or higher term premium) from 2014 onwards. At the longer end, we estimate
                                      that the 5y5y fwd rates is already about 65bp below the low end of the range we would
                                      expect based on: 1) the level of short end rates (which are broadly fair versus our base-case
                                      monetary policy expectation or the next two years); and 2) medium-term nominal growth
                                      expectations of 3% (a fairly unchallenging 2% inflation, 1% real growth). Post 10y rates are
                                      already well below that (15y15y fwd at below 2%).

1 June 2012                                                                                                                          26
Barclays | Global Rates Weekly


                                 On a Greece exit, a knee-jerk reaction would likely push all yields lower, as we would expect
                                 large medium-term GDP losses (5y5y fwd should move about one–for-one with moves in
                                 medium-term nominal growth expectations according to our models). But in outright and
                                 RV terms, the 5y sector is likely to benefit the most, in our view.

                                 We like receiving the 5y sector versus 2 and 10s 1y fwd: this should benefit from low rates
                                 for long, but is not too exposed to the 10y sector rates. On an outright or asset swap basis,
                                 in the case of a Greece exit, we believe that UK or US rates would perform better than
                                 German ones, as the policy response from the Bank of England or from the Federal Reserve
                                 are likely to involve some renewed quantitative easing/bond buying.




                                 Figure 5: Medium-term EUR swap forward rates are already at very low levels

                                    11                            EUR 5yr5yr
                                    10
                                                                  Model for OIS 5y5y (1999 to Apr11)
                                     9
                                                                                       Current fair value and range
                                     8                                                 based on LT nominal growth
                                     7
                                     6
                                     5                                                                                4.04% FV for
                                                                                                                      3.20% growth
                                     4
                                     3
                                                                                                                      2.85% FV for
                                     2                                                                                2.70% growth
                                         91    93      95    97    99     01    03     05    07        09   11

                                 Source: Barclays Research


1 June 2012                                                                                                                          27
Barclays | Global Rates Weekly


EUROPE: MONEY MARKETS

               Giuseppe Maraffino          Market has brought forward expectations of ECB cut
              +44 (0)20 3134 9938
giuseppe.maraffino@barclays.com            While remaining on hold, the ECB is very likely to leave the door open to a rate cut at
                                           next week’s meeting. The market has already brought forward its expectations of a rate
                  Laurent Fransolet        cut, but dovish comment should support a further short rates rally.
              +44 (0)20 7773 8385
                                           With the ECB being the only euro institution that can react quickly to market turmoil, all eyes
 laurent.fransolet@barclays.com
                                           next week will be on the ECB’s meeting (on Wednesday, 6 June). Since the previous meeting,
                                           on 3 May, market sentiment and growth prospects have significantly deteriorated and
                                           inflation has moderated. Furthermore, April M3 data failed to provide strong evidence of
                                           improvement in the lending to the economy. As a consequence, with investors in a risk-off
         Sharp deterioration of the        mode, the liquidity in the EGB market has crumbled, with a consequent increase in volatility.
     eurozone crisis over the past         However, it is worth noting that the tensions in the EGB market have not affected the euro
                               month       liquidity markets, which have been insulated by the 3y liquidity provided by the ECB.
                                           Unsecured rates (Euribor, CD rates) have continued to decline and in the repo market, GC
                                           rates for Italy and Spain have remained broadly stable (with some increase over the past few
                                           days, not followed, however, by signs of tensions in the liquidity market).

 We expect the ECB to remain on            Despite the sharp worsening of the situation, we do not expect the ECB to announce any
  hold but to leave the door open          particular measures on policy rates and on liquidity measures at next week’s meeting. We
                              to a cut     believe that they will prefer to wait for the June events (Greek elections, Parliamentary
                                           elections in France, Ecofin meeting) before announcing the next monetary policy steps. It is
                                           very likely, however, that due to a worsening of the economic outlook, they will leave the
                                           door open to a policy rates cut. In this respect, the downward revision of the
                                           growth/inflation forecasts in the usual quarterly update will provide the opportunity to
                                           signal to the market the shift towards an easing bias.

                                           Still, at the June meeting, the ECB is expected to announce its decision on the full allotment
                                           that will expire in mid-July. The extension of the unlimited funding for European banks
                                           should not be a surprise to the market. We expect the extension to at least the end of the
                                           year (or even longer due to the critical situation in the eurozone). Indeed, even if almost

Figure 1: Sharp fall in the Eurozone PMIs                                Figure 2: Stable repo market rates (bp)

  2.0                                                                      120                       1M GC rate vs eonia - Italy
  1.5                                                                      100
  1.0                                                                       80
  0.5                                                                       60
  0.0
                                                                            40
 -0.5
                                                                            20
 -1.0
                                                                             0
 -1.5
 -2.0                                                                      -20

 -2.5                                                                      -40                                  First 1y LTRO
                Real GDP, % q/q
 -3.0                                                                      -60
                BarCap PMI-based GDP indicator
 -3.5                                                                      -80
        00 01 02 03 04 05 06 07 08 09 10 11 12                               Jan-11      Apr-11       Jul-11    Oct-11     Feb-12   May-12

Source: Haver, Markit, Barclays Research                                 Source: Barclays Research




1 June 2012                                                                                                                                  28
Barclays | Global Rates Weekly


Extension of the full allotment at     90% of the current OMO liquidity outstanding (MRO+STRO+LTROs) is in the two 3y LTROs
              least until year end     and the demand for liquidity at the other ECB’s operations is currently quite low (out of a
                                       total of €1148bn of OMO liquidity, €51.7bn is at the MRO, €13bn is at the STRO and a total
                                       of €55bn is at the three 3m LTROs), dropping the unlimited funding in the current very
                                       fragile environment would send a negative message to the markets. Also, unlimited liquidity
                                       at the ECB’s operations could be an important backstop for banks (at least initially) in the
                                       case of deposit flight, even if the big issues for some banking systems could be the
                                       availability of eligible collateral, in the case of further rating downgrades both on the
                                       sovereign and on banks. In this respect, we believe that the room for a further easing of the
                                       collateral rules (after the decision on ABS and credit claims announced in December 2011
                                       and February 2012) within the Eurosystem framework is quite limited (taking into account
                                       that the broadening of the collateral comes at the cost of increased haircuts).

                                       Furthermore, even if banks, especially in the peripheral countries, are well funded with term
                                       liquidity, they have continued to use the liquidity market (secured and unsecured) for
                                       liquidity management operations. We suspect that the worsening of funding conditions for
                                       some banks (especially the Spanish ones after the recent increase in margins by LCH, likely
                                       to be increased further given the widening of the Bonos yield spreads vs a AAA basket)
                                       could lead them to move back to the ECB operations. Indeed, with Greek banks likely to
                                       return to the OMO operations only next week, we suspect that the increase in the MRO
                                       borrowing this week was probably due to Spanish banks moving some repos from LCH to
                                       the ECB. While the ECB CCP data shows that Spanish banks still have €60bn of CCP (LCH
                                       mostly) repos, the Tesoro data, as well as the Balance of Payment data, suggests this has
                                       declined much more, likely towards the €40bn level.

                                       Market reaction

 Market has brought forward its        Over the past few days the market has brought forward its expectations of a rate cut to the
  expectations of polity rates cut     summer from later in the year. The Eonia curve has moved further down, with the 1y1y
                                       forward at 27bp. The Eonia forwards curve prices in the fixing at 29bp in the June reserve
                                       period, which would correspond to about 20% probability of 25bp policy rates cut (both in
                                       the refi rate and in the deposit facility, assuming the average spread Eonia vs deposit facility
                                       at around10bp) in June. Such probability increases to 50% in September. Alternatively, the
                                       current forward pricing is consistent with a 100% chance of a 25bp refi rate cut with a
                                       tightening of the monetary policy corridor that would imply a deposit facility at 10/15bp.

                                       Looking at Euribor, the fixing has continued to creep down and is now at 66.5bp, still
                                       consistent with out target of 65bp at mid June. The Euribor futures have rallied over the past
                                       few days (with a moderate tightening of the Fra/Eonia component – no widening at all)
                                       and, consistent with the expectations priced in the Eonia forwards, now prices in Euribor at
                                       60.5bp on 18 June (maturity of the ERM2) and flat at 55bp until September 2013.

   However a further short rates       A dovish ECB rhetoric should suggest a policy rate cut already in July, which would be
                     rally is likely   supportive of a further Eonia rally, especially at the short end of the curve that is not yet
                                       pricing fully a cut (in contrast, in the case of no cut in June as we expect, June Eonia should
                                       sell-off as the current pricing considers around 20% probability of a rate cut in June,).
                                       Indeed, in the case of a 25bp cut (with the deposit facility moving to 0), we expect Eonia to
                                       go to 10bp and the 3m Euribor to fix at around 40bp. Therefore, we suggest receiving
                                       July/August Eonia as there is room for a further decline from the current value of 24/25bp.
                                       Euribor futures should rally with a widening of the whites/reds spreads (and potentially
                                       some sell-off on ERM2). Even in the absence of any hints of refi rate cuts on Wednesday, we
                                       do not believe that the market will change its current market expectations too much. While
                                       there might be volatility, the markets will keep pricing in some easing.

1 June 2012                                                                                                                         29
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                                          ECB’s options

                                          In general, the ECB has several options but their effects are likely to be very limited. We
                                          believe that if a large monetary policy stimulus is required, the ECB will have to move more
                                          towards asset purchases (separately from the SMP).

                                          Policy rates cut

 Our thoughts on the policy rates         The room for a further decline in policy rates is very limited and already (partially) priced in
                               cut…       the market. However it would have the implication of weakening the euro, thus supporting
                                          the economy via the external sector. The ECB could cut just the refi rate or both the refi rate
                                          and the deposit facility rate:

                                              A cut of only the refi rate would have an impact on Euribor, and no particular impact on
                                              Eonia (which is priced on the deposit facility rate given the abundant liquidity).
                                              Therefore, in the absence of widening of the credit risk component, Euribor should
                                              decline (albeit probably not to the same extent as the refi) and stabilize at around 45bp,
                                              slightly lower than the current market expectations.

                                              Cutting the refi and the deposit facility rates would have an impact on the whole structure
                                              of short interest rates (Eonia and Euribors, and associated rates), probably close to one-
                                              for-one with the size of any rate cut. However, with the deposit facility already at 25bp, a
                                              further cut would imply the deposit facility at zero and would have significant implications
                                              in the repo market, where the AAA general collateral rates that usually trade at 15/20bp vs
                                              Eonia should go negative. In order not to have a zero bound, the ECB could decide to
                                              tighten the corridor, cutting the deposit facility rate by less than 25bp.

                                          The decision on which rates to cut would have important implications also for banks.
                                          Indeed, the reduction in the refi rate would reduce the cost of the ECB borrowing (the rate
                                          at the 3y LTRO is the average of the refi rate during the life of the operations) thus
                                          supporting banks, especially those in the peripheral countries. The cut in the deposit facility
                                          would affect especially the revenues of banks in core countries that are able to fund
                                          themselves in the market at close-to-zero rate (short-term German GC is at 9bp) and park
                                          their liquidity at the ECB’s deposit facility (25bp), or the 1-week term deposit (the average
                                          rate over the past few weeks has stabilised at 26bp).


Figure 3: Limited room for a further decline in short -term             Figure 4: A rate cut expected in the summer (%)
rates (%)

 6.0                        1Y OIS    1y1y fwd OIS                        0.50
                                                                                                EONIA ECB meeting forward

 5.0
                                                                          0.40

 4.0
                                                                          0.30
 3.0
                                                                          0.20
 2.0

                                                                          0.10           01-Jun-12        25-May-12         02-May-12
 1.0

 0.0                                                                      0.00
   Jan-08          Feb-09        Mar-10        Apr-11        May-12          Jun-12 Sep-12 Dec-12 Apr-13 Jul-13 Oct-13 Feb-14

Source: Barclays Research                                                     Source: Barclays Research


1 June 2012                                                                                                                             30
Barclays | Global Rates Weekly


                                 Very Long-Term Refinancing Operation

  …and on an additional VLTRO    New very long LTROs (VLTROs) are possible but they are more suited to addressing bank
                                 liquidity problems than economic weakness. Following the two 3y LTROs, banks are well
                                 funded and it is also questionable how much more additional liquidity banks would actually
                                 take from the ECB: at the first two 3y LTROs, 66% of the €1trn liquidity was borrowed by
                                 peripheral countries banks. The net new take-up in both LTROs was about €250bn, while
                                 €250bn in each was used to refinance existing ECB OMOs. Given there are very few other
                                 ECB OMOs to refinance, we would expect any take up to be much more limited: probably
                                 below €200bn. The availability of eligible collateral, and the weight of ECB borrowing vs the
                                 size of the balance sheets, could reduce their borrowing capacity. Furthermore, banks in the
                                 peripheral countries have already increased significantly their holdings of government
                                 securities and a further increase could fuel concerns on their sovereign exposure. Still, it is
                                 fairly low cost for the ECB to announce a new set of 3y LTROs (say in June, Sep and Dec),
                                 and this could be announced as soon as next week.

                                 Conclusion

                                 Even if we do not expect the ECB to act at next week’s meeting, dovish comment should
                                 reinforce the current markets expectations of an easing, thus favouring a further rally of
                                 short rates. (However, in the case of no cut in June as we expect, June Eonia and ERM2
                                 should sell-off as the current pricing considers around 20% probability of a rate cut in June,
                                 as we said previously). However, due to the deterioration of sentiment, it is very unlikely
                                 that the market will change its current expectations even in the absence of any hints of
                                 policy rates cut. Therefore, we suggest receiving Eonia and going long Sep12 and Dec12
                                 Euribor. The long end of the money markets curve is already at a very low level, but we
                                 believe a sell-off is unlikely in the very near term due to the current fragile situation.




1 June 2012                                                                                                                  31
Barclays | Global Rates Weekly


SPAIN: SPECIAL TOPIC

                                     Spain debt flows: Big challenges ahead
                 Laurent Fransolet   This article was previously published on 30 May 2012.
              +44 (0)20 7773 8385
    laurent.fransolet@barcap.com     While Spain is well advanced in its bond issuance, and foreign selling has abated, the
                                     prospect of extra issuance for bank recapitalisations and low T-bill issuance YTD will
                                     continue to weigh on the Spanish market.

                                     The May Spanish treasury monthly bulletin released on 25 May, and the ECB M3-related
                                     data published on 30 May, provide some updated information about holders of Spanish
                                     government debt in recent months (end of March 2012 for the Treasury bulletin, end of
                                     April for the ECB). A few things are worth noting.

                                         Non-resident (ex ECB) investor flows showed net selling of about EUR5bn in March
                                         (-EUR6.4bn in bonds, +EUR1bn in bills) following a nearly flat February (-EUR0.3bn).
                                         There is no official indication for the April data yet: actual selling flows were limited, but
                                         the overall stock of Spanish bonds fell EUR12bn because of a redemption; thus, we
                                         expect foreigners holdings declined as well, by about EUR6bn (consistent with the
                                         decline in domestic banks’ holdings of government debt as released by the ECB, and
                                         limited flows from other Spanish bond holders). For May, based on our own flows, we
                                         expect a decline in non-resident holdings of about EUR3-4bn. Thus, the average
                                         monthly decline up until May would be about EUR4.5bn, about half that from May to
                                         December 2011. Foreign holdings of Spanish debt likely now account for 22.6% of the
                                         total, or about EUR15bn in bond terms (+EUR25bn of T-bills and EUR11bn of STRIPs).

                                         Non-bank Spanish resident holdings increased EUR2.3bn in March, following a
                                         EUR2.6bn decline in February. Overall, in the first quarter, domestic buying by non-
                                         banks has totalled just EUR1.6bn (about EUR0.5bn a month), much lower than the pace
                                         in 2011 (EUR2.8bn/month) and 2010 (EUR3.8bn/month).

                                     Figure 1: Flows in Spanish central government debt securities

                                         40       € bn
                                         30
                                         20
                                         10
                                          0
                                        -10
                                        -20             ECB SMP
                                        -30             Bde
                                                        Non residents
                                        -40             General govt                             April/May are Barclays
                                                        Mutual funds, NFCs, OFIs, households   forecast based on M3 data
                                        -50
                                                        Incos & PFs                                and our own flows
                                        -60             Banks
                                              Jul09   Oct09 Jan10 Apr10 Jul10 Oct10 Jan11 Apr11 Jul11 Oct11 Jan12 Apr12


                                     Note: Source is Spanish Treasury data, except for April/May 2012, which is a Barclays forecast based on ECB M3-
                                     related data and our own flows. Source: Spanish Treasury, ECB, Barclays Research


                                         According to the Treasury data, Spanish banks bought EUR8.8bn of securities in March
                                         (+EUR11bn of bonds minus EUR3bn of bills), following EUR10.6bn in February.
                                         Anecdotal evidence and the related ECB data suggest there was a decline in holdings of
1 June 2012                                                                                                                                            32
Barclays | Global Rates Weekly


                                        about EUR5bn in April, followed by about EUR6bn of buying in May. In Q1 12, banks
                                        bought EUR37bn of Spanish government debt (official treasury data), and our estimates
                                        suggest this number has not changed much up until end of May. This compares with
                                        net issuance until March of EUR28.8bn and of EUR19.3bn until the end of May.

                                        The Spanish Treasury data show that (Spanish) banks have bought about EUR5bn fewer
                                        central government securities in each of the past four months than the widely quoted
                                        M3-related data released by the ECB (which is subject to revisions in any case). The
                                        difference is likely that Spanish banks have bought Spanish agency debt (eg, FROB and
                                        Fade), Spanish regional debt or some non-Spanish government bonds (EUR8bn in Q1
                                        12 according to the Bank of Spain) – all are included in the ECB data, but not the
                                        Treasury data. The April ECB data, which show a net flow of just -EUR0.7bn for Spanish
                                        banks, is likely similarly overstated by about EUR5bn compared with the Treasury data.

                                        Looking at the Treasury data, banks continued to reduce bonds held on repos at LCH or
                                        domestically, by about EUR19bn in March: this funding seems to have moved to the
                                        ECB. We suspect this trend has continued in April and May, as margins on Spanish
                                        bonds and Spanish banks have made using the LCH more expensive, despite repo rates
                                        on Spain not moving much (at about 35bp). The ECB CCP data showed only a slight
                                        decline for Spain in April (-EUR3bn), and the data still looks about EUR25bn too high
                                        compared with what the Treasury and BdE data suggest.

 Foreigners own only 22-25% of      Figure 2 summarises the flows by various investors categories in the past few years and
  Spanish government securities     year-to-date. As a result of the strong domestic bias of buying in the past few years, non-
  now, close to half of what they   resident investors (ex ECB) owned about 24% of the total securities as of the end of March,
               held in early 2010   and probably about 22.6% at the end of May (about 10pp higher in bills, but a few pp lower
                                    in bonds). There is only limited information as to where the foreign debt holdings are, but
                                    we suspect most of the remaining bonds and bills are now held by euro area investors.

                                    Issuance well advanced on the bond side, but not in T-bills
                                    For the remainder of the year, Spain needs to issue another EUR38bn gross on the total
                                    initial funding plan of EUR86bn of bonds (although this may obviously be revised up due to
                                    fiscal slippage). During the same period, EUR35bn of bonds will mature (EUR13bn at the
                                    end of July, EUR20bn end of October, EUR2bn in September); hence, in net terms (net
                                    issuance of just +EUR3bn), according to the initial funding plans, the total amount of bonds
                                    outstanding at year end will be little changed from current levels. Note that so far this year,
                                    Spain is well behind in its T-bill issuance: the stock of T-bills has declined from EUR90.7bn
                                    to EUR75bn as at end-May, while the plan is for no change by the end of the year. While
                                    some intra-year volatility is usual in T-bills, Spain will need to step up a lot its T-bill issuance,
                                    to nearly EUR10bn a month (versus EUR7bn a month YTD) if it is to keep its stock of T-bills
                                    flat (it may want to reduce T-bills and issue more bonds to limit the decline in the average
                                    maturity of the debt brought by the issuance of shorter bonds, though).

                                    Extra issuance for bank recapitalisations
                                    On the bond side, EUR38bn of gross issuance in the coming seven months should equal
                                    monthly gross issuance volumes of about EUR5.5bn, split in the usual two auctions sets.
                                    Issuance volumes could be increased substantially if bonds need to be issued in the market
                                    to finance bank recapitalisation.

                                    If Spain needs to issue EUR19bn of extra government bonds for Bankia (or FROB bonds, even if
                                    they are not captured in this data), then the key question is whether this needs to be done in
                                    the coming month (it is unlikely that Spain can issue EUR20bn of bonds without a very large
                                    price effect) or spread over a period of time and through various sources of funds (which seems
1 June 2012                                                                                                                           33
Barclays | Global Rates Weekly


                                 more feasible). The Spanish Treasury has some cash at hand (probably about EUR45-55bn by
                                 the end of May at the central government level, which can probably be run down by EUR10-
                                 15bn), and not all FROB resources have been used (up to EUR5bn likely available currently). It
                                 could also initially issue T-bills rather than bonds to smooth the issuance effect (on top of the
                                 T-bills it would normally issue). In our view, this would make it more likely that it can contribute
                                 close to EUR20bn in a short period of time, even if it is not going to be easy (and the EUR20bn
                                 for Bankia might have to be topped up for other entities by a similar amount).

                                 Two other considerations are worth mentioning. On the one hand, the markets, and
                                 domestic investors especially, also have to absorb additional Spanish risk in the form of
                                 regional debt (directly or via the ICO lines), as well as the suppliers debt (via a syndicated
                                 loan, already agreed). On the other hand, any FROB bonds or Spanish government debt can
                                 be used to access ECB financing at fairly low haircuts.

                                 In any case, in our opinion, it is likely that in the foreseeable future, domestic investors will
                                 remain the only buyers of the debt and will have to replace further non-resident investors,
                                 who will continue to bring down their holdings even if not at the same pace as in H2 11.

                                 Do domestic investors have the capacity to buy the new debt?
                                 As we have said before, even if we assume that none of the maturing debt held by
                                 foreigners is rolled over (ie, 25-40% of the EUR35bn maturing, or EUR9-14bn), this could be
                                 bought by domestic investors (on top of them rolling their exposures and increased T-bill
                                 issuance) over the remainder of the year. Net bond issuance would be EUR3bn, in addition
                                 to EUR15bn of T-bills issuance, and EUR14bn of foreigners not rolling their debt; in total, it
                                 would add to EUR32bn of buying needed by year-end. Year-to-date, we estimate domestic
                                 investors have bought about EUR40bn of the treasury debt: adding to this the EUR32bn and
                                 some extra issuance related to FROB, some fiscal slippage, etc, would bring this total to
                                 about EUR90-100bn, which is comparable to the EUR90bn all domestic investors bought in
                                 2011. While this may be stretching the limits of domestic demand (even with some ECB
                                 financing), it may still be possible, in our opinion. However, we continue to believe that any
                                 large outright liquidations by non-residents, or any large increase in financing needs, are
                                 likely to be much more difficult to absorb from here, especially in the current volatile
                                 environment. This would more likely necessitate either a resumption of the ECB SMP or
                                 some other funding mechanism.

                                 Figure 2: Flows in the past few years and current ownership
                                                                                              Other        General    Non        Banca de
                                 Net flows                        Banks          Incos & PFs residents     govt       residents Espana ECB SMP Total
                                 2008                                       20             -3            4          9         22         0    0       53
                                 2009                                       29              5           -1         12         54         3    0      102
                                 2010                                      -10            21            10         16         30         3    0       69
                                 2011                                       50            22             9          3        -81         6   46       56
                                 Jan-Mar2012                              37.0            2.5         -5.4        4.4      -12.5       0.5  2.3    28.8
                                 Apr12 (Barclays fcst)                    -5.4          -0.8           0.0       0.0        -6.3      0.0   0.0   -12.4
                                 May12 (Barclays fcst)                     5.8           1.0           0.0       0.0        -3.9      0.0   0.0      2.9

                                 Holdings Mar12                        214.8           75.2        48.6       66.8     150.6      24.8     48.6  629.4
                                 % of total                           34.4%          12.1%        7.8%      10.7%     24.1%      4.0%     7.8% 100.9%
                                 Holdings May12 (Barclays fcst)        215.2           75.5        48.6       66.8     140.4      24.8     48.6  619.9
                                 % of total                           34.7%          12.2%        7.8%      10.8%     22.6%      4.0%     7.8% 100.0%
                                 Note: Source is Spanish Treasury data, except for April/May 2012, which is a Barclays forecast based on ECB M3-
                                 related data and our own flows. Source: Spanish Treasury, ECB, Barclays Research




1 June 2012                                                                                                                                          34
Barclays | Global Rates Weekly


EUROPE: SOVEREIGN SPREADS

                                       Spain: Taking stock
                Huw Worthington        In Spain, the evolution of yields will be driven by developments in the recapitalisation of
              +44 (0)20 7773 1307      BANKIA. However, in the absence of a dramatic effect on yields in the short term,
 huw.worthington@barcap.com            current market conditions suggest Spain should not need to seek official assistance yet.

                                       Further to “Spain debt flows big challenges ahead” it is also worth comparing the current
                Ugofilippo Basellini
                                       situation in Spain with that of the three previous eurozone country bailouts that have taken
              +44 (0)20 3134 6540
                                       place in Greece, Ireland and April over the past two years. Figures 1 and 2 below show the
ugofilippo.basellini@barcap.com
                                       prevailing yields, spreads and CDS protection costs that were in place immediately prior to
                                       the bailouts, and compare them to the comparable figures in Spain and Germany.

                                       Clearly, the situation in Greece in May 2010 was dramatically different to that which faces Spain
                                       currently, with yields of almost 20% in the front end and 14% in the 10y area. Prior to its bailout,
                                       Portugal too was trading well in excess of where Spain is currently, at 10-12% across the curve.
                                       Optically, at least, the situation in Spain is a bit more comparable to Ireland: Irish yields were
                                       around 1% higher at the very front end of the curves but still 250bp higher in 10y maturities than
                                       in Spain currently. They had been in excess of 7% in the 10y area for a month prior to the
                                       eventual Irish package. Of course, fundamentally (debt to GDP growth, etc) the situation
                                       between the two is not identical.


                                       Figure 1: Selected EGB yield curves

                                        20                           Spain Now               Germany Now            Portugal - Bailout
                                        18                           Ireland - Baliout       Greece Bailout
                                        16
                                        14
                                        12
                                        10
                                          8
                                          6
                                          4
                                          2
                                                                                    Years to maturity
                                          0
                                              0            5         10             15          20            25          30             35

                                       Source: Barclays Research


                                       Looking at spread levels, initially the situation in Spain also looks vastly different from what
                                       we saw in Greece, where spreads versus bunds were approaching 1000bp. However,
                                       current Spanish spreads appear to be more comparable with the situation seen in Portugal
                                       and Ireland in November 2010 and April 2011 with Spain only trading a few bp richer then
                                       Portugal in terms of both countries’ 10y spread to bunds. This again is somewhat
                                       misleading in that in the intervening period German yields have rallied to record lows by in
                                       excess of 230bp in the 10y area and almost 200bp in the front end, making this comparison
                                       less useful in terms of the resulting absolute yield levels.

                                       The shape of the curve is also different in Spain, with 2y yields still well below the 10y area,
                                       while in Greece and Portugal the curve was more than 700bp and 180bp more inverted
                                       than Spain sees currently. The only metric where Spain fares worse than Portugal and
1 June 2012                                                                                                                               35
Barclays | Global Rates Weekly


                                      Ireland is on CDS protection cost, which is some 45bp and 75bp, respectively, in excess of
                                      where Portuguese and Irish protection traded previously, although in this regard it is worth
                                      noting that Germany too trades 60-70bp higher than seen previously.

                                      Figure 2: Selected yield and spread metrics for programme countries vs Spain and Germany
                                                                                                         Spread vs 10y
                                                                 2y Yield    10y Yield    2s10s Curve       Bunds        5y CDS Rate

                                      Greece - May 10              17.96      12.44          -551.4          957.7          954.2
                                      Ireland Dec 10               7.05        9.09          275.7           677.6          514.5
                                      Portugal April 11            9.38        8.68          -26.9           534.1          543.5
                                      Spain - Now                  4.95        6.45          150.4           521.4          591.9
                                      Germany - Now                0.00        1.17          117.0            NA            105.0
                                      Source: EcoWin, Barclays Research


                                      Focusing on the level of elevated bond and CDS spreads in Spain is thus much less useful
                                      than looking at the outright level of yields given the extreme flight-to-quality bid seen in
                                      Germany at present. The evolution of yields will clearly be driven by developments in the
                                      recapitalisation of BANKIA, and as we highlight elsewhere, the ability of domestic investors
                                      to take any supply down to fund this. However, unless this has a dramatic effect on yields in
                                      the short term, current market conditions should not be seen as at a level where Spain will
                                      need to seek official assistance yet.

                                      Next week’s cash flows
                                      Next week will be quite busy in terms of issuance, with Germany, France and Spain selling bonds.
                                      We expect gross issuance to be around €16bn. On Wednesday, Germany will tap €5bn of the 5y
                                      OBL Apr ’17. The following day Spain will sell 2y, 4y and 10y SPGB for an amount that we expect
                                      to be around €3bn, while France will auction 7y, 10y, 15y and 50y OATs for a total announced
                                      range of €7-8bn. Support for the market will be minimal during the week. Redemptions will
                                      amount to €0.22 coming only from Belgium, while coupons from Italy and Belgium will be
                                      around €0.07bn. As such, net supply is expected to be positive by about €15.71bn.

Figure 3: Barclays’ cash flows expectations for week beginning 04 Jun
                     Beginning                                Auction Date   Issuance    Redemptions     Coupons     Net Cash Flow
                                 21-May          12.94          Germany        5.00          0.00          0.00           5.00
Weekly                           28-May           8.29            France       8.00          0.00          0.00           8.00
Net                              04-Jun       15.71                Italy       0.00          0.00          0.05           -0.05
Cash flow                         11-Jun       -23.25              Spain       3.00          0.00          0.00           3.00
                                  18-Jun        16.61            Belgium       0.00          0.22          0.02           -0.24
                                                                  Greece       0.00          0.00          0.00           0.00
 Net Cash Flow is issuance minus redemptions                      Finland      0.00          0.00          0.00           0.00
 minus coupons. Negative number implies cash
                                                                  Ireland      0.00          0.00          0.00           0.00
 returned to the market.
                                                                 Holland       0.00          0.00          0.00           0.00
                                                                 Austria       0.00          0.00          0.00           0.00
Total issuance                                    16.00          Portugal     0.00           0.00         0.00            0.00
Total redemptions                                   0.22          Total       16.00          0.22         0.067           15.71
Total coupons                                       0.07
Net cash flow                                     15.71
Source: Barclays Research




1 June 2012                                                                                                                         36
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UNITED KINGDOM: RATES STRATEGY

                                              The irresistible force
                       Moyeen Islam           MPC members have hinted that further QE might not be appropriate for the economy.
              +44 (0)20 7773 4675             Current valuations have not been driven by “safe haven” status but rather by position
      moyeen.islam@barcap.com                 squaring from domestics. If this continues, the beleaguered flattener will come into its own.

                                              MPC external member Ben Broadbent’s most recent speech (“Costly capital and the risk of
                                              rare disasters”) gave an interesting perspective on risk premium and the effect it has on the
                                              real economy. While pointing out that risk-free rates had fallen, anecdotal evidence
                                              suggests the hurdle rate from investment may have actually risen, thus curtailing
                                              investment – counter to what textbook economic theory suggest should happen. Broadbent
                                              explains this by suggesting that in a world in which concerns about downside risks are
                                              growing and intensifying, it leaves the appetite to invest, particularly in irreversible
                                              investments, very low. This subdued nature of “animal spirits” from the private sector,
                                              driven by fears of what Broadbent terms “rare disasters”, means that overall risk premium
                                              has risen. But as well as affecting the demand side of the economy, this has implications for
                                              the supply side of the economy since the lack of investment on intangible expenditure, for
                                              example, will leave productivity low. His observation that there are supply-side implications
                                              for low rates chimes with comments from BOE Chief Economist Spencer Dale who also
                                              suggested that further QE might not be the answer for the UK.

                                              It is certainly the case that the combination of credit rationing and elevated credit costs has
                                              played its role in the rise in risk premium. The fall in rates has not been seen in wider
                                              borrowing rates. Figure 1 shows 2y, 3y and 5y mortgage rates from the Bank of England’s
                                              series versus GBP 5y OIS rate as a proxy for a risk-free rate. What is apparent is that the
                                              lowering of risk-free rates via subdued rate expectations and QE has only widened credit
                                              spreads. It seems unlikely t this point that the BOE will pursue QE via the non-gilt purchase
                                              channel, which would be the obvious way to compress credit spreads and was the inference
                                              that could be drawn from Ben Broadbent’s speech. Indeed, our economists raise this issue
                                              in UK Economic Outlook: Can the policy straitjacket be loosened?, 30 May 2012. It seems
                                              somewhat futile to consider the case for buying, for example, Prime RMBS and covered
                                              bonds as part of a QE programme, given that Governor King has been adamant that QE

Figure 1: UK mortgage rates vs 5y OIS                                       Figure 2: Comparing 5/10/30s across markets

                                                                              120                       Germany 5/10/30            Gilt 5/10/30
  7                                                                           100                       Japan 5/10/30              UST 5/10/30

  6                                                                            80
                                                                               60
  5
                                                                               40
  4
                                                                               20
  3
                                                                                0
                GBP 5yr OIS
  2             2yr fixed (75% LTV)                                           -20

  1             3yr fixed (75% LTV)                                           -40
                5yr fixed (75% LTV)                                           -60
  0
                                                                                Jun-09    Dec-09        Jun-10   Dec-10   Jun-11     Dec-11
  Jan-07      Jan-08       Jan-09      Jan-10       Jan-11    Jan-12
Source: Bank of England, Haver Analytics, Barclays Research                 Source: Barclays Research


1 June 2012                                                                                                                                       37
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                                          would only be pursued by gilt purchases and that he regards this as an operational decision
                                          for the Bank of England rather than a policy one for the members of the MPC. We outlined
                                          the case for QE to be directed via purchases of linkers and bank paper in September 2011
                                          (see Global Rates Weekly from 9 September 2011 and 16 September 2011), and we still
                                          retain these views. At the moment, though, this is something of an academic argument.

                                          Meanwhile, rates have reached new lows with 10y rates below 1.60%. The rally in global
                                          rates markets has seen a compression in risk premium on the curve and a richening in
                                          5/10/30s. This is shown in Figure 2, where we compare 5/10/30s butterfly. It is notable
                                          that for the two markets in which central banks have eased policy most aggressively (the
                                          UK and Japan – monetary expansion led the central bank’s balance sheet grow to about
                                          22% of GDP in the UK and about 30% of GDP in Japan), the butterfly is most extreme.
                                          This suggests that the longer end of the curve has lagged in the bull flattening of the front
                                          end. Indeed, JGB 10/30s at 94bp is markedly steeper than its German equivalent (+51bp),
                                          but closer to the UST 10/30s (+107bp). The real outlier remains Gilt 10/30s, which at
                                          +135bp is very steep. Does this reflect the risk premium being repriced from the shorter
                                          end of the curve into the longer end? The recent steepening move has been broadly in
                                          line with the bull flattening in the front end of the curve (Figure 3). but we are perhaps
                                          reaching the real limit of how steep the curve can get given that gilt forwards in the 15-
                                          20y are in excess of 4%.

                                          There is a widespread view that the current valuation of gilts reflects “safe haven” flows
                                          from overseas investors. However, this does not seem to be borne out by the flow data.
                                          Figure 4 shows the 3-month rolling sum of non-resident gilt flows versus that of non–MFI
                                          domestic investors. As can be seen, up until the end of April, overseas investors had in fact
                                          been net sellers of gilts, while domestic non-MFIs had begun to reverse their sizeable short,
                                          which had come about due to QE. We expect May’s data to continue this trend. Given that
                                          most overseas holdings are predominantly in shorter maturities on the curve, while
                                          domestics are largely in the long end, this gives the curve a natural flattening bias in terms
                                          of flow going forward.




Figure 3: Gilt 2/10s vs Gilt 10/30s (bp)                                Figure 4: Domestic vs non-domestic gilt flow (3m rolling
                                                                        sum, £mn)

 350                                                           0          50,000            UK: M4, Flow: Private Sector Holdings of Gilts
                       Gilt 2/10
                                                                          40,000            UK: M4, Flow: Nonresident Holdings of Gilts
                       Gilt 10/30 (RHS, inverted)              20
 300                                                                      30,000
                                                               40
                                                                          20,000
 250                                                           60
                                                                          10,000
                                                               80
                                                                                 0
 200                                                           100
                                                                         -10,000
                                                               120       -20,000
 150
                                                               140       -30,000

 100                                                            160      -40,000
   Jan-10       Jul-10      Jan-11    Jul-11    Jan-12     Jul-12               Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Source: Barclays Research                                               Source: Bank of England, Haver Analytics, Barclays Research


1 June 2012                                                                                                                                  38
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SUPRANATIONAL, SUB-SOVEREIGN & AGENCIES

                                      Single versus multiple-guarantee structures
                                      (This is an edited extract from The AAA Investor, published 1 June 2012)

                    Fritz Engelhard
                                      The challenge continues
                 +49 69 7161 1725
    fritz.engelhard@barcap.com        Spain has become (yet again) the focus of attention of financial markets. This has been the
                                      result of a large 2011 fiscal underperformance (mainly by the regions), a poorly managed
                  Michaela Seimen     upward revision to the 2012 deficit target, confirmation that the country re-entered
              +44 (0) 20 3134 0134    recession in the first quarter, and a perception that the ECB’s recent injection of liquidity
  michaela.seimen@barcap.com          may have reached the limit of its effectiveness. More recently, market stress has escalated
                                      under the market perception that the clean-up of the banking sector is incomplete (despite
                        Jussi Harju   intervention by the state in Bankia) and may result in larger fiscal costs than currently
                 +49 69 7161 1781     envisaged by the sovereign. However, since the new government took office in December
         jussi.harju@barcap.com       2011, and despite elevated market stress, it is also fair to say that the government has taken
                                      some bold steps to regain control of the fiscal performance of the regions.

                                      To contain fiscal deficits, including the regions, the parliament approved a new organic law on
                                      budgetary stability and financial sustainability of public administrations in May 2012. Of
                                      particular interest is that the law lays out the mechanisms of control for the central
                                      government in the event of fiscal deviations in the regions. Furthermore, the law also
                                      implements Article 135 of the Spanish Constitution (a new constitutional amendment
                                      approved by the parliament in September 2011), which legally enables the central government
                                      to intervene in a region that does not comply with the new fiscal stability framework.

                                      Among the various challenges confronting Spain, the ability to control the central
                                      government and regional deficits is one of the top priorities. The powers endowed to the
                                      central government under the new fiscal stability law are likely to be put to the test soon, in
                                      our view. Will those be enough to effectively limit future fiscal slippages and will the central
                                      government be able to control the regions?

                                      Constitutional amendment of Article 135 & Fiscal Stability Law
                                      In mid-September 2011, the Socialist government (now the opposition), with the support of
                                      the main opposition party (now in government), approved a “constitutional debt brake”
                                      consistent with the European new fiscal compact rules. The amendments are already
                                      enshrined in the Spanish constitution and include: 1) the principle of a structural balanced
                                      budget for the central government and the regions; local governments will also be required
                                      to run zero headline balances; 2) a ceiling for public debt of 60% of GDP; and 3) a change in
                                      the priority of government expenditures, whereby interest payments and amortisations of
                                      public debt will have the highest priority.

                                      Technical details on the definition of the structural budget, including the “phase-in” period
                                      for the application of the rule and the specific mechanisms of adjustment in the event of
                                      deviations, are key features defined in the new, separate organic law (recently approved by
                                      the parliament) on budgetary stability and financial sustainability of public administrations.
                                      This new law has been drafted to be consistent with the agreements reached at the euro
                                      area level on the new “fiscal compact”. The law also automatically incorporates any future
                                      amendments to the European fiscal rules.



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                                 The new organic law defines the mechanisms available to the central government to rein in
                                 any fiscal slippages in the regions. Various mechanisms of ex-ante control, which are
                                 lacking so far, are now part of the new fiscal framework. These mechanisms include
                                 preapproval of regional budgets by the central government and the possibility for the
                                 central government to recommend or even impose fiscal consolidation measures on the
                                 regions. The regions also adopted new rules for the set-up of expenditure ceilings.. These
                                 new elements of “ex-ante fiscal control” are now feasible legally for the central government
                                 (and certainly desirable) following the constitutional amendment approved in September.

                                 Please see the Appendix of The AAA Investor, 1 June 2012 for details of the Fiscal Stability
                                 Law as well as new preventive and corrective mechanisms for central government control of
                                 the regions.

                                 The 2012-13 fiscal targets are unnecessarily overambitious
                                 Following a series of fiscal data revisions, the 2011 fiscal deficit currently stands at 8.9% of
                                 GDP, compared with a target of 6% of GDP. Of the overall 2.9pp slippage, the lion’s share
                                 corresponds largely to the regional budgets (about 70% of the slippage), with the rest of the
                                 deviation split between social security and central government. The regions with the largest
                                 slippages in terms of regional GDP were Castilla la Mancha, Valencia and Murcia, regions in
                                 which the boom-bust in real estate has been the most severe. However, in absolute terms,
                                 the largest contributors to the overall 2011 fiscal slippage were Valencia, followed by
                                 Catalunya and Andalucía (three of the largest four).

                                 On 30 March, the Spanish government presented the 2012 budget for the central government,
                                 which includes measures worth EUR27.3bn (c.2.5% of GDP). When the government took office
                                 in December 2011, it announced a first round of fiscal consolidation measures totalling
                                 EUR15bn, including changes to personal income tax, capital gains, and property tax. The central
                                 government, social security, regions, and municipalities altogether will need to achieve a fiscal
                                 swing of 4.2% of GDP by reducing the public sector deficit to 5.3% of GDP in 2012.

                                 Is the 2012 fiscal target achievable? The short answer is not under the existing measures.
                                 But we do not believe it is necessary to achieve fiscal solvency in the medium term. In our
                                 view a more moderate fiscal consolidation path, which ensures a fiscal swing of about 8%
                                 of GDP over the next 5-6 years would be sufficient to restore solvency. Specifically, for
                                 Spain, we think it is reasonable to assume that a 1% fiscal consolidation only produces an
                                 effective deficit reduction of 0.7% (see Spain: dealing with sudden reversals, 4 May 2012).
                                 Using the government target, to achieve 4.2% of GDP consolidation in 2012 would require
                                 fiscal measures worth nearly 6% of GDP. Our more conservative estimate of a 3% of GDP
                                 consolidation in 2012 is based on adjustment measures worth slightly over 4% of GDP.

                                 There are three main differences between the more aggressive government adjustment
                                 path and ours. First, the government is probably using fiscal multipliers of smaller size than
                                 ours. We think this is because the government is considering that a large share of the
                                 expenditure cuts can be applied to activities (such as transfers) with a low fiscal multiplier.
                                 Second, we are assuming a larger GDP contraction than the government (Barclays -2.0%;
                                 Spanish government -1.7%). Third, we are also assuming slightly less fiscal adjustment in
                                 2012 than the government. For example we are excluding the EUR2.5bn expected revenues
                                 from a tax amnesty, which may or may not yield such revenues




1 June 2012                                                                                                                    40
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                                 Figure 1: The 2012 fiscal plan (% of GDP)
                                                              2011 target      2011 execution   2012 target    Fiscal consolidation

                                 Central government                -4.8               -5.1         -3.5                -1.6
                                 Regions                           -1.3               -3.3         -1.5                -1.8
                                 Municipalities                    -0.3               -0.4         -0.3                -0.1
                                 Social security                   0.4                -0.1          0                  -0.1
                                 Total                              -6                -8.9         -5.3                -3.6
                                 Source: Spanish Ministry of Finance, Barclays Research
                                 While the slippages are likely to occur across all the components of the general government, we
                                 still think that the largest fiscal risks remain in the regional fiscal consolidation targets. We
                                 estimate that, instead of the deficit target of 1.5% of GDP, a more likely outcome is in the range
                                 of 2.0% to 2.5% of GDP. The central government will have to help the regions by redefining the
                                 size of the welfare state that the Spanish economy can afford consistent with the targets of the
                                 regions. It will ultimately fall to the regions to implement the policies. Specifically, we believe
                                 significant cuts in health, education and social spending will be required. In fact, the government
                                 has proposed cuts on health and education spending cuts worth EUR10bn.

                                 The social security fiscal target, which aims for a balanced budget, also seems quite
                                 challenging as the economic outlook has worsened relative to 2011. In 2011, social
                                 contributions fell c.3% and pension costs rose 4%; as a result, social security was -0.1% of
                                 GDP, versus the target of +0.4%. In 2012, a deficit larger than in 2011 seems likely (ie, a
                                 balanced budget strikes us as far-fetched) as pension spending continues to rise along with
                                 unemployment benefits, while social contributions are likely to continue falling.

                                 Are there any safeguards against these risks?
                                 First, the central government is backed by a brand new constitutional debt brake and a new
                                 organic law that sets expenditure-ceiling rules for all the sub-central government levels and
                                 allows the central government, if needed, to potentially “intervene in a region” and take away
                                 fiscal responsibilities. Also, the new draft law of “good governance” proposes that any local
                                 authority that fails to comply with the fiscal consolidation targets (ie, that fails to comply with the
                                 new constitutional amendment or the new organic law above mentioned) can be dismissed and
                                 be banned from running for public office for a period of up to 10 years. In practice, however,
                                 these brand new mechanisms of fiscal control have not yet been put to the test. We think that
                                 politically it would be very costly for the central government to revert the process of fiscal
                                 devolution by taking responsibilities away from any region, even if temporarily.

                                 Second, the central government controls a large share of the regional taxes. Specifically, the
                                 central government controls the tax rates of the personal and corporate income tax (PIT
                                 and CIT), as well as the VAT. The fiscal revenues from these taxes are shared between the
                                 central government and the regions (50% each). Hence, any decision by the central
                                 government to increase the PIT, CIT and VAT rates has a direct impact on the fiscal revenue
                                 of the regions. In the approved 2012 budget and in the new 2012-15 stability and
                                 convergence programme, the government has approved (or proposed) changes to the
                                 corporate and personal income tax regime as well as an increase to indirect taxes, including
                                 a hike to the VAT rate in 2013 (the standard VAT rate is currently 18%, which is 3pp below
                                 the standard rate of Italy and 5pp below Ireland, Portugal and Greece).

                                 Third, the government is taking stock of all state-owned real estate assets and planning
                                 more active management of these assets to reduce expenditures and privatise the more
                                 marketable assets to reduce public debt. It has set up a public sector entity to coordinate
                                 the disposal of these assets. While the government does have an inventory of its real estate
                                 assets, it has not yet indicated the assets it is planning to privatise or the possible valuation.



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                                              Finally, the government will target further structural reforms, in addition to the already
                                              approved labour market reform. New reforms will be aimed at enhancing competitiveness
                                              by reducing production costs and improving market flexibility, and will cover the energy
                                              sector, market integration, housing rental market, and innovation and R&D activities.

                                              With the presentation of 2012-14 regional budget plans on 17 May 2012, the first part of the
                                              fiscal planning is finally complete. We believe the targets set for the regions are overly ambitious.
                                              Although we appreciate that there are segments that would need more comprehensive cuts, we
                                              nevertheless believe the restructuring of public economies is a rather longer-term project and
                                              market participants could be mislead by more limited short-term achievements.

                                              In the short term, the government will also need to focus on the funding of the regions.
                                              With strong risk aversion in the market and ongoing concerns regarding peripheral
                                              economies, we believe market access for Spanish regions will be rather limited in the near
                                              and medium term. As such, the government already tried to ease the burden by establishing
                                              a support fund to finance debt the regions had accumulated with its suppliers (Fondo para
                                              la Financiacion de Pago a Proveedores, more on this below).

                                              Furthermore, we understand that the government is working on establishing so-called
                                              ‘Hispabonos’ to support the capital market funding of the regions. While the details of the
                                              Hispabonos have not been revealed, we think it is likely that the new instruments will: 1)
                                              carry a sovereign guarantee; 2) be responsible for (most of) the funding of the regions; 3)
                                              enhance liquidity relative to each region tapping the market separately; and 4) reduce the
                                              effective funding cost for most of the regions (albeit potentially at the expense of a higher
                                              funding cost for the central government).

Figure 2: Spanish regions – debt & deficit situation
                                                                         Debt maturities in 2012                  2012
                                                                          per quarter in EUR mn                 deficit in
                                                                                                        Total  EUR mn to 2012
                                                                                                        debt     reach     deficit         2011
                               Total       Regional                                                   maturing   1.50%     target   2011  deficit
                              debt in       GDP in       Debt/GDP                                    in 2012 in deficit of GDP deficit in of GDP
Region                        EUR mn       EUR mn          in %          Q1      Q2     Q3    Q4      EUR mn     target     in %   EUR mn  in %

Catalunya                      41,778       200,323         21%         816      6905   959   4796    13,476    -2,967.0   -1.50% -7,418.0 -3.70%
Comunitat Valenciana           20,762       102,942         20%         1558     3678   268   2615     8,119    -1,535.9   -1.50% -4,657.2 -4.50%
Comunidad de Madrid            15,447       189,432          8%          85      1264   975   369      2,693    -2,835.6   -1.50% -4,231.0 -2.21%
Andalucia                      14,314       145,452         10%         327      504    112   1497     2,440    -2,183.0   -1.50% -4,716.0 -3.22%
Galicia                         7,009        57,678         12%          66      127    132   355      680      -861.0     -1.50% -2,530.0 -4.37%
Castilla-La Mancha              6,587       37,979          17%         313      1319   115   590      2,337    -568.2     -1.50% -2,789.6 -7.31%
Pais Vasco                      5,536        66,575          8%           5       10     4    196      215      -979.3     -1.50% -1,687.0 -2.56%
Castilla y Leon                 5,476       57,491          10%         147      155    28    220      550      -856.1     -1.50% -1,488.7 -2.59%
Illes Baleares                  4,432        26,859         17%         467      110    53    159      789      -395.6     -1.50% -1,063.5 -4.00%
Canarias                        3,718        41,733          9%          93      130     3    518      744      -612.9     -1.50%    -734.0    -1.80%
Aragon                          3,403        34,098         10%           1       88    161    3       253      -505.0     -1.50%    -978.0    -2.88%
Region de Murcia                2,806        28,169         10%          94      273    133   297      797      -426.0     -1.50% -1,237.0 -4.33%
Comunidad Foral de
Navarra                         2,446        18,726         13%           0       18     0    73        91      -274.5     -1.50%    -348.0    -1.88%
Principado de Asturias          2,155        23,175          9%           9       93     9    65       176      -277.0     -1.50%    -843.0    -3.64%
Extremadura                     2,021        17,491         12%         202       25    12    107      346      -263.4     -1.50%    -812.0    -4.59%
Cantebarias                     1,293        13,290         10%           6       25    32    37       100      -195.0     -1.50%    -532.7    -4.00%
La Rioja                         900         8,171          11%         523      508    477   463      1,971     -60.8     -1.50%    -131.2    -1.97%
Total                         140,083      1,069,584       13.10%                                     35,777   15,796.3             36,196.9
Source: Bank of Spain, Regional budgets for 2012 until 2014, Barclays Research

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                                                 Fondo para la Financiación de Pago a Proveedores
Suppliers support fund to reduce                 In 2011, we referred in our AAA Handbook overview of the Spanish sub-sovereign market to the
  strain on economy and funding                  problem of ‘hidden debts’, particularly for suppliers receiving delayed payments. Such payments are
                   needs for regions             recorded in accounts payable and by the Bank of Spain; as such, an increase of these amounts was
                                                 noted in recent years. Although such a development is not unexpected, as these accounts tend to
                                                 behave pro-cyclically, delays in payments were partly used to bridge periods of a more difficult
                                                 funding climate. However, the economy and SMEs in particular are constrained by such delays. To
                                                 address this problem, the Spanish government has set up a fund – the Fondo para la Financiacion
                                                 de Pago a Proveedores – to pay the mounting debt local and regional authorities (territorial
                                                 administrations) have to their suppliers. The fund – effectively an intermediary between financers
                                                 and territorial administrations – has been created through a subscribed syndicated loan totalling
                                                 EUR30bn at the time of writing, and can be increased to EUR35bn, which is the current estimate of
                                                 excess accounts payable to suppliers according to publications by the Ministry of Finance and
                                                 Public Administration (Treasury) and the Ministry of Economy and Competitiveness. Repayments
                                                 are set to commence on 31 May this year for local authorities, and 30 June for regional authorities,
                                                 and will be made directly from the fund to the suppliers approved for repayment.

                                                 The fund, FFPP, will grant loans to territorial administrations for up to 10 years, with a 2-
                                                 year grace period; in turn, these administrations will have to come up with a sustainable
                                                 long-term adjustment plan guaranteeing the repayment of future loans. This adjustment
                                                 plan will be supervised by the Ministry of Finance and Public Administrations (ie, Treasury).

                                                 The fund is set up through a syndicated loan, the biggest in Spanish history, made by 26
                                                 Spanish financial institutions, and will have a 5-year tenor (with a 2-year grace period). It
                                                 will be guaranteed by the Treasury, which will assume the transition of the 5-year
                                                 syndicated loan to the 10-year loan to the territorial authorities. The Treasury, in turn, will
                                                 have a counter-guarantee against the local and regional revenues (Participación en los
                                                 Ingresos del Estado). The loan will be made at 3-month Euribor plus a premium added for
                                                 market conditions, which will make the loan cost about 5.9%.

                                                 Spain hopes this operation will inject liquidity equivalent to 3% GDP into the economy, which is
                                                 respectively expected to increase by 0.4% between 2012 and 2013. The operation will mainly
                                                 benefit small and medium-sized enterprises, and Spain is hoping to generate a further 100,000-
                                                 130,000 new jobs.

Figure 3: Fondo para la Financiación de Pago a Proveedores - structure


                                                      1              Fondo para la                           3
                  26 Spanish                                                                                         Local and regional
                                                                    Financiacion de                       Loan          authorities
                   Financial                       Loan
                                                                         Pago a                          repmt
                  Institutions
                                                                      Proveedores

                                                                                               pa
                                                                                                  ym                      Claims
                   Guarantee                                                                        en
                                                                                                                         +
                                                                                                                         +



                                                                                                         t
                                                                                                                 2
              Public Treasury               #
           1. Financial Institutions lend money to the fund, guaranteed by the Treasury
           2. Fund reimburse the suppliers, who cancel their claims                                                      Suppliers
           3. Local and Regional authorities repay the loan over 10 year period
           #. In 5 years time, the Treasury will replace the financial institutions

Source: Ministry of Finance, Barclays Research



1 June 2012                                                                                                                                       43
Barclays | Global Rates Weekly


                                 Funding outlook – a tricky business
                                 In their recent 2012-14 Budget planning announcements, the regions also presented an
                                 overview of the quarterly maturity structures of their debt in 2012 (see Figure 3). However,
                                 due to short-term extensions, private placements and rolling bank loans, it is rather difficult
                                 to follow an exact debt profile for each region.

                                 Furthermore, the newly established support fund to pay suppliers, plus additional ICO
                                 liquidity lines, shifted the funding needs of the regions slightly.

                                 In the last 2 years retail bond issuance became an interesting alternative funding tool for
                                 some regions, as to being able to place larger bonds in the market. However, funding costs
                                 for this instrument are rather uneconomical; furthermore, it is our understanding that this
                                 funding source could come to a sudden stop, as more recently some regions have been
                                 downgraded to non-investment grade by some rating agencies, which would undermine
                                 the region’s ability to use the retail market segment.

                                 Figure 4: Rating overview Spanish regions – Non-investment grade highlighted
                                 Region                         Bloomberg Ticker Moody's    S&P          Fitch

                                 Andalucia                      ANDAL           Baa2 (NEG) BBB (NEG)     BBB (NEG)
                                 Aragon                         ARAGON          NR          BBB (NEG)    NR
                                 Canarias                       CANARY          NR          BBB+ (NEG) BBB (NEG)
                                 Cantebarias                    CMDCA           NR          NR           BBB+ (NEG)
                                 Castilla y Leon                CASTIL          A3 (NEG)    NR           NR
                                 Castilla-La Mancha             MANCHA          Ba2 (NEG)   NR           BBB- (NEG)
                                 Catalunya                      GENCAT          Ba1 (NEG)   BBB- (NEG)   BBB- (NEG)
                                 Comunidad de Madrid            MADRID          A3 (NEG)    BBB+ (NEG) A- (NEG)
                                 Comunidad Foral de
                                 Navarra                        NAVARR          NR          A (NEG)      NR
                                 Comunitat Valenciana           VALMUN          Ba3 (NEG)   BB (NEG)     WD (12/12/2011)
                                 Extremadura                    JUNTEX          A3 (NEG)    NR           NR
                                 Galicia                        JUNGAL          A3 (NEG)    BBB+ (NEG) NR
                                 Illes Baleares                 BALEAR          NR          BBB- (NEG)   NR
                                 La Rioja                       PRIO            NR          NR           NR
                                 Pais Vasco                     BASQUE          A2 (NEG)    A (NEG)      A+ (NEG)
                                 Principado de Asturias         PRIAST          NR          NR           BBB+ (NEG)
                                 Region de Murcia               MURCIA          Ba1 (NEG)   NR           BBB (NEG)


                                 Spain                                          A3 (NEG)    BBB+ (NEG) A (NEG)
                                 Source: Bloomberg, Barclays Research


                                 As of year-end 2011, the Bank of Spain published the following overview on the short- and
                                 longer-term funding of Spanish regions (Figure 6).




1 June 2012                                                                                                                   44
Barclays | Global Rates Weekly



Figure 5: Regional governments – Debt general summary
                                                                                                                         Loans

                                                             Euros           Securities                           Financial Institutions
                                                                                 in
                                                                 Bonds and   currencies                                             Medium
                                               Short-term      nonmarketable other than                                  Short-    and long- Rest of
                                      Total     securities         debt         Euro             Total      Total         term       term    the world

Total                               140,083        7,790             53,102              2,545   76,646    49,804       12,883      36,921    26,842

Andalucia                            14,314         22               7,005               535     6,752      5,122        1,307       3,816     1,630
Aragon                               3,403                           1,225                       2,178      1,241          25        1,216      937
Principado de Asturias               2,155                                                       2,155      1,296          0         1,295      859
Illes Baleares                       4,432                           1,685                       2,747      2,398         336        2,062      349

Canarias                             3,718                           1,582                       2,135      1,982         179        1,803      153
Cantabria                            1,293                             40                        1,253      1,048         117         931       206
Castilla-La Mancha                   6,587                           1,732               300     4,556      3,215        1,225       1,989     1,341
Castilla y Leon                      5,476                           1,264                       4,212      2,680         220        2,460     1,532

Catalunya                            41,778        5,289             16,335              916     19,237    12,408        5,074       7,334     6,830
Extremadura                          2,021                             41                        1,980      1,550         203        1,348      430
Galicia                              7,009                           3,625                       3,384      2,079          24        2,055     1,305
La Rioja                              900                                                         900        708          220         489       191

Comunidad de Madrid                  15,447                          7,012               576     7,858      4,071         381        3,690     3,787
Region de Murcia                     2,806          300               714                        1,792       977           62         914       816
Comunidad Foral de Navarra           2,446                           1,345                       1,101       801          133         668       300
Pais Vasco                           5,536                           2,695                       2,841      1,497          1         1,496     1,344
Comunitat Valenciana                 20,762        2,179             6,802               218     11,563     6,731        3,376       3,356     4,832

Public Enterprises                   13,870                          1,424                       12,446     7,868         459        7,409     4,578
Source: Bank of Spain, Barclays Research



                                              Figure 6: Debt distribution Spanish regional governments
                                                                                                    Short term
                                                                        Loans rest of the            securities
                                                                            world                       6%
                                                                             19%



                                                           Medium and long-                                            Bonds and
                                                            term loans with                                          nonmarketable
                                                                 Financial                                               debt
                                                               Institutions                                              38%
                                                                   26%

                                                                      Short-term loans                          Securities in
                                                                       with Financial                         currencies other
                                                                        Institutions                             than Euro
                                                                             9%                                     2%

                                              Source: Bank of Spain, Barclays Research


                                              We do not believe the funding pressure for the regions will decrease substantially in the
                                              near term despite the efforts to meet the 1.5%-deficit agreement. In our view, this target is
                                              very ambitious and could lead to misjudgements regarding the progress regions will have to

1 June 2012                                                                                                                                            45
Barclays | Global Rates Weekly


                                                               make to get their budgets and deficits under control. Instead, we tend to review the
                                                               progress of the regions on a more gradual and broader view. In the meantime, we will focus
                                                               on the implementation of the government’s control measures and systems and the
                                                               respective triggers for penalties on regions that do not follow austerity measures on an
                                                               ongoing basis.

                                                               However, in the long term, the success of the penalty/intervention structure is also
                                                               dependent on central government political backing in the region. As long as the PP -
                                                               People’s Party - holds a majority in the regions, changes and control mechanisms and
                                                               penalty structures are more likely to be enforced. However, if this situation should change In
                                                               the future, approvals for interventions could become more difficult.

                                                               Hispabonos
                                                               Hispabonos, although not in existence yet, will be bonds issued by the autonomous regions that
                                                               the state intends to issue on a state-wide level to increase liquidity and lower the cost of debt.
                                                               Basically, it is too costly for the autonomous regions to issue and service debt; as a result, the
                                                               government might be obliged to intervene when the autonomous regions cannot pay.

                                                               The Spanish regions (some more than others) are struggling with large refinancing needs of
                                                               c.EUR50bn this year. Given several Spanish regional authorities already have large amounts of
                                                               debt outstanding (c.13% of GDP), it is more difficult for these to enter the market at reasonable
                                                               levels. In addition, several regions have recently been downgraded to non-investment grade
                                                               levels by Moody’s. For example, Catalunya alone has more then EUR41bn of debt outstanding,
                                                               followed by Valencia with c.EUR20bn and Madrid with c.EUR15bn (see Figure 8). Valencia had to
                                                               refinance a EUR500mn loan at a cost of 7% with a 6-month tenor in May this year, according to
                                                               Bloomberg data, which is unsustainable even in the medium term.


Figure 7: Spanish regions – total debt (EUR mn)

  45,000 41,778
  40,000
  35,000
  30,000
  25,000        20,762
  20,000               15,447 14,314
  15,000
  10,000                             7,009 6,587                                             5,536 5,476 4,432                      3,718 3,403          2,806 2,446 2,155
   5,000                                                                                                                                                                           1,293          900
       0
                                                                                                                                                         Region de
                                                                                                            Castilla y




                                                                                                                                                Aragon
                                          Comunidad




                                                                                                                                                                     Comunidad
                                                                                              Pa is Vasco




                                                                                                                         Baleares

                                                                                                                                     Canarias




                                                                                                                                                                     de Asturias

                                                                                                                                                                                    Cantebarias
                            Comunitat
                Catalunya



                            Va lenciana




                                                       Andalucia


                                                                    Galicia

                                                                              Ca stilla-La




                                                                                                                                                                                                  La Rioja
                                                                                                                                                                      Principado
                                           de Madrid




                                                                                                                                                          Murcia
                                                                               Mancha




                                                                                                                                                                       Foral de
                                                                                                                                                                       Navarra
                                                                                                                           Illes
                                                                                                              Leon




Source: Bank of Spain, Barclays Research


                                                               For some regions, a recent source of funding has been larger retail bond issuance.
                                                               Catalunya is one such region, issuing retail bonds, with severe additional costs attached.
                                                               According to media reports, on top of paying 2.85% more in coupon than treasury
                                                               securities with similar maturities, which were offering 1.94% at the time, the Generalitat of
                                                               Catalunya also had to incur a further 3% in insurance costs and 2% as a commission to the
                                                               individual banks selling the bonds, taking the total cost of the issue close to 10%. It is our


1 June 2012                                                                                                                                                                                                  46
Barclays | Global Rates Weekly


                                 understanding that this is not unusual as banks charge higher prices to insure and promote
                                 products that are difficult to commercialise.

                                 Given the restrictions and risk aversion Spanish issuers face, we believe the plan to provide a
                                 joint issuance platform for the regions would be beneficial because there are several points
                                 the potential Hispabono could address:

                                    The issues would more likely be placed with institutional investors (and made repo-able
                                    at the ECB), which would be cheaper than trying to place them with private clients, as in
                                    the previously mentioned example of the retail bond issuance.

                                    Furthermore, the issues would also be larger in size, thus making them more liquid, as
                                    opposed to the individual, smaller sizes issued when needed by the regional authorities.

                                    According to a Reuters report, the financing costs incurred by regional authorities could
                                    be reduced more than EUR1bn per year by issuing Hispabonos. This represents an
                                    important 2% reduction in financing costs in 2012.

                                 Nevertheless, the concept of Hispabonos also faces some opposition. Regional authorities
                                 that have smaller deficits, a comparatively small stock of outstanding debt and benefit from
                                 higher credit ratings are some more reserved about pooling funding and thus facing a
                                 higher funding cost. Also, some market participants raised concerns that easier and more
                                 liquid market access could undermine current efforts to reduce spending.

                                 The establishment of Hispabonos is being discussed at a government level, but no details
                                 regarding the format or structure of such bonds have been made public. From various
                                 media reports, we understand that different proposals are currently reviewed. In our view,
                                 an important feature would be a potential guarantee structure by the state, which is not
                                 necessarily envisaged however. Reuters, Cincodias and elConfidencial, among others
                                 reported on developments in regard to Hispabonos, with some articles mentioning that the
                                 state will guarantee the bond, while others merely say it will be backed by the state, which
                                 in our opinion is more akin to an implied guarantee as opposed to the full faith and credit of
                                 the Spanish government. In our view, since the regions have legal independence, we find it
                                 unlikely that Hispabonos would be backed by a full guarantee of the Spanish government.

                                 However, given the current sensitivity in the market, we believe correlation risk between
                                 Spain and any Spanish issuer is extremely high. As such, any failure in the sub-sovereign or
                                 agency or banking sector, for example, would have immediate implications for the state.

                                 However, the government has passed a constitutional amendment and an organic law to have
                                 better control of the fiscal performance of the regions and repeatedly has stated in public that
                                 they will not let any region default – which is a very strong implicit guarantee in our view. For
                                 example, Treasury Minister Montoro was recently cited in el Confidencial that the state would
                                 always be there when an autonomous region would require help, although we note this does not
                                 alleviate any region from its responsibility to control its budgets and reduce the deficit. The new
                                 government already proved its commitment to the regions, when it helped in December,
                                 according to Bloomberg, the region of Valencia to make a EUR123mn payment to Deutsche
                                 Bank. The Spanish treasury gave a verbal guarantee to an unidentified lender in order to advance
                                 the funds the regional government needed to make the payment.

                                 From a timing perspective, we expect a decision on Hispabonos in the near future, as
                                 funding requirements for regions would need to be addressed at the latest in Q3 12.
                                 Bloomberg reported on 1 June 2012 that Spain is working on a mechanism to help its
                                 regions finance themselves in the financial markets and will publish details of the

1 June 2012                                                                                                                      47
Barclays | Global Rates Weekly


                                 programme the following week. The mechanism will mean changes to Spanish law and
                                 impose stricter conditions on regions while leaving them responsible for their own debts,
                                 Budget Minister Cristobal Montoro said at a press conference in Madrid.

                                 Full implementation and legal foundation could be considerably lengthier though, as a
                                 financing mechanism must be set up and most likely reviewed by the rating agencies before
                                 any significant issuance takes place.

                                 Either way, based on recent comments by government members cited in the media, we are
                                 confident that the establishment of Hispabonos will be addressed in the near future and
                                 that this new instrument will be implemented as an economical solution to finance the
                                 Spanish regions.

                                 For an indication of pricing and investor acceptance in the market, we believe a comparison
                                 with other Spanish government related debt is sensible. In the past, there has been a
                                 relatively widely diversified investor base in Spanish government guaranteed debt, such as
                                 ICO, FROB or FADE. However, with increased concerns regarding European peripheral
                                 issuers, international investor interest in these markets has become rather subdued and has
                                 been nearly completely replaced by a national investor base.


                                 Figure 8: Investor distribution of regional debt and other public institutions

                                    100
                                     90
                                     80
                                     70
                                     60
                                     50
                                     40
                                     30
                                     20
                                     10
                                      0
                                                                  2010                                     2011

                                              Financial institutions        Private investors            Other financial institutions
                                              Non-residents                 Non-financial institutions   Public entities

                                 Source: Bank of Spain, Barclays Research


                                 However, investors have focussed on the regions for a long time. Despite missing explicit
                                 guarantee structures, but more or less being based on the assumed large correlation risk
                                 with the Spanish sovereign, the higher spreads currently attract renewed investor interest in
                                 this segment. With the fractured market currently and a separate risk assessment necessary
                                 for each region due to complex and partially unclear data, some investors regard current
                                 spreads and the remaining insecurity about missing guarantee structures as insufficient to
                                 provide relative value in sub-sovereign investments.

                                 However, in this respect, Hispabonos could add value by replacing a complex individual risk
                                 assessment for each region with a guarantee structure. Nevertheless, we expect investors to
                                 demand a pick up over Spanish sovereign bond issuance and given of our expectation of a
                                 more implicit guarantee structure, the pick up has to be also considered to be currently
                                 slightly above government guaranteed debt.




1 June 2012                                                                                                                         48
Barclays | Global Rates Weekly



                                 Figure 9: Spread pick-up of Spanish government guaranteed debt versus sovereign debt
                                 in 3- and 5-year maturity brackets

                                  90
                                  80
                                  70
                                  60
                                  50
                                  40
                                  30
                                  20
                                  10
                                   0
                                   May-11                    Aug-11           Nov-11              Feb-12


                                                  ICO3.750Jul15 - SPGB3.000Apr15       ICO4.125Sep17 - SPGB3.800Jan17

                                 Source: Barclays Research


                                 With the introduction of a new issuance instrument, we expect maturity levels of new
                                 bonds to be skewed towards the shorter end of the maturity spectrum. As such, we expect
                                 bonds with a maturity of three years to most likely trade with an additional spread pick-up
                                 to fully guaranteed debt (eg, ICO currently is priced about 60bp over government debt). At
                                 first glance, this might appear to be an expensive option. However, with the limited liquidity
                                 and market access of Spanish regions, spreads of Spanish regional debt have been about
                                 400bp over Spanish government debt.

                                 Given the difference in credit quality of the regions based on the ratings and the
                                 indebtedness, we do not believe that the funds would be distributed at equal costs to the
                                 regions. As such, we would envisage a system, where funds raised via such an instrument
                                 would be distributed at a cost linked to the respective credit quality of the region.




1 June 2012                                                                                                                  49
Barclays | Global Rates Weekly


COVERED BONDS

                                              Relative value in spotlight: Dislocation between
                                              major issuers in Spanish and Italian covered bond
                                              markets
                                              (This is an edited extract from The AAA Investor, published 1 June 2012)

                     Fritz Engelhard          The recent pressure on the Spanish sovereign has had a severe effect on Spanish covered
                 +49 69 7161 1725             bonds. Asset swap spreads on 5y SANTAN covered bonds widened from 215bp in mid-
     fritz.engelhard@barcap.com               March to 375bp currently. The effect of renewed pressure on peripheral sovereigns has
                                              been more benign in the Italian market. Asset swap spreads on 5y ISPIM covered bonds
                  Michaela Seimen             widened only from 205bp in mid-March to 280bp currently. When comparing the covered
              +44 (0) 20 3134 0134            bond spreads with CDS spreads of the underlying banks, an interesting observation can be
  michaela.seimen@barcap.com                  made. The basis on SANTAN covered bonds widened to 220bp, while the basis on ISPIM
                                              covered bonds tightened to 50bp, leading the gap between the two basis packages to an
                            Jussi Harju       historical wide of 170bp. While this also partly reflects the relative scarcity of Italian versus
                 +49 69 7161 1781             Spanish covered bonds, we regard this as a significant distortion and recommend buying 5y
          jussi.harju@barcap.com              SANTAN covered bonds versus CDS, while selling 5y ISPIM covered bonds versus CDS.




Figure 11: SANTAN and ISPIM 5y covered versus CDS spreads                    Figure 12: Basis gap 5y SANTAN versus 5y ISPIM

  300 (bp)                                                                    200     (bp)
  250
                                                                              150
  200
  150                                                                         100
  100
    50                                                                          50

     0
                                                                                 0
   -50
 -100                                                                          -50
   May 11       Jul 11      Sep 11   Nov 11     Jan 12 Mar 12                   May 11       Jul 11      Sep 11   Nov 11   Jan 12   Mar 12

              SANTAN 5Y Senior CDS - SANTAN 3.625 Apr 17 ASW                              SANTAN 5Y Senior CDS - SANTAN 3.625 Apr 17 ASW
              ISPIM 5Y Senior CDS - ISPIM 3.25 Apr 17                                     vs. ISPIM 5Y Senior CDS - ISPIM 3.25 Apr 17

Source: Barclays Research                                                    Source: Barclays Research



                                              Update on the Spanish bank mergers
                                              In Spain, banking sector consolidation has continued. The latest announced merger is
                                              between Ibercaja Banco (which had already been in talks with Cajatres) and Liberbank.

                                              These mergers will also affect the risk exposure covered bond investors have as the
                                              resulting risk exposure from two (or more) merged entities can differ greatly from an
                                              investor’s original risk exposure. In addition, in conjunction with these mergers, cover pools
                                              from the merging savings banks are often merged as well. Therefore, we provide an update
                                              of the recent merger activity in Spanish banking sector affecting covered bond issuers.



1 June 2012                                                                                                                                  50
Barclays | Global Rates Weekly



                                               Figure 13: Recently announced bank mergers in Spain
                                               Date                     Acquiring entity                           Acquired entity

                                               30-May-2012              Ibercaja Banco SAU                         Liberbank SA
                                               16-Mar-2012              Unicaja Banco SA                           Caja Espana-Duero
                                               13-Mar-2012              Caixabank SA                               Banca Civica SA
                                               07-Mar-2012              Banco Bilbao Vizcaya Argentaria SA         Unnim Banc SA
                                               29-Feb-2012              Ibercaja Banco SAU                         Banco Grupo Cajatres SA
                                               07-Dec-2011              Banco de Sabadell SA                       Caja de Ahorros de Mediterraneo
                                               10-Oct-2011              Banco Popular SA                           Banco Pastor SA
                                               Source: Company filings, news reports


                                               The merger activity among Spanish banks and savings banks has resulted in significant
                                               concentration. Figure 14 provides an overview of the entities in which the original 45
                                               savings banks have ended up. So far, only two rather small entities have not yet been
                                               involved in any merger (Caixa Ontinyent, Caixa Pollensa).

Figure 14: Small and mid-sized Spanish savings banks: Where have they ended up?
                             Total         Total
                             assets*       equity*                                                                                            No. of
Name                         (EURmn)       (EURmn) Ticker           Former cajas                                                              cajas

Banco Bilbao Vizcaya
Argentaria SA                597,688       40,058       BBVASM      Unnim Banc SA (Sabadell / Terrasa / Manlleu)                              3
                                                                    Madrid / Bancaja / Ávila / Segovia / Rioja / Laietana / Insular de
Bankia SA                    305,820       16,352       BKIASM      Canarias                                                                  7
                                                                    La Caixa / Girona / Banca Civica SA (Cajasol / Guadalajara / Navarra /
Caixabank SA                 270,425       20,715       CABKSM      General e Canarias / Municipal de Burgos)                                 7
Banco de Sabadell SA         100,437       5,934        SABSM       Cajame                                                                    1
                                                                    Ibercaja / Banco Grupo Cajatres SA (CAI / CC Burgos / Badajoz) /
                                                                    Liberbank SA (CajaStur (Caja Asturias / Caja Castilla La Mancha) / Caja
Ibercaja Banco SAU**         96,084        6,216        CAZAR       Extremadura / Caja Cantabria)                                             8
Catalunya Banc SA            76,528        2,413        CAIXAC      Catalunya / Tarragona / Manresa                                           3
NCG Banco SA                 72,236        2,740        NOVAGA Caixanova / Galicia                                                            2
Banco Mare Nostrum SA 68,797               2,674        BMARE       Murcia / Penedes / Sa Nostra / Granada                                    4
Unicaja Banco SA             38,820        2,641        UNICAJ      Unicaja Banco SA (Unicaj / Jaen) / Caja Espana-Duero (Espana / Duero)     4
Kutxabank SA                 -             -            KUTXAB      KUTXA / Caja Vital / BBK Group (BBK / Cajasur)                            4
Caixa Ontinyent              -             -            CAONTE      Caixa Ontinyent                                                           1
Caixa Pollensa               -             -            -           Caixa Pollensa                                                            1
Notes: *As of YE 2011. **Pro forma balance sheet data. Source: Company filings, Banco de Espana, news reports


                                               The merger process also has significant implications for the Spanish multi-cedula segment.
                                               In some transactions, tier 1 banks, such as BBVA and Caixabank, will have joint participation
                                               of up to 39% or more. Please see the AAA Investor, 1 June 2012 for an overview of the
                                               participation of major entities in individual multi-cedula transactions.

                                               Another week, a new criteria...
                  First it was Fitch...        This week the rating agencies have been busy announcing new criteria changes or
                                               proposals to amend the existing criteria. First, Fitch announced on Wednesday the exposure
                                               draft to its covered bond criteria. The proposed criteria follows broadly the outlines Fitch
                                               provided in its 16 May 2012 communication, which we discussed in our 17 May 2012 AAA


1 June 2012                                                                                                                                            51
Barclays | Global Rates Weekly


                                        Investor. The new criteria clarify certain aspects of Fitch’s current covered bond criteria and
                                        tighten the link between sovereign ratings and covered bond ratings. Importantly, the
                                        linkage between the sovereign rating and covered bond rating tightens when the sovereign
                                        rating of the country where the issuer is domiciled deteriorates.

              ...then S&P a day later   Fitch's announcement was followed a day later by S&P’s long-awaited counterparty criteria
                                        articles for covered bonds and structured finance instruments. This is the criteria applied to
                                        derivate counterparties, bank account providers and other parties providing various services
                                        and support to a covered bond programme. In its press release S&P indicated that the new
                                        criteria could affect 50% of the outstanding covered bond ratings if no remedial actions are
                                        taken by the issuers and/or counterparties. The new criteria will become effective on 12 July
                                        2012 and the agency indicated that all ratings at risk will be placed on CreditWatch.
                                        However, the CreditWatch placement only applies if an issuer has not submitted a 'feasible'
                                        plan (determination of which is at S&P's discretion) on how it will comply with the new
                                        criteria before the effective date on 12 July 2012. Therefore, it is likely that only a limited
                                        number of covered bond programmes will be placed on CreditWatch on or prior to the
                                        effective date. Furthermore, S&P stated that it will allow issuers six months to adapt the
                                        programmes to the new criteria and it will update the ratings on all covered bonds at the
                                        latest by 11 January 2013




1 June 2012                                                                                                                          52
Barclays | Global Rates Weekly


SCANDINAVIA: RATES STRATEGY

                                              Sweden: No recession, no rate cut?
               Mikael Nilsson Rosell          We maintain our base case scenario of a 25bp cut at the 3 July policy meeting, despite
               +44 (0)20 7773 6057            recent data surprises. We also continue to see value in SEK/EUR 1y6m forward tighteners
     mikael.nilsson@barcap.com                as the assumption of an orderly resolution of the debt crisis likely will remain challenged.

                                              The Swedish economy grew stronger than expected in the first quarter (0.8% q/q; 1.5%
                                              y/y), brushing aside fears it might dip into a technical recession after the abrupt slowdown
                                              in Q4 11 (-1.0% q/q; 1.0% y/y). Earlier this week survey data also showed that sentiment in
                                              the Swedish economy remained surprisingly robust until mid-May. While recent data
                                              releases implies an increased probability that the Riksbank (RB) will stick to its “wait-
                                              and-see” approach at the 3 July policy meeting we maintain our non-consensus base case
                                              scenario of a 25bp cut to 1.25%. That said, rather than positioning in the very front end, we
                                              continue to prefer holding SEK/EUR 1y6m tighteners. However, after recent decisive moves
                                              we recommend taking profit on any outstaying SEK/EUR 2y2y/5y5y steepeners.

                                              Despite the prospects for near-term rate cuts we remain constructive on the outlook for the SEK,
                                              targeting EUR/SEK at 8.70, or decade lows within six months and 8.50 within 12 months.

     The Q1 GDP report probably               Despite a significant negative GDP contribution from inventories (-1.1 percentage points
         overstates the underlying            q/q and -2.2 percentage points), the Q1 12 GDP report comfortably beat consensus
                 growth momentum              estimates of marginal positive growth and the RB forecast (0.4% q/q; 1.2% y/y), as demand
                                              rebounded from the suppressed levels of year-end 2011 (Figure 1). However, despite the
                                              surprisingly broad-based recovery, we believe that the numbers should be viewed with
                                              caution. National account data have been volatile in recent quarters and a detailed
                                              examination of the numbers suggests that the Q1 surprise partly is explained by factors that
                                              are unlikely to repeat. Hence, in our view, it is currently unusually hard to derive the
                                              underlying growth trend, but going into the summer we stick to our approximation that the
                                              growth momentum is roughly flat (0.2-0.0% q/q).

  Downside risks dominate going               More importantly, in our view, the renewed wave of uncertainty going through Europe
                    into the summer           seems to have had a more materially negative effect on activity on Sweden’s main trading
                                              partners. Historically, Swedish exports, mainly concentrated on investment and durable

Figure 1: GDP rebound in Q1 should be interpret cautiously                  Figure 2: Stable sentiment, but employment plans decline

 10.0    yy                                                                         Points                                            y/y
                                                                                                                                                    -30
  8.0                                                                         25
                                                                                                                                                    -20
  6.0
                                                                              15
  4.0                                                                                                                                               -10
  2.0                                                                           5
                                                                                                                                                    0
  0.0
                                                                               -5 06     07      08     09      10        11   12   13              10
  -2.0
  -4.0                                                                        -15                                                                   20
                                                                                                                                         Forecast




  -6.0                                                                        -25                                                                   30
  -8.0
         06          07       08        09         10      11        12       -35                                                                   40
              Inventory, changes                 Consumption
              Capital formation                  Net trade                    -45                                                           50
              GDP, y/y                                                                 Employment plans                    Unemployment (RHS)

Source: Reuter EcoWin and Barclays Research                                 Source: Reuter EcoWin and Barclays Research


1 June 2012                                                                                                                                               53
Barclays | Global Rates Weekly


                                            consumer goods, have also tended to be hard hit during periods of heightened uncertainty.
                                            In our view, the dramatic events in Europe and subsequent underperformance of risky
                                            assets also look set to weigh negatively on the sentiment in the Swedish economy. Hence
                                            we believe that the Executive Board will face a significantly less benign set of short-term
                                            indicators when it convenes in one month’s time. While the RB, like us, looks unlikely to
                                            change its base assumption of a relative orderly resolution of debt crisis in Europe, it is likely
                                            to attach an increased probability to a more adverse outcome, which indirectly should
                                            weigh negatively on its main scenario. Indeed, the RB has emphasised that it stands ready to
                                            act decisively after any material worsening of the European debt crisis, not least via
                                            presenting various alternative scenarios for the economic development and the policy rate.

          Probabilities still skewed        All in all we currently continue to believe that probabilities are skewed towards a front-loaded
towards front loaded rather than            rather than a more back-loaded (“wait-and-see”) RB response. While the forward-looking
         back loaded RB response            sentiment indicators remained surprisingly robust until mid-May, it is notable that the business
                                            sector’s employment plans fell quite sharply. We fear that leading labour market indicators will
                                            continue to weaken in the weeks to come, which again if anything would be suggestive of a
                                            more front-loaded policy response. Lastly, while policy rates already are expansionary levels
                                            the inflation outlook remains benign and there in itself doesn’t contradict an even lower policy
                                            rate to fend-off potential downside risks going into the summer.

                            Trade ideas     That said, rather than positioning in the very front-end of the money market curve we
                                            continue to see value in holding SEK/EUR 1y6m forward tighteners, despite recent
                                            headwinds. The spread (c. 87bp) has tightened somewhat since its recent highs, but still
                                            remains significantly above the lows during end-2011 (c 10bp), suggesting a relative limited
                                            downside if macro conditions improve, and a significant upside if worsens sharply. In our
                                            view, the downside risks should also be limited by the relative low inflation in Sweden.
                                            Indeed, we anticipate that Swedish inflation will remain we below euro area inflation until
                                            mid-2013. While we retain a steepening bias, we now recommend taking profit on any
                                            outstanding SEK/EUR 2y2y/5y5y forward steepeners, which performed significantly since
                                            the beginning of May (Figure 4).




Figure 3: Hold SEK/EUR 1y6m fwd tighteners                                 Figure 4: Take profit on SEK/EUR 2y2y/5y5y fwd steepeners

 120                                                                        -40

 100
                                                                            -50
   80
                                                                            -60
   60
                                                                            -70
   40

   20                                                                       -80

   0
                                                                            -90
   May-11      Jul-11       Sep-11 Nov-11    Jan-12 Mar-12
                                                                              Sep-11        Nov-11      Jan-12     Mar-12      May-12

                                SEK/EUR 1y6mth fwd                                                     SEK/EUR 2y2y/5y5y fwd

Source: Barclays Research                                                  Source: Barclays Research


1 June 2012                                                                                                                                54
Barclays | Global Rates Weekly


EURO AREA: INFLATION-LINKED MARKETS

                                           5y euro HICPx cheap and less risky than bonds
                            Alan James     Euro inflation swaps have cheapened significantly recently, by much more than is
              +44 (0)20 7773 2238          justified by downside inflation surprises. 5y HICPx is attractive value below 1.4% and is
         alan.james@barcap.com             notably less vulnerable to further market tension than bond breakevens.

                                           While euro breakevens have cheapened sharply recently, it is notable that euro inflation
                                           swaps have cheapened almost as much once allowing for carry differentials. For instance,
                                           while the DBR€i16 breakeven has fallen by more than 100bp since the start of April, the
                                           difference between the issue and the nominal German curve in asset swap is almost
                                           unchanged. This is in marked contrast to the previous periods of sharp breakeven
                                           cheapening in September and late November last year, when in each period the bond
                                           cheapened by over 30bp more than HICPx swaps. 5y euro HICPx is now at its cheapest
                                           since August 2010 and has only ever traded significantly lower in Q4 2008. We see it as
                                           economically attractive at below 1.4%, while swaps are much less exposed to event risk
                                           than bond breakevens.

       HICPx swaps no longer rich          Although inflation data for May has been weaker than expected, while energy prices have
                     versus OAT€is         continued to fall, we suspect the recent weakness in euro HICPx swaps stems at least as
                                           much from renewed activity in OAT€i asset swaps in the first half of May. For instance,
                                           despite the broader market tension, the OAT€i20 relative asset swap is at the tighter end of
                                           its range since last November, having fallen 20bp from its early May wide. This is likely to
                                           have left risk-averse dealers long euro HICPx swaps, leaving swaps vulnerable to any
                                           significant further downward pressure on inflation. We see it as unlikely that there would be
                                           further OAT€i asset swap interest unless the overall environment for risk improves notably,
                                           in which case we would expect HICPx swaps to have already rallied. Even if there is
                                           continued French asset swap interest, the BTANi16 and OATi17 remain notably cheaper
                                           and French CPIx swaps are likely to be better defined following confirmation that Livret A
                                           savings allowances for individuals are being doubled.




Figure 1: 5y HICPx cheap, DBR€i16 breakeven more risky                  Figure 2: 5y inflation in euro area has not been below 1.5%

 2.7            5y HICPx                                        -20        5.0           5y average euro HICP inflation (E11 prior to 1999)
                DBR€i16 breakeven
 2.4            DBR€i16 relative asw (rhs inv)                  -10                      Euro HICP inflation (E11 prior to 1999)
                                                                           4.0
 2.1                                                            0
 1.8                                                            10         3.0
 1.5                                                            20
                                                                           2.0
 1.2                                                            30
 0.9                                                            40         1.0
 0.6                                                            50
                                                                           0.0
 0.3                                                            60
 0.0                                                            70        -1.0
   Jan-10       Jul-10        Jan-11     Jul-11    Jan-12                    1995        1998       2001      2004    2007         2010

Source: Barclays Research                                               Source: Eurostat, Barclays Research


1 June 2012                                                                                                                                   55
Barclays | Global Rates Weekly


   5y HICPx swaps now cheaper          Inflation in the euro area has not averaged below 1.5% over any five-year period. Average
              than any 5y period in    inflation among constituent countries was never below this level prior to the introduction of
                  realised inflation   the euro either,, though both France and Germany have had 5y periods of average inflation
                                       just above 1%. While our economists’ central forecast is for modest inflation into 2013, with
                                       a y/y low of 1.5% in April 2013, absent a further sharp fall in energy prices, we see euro
                                       inflation risks skewed to the upside, even allowing for the tail risk from potential Greek exit
                                       from the euro area. This stems for two factors, indirect taxes and currency effects, which in
                                       recent years have more than offset the disinflationary pressure from fiscal austerity.

    Currency effects and indirect      The trade-weighted euro has cheapened 10% over the past year and our FX strategists
              taxes may than offset    forecast a further 6% fall over the coming year. In recent years, it has been notable how
         disinflationary impact of     movements in other G10 currencies have prompted a much higher pass through into
     economic downturn in 2013         domestic inflation than seen in previous decades, most obviously pushing inflation up in the
                                       UK and down in Australia. We suspect that this is due in part to the internet increasing the
                                       degree of tradable goods price convergence. If repeated in the euro area, this implies that
                                       currency effects alone might be sufficient to offset the economic impact of the sovereign
                                       crisis. This effect is relatively hard to measure though, whereas indirect taxes have been a
                                       factor that has been sufficient to leave southern European inflation above that in northern
                                       Europe in recent years, albeit several northern European countries have also either had or
                                       plan notable rises, including the Netherlands. Italy would be unlikely to be able to avoid its
                                       mooted 2% increase in VAT in October on any further increase in either sovereign tensions
                                       or economic weakness. Spain is likely to have more significant indirect tax increases in
                                       2013. Its 18% standard VAT rate is one of the lowest in Europe so a modest increase is
                                       likely, but in addition the coverage of this band is unusually narrow, so we would expect a
                                       significant number of items to be moved out of the 6% reduced rate bracket, while excise
                                       duties are also well below the euro area average.

 Receive 5y euro HICPx inflation,      Over the coming years we would not be surprised if the ECB is slightly less rigorous in
targeting rebound above 1.8% in        enforcing price stability, in order to facilitate real economic adjustment within the euro area.
                the coming months      By contrast, market pricing is skewed towards a significant risk of a disinflationary phase,
                                       which appears unlikely to us if the euro area continues in a form similar to its current one. It
                                       appears to us that the market is either significantly underestimating the ability of the ECB to
                                       push against such an disinflationary shock, something it is notably better set-up for than
                                       addressing sovereign concerns, or more likely inflation pricing reflects an exaggerated
                                       market pressure that we see as unlikely to become significantly more intense in a relatively
                                       clean euro HICPx swaps market. Unlike in late 2008, when there was pressure from dealer
                                       exposures in 0% floors, which caused significant cheapening to be self-reinforcing, such a
                                       dynamic is relatively hard to envisage in swaps this time around, even if bond breakevens
                                       could easily fall further in the event of increased market stress. Hence we recommend
                                       receiving 5y euro HICPx inflation below 1.4%. Taking such a position at the start of the
                                       month provides potential to have this as a tactical front month trade, whereas liquidity after
                                       June will be lower. Our tactical target is a rebound to 1.65%, but we see potential for 5y
                                       swaps to rebound above 1.8% in the coming months, as they had traded in the six months
                                       until early May. We place a stop at 1.15%, a level below which swaps only traded for a
                                       month during the extreme dislocations in Q4 2008.




1 June 2012                                                                                                                         56
Barclays | Global Rates Weekly


UNITED KINGDOM: INFLATION-LINKED MARKETS

                                           Fear trumps fundamentals
                      Henry Skeoch        A sharp richening in 10y nominal gilt yields has seen 10y linker breakevens compress to
              +44 (0)20 7773 7917         multi-year lows. The IL20 stands out as a particularly cheap bond on all metrics except
       henry.skeoch@barcap.com            real yield. We recommend buying the IL20 versus paying nominal swaps.

                                          Benchmark 10y gilt yields rallied 53bp during the course of May, as continued investor
                            Alan James
                                          fearfulness surrounding the outlook for Europe saw gilt yields plummet to fresh record lows.
              +44 (0)20 7773 2238
                                          This is one of the sharpest monthly moves in the past 20 years, and in such a fearful
         alan.james@barcap.com
                                          environment it is unsurprising that breakevens have suffered as linkers rarely find support
                                          from safe haven flows. The IL20 has proved a particular laggard in the recent move, with a
                                          breakeven below 2.2% implying a significant medium-term undershoot of the MPC 2% CPI
                                          target on even a very conservative RPI/CPI basis assumption. The RPI/CPI basis came into
                                          considerable focus last week following commentary suggesting that the ONS is considering
                                          eradicating the Formula Effect. As we commented in Potential changes to the UK RPI and
                                          the implications for index-linked gilts, 25 May 2012, we see little chance such changes will
                                          go through, given the hurdles involved and potential negative ramifications for gilt market
                                          stability, in particular in the gilt linker market.

   RPI/CPI basis likely to average        We regard 1% as a realistic long-term RPI/CPI basis assumption, versus which the IL20
     close to 1pp in medium term          breakeven represents extremely attractive economic value. Prior to methodological changes
   even if formula effect reduced         to measurement of clothing and footwear in 2010, the formula effect was consistently close
                                          to 50bp, roughly half of its current magnitude. We would expect only a partial reversal of the
                                          increase if the ONS implements alterations to the price collection processes to minimise the
                                          increased dispersion rather than changing the calculation methodology. Beyond the
                                          formula effect, the other major components of the RPI/CPI basis are differences in
                                          weightings of specific subgroups and measures of housing costs included in RPI but
                                          excluded from CPI. Mortgage Interest Payments (MIPS) and Depreciation collectively
                                          account for 8.5% of RPI. Short-dated interest rates implied by forward swap curves to 2020
                                          suggest that the interest component of MIPS should be worth approximately 15bp for the
                                          IL20. While there is uncertainty surrounding house prices, a normalisation of house price
                                          growth above inflation would likely create a long-term bias. If house prices only increase in

Figure 1: Effective 10y breakevens versus swaps more stable             Figure 2: IL20 very cheap in relative value

 3.4                                                                      15                                                                30

 3.2                                                                                                                                        25
                                                                          10
                                                                                                                                            20
 3.0
                                                                            5                                                               15
 2.8                                                                                                                                        10
                                                                            0                                                               5
 2.6
                                                                                                                                            0
 2.4                                                                       -5
                IL20 breakeven
                                                                                       IL20 vs IL17+IL22 z-spread asw (bp)                  -5
                IL20 real yield versus maturity matched IRS                            IL20 vs IL17+IL22 real yield barbell (rhs, bp)
 2.2                                                                     -10                                                                 -10
   Jan-10       Jul-10         Jan-11    Jul-11    Jan-12                 Mar-11        Jun-11      Sep-11    Dec-11     Mar-12         Jun-12

Source: Barclays Research                                               Source: Barclays Research


1 June 2012                                                                                                                                      57
Barclays | Global Rates Weekly


                                   line with consumer inflation over the medium term, given that any change to RPI
                                   measurement could not be implemented before February 2013 at the earliest, even if the
                                   aggregation methodology of RPI inflation were changed to entirely remove the Formula
                                   Effect, the current 2.20% breakeven on the IL20 would still imply average CPI inflation of
                                   less than 2.0%.

                                   Such cheap breakeven valuations would typically have generated buying interest. The
 Buy IL20 versus paying maturity
                                   firmness of the fear-driven moves in nominal gilts has likely led investors to be justifiably
  matched nominal swap as less
                                   concerned about a continuation of this move and therefore potential for further downwards
  volatile than simple breakeven
                                   moves in breakevens. Against the current backdrop, we feel that the low level of breakevens
                                   is a consequence of a significant liquidity premium in nominal gilts, rather than a genuine
                                   view on likely inflation accrual. The noise surrounding the RPI/CPI basis will likely have
                                   further increased reluctance to fade the move. Effective breakevens comparing linker real
                                   yields with nominal swaps (sometimes termed ‘synthetic breakevens’) have proved
                                   significantly more stable over the past year, with the IL20 cheapening to economically
                                   attractive levels versus nominal swaps. Switching out of rate hedges in nominal swaps into
                                   gilt linkers has been a significant feature of linker demand this year at the long end of the
                                   curve. We see potential for such demand to crystallise at shorter-dated maturities, with the
                                   IL20 a logical bond to buy versus paying nominal swaps given its cheapness in relative
                                   value. Although other old-style linkers have lagged new styles in the recent risk aversion,
                                   the IL20 has lagged its neighbours notably more. We recommend buying the IL20 versus
                                   paying the fixed rate on a maturity matched nominal interest swap from an effective entry
                                   level of 2.80%, targeting a move to 3.15% with a stop at 2.60%. This trade has the
                                   advantage of capitalising on cheap inflation protection but is less sensitive to safe haven
                                   flows into nominals than the simple breakeven.




1 June 2012                                                                                                                   58
Barclays | Global Rates Weekly


EUROPE: VOLATILITY

                                              Cheaper and steeper
                        Piyush Goyal          EUR intermediate-expiry vol is high for the current level of yields. We like 1y*5y receiver ladder
                   +1 212 412 6793            and 1y*(5y5y) vs 6y*5y calendar spread to position for a cheaper and steeper vol surface.
       piyush.goyal@barcap.com
                                              Intermediate expiry vol in EUR, such as 1y*5y, is high on at least two measures.

                     Hitendra Rohra           First, it is at a considerable premium to realized vol (Figure 1). Although this is partly due to
              +44 (0)20 7773 4817             nervousness surrounding the eurozone; it is also in part a reflection of the recent drift in
     hitendra.rohra@barcap.com                rates. For example, the EUR 10y swap rate has richened in excess of 50bp in the past month.
                                              Therefore, even as delta-hedged long option portfolios have not done well as a result of the
                                              low delivered vol, investors are willing to pay a premium for options to gain from any
                                              subsequent drift in rates. A slight let up of the eurozone uncertainty, however, could change
                                              this dynamic and cause the implied to realized vol premium to come off.

    Intermediate expiry vol is at a           Second, yields have now compressed to a level where yield compression should start affecting
         considerable premium to              the level of normal vol. For example, in Japan, where the 1y5y fwd rate has stayed within 25bp
                       realized vol…          and 2% for most of the past decade, 1y*5y has averaged less than 50bp/y (Figure 2). More
                                              specifically, at current levels of ~ 1.4% for the 1y5y forward swap rate, the JPY 1y*5y has
                                              traded within 50-80bp/y. EUR 1y*5y at 70bp/y+ is clearly at the higher end of this range.

…And is rich for the current level            More recently, the effect of yield compression has played out in USD vol. As yields have
                             of yields        fallen, vol has come off also (Figure 3). Current USD 1y5y yield levels are similar to EUR, at
                                              about 1.4%, but USD 1y*5y is about 15% cheaper. While event risk associated with the
                                              eurozone should keep EUR vol richer than USD vol, this premium is already high in a
                                              historical context. Given that USD vol is itself vulnerable to a decline (see Sell 1y*10y, May
                                              25, 2012), we expect EUR vol to come off.

                                              We like two trades to position for a decline in intermediate expiry vol. The first is a 1x2 receiver
                                              ladder, which also stands to benefit from a decline in low-strike skew and rates staying low for
                                              a long time. The other is a calendar spread in mid-curve options, which is a limited loss way of
                                              benefiting from range-bound rates and possible steepening of the vol surface.



Figure 1: Implied vol is at significant premium to realized vol               Figure 2: JPY 1y*5y has averaged 47b p/y for past decade

 Imp Vol              2 Yr          5 Yr           10 Yr       30 Yr
                                                                               (in bp/y)
     3m                55            68             85          98             90
     6m                54            71             85          94
     1y                53            74             87          92
                                                                               70
 20d rlzd vol         2 Yr          5 Yr           10 Yr       30 Yr
     3m                46            47             56          65
     6m                46            50             58          66             50
      1y               46            54             61          67

                                                                               30
 Imp/rlzd            2 Yr           5 Yr           10 Yr       30 Yr
    3m               1.20           1.45           1.52        1.51
    6m               1.16           1.42           1.47        1.42            10
     1y              1.17           1.38           1.43        1.36            May 02        May 04        May 06       May 08        May 10        May 12

Note: Data are as of May 31, 2012. Source: Barclays Research                  Note: The dashed line corresponds to the average value of JPY 1y*5y vol over the
                                                                              past decade. The last data point is as of May 31, 2012. Source: Barclays Research


1 June 2012                                                                                                                                                 59
Barclays | Global Rates Weekly


                                              Trade 1: Receiver ladder
                                                   Buy EUR 100mn 1y*5y receiver 1.25%

                                                   Sell EUR 200mn 1y*5y receiver 1%

        We recommend 1x2 1y*5y                Besides being short vol, the trade is short the low-strike skew and benefits from rates
receiver ladder to fade the vol...            staying low for long.

                                              For the former, we note that although low-strike EUR skew has cheapened lately, it has yet
                                              to catch up with the USD skew. To compare, USD 1y*5y 50bp low-strike options are priced
                                              at 10bp/y lower than ATM vol, while EUR 1y*5y 50bp low-strike options are cheaper by
                                              ~ 7-8bp/y. Ceteris paribus, the 1y*5y 1x2 receiver ladder should gain as the EUR skew
                                              cheapens to match the level of its US counterpart.

         …And gain further if rates           From a terminal held-to-expiry perspective, 5y swaps would have to be lower than 0.75% in
remain low for long or if the low-            one year to incur any losses. This is even below the all-time low yield levels seen in USD,
               strike skew cheapens           where the central bank has committed to staying on hold for longer (Figure 4).

                                              Trade 2: Calendar spread
                                                   Sell EUR 100mn 1y*(5y5y) straddles

                                                   Buy EUR 100mn 6y*5y straddles

   We also recommend calendar                 We like this trade for many reasons. First, the trade is limited loss in nature – a useful feature
 spread through short 1y*(5y5y)               in the current uncertainty. This is because, at the expiry of shorter options (ie, in one year’s
         vs long 6y*5y position as a          time), the remaining 6y*5y straddle would have the same intrinsic value as the just-expired
              limited loss strategy…          1y*(5y5y) mid-curve option, but a non-negative time value. Therefore, the structure cannot
                                              be worth less than zero under any rate scenario, and loss on the trade is limited to the initial
                                              premium laid out.

    …that benefits further if rates           Second, the EUR 5y5y rate has rallied significantly in the past month (about 70bp) and is at its
              remain range-bound…             lowest ever levels. At the same time, a large back-up in rates seems unlikely, given that
                                              eurozone issues may persist for some time. Should the EUR 5y5y rate fail to drift, the trade
                                              could gain significantly on carry: 42cts in 3 months and 84cts in 6 months.



Figure 3: Even in the US lower yields have generally meant                        Figure 4: EUR 1x2 receiver ladder would generate profit
lower vol in the past three years                                                 unless the 5y swap rate was below 0.75%

  1y*5y Vol (bp/y)                                                                 (in %)
 180                                                                                6

 160                                                                                5

 140                                                                                4

 120                                                                                3

 100                                                                                2

   80                                                                               1

   60                                                                              0
        1.0              2.0                3.0                 4.0                May 02        May 04       May 06        May 08        May 10       May 12
                                1y5y rate (%)                                                                   EUR 5Y           USD 5Y

Note: Data for the chart is from May 29, 2019 to May 31, 2012. Source: Barclays   Note: The black dashed line corresponds to 0.75%, ie, the lowest level above
Research                                                                          which the 1x2 receiver ladder generates profit. Source: Barclays Research


1 June 2012                                                                                                                                                      60
Barclays | Global Rates Weekly


                                      Third, EUR 1y*(5y5y) implied vol (at 100bp/y) is currently at a premium of 75% to realized
                                      vol. This is much higher than the 40-50% premium charged on 1y expiry options with 5y-
                                      10y tenors. In the context of range-bound rates, this vol looks extremely rich and more
                                      vulnerable to a decline.

 …And a dearth of option supply       Last but not least, there is a dearth of option supply from EUR-denominated structured
         steepens the vol surface     notes (please see EUR 5y*5y vs USD 5y*5y, May 18, 2012). This is because concerns about
                                      the credit quality of issuers (mainly euro area banks) have caused some investors to shy
                                      away from these products. We therefore expect mid to long expiry vol in EUR to rise and the
                                      vol surface to steepen, thereby benefiting the long 6y*5y straddle portion of the trade.

                                      Risk to the trades
  The chief risk to the trades is a   The major risk to both the trades is a full-scale blowout of the eurozone situation. In such a
         full-scale blowout of the    scenario, the ECB would be compelled to keep rates low (possibly close to zero) for a long time
              eurozone situation      and inject even greater amounts of liquidity into the system, bringing down the front end. At
                                      the same time, the back end would rally on risk aversion and weak growth prospects.

 However, losses on both trades       For the calendar spread, losses are limited and it is unlikely to incur runaway losses if
    should be limited even in this    eurozone conditions worsen significantly. The 1x2 receiver ladder does have unlimited
                         scenario     downside, but any losses in reality would likely be limited. This is because the FRA-OIS
                                      would probably widen as credit quality concerns take over. This would cushion the rally and
                                      prevent the 5y rate from falling too far below the already low breakeven limit of 0.75%.

                                      Conclusion
                                      Intermediate-expiry vol in EUR is currently rich, on an implied-to-realized as well as a cross-
                                      currency basis. Given that rates have rallied to new lows, we expect yield compression
                                      effects (already seen in USD and JPY) to lower vol in the days ahead.

                                      We recommend initiating a 1x2 1y*5y receiver ladder to fade vol. The trade also benefits if
                                      rates remain low for long and the low-strike skew catches up with its US counterpart.
                                      Additionally, we recommend a calendar spread through short 1y*(5y5y) vs long 6y*5y
                                      position. The trade is short intermediate expiry vol, and benefits from range-bound rates as
                                      well as a steepening of the vol surface.




1 June 2012                                                                                                                        61
Barclays | Global Rates Weekly


JAPAN: RATES STRATEGY

                                             Assessing lifers’ capacity to buy super-long JGBs
                    Chotaro Morita          Looking at superlong purchasing capacity at life insurers, we find the pace of portfolio
                  +81 3 4530 1717           duration extension has slowed in FY 11 due to the decline in yields. We estimate their
    chotaro.morita@barcap.com               potential annual superlong capacity at ¥13-14trn. We recommend choosing JL current
                                            issues for JL swap spread long positions.
            Reiko Tokukatsu, CFA
                                            We discussed last week how the JGB bull flattening trend over the past month has not been
                  +81 3 4530 1532
                                            led by speculative flattening trades by the banks as in 2010. In bull flattening phases
    reiko.tokukatsu@barcap.com
                                            encompassing the superlong sector, the decisive factor is not life insurers, the main player in
                                            superlongs, but the investment stance of the banks. Conversely, when absolute yields are in
                     Noriatsu Tanji
                                            decline, life insurers tend to have less interest in lengthening their portfolios. The pace of
                  +81 3 4530 1346
                                            JGB superlong acquisitions by life insurers had already slowed notably in April compared
      noriatsu.tanji@barcap.com
                                            with the preceding month. Their purchasing in this sector, which hit a record ¥16trn in FY
                                            11, had been expected to slow in FY 12 due to lower sales of single-premium products
                                            through the banks. How will life insurer investment trends be affected by these two negative
                                            superlong factors (drop in absolute yields, slowdown in bank sales)? Now that life insurers
                                            have all reported their results, we consider this question using the latest data.

    We calculate what volume of             We look at European embedded value (EV), which life insurers have disclosed since around
superlongs insurers need to plug            2009. The data show the sensitivity of EV to 50bp changes in yields, and we believe the
     asset/liability duration gaps          figures are affected considerably by the size of the duration gap between assets and
                                            liabilities. In a general approximation, we calculate in reverse from this sensitivity to
                                            determine what volume of additional superlongs the insurers will have to buy to plug their
                                            asset/liability duration gaps (Figure 1).

Figure 1: Estimated portfolio lengthening needs at life insurers (JPY trn)
                                                                          Mar-09                Mar-10                 Mar-11                Mar-12
  Rate of EV decline when yields fall 50bp                                -14.9%                 -12.6%                -12.3%                -13.9%
  Asset duration shortfall (a)                                              18.6                  12.4                   10.9                  11.2
  Sum necessary to maintain current duration (b)                             8.4                   9.0                   10.0                  10.8
  Sum of superlong bond purchases needed to cover
                                                                            14.6                  13.1                   13.7                  14.5
  shortfall over 3 yrs (c)=(a)/3+(b)
  Sum of superlong bond purchases needed to cover
                                                                            12.1                  11.5                   12.2                  13.0
  shortfall over 5 yrs (d)=(a)/5+(b)
(a) Required superlong purchasing volume assuming 7% EV decline. Assuming purchasing of 20y, 30y and 40y based on the weighting by issue amounts.
(b) Annual superlong buying needed to offset natural shortening in asset durations.
Source: Life insurer earnings, Barclays Research


           We assume a target EV            EV sensitivity to yields does not necessarily have to be zero. We assume here a target value
      sensitivity of 7% for a 50bp          of 7% for a 50bp change. Also, only six of the nine major life insurers disclose EV,
                    change in yield         representing only around 62% of the whole by total assets. There will naturally be a large
                                            margin of error in estimates for the industry overall, ie, including insurers other than just the
                                            majors. The figure is thus an extremely rough estimate.

       ¥11.2trn in superlong JGBs           Assuming insurers have to extend their asset duration to achieve the EV sensitivity targets
 needed to extend asset duration            immediately at the start of FY 12, we find that they must buy ¥11.2trn in superlong JGBs based
               at the start of FY 12        on weightings by issue amounts. Of course, they may not have to achieve the target so
                                            quickly, so we have estimated the amount needed to bury the asset/liability duration gap over
                                            both a five- and three-year period. Insurers must also buy superlongs for maintenance

1 June 2012                                                                                                                                           62
Barclays | Global Rates Weekly


                                           purposes in order to avoid a natural contraction in durations in their existing bond portfolios
                                           with the passage of time. We assume a certain level of new contracts to sustain their liability
                                           durations. Durations in their existing portfolios (including fixed-rate loans and foreign bonds)
                                           are already quite long, so the amount of purchasing required to maintain this is also growing
                                           longer each year. Purchases for duration maintenance should come to 70-80% of their total
                                           superlong purchases (though it is difficult in practice to separate this amount from the total).

          ¥13.0-14.5trn in annual          The five- and three-year cases will require ¥13.0-14.5trn in annual superlong purchases to fill
superlong purchases required to            the duration gap. From that perspective, the ¥16trn logged in FY 11 appears high. However,
          fill the duration gap over       even if the impact of bank sales should fall ¥2-3trn, there would be latent purchasing demand
                             3-5 years     at the FY 09 and FY 10 levels for the next several years. Therefore, depending on yield levels
                                           this factor should not lead to any significant damage in superlong supply/demand. Looking at
                                           yield levels, we find that asset duration shortfall widened somewhat from FY 10 to FY 11
                                           (Figure 1). This suggests that a decline in superlong yields may dampen the pace of the
                                           duration extension. If yields should remain in their present range through FY 12, we could see
                                           an unexpectedly large slowdown in superlong buying by life insurers.

                                           Selecting attractive sectors for JL swap spread
    Rolldown for JL swap spreads           In the term structure of JL swap spreads, the 18-20y sector is usually either inverted or flat
    starts from the 18-17y sector          and rolldown starts from the 18-17y sector (Figure 2). Therefore, the 18-17y sector may
                                           appear to be most attractive from rolldown point of view; however, the rolldown is not that
                                           large, at 1-2bp/year, and it is worth testing historically whether the rolldown was
                                           monetized.

                                           We selected a few dates where JL swap spreads were cheap (about 9bp, and therefore likely
                                           to establish long position). On those dates, we compared 6m rolldown and 3m changes in
                                           swap spreads for individual JL issues (Figure 3). We recognize a subtle relationship. We
                                           looked at how some issues performed over time, for example, the best roll-down issue on
                                           December 2011 (JL110 with 1.8bp) and a slightly good roll-down issue on November 2011
                                           (JL108 with 0.8bp). Figure 4 shows their performance relative to the then current issue.
                                           While both issues in the end have performed since March, they moved either parallel or
                                           even underperformed during December-February. JL108 underperformed vs the current
                                           issue by almost 2bp. We think that the recent outperformance of JL110 and JL108 is not due to
                                           roll-down but due to the change of the curve shape.



Figure 2: Term structure of JL swap spread (bp)                          Figure 3: 6M rolldown vs. 3M swap spread change by JL issue

                                                                11.0                                7
 13.0                                                                                               6                                              JL110
                                                                10.5
                                                                           3M change in ASW (bp)




                                                                                                    5
 12.0                                                           10.0                                4
                                                                9.5                                 3
                                                                                                                                               JL110
 11.0                                                                                               2
                                                                9.0                                 1
 10.0                                                           8.5                                 0
                                                                                                   -1                                JL108
                                                                8.0
   9.0                                                                                             -2
                                                                7.5                                -3
                 Current (LHS)           Feb 1 (RHS)
                                                                                                        -2        -1        0        1         2           3
   8.0                                                         7.0
      19.75     19.00       18.25 17.50 16.75      16.00   15.25                                                           6M rolldown (bp)
                               maturity (years)                                                              10-Aug-11   10-Nov-11 15-Dec-11   17-Feb-12

Source: Barclays Research                                                Source: Barclays Research

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Figure 4: JL asw difference between best-roll vs. current issue                             Figure 5: Cheapest sector of swap spreads in JL

   4                                                                             3.0          19.5                                                                            16
                  difference between JL110 vs. JL131 (LHS)                                                                                                                    14
   3                                                                             2.5          19.0
                  difference between JL108 vs. JL129 (RHS)                                                                                                                    12
   2                                                                             2.0          18.5
                                                                                                                                                                              10
   1                                                                             1.5          18.0                                                                            8

   0                                                                             1.0                                                                                          6
                                                                                              17.5
                                                                                                                                                                              4
  -1                                                                             0.5          17.0
                                                                                                                                                                              2
  -2                                                                             0.0          16.5                                                                            0
                                                                                                 Aug-11           Oct-11          Dec-11          Feb-12       Apr-12
  -3                                                                             -0.5
   Nov-      Dec-       Jan-     Feb-      Mar-          Apr-      May-                                            Cheapest sector (years, LHS)
     11       11         12       12        12            12        12                                             Constant maturity 20Y ASW (bp, RHS)
Source: Barclays Research                                                                   Source: Barclays Research


                                                  These examples suggest that 3 months is too short to monetize rolldown. Figure 5 shows
 We find 3 months is too short to                 the cheapest sector in JL swap spread over time. We can see that the cheapest sector
                  monetize rolldown               changes quite significantly and also that the relationship with the level of swap spread is not
                                                  so clear. Unlike the JGB 7-10 rates curve, the shape of JL swap spread term structure is not
                                                  so stable. Therefore, curve shape is more important than rolldown for a trade with a
                                                  relatively short horizon like 3 months (short compared to real money investors who view
For investors looking to establish                swap spreads as synthetic floaters). As for now, we can see that the swap spread for JL
JL swap spreads, we recommend                     current sector has cheapened much more than 16-18y sector vs 3 months ago. For
            selecting current issues              investors looking to establish JL swap spreads, we recommend selecting current issues.

Figure 6: Trade recommendation updates (bp)
                                               Year                           Current
                                               end/               Level at      (incl     Weekly       Risk
                                   Entry       Entry            last report   carry)or      P&L       (DV01,      Target
                                   date        level             (24-May)      closed    (JPY mn)    JPY mn)    (incl carry)   Stop     Horizon    Action
                                                                                                                                        medium-
          JGB 5-10Y flattener     27-Apr       67.0                67.0        63.0        40.0       10.0        63.0         71.0             Take profit
                                                                                                                                         long
 JGB
          sell JBM2JBU2                                                                                100
                                 24-May        20.0                20.0        17.0        3.0                    15.0         25.0      1-2w     Hold
          calendar spread                                                                            contract
          Pay 2s5s10s            11-May        -39.0              -37.1        -36.1       5.0        10.0        -35.0        -45.0    medium Take profit
                                                                                                                                                  New (30 May Intraday
                                                                                                                                                  comment, while already went
 Swap     1mx20y receiver
                                                                                                                                                  against, we think the flight-to-
          spread short           30-May        -41.0               n/a         -70.0       -5.8      2bn face      0.0         -100.0      1m
                                                                                                                                                  quality rally is near peak and
          (1.5%-1.4%)
                                                                                                                                                  time decay is likely to help the
                                                                                                                                                  position)
          10Y ASW (JB318)         25-Nov          0.1              -0.3         -0.4       1.0         10          -5.0         8.0       long    Hold
          9Y ASW (JB312)          20-Apr          -3.4             -2.7         -3.6       4.5          5          -6.0         2.0       long    Hold
 Swap
 spread 20Y ASW vs. 3month        28-Oct       36.0                33.2        33.7        -5.0        10         25.0         42.0       long    Hold
        (JL129)
          20Y ASW (JL135)        22-May        11.4                10.9        12.6        -8.5         5          4.0         18.0       long    Hold
                                                                                                                                        medium-
 Xccy     Pay 6mx1y              18-May        -53.0              -55.0        -56.0       -5.0         5         -30.0        -80.0            Hold
                                                                                                                                         long
 basis
 swap                                                                                                                                   medium-
          Rec 20yx10y             27-Jan       38.0                33.0        33.7        -2.1         3         20.0         45.0             Hold
                                                                                                                                         long

Weekly P/L = 27.1; Total P/L since 2012: 516; Balance sheet 0.0; 1 day VaR (x2.33 std) 60.7
Note: Current levels based on the absolute maturity to capture rolldown correctly; therefore, it is different from the constant-maturity spread.
Source: Barclays Research




1 June 2012                                                                                                                                                                    64
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TRADE RECOMMENDATIONS

                                   New trades
                    Piyush Goyal   US TIPS
                +1 212 412 6793      Theme: Inflation risk premium
      piyush.goyal@barcap.com
                                     −   Long $15k dv01 10y10y vs 5y5y breakeven, initiated on June 1 2012, P&L -$45k.
                                         Entry levels are good, and inflation risk premium could increase as QE is priced in.

                                   UK TIPS
                                     Macro

                                     −   Buy GBP 7mn notional IL20 vs. pay matched-maturity swap, initiated on June 1
                                         2012, P&L -$58k. Breakevens are cheap.

                                   US Treasury
                                     No new trades.

                                   US Swaps/Treasury futures
                                     No new trades.

                                   US BMA
                                     No new trades.

                                   US Options
                                     No new trades.

                                   EUR Options
                                     Macro

                                     −   Initiate EUR 20mn 1x2 1y*5y receiver ladder 1.25% vs. 1%, initiated on June 1st
                                         2012, P&L - $25k. Vol is high for the current level of yield.

                                   JPY Options
                                     Higher rates

                                     −   Sell $27mn equivalent JPY 1m*20y receiver spread, initiated on May 30th 2012, P&L -
                                         $77k. Long-end JPY swaps are too rich.

                                   Current trades
                                   US TIPS
                                     Macro

                                     −   Buy $500mn Jan14 TIPS asset swap, initiated on January 12, 2012, P&L $482k. A
                                         significant yield pickup vs other assets in the short end.

                                     Relative Value

                                     −   Long 10y TIPS asset swap vs short nominal 10y asset swap, $10k dv01, initiated on
                                         March 29, 2012, P&L $10k. We unwind the trade this week.

                                     Theme: Normalization


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                                   −   Buy $30k dv01 Apr13 TIPS hedged with 25 XBH3 and short CPI caps at 2%, initiated
                                       on November 2, 2011, P&L $511k. Front-end breakevens have lagged the recent
                                       move in risky assets.

                                   Theme: Euro area contagion risk

                                   −   Buy $50k dv01 Apr17 vs Jan17, initiated on April 19, 2012, P&L $200k.

                                   −   Short $50mn (on 5y) 2y-5y-10y breakeven fly hedged with selling 15 XBZ2, initiated
                                       on May 18, 2012, P&L $76k.

                                 US Treasury
                                   Relative value

                                   −   Short $50k dv01 high-coupon Nov15 Ps vs high-coupon Feb15 Ps, initiated on May
                                       10, 2012, P&L -$240k. We recommend switching from the rich 9.875% Nov15s to
                                       the cheaper issue 11.25% Feb15s, as the latter have cheapened unduly after
                                       becoming eligible for Fed sales under Operation Twist.

                                   −   Short $50k dv01 5y-7y-10y Treasury fly, initiated on May 10, 2012, P&L -$325k. We
                                       stop ourselves out of the trade.

                                 US Swaps/Treasury futures
                                   Macro

                                   −   Sell $50k dv01 30y swap spreads, initiated on January 6, 2012, P&L -$237.5k.
                                       Corporate issuance should tighten long-end swap spreads.

                                   −   $50kdv01 March 2014 FRA-OIS widener, initiated on April 6, 2012, P&L $300k.
                                       Eurozone concerns should widen the front-end spreads.

                                   Calendar roll

                                   −   Long 2000 TU calendar roll, initiated on May 18, 2012, P&L +$70k. We unwound the
                                       trade on May 30.

                                   −   Long 2000 TY calendar roll, initiated on May 18, 2012, P&L +$110k. We unwound
                                       the trade on May 30.

                                 JPY Swaps
                                   Macro

                                   −   Long $60k dv01 20y swap spreads, initiated on May 22nd 2012, P&L -$72k. Entry
                                       levels are good; the spread is less vulnerable to funding stress and carries well.

                                   Theme: Good carry trade with stable front end

                                   −   Pay $60k dv01 6mx1y, initiated on May 18, 2012, P&L -$180k. USD/JPY Xccy basis
                                       moved downward except for the very short end. We think it is attractive to pay
                                       6mx1y as the improved carry of 6bp/month is twice 1y1y.

                                   Theme: Calendar roll

                                   −   Sell 100 contracts JBM2-JBU2 calendar roll, initiated on May 24, 2012, P&L $39k. The
                                       roll should be dominated by long roll.

                                 US Options
                                   Macro

1 June 2012                                                                                                              66
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                                   −   Sell $20mn 1y*10y straddles hedged with $200mn 1y*1y 1.001.25% payer spread,
                                       initiated on May 24, 2012, P&L -$150k. The mid-expiry vol should decline as
                                       expectations of range trading in rates come back.

                                   −   Sell $20mn 2y*10y straddles, initiated on May 25, 2012, P&L -$70k. The mid-expiry
                                       vol should decline as expectations of range trading in rates come back.

                                   Relative value

                                   −   Buy $50mn 3y*10y payer at 5% vs sell $350mn single-look 10y CMS cap at 5%,
                                       initiated on February 17, 2011, P&L $100k. We look to monetize the high convexity
                                       adjustment.

                                   −   Long $100mn 1y*5y straddles vs 2000 3EM2 straddles, initiated on April 16, 2012,
                                       P&L -$80k. The trade aims to gain from range-bound rates.

                                   Theme: Eurozone contagion

                                   −   Buy $90mn 1y*2y ATM vs 50bp high-strike payer spread vs sell $20mn 1y*10y ATM
                                       vs 50bp high-strike payer spread, initiated on August 18, 2011, P&L $200k. The
                                       trade seeks to keep the premium intake from initiation.

                                   −   Buy $490mn 6m*1y payer spread vs sell $100mn 6m*7y payer spread, initiated on
                                       January 6, 2012, P&L +$405k. Libor-OIS widening and the pushing out of hike
                                       expectations should benefit the trade.

                                   −   Long $100mn 1y*1y payer spread (0.55% vs 1.05%), initiated on February 3, 2012,
                                       P&L $20k. 1y tails are cheap, and FRA-OIS should eventually widen.

                                   −   Buy $200mn 1y*30y digital floor 2.25% vs $200mn 3m*30y digital floor 2.25%,
                                       initiated on May 18, 2012, P&L -$240k. The trade seeks to gain from an unexpected
                                       crisis in the eurozone.

                                   Theme: Hike expectations

                                   −   Buy 1y*1y-1y*3y-1y*5y payer fly, initiated on February 9, 2012, P&L -$130k. A re-
                                       pricing of hike expectations should cause the fly to cheapen in a sell-off.

                                   Theme: Higher longer rates

                                   −   1x1 $100mn 5y*10y payer spread, initiated on January 15, 2009, P&L $369k. We
                                       added the short CMS cap at 5% on July 2, 2010. We sold $100mn 3m*10y payer at
                                       2.75%, on September 8, 2011. We sold $75mn 6w*10y payer at 2.75% on
                                       November 10, 2011. The trade is short duration and long vol. We like the risk profile,
                                       so we continue to hold the trade.

                                 EUR options
                                   Capped steepener

                                   −   EUR 90mn vs 20mn 2y5y vs 2y30y bear steepener, sell EUR 210mn 2y single-look
                                       5y-30y curve cap @ 75bp, initiated on March 9, 2012, P&L $140k. The trade exploits
                                       high 2y*5y vol and aims to generate positive carry.

                                 Cross-currency
                                   US vs. EUR gamma



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                                   −   Short 100 TYM2 straddles at 131 vs EUR100mn 4m*7y straddles, initiated on
                                       January 26, 2012, P&L $180k. The trade expired on May 25.

                                   −   Short 750 TYU2 straddles @ 130.5 vs EUR50mn 8/24/12 ->7y straddles, initiated on
                                       April 19, 2012, P&L -$265k. Both EUR and US rates would remain range-bound. But
                                       EUR vol is cheaper than US vol.

                                   US vs. EUR vol

                                   −   Short USD75mn 5x10 caps at 8% vs long EUR50mn 5x10 caps at 5%, initiated on
                                       October 15, 2009, P&L $670k. The trade benefits if US inflation concerns remain
                                       contained for several months.

                                   −   Long EUR 10mn 3y*10y payer at 4% vs USD 13mn 3y*10y payer at 4%, initiated on
                                       February 3, 2012, P&L +$30k. EUR vol and skew should richen relative to US.

                                   EUR vs. GBP hike expectations

                                   −   Buy EUR 100mn 6m*2y payer 0.95% vs GBP 82mn 6m*2y payer 1.48%, initiated on
                                       May 4, 2012, P&L +$145k. This is a tactical trade to position for some normalization
                                       of short rates in both currencies.

                                 US BMA
                                   Macro

                                   −   Buy 3m forward 1y ratio and sell notional neutral 3y forward 1y ratio, initiated on
                                       January 12, 2012, P&L $100k. SIFMA should set low for a long time, although we see
                                       the possibility of a near-term downward drift in Libor.

                                   −   Sell $200mn 3y ratio, initiated on May 10, 2012, P&L $0k. SIFMA should set low for a
                                       long time, relative to Libor.




1 June 2012                                                                                                              68
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TRADE PORTFOLIO UPDATE

                                   Unchartered territory
                    Piyush Goyal   The portfolio lost $2,120k last week, mostly because the eurozone crisis worsened and the
                +1 212 412 6793    weak US payroll data pushed yields to record lows. The portfolio is down $77k for 2012 and
      piyush.goyal@barcap.com      has gained $40mn since inception. 7

                                   Figure 1: Mark-to-market performance of the portfolio – Cumulative P&L, $mn

                                       45
                                       40                                                                                                           $40.0
                                       35
                                       30
                                       25
                                       20
                                       15
                                       10
                                        5
                                        0
                                        Jan-09          Aug-09         Feb-10           Sep-10          Mar-11            Oct-11           Apr-12


                                   Note: As of June 1, 2012. Portfolio stop loss = $10mn. Given this total loss allowed, we allocate $500k as the stop-loss
                                   for high-conviction trades and less for low-conviction trades. Source: Barclays Research


                                   Total equity = $100mn, stop-loss = $10mn
                                   We estimate an initial and variation margin for each derivative trade and a haircut for cash
                                   trades. The total of all such margins and haircuts is less than $100mn. In other words, the
                                   portfolio is assumed to have $100mn of equity. Thus, all returns are computed on a base of
                                   $100mn. Any unused equity is invested in fed funds and assumed to earn the daily funds rate.




                                   7
                                       Since January 2009.

1 June 2012                                                                                                                                              69
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Trade Portfolio

New Positions
                                                                                                            Levels @                    Net Change (Gain   Total Stop Loss                              Variation
  Inception Date           Theme                           Trade                  Weights/Notional Amount   Inception   Current Level     (+) /Loss (-))         (bp)        Horizon   Initial Margin               Total Margin
                                                                                                                                                                                                         Margin
     US TIPS
    6/1/2012        Inflation risk premium        Long 10y10y vs 5y5y BE                 $15k dv01            -19bp        -22bp           ($45,000)         ($150,000)        3m       $1,655,000      $45,000     $1,700,000



     UK TIPS
    6/1/2012               Macro             Long IL20 vs. pay match-maturity            GBP 7mn             280bp         278bp           ($58,140)         ($250,000)        3m        $431,200       $58,140      $489,340
                                                           swap

   EUR Options
    6/1/2012              Short vol          EUR 1x2 1y5y 1.25 vs 1 recr ladder      EUR 20mn: (40mn)          $0        ($25,000)         ($25,000)         ($250,000)        6m        $744,000       $25,000      $769,000



   JPY Options
    5/30/2012           Higher rates            Sell 1m*20y receiver spread               $27mn               41cts        70cts           ($77,000)         ($225,000)        1m        $421,200       $77,000      $498,200


Note: All prices as of June 1, 2012.
Source: Barclays Research




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Trades Outstanding
  Inception                                                                             Weights/Notional      Levels @                       Net Gain (+)                                                      Variation    Balance Sheet
                      Theme                               Trade                                                              Current Level                  Stop Loss (bp)      Horizon       Initial Margin
    Date                                                                                    Amount            Inception                       /Loss (-)                                                         Margin          Used
   US TIPS                                                                                                                                                                                                                  $6,971,000
  11/2/2011       Normalization        Long Apr' 13 TIPS vs. sell 2% CPI cap and sell     $30k dv01; 45     -103bp, -36bp,   -18bp, -12bp,    $511,000       ($500,000)         Maturity       $2,150,000      ($511,000)   $1,639,000
                                                          XBH3                              contracts           249.83            245
  1/12/2012      Front-end Asset                  Long Jan '14 TIPS ASW                     $500mn           Libor - 13bp     Libor - 15bp    $482,000       ($250,000)           6m           $2,500,000      ($482,000)    $2,018,000
                 Swap Tightener
  3/29/2012       Relative Value           Long TII Jan 22 Relative Asset Swap              45k dv01            33bp             31bp         $10,000        ($500,000)         Unwound        $1,500,000      ($10,000)     $1,490,000
  4/19/2012    Eurozone contagion                 Long Apr '17 vs Jan '17                   $50k dv01            6bp              1bp         $200,000       ($500,000)            1y          $1,600,000      ($200,000)    $1,400,000

  5/18/2012       Normalization        Short 2y-5y-10y breakeven fly, hedged with       $50mn on 5y: (15)   9.54bp, 254.48     16bp, 235      $76,000        ($500,000)           3m            $500,000       ($76,000)      $424,000
                                                         XBZ2


 US Treasury
                                                                                                                                                                                                                            $4,565,000

  5/10/2012       Relative Value          Short HC Nov '15 Ps vs. HC Feb '15 Ps             $50k dv01          6.25bp           1.75bp       ($240,000)      ($300,000)           1m           $2,000,000      $240,000      $2,240,000
  5/10/2012         Fading 7yr                     Short 5yr - 7yr - 10yr                   $50k dv01          -12.2bp         -18.2bp       ($325,000)      ($300,000)         Stop-out       $2,000,000      $325,000      $2,325,000


 US Swaps /
                                                                                                                                                                                                                            $6,054,313
   Futures
  1/6/2012           Issuance                        Sell 30y spreads                       $50k dv01           -31bp          -26.25bp      ($237,500)      ($250,000)           6m           $1,812,500      $237,500      $2,050,000
  4/6/2012        Front-end spd           March '14 FRA-ois (USFOSC8) widener               $50k dv01          38.5bp           44.5bp        $300,000       ($250,000)           3m           $2,000,000      ($300,000)    $1,700,000
                     widener
  5/18/2012       Calendar Roll                  Long TUU2 Short TUM2                      2000:(2000)       2.875 (ticks)    1.75 (ticks)     $70,313       ($250,000)      Unwound on May    $1,242,000      ($70,313)     $1,171,688
                                                                                                                                                                                  30
  5/18/2012        Calendar Roll                 Long TYU2 Short TYM2                      2000:(2000)       31.75 (ticks)     30 (ticks)     $109,375       ($250,000)      Unwound on May    $1,242,000      ($109,375)    $1,132,625
                                                                                                                                                                                  30


  JPY swaps                                                                                                                                                                                                                 $2,543,000
  5/18/2012    Good carry trade with                    6mx1y pay                           $60k dv01           -53bp           -56bp        ($180,000)      ($420,000)          3-6m           $600,000       $180,000      $780,000
                 stable front end.

  5/24/2012        Calendar Roll            Short calendar spread (JBM2-JBU2)             100 contracts        20 ticks        17 ticks        $39,000        ($12,500)           2w            $250,000       ($39,000)      $211,000
  5/22/2012        Long spreads                   Long 20Y swap spread                      $60kdv01             11.4            12.6         ($72,000)      ($400,000)          3-6m          $1,480,000       $72,000      $1,552,000


 US Options                                                                                                                                                                                                                 $16,961,100
  1/15/2009     Longer Rates could     Buy 5y*10yr Payr Spd (ATM vs 100 bp high), $100mm: - $100mm          ($1,924,000)     ($1,555,000)     $369,000       ($250,000)            4y          $2,892,500      ($369,000)    $2,523,500
                       Rise            added the short CMS cap @ 5% on 7/2/10 ;
                                        sell 6w*10y payer @ 2.75% on Nov 10 '11

  2/17/2011       Relative Value       Buy 3y*10y payer @ 5% Sell 3y SL 10y CMS         $50mn: ($350mn)      ($100,000)           $0          $100,000       ($500,000)            2y          $1,105,000      ($100,000)    $1,005,000
                                                      Cap @ 5%
  8/18/2011    Eurozone contagion        Long 1y2y payer spread vs 1y10y payer           $90mn: $20mn        ($130,000)        $70,000        $200,000       ($500,000)            1y          $1,033,600      ($200,000)     $833,600
                                                         spread
  1/6/2012     Eurozone Contagion        Long 6m1y payer spread vs. short 6m7y          $490mn: ($100mn)     ($340,000)        $65,000        $405,000       ($500,000)          Expiry        $4,860,000      ($405,000)    $4,455,000
                                                     payer spread
  2/3/2012     Eurozone contagion       Long 1y1y payer spread (0.55% vs 1.05%)             $100mn            $105,000         $125,000        $20,000        ($50,000)          Expiry         $220,000       ($20,000)      $200,000

  2/9/2012      Hike expectations          Long 1y*1y - 1y*3y - 1y*5y payer fly         ($300mn): $200mn:     ($30,000)       ($160,000)     ($130,000)      ($500,000)           6m           $1,464,000      $130,000      $1,594,000
                                                                                             ($60mn)
  4/26/2012     Rangebound rates          Long 1y5y straddles vs 3EM2 straddles           $100mn:(2000)      $1,500,000       $1,420,000      ($80,000)      ($500,000)           2m           $2,310,000       $80,000      $2,390,000

Note: All prices as of June 1, 2012. Source: Barclays Research

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 Inception                                                                             Weights/Notional     Levels @                      Net Gain (+)                                                Variation    Balance Sheet
                       Theme                                Trade                                                         Current Level                  Stop Loss (bp)   Horizon    Initial Margin
    Date                                                                                   Amount           Inception                      /Loss (-)                                                   Margin          Used
 US Options                                                                                                                                                                                                        $16,961,100
  5/18/2012      Eurozone blow-up         Buy 1y*30y flr 2.25% vs 3m*30y flr 2.25%     $200mn: ($200mn)     $350,000        $110,000      ($240,000)      ($250,000)        3m        $1,740,000      $240,000      $1,980,000

  5/24/2012           Short vol           Short 1y*10y straddles vs. long 1y1y payer   ($20mn): $200mn     ($1,160,000)   ($1,310,000)    ($150,000)      ($500,000)        6m         $880,000       $150,000      $1,030,000
                                                       spread 1- 1.25
  5/25/2012           Short vol                    Short 2y*10y straddles                  ($20mn)         ($1,830,000)   ($1,900,000)     ($70,000)      ($500,000)        6m         $880,000        $70,000       $950,000


 EUR Options
                                                                                                                                                                                                                   $3,935,850

  3/9/2012        Capped steepener      2y5y vs 2y30y bear steepener, short 2y SL 5y-   (EUR 90mn: EUR     ($1,032,000)    ($892,000)      $140,000       ($500,000)       Expiry     $2,210,000      ($140,000)    $2,070,000
                                                   30y curve cap @ 75bp               20mn: (EUR 400mn)

  4/13/2012         Higher rates          Buy EUR 3m*5y payer 1.55% KO 2.05%              EUR 100mn         $560,000        $50,000       ($510,000)      ($500,000)      Stop-out    $1,355,850      $510,000      $1,865,850



   Cross-
                                                                                                                                                                                                                   $4,430,541
  currency
 10/15/2009        Cross -currency      Short 5x10 US caps @ 8% vs Long 5x10 EUR ($75mm): EUR 50mm         ($200,000)       $470,000       $670,000       ($500,000)        3y        $1,378,125      ($670,000)     $708,125
                                                        caps @ 5%
  1/26/2012        Cross -currency          Long EUR 4m*7y vs TYM2 straddles       EUR 10mn: (100)          ($20,000)       $160,000       $180,000       ($500,000)      Expired      $271,700       ($180,000)     $91,700
  2/3/2012         Cross -currency      Long EUR 3y10y P @ 4% vs USD 3y10y P @         EUR 10mn: (13mn)     ($90,000)      ($60,000)        $30,000       ($500,000)       Expiry      $450,840       ($30,000)      $420,840
                                                          4%
  4/20/2012       Long EUR vs. US           Long EUR 4m*7y std vs. TYU2 std             EUR 50mn: (750)    ($945,000)     ($1,210,000)    ($265,000)      ($500,000)       Expiry     $1,358,500      $265,000      $1,623,500
                     gamma
  5/4/2012           Tactical           Long EUR 6m*2y payer vs GBP 6m*2y payer           EUR 100mn            $0           $145,000       $145,000       ($250,000)        3m        $1,731,376      ($145,000)    $1,586,376
                                                                                          :(GBP82mn)



    BMA                                                                                                                                                                                                            $1,500,000
  1/12/2012     Sell Front-end Ratios     Long 3m1y BMA ratio vs short 3y1y ratio;     $200mn : ($200mn)      54, 84         50, 80        $100,000       ($250,000)        6m         $800,000       ($100,000)    $700,000
                                           3m1y matured on 4/12 at 1y ratio = 50,
                                                   implying p&l -$42k
  5/10/2012     Sell Front-end Ratios                 Short 3y ratio                       $200mn             67.375         67.375           $0          ($250,000)        6m         $800,000          $0          $800,000



    Cash                                                                                                   5/24/2012       6/1/2012
           Cash Used as Collateral/ Haircut                                                                $44,103,053    $46,960,803
              Fed Funds (residual cash)                                                                    $57,969,314    $52,993,018
                                                    Return on Fed Funds                                     $28,868         $30,821
                                                      Return on trades                                                     ($77,000)
                        Total                                                                                             $99,953,821

Note: All prices as of June 1, 2012. Source: Barclays Research




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Trades Unwound
Inception     Unwound                                                                                          Weights/Notional     Levels @      Levels @      Net Change (Gain   Total Stop
Date          Date                   Theme                                      Trade                              Amount           Inception      Unwind         (+) /Loss (-))   Loss (bp)      Horizon
US TIPS
9/29/2011     1/12/2012      Front-end Asset Swap                      Long Jan '12 TIPS ASW                        $500mn            Libor -    Libor - 34bp      $170,000        ($250,000)    Unwound
                                   Tightener                                                                                         15.75bp
1/6/2012      1/19/2012          Supply Trade                       Sell Apr '16 - Jul '21 - Apr '28               $25k dv01           20bp         21bp             $25,000       ($500,000)     Unwound
10/20/2011    2/23/2012          Relative Value                    10y-30y breakeven steepener                     $20k dv01          21.5bp        5bp            ($260,000)      ($250,000)   Stopped -out
3/9/2012      3/28/2012          Relative Value                  Long Apr '14 - Apr '15 breakeven                  $30k dv01          165bp        185bp            $500,000        $200,000      Unwound
1/27/2012     4/6/2012            Dovish Fed                           Long 5y5y breakevens                        $20k dv01          232bp        251bp            $250,000        $300,000      Unwound
6/16/2011     4/19/2012       Eurozone contagion            Long the belly Jan '16 - Apr '16 - July '16 real       $20k dv01          5.5bp         7bp             ($20,000)       ($75,000)     Unwound
                                                                               yield fly
8/5/2011      5/24/2012            Long TIPS                Long July'12 TIPS energy hedged; bought 20         12k dv01, Short 40    -60.5bp,    -253bp, 288       $865,000           $0         Unwound
                                                                    XBM2 on 4/6/12 for 327.66                    XBH2 (XBM2)          267.76



US Treasury
1/12/2012     1/26/2012           Fed-on-hold                       Long 2y-5y-10y treasury fly                    $50kdv01          -49.5bp       -66.5bp         $850,000        ($500,000)    Unwound
1/19/2012     1/26/2012            Dovish Fed                       10y-30y tsy curve steepener                    $50k dv01        106.25 bp     117.25 bp        $550,000        ($500,000)    Unwound
2/9/2012      2/23/2012         Unwind of auction                    7y-30y tsy curve flattener                    $50k dv01        177.75bp      174.75bp         $150,000        ($500,000)    Unwound
                                   concession
3/1/2012      3/9/2012      Bond auction concession                 10y-30y tsy curve steepener                    $50k dv01         111.5bp      116.25bp          $237,500       ($500,000)    Unwound
3/29/2012     4/6/2012      Bond auction concession                 10y-30y tsy curve steepener                    $50k dv01         111.5bp       117.5bp          $305,000       ($500,000)    Unwound
3/1/2012      4/19/2012      Increase in odds of QE3                    Long 5y-10y-30y fly                        $50k dv01          1.75bp        -1.7bp          $172,500       ($500,000)    Unwound
3/1/2012      4/19/2012            Fading 7yr                          Short 5yr - 7yr - 10yr                      $50k dv01          -4.5bp       -11.8bp         ($365,000)      ($500,000)    Unwound
3/16/2012     4/19/2012            Dovish Fed                                Long ct2                               75k dv01          36.9bp        26.7bp          $865,000       ($500,000)    Unwound
4/20/2012     5/17/2012   Low front-end term premium               Vol weighted 2y - 3y steepener               $80k dv01: ($50k       -2bp         -7.5bp         ($270,000)      ($500,000)    Unwound
                                                                                                                     dv01)
4/26/2012     5/17/2012     Bond auction concession                 10y-30y tsy curve steepener                    $50k dv01         117.2bp      112.2bp          ($250,000)      ($500,000)    Unwound

Eurozone Sovereign debt
4/19/2012    5/17/2012        Eurozone contagion            Short FRTR Apr '20 vs. 50% RFGB Apr '20 and            $35k dv01          -42bp        -58.5bp         $542,500        ($250,000)    Unwound
                                                                         50% RAGB Jul '20
4/27/2012     5/25/2012           Italy vs. Spain          Short BTPS 3.75% Mar 21 vs SPGB 5.5% Apr 21            $12.5k dv01         -37bp         -70bp          ($425,000)      ($350,000)    Stop-out



US Swaps/ Futures
1/19/2012    2/23/2012           Calendar roll                      USH2 invoice spread widener                   $100k dv01          0.45bp       -2.4bp          ($285,000)      ($500,000)    Unwound
1/6/2012     3/15/2012        Eurozone Contagion                       Short EDU2 Long EDU4                      2000 contracts      47.75bp      54.75bp          ($525,000)      ($500,000)    Stop-out
3/16/2012    4/6/2012           Spread widener                       FV invoice spread widener                     $50k dv01         17.75bp      28.25bp           $525,000       ($500,000)    Unwound
4/19/2012    5/24/2012           Relative Value             Sell TYM2 Invoice spread vs. 1/3rd dv01 1y1y          $50k DV01          12.15bp      19.7bp           ($377,500)      ($500,000)    Unwound
                                                                              libor-OIS
JPY swaps

5/18/2012     5/25/2012   Fade excessive bull-flattening                 6x2-8x2 steepener                        $120k dv01         48.75bp       50.5bp          $210,000        ($450,000)    Unwound

US Options
10/7/2011     1/9/2012          Sell GBP Gamma                         Sell 3m5y straddles                   GBP 25mn               ($650,000)   ($491,000)        $159,000        ($500,000)     Expired
10/7/2011     1/9/2012          Sell EUR Gamma                      Sell EUR 3m2y straddles                  EUR 25mn               ($225,000)   ($175,000)        $50,000         ($100,000)     Expired
10/20/2011    1/20/2012          Sell US Gamma                        Sell 3m*10y straddles                   $10mn                 ($420,000)   ($285,000)        $135,000        ($125,000)     Expired
1/19/2012     1/26/2012             Steepener              Long 4m30y payer spread (1.8 vs 2.1) and short $100mn: (2400)            ($100,000)    $700,000         $800,000        ($500,000)    Unwound
                                                                       TYM2 puts @ 128.5
11/18/2010    2/3/2012            Fed on hold                            long 1y1y collar                $300mm:($300mm)            $1,546,000   $2,069,000        $523,000        ($500,000)    Unwound

3/10/2011     2/3/2012            Fed on hold                            1y5y covered call                          $10mn           ($150,000)    $108,000         $258,000        ($250,000)    Unwound
5/19/2011     2/3/2012        Hedge to Fed on hold         Long 1y*2y payer spread (atm vs 100bp high-         $240mn: ($100mn)         $0        $100,000         $100,000        ($250,000)    Unwound
                                                              strike) and sell high-strike 1y*5y payer;
                                                             unwound the long 1y2y payer on 9/2/11

7/8/2011      2/3/2012            GBP options              1y1y vs 1y5y bear flat; unwound the long 1y1y        470mn: (100mn)      ($125,000)    $517,000         $642,000        ($250,000)    Unwound
                                                                        payer on Sep 22 '11
2/4/2011      2/9/2012            Fed on hold                 Rec 1y1y and sell 25bp low 1y*1y recr                 $100mn          ($225,000)    $249,000         $474,000        ($250,000)     Expired

11/4/2011     2/6/2012          Sell US Gamma                          Sell 3m*10y straddles                         $10mn          ($431,000)   ($233,000)         $198,000       ($250,000)     Expired
11/17/2011    2/17/2012         Sell US Gamma                          Sell 3m*10y straddles                         $10mn          ($440,000)   ($134,000)         $306,000       ($250,000)     Expired
12/2/2011     3/2/2012          Sell US Gamma                          Sell 3m*10y straddles                         $10mn          ($393,000)   ($259,000)         $134,000       ($250,000)     Expired
12/15/2011    2/24/2012         Sell US Gamma                            Sell TYH2 straddles                           100          ($284,375)    ($64,375)         $220,000       ($100,000)     Expired
11/10/2011    3/9/2012        Eurozone contagion                   6m 10y-30y CMS Bull Flattener                   $50k dv01         $225,000    ($350,000)        ($575,000)      ($500,000)    Stop-out
2/3/2012      3/22/2012            Steepener                       5y*2y vs 5y*30y bear steepener               ($200mn):$20mn       ($90,000)   ($630,000)        ($540,000)      ($500,000)    Stop-out
2/16/2012     3/22/2012            Steepener                      2y*10y vs 2y*30y bear steepener              ($112.5.mn): $50mn    ($20,000)   ($560,000)        ($540,000)      ($500,000)    Stop-out

2/9/2012      3/23/2012         Sell US Gamma                          Sell TYJ2 straddles                           100            ($201,000)   ($150,000)        $51,000         ($100,000)     Expired
2/23/2012     4/20/2012         Sell US Gamma                         Sell TYK2 straddles                            100            ($232,813)    ($67,813)        $165,000        ($100,000)     Expired
3/1/2012      4/20/2012         Sell US Gamma                         Sell TYK2 straddles                            100            ($212,500)   ($117,500)        $95,000         ($100,000)     Expired
11/4/2011     5/4/2012        Eurozone contagion           Long 6m1y payer spread vs. short 6m5y payer         $485mn: ($100mn)         $0           $0               $0           ($250,000)     Expired
                                                                             spread
2/9/2012      5/9/2012        Eurozone contagion           Long 3m1y payer spread vs. short 3m7y payer         $490mn: ($100mn)     ($110,000)    $270,000         $380,000        ($500,000)     Expired
                                                                             spread
2/23/2012     5/11/2012           Higher rates                 Buy 3m*10y payer 2.25% KO 2.75%                      $100mn          $570,000      $40,000          ($530,000)      ($500,000)    Unwound
11/17/2011    5/11/2012       Eurozone Contagion              Buy 6m2y payr spd vs 6m10y payr spd                 EUR 225mn:           $0           $0                 $0          ($500,000)    Unwound
                                                                                                                  (EUR50mn)
3/9/2012      5/17/2012         Sell US Gamma                          Sell TYM2 straddles                            100           ($245,313)   ($320,313)         ($75,000)      ($100,000)    Unwound
3/29/2012     5/17/2012         Sell US Gamma                          Sell TYM2 straddles                            200           ($440,625)   ($750,625)        ($310,000)      ($100,000)    Unwound
4/6/2012      5/17/2012         Sell US Gamma                          Sell TYM2 straddles                            100           ($190,625)   ($280,625)         ($90,000)      ($100,000)    Unwound
4/12/2012     5/17/2012         Sell US Gamma                          Sell TYM2 straddles                            100           ($193,750)   ($273,750)         ($80,000)      ($100,000)    Unwound
4/19/2012     5/17/2012         Sell US Gamma                          Sell TYN2 straddles                            100           ($221,875)   ($266,875)         ($45,000)      ($100,000)    Unwound
4/26/2012     5/17/2012         Sell US Gamma                          Sell TYN2 straddles                            100           ($192,188)   ($192,188)         ($30,000)      ($100,000)    Unwound
3/22/2012     5/17/2012        Rangebound rates             Long 1y30y @ 3.1% vs short 3m30y @ 3.1%             $20mn:($20mn)       $1,540,000   $1,035,000        ($505,000)      ($500,000)    Stop-out


Source: Barclays Research


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GLOBAL TRADERS’ GUIDE

                                 Key data and events
                                 US
                                   We look for a narrowing in the April nominal trade deficit to $49.5bn (Friday; consensus:
                                   $49.4bn, previous: $51.8bn). This would represent payback for the sharp widening in
                                   March, which was driven by very strong import growth.

                                   The May nonmanufacturing ISM is expected to decline to 53.0 (Tuesday; consensus:
                                   53.8, previous: 53.5), which would be consistent with the softening in the new orders
                                   component in April. In our view, this would reflect some easing in the pace of implied
                                   nonmanufacturing growth relative to a robust Q1.

                                   We project April factory orders to increase by 0.2% m/m (Monday; consensus: 0.3%,
                                   previous: -1.9%). The focus will be on any revisions to the estimates of core capital goods
                                   orders and shipments, which are applicable to our Q2 GDP tracking estimate.

                                 Europe
                                   On balance, we look for the ECB (Wednesday) to announce a further LTRO for late June
                                   as insurance against a potential intensification of deposit flight, while we do not expect
                                   a rate cut, given the many additional uncertainties and the very limited effective scope
                                   to lower rates further (with EONIA trading around 0.35pc all year). We don't expect the
                                   SMP to be reactivated as its effectiveness post Greek PSI, with the ECB now senior to
                                   other bond holders, likely to be a brake in its usage.

                                   Also, we expect euro area retail sales to have slightly increased by 0.2% m/m (Tuesday;
                                   consensus: -0.2%, last: 0.6%). We look for German industrial production to have slightly
                                   fallen by 0.5% m/m (Wednesday; consensus: -1.0%, last: 2.8%) on the back of weak
                                   PMI and IFO survey data and for Italian industrial production to have declined 0.4%
                                   m/m (Friday; consensus: -0.5%, last: +0.5%).

                                   In the UK, we expect the construction PMI to fall to 54.0 from 55.8 (Wednesday; consensus: 54.6)
                                   and the services PMI to fall to 51.5 from 53.3 (Thursday; consensus: 52.5). We expect the BoE
                                   (Thursday) to leave Bank Rate at 0.5% and the stock of asset purchases to remain at £325bn. We
                                   forecast producers’ input prices to fall by 2.1% m/m (Friday; consensus: -1.2%, last: -1.5%),
                                   output prices to fall by 0.1% m/m (consensus: +0.2%, last: 0.7%) and core output prices to rise by
                                   0.1% m/m (consensus: 0.2%, last: 0.6%).

                                 Japan
                                   In Japan, we expect Q1 real GDP to be raised to 5.0% q/q saar in the second preliminary
                                   data (Friday) from 4.1% in the initial release, primarily reflecting an upward revision to
                                   capex (to -1.5% q/q from -3.9%). In Australia, notwithstanding an expected
                                   improvement in Q1 GDP growth (to be released on Wednesday), we expect RBA to cut
                                   rates by 25bp to 3.5% as growth prospects deteriorate (Tuesday; consensus/last:
                                   3.75%). The steep decline in AUD/USD since late April makes a 50bp rate cut unlikely. In
                                   Korea, we and the consensus expect the BoK (Friday) to remain on hold but sound less
                                   hawkish now that inflation and inflation expectations have eased.




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GLOBAL WEEKLY CALENDAR

Sunday 03 June                                              Period               Prev 2                         Prev 1          Latest        Forecast     Consensus
     -      G8/G20: Summit (to 9/06)
   18:00    US: Minneapolis Fed President Kocherlakota (FOMC non-voter) speaks in Minnesota

Monday 04 June                                               Period                              Prev 2         Prev 1          Latest        Forecast     Consensus
    -       Germany: Chancellor Merkel speaks with Coalition Party Leaders
    -       UK: Public holiday
    -       Russia: Overnight repo rate (%) (to 15/06)       Jun                                  5.25            5.25            5.25            5.25          5.25
    -       Russia: CPI, % y/y (to 5/06)                     May                                    3.7             3.7             3.6             3.7           3.6
  00:30     Australia: Inflation expectations, % m/m         May                                    0.1             0.5             0.3               -             -
  01:30     Australia: Company operating profit, % q/q       Q1                                     6.6             4.7            -6.5               -          -2.5
  01:30     Australia: Inventories, %                        Q1                                     1.6            -0.7             1.4               -           0.7
  01:30     Australia: Job advertisements, % m/m             May                                    3.3             0.7            -3.1               -             -
  07:00     Turkey: CPI, % y/y                               May                                  10.4             10.4            11.1             8.7           9.0
  07:30     Sweden: Service production, % m/m (y/y)          Apr                              0.1 (2.2)       0.0 (1.3)       0.9 (2.8)       0.4 (2.6)             -
  09:00     E17 : PPI, % m/m (y/y)                           Apr                              0.8 (3.8)       0.6 (3.6)       0.5 (3.3)       0.2 (2.7)     0.2 (2.7)
  14:00     US: Factory orders, %m/m                         Apr                                   -2.0             1.5            -1.9             0.2           0.3
  17:00     Uruguay: CPI, % m/m                              May                                  0.83             0.99            0.82               -          0.40
  02:30     Korea: 3y Bonds Auction                                                                                                                    KRW 1450 bn
  04:00     Malaysia: 63d/91d/126d Notes Auction                                                                                                MYR 1.0/0.7/0.5 bn
  09:00     Holland: DTC 31Aug12 & 27Dec12                                                                                                             € 1/2-1/2 bn
  12:50     France: BTF 30Aug12, 29Nov12 & 30May13                                                                                        € 3.6/4 + 1.6/2 + 1.6/2 bn

Tuesday 05 June                                                 Period               Prev 2      Prev 1       Latest     Forecast    Consensus
     -       UK: Public holiday
     -       Global: EC VP Rehn, Swedish FM Borg, ECB Executive Board member Asmussen and IMF MD Lagarde meet in Latvia
     -       E27: EC President Rompuy and Dutch PM Rutte to discuss euro zone crisis, EU growth and the EU budget in Hague
   04:30     Australia: RBA cash rate, %                        Jun                    4.25        4.25         3.75         3.50           3.75
   11:00     US: Dallas Fed President Fisher speaks in Scotland
   13:00     Canada: Interest rate announcement, %              Jun                    1.00        1.00         1.00         1.00               -
   13:30     E17: ECB Executive board member Asmussen speaks at a conference “Lessons from the Recovery in the Baltics” in Latvia
   16:30     Portugal: FM Gaspar speaks on "Achievements and Challenges on the Way Back to Bond Market Financing" in Geneva
   18:15     US: St. Louis Fed President Bullard (FOMC voter) speaks in Missouri
   23:15     US: Chicago Fed President Evans (FOMC voter) speaks in New York
     -       Venezuela: CPI, % m/m (to 14/06)                   May                    1.10         0.90         0.80            -              -
   00:30     Taiwan: CPI, % y/y                                 May                      0.2         1.3          1.4          1.6            1.4
   01:00     Philippines: CPI, % y/y                            May                      2.7         2.6          3.0          3.2            2.9
   01:30     Australia: Current account balance, AUD mn         Q1                   -6660        -5824       -8374              -       -14650
   06:00     Finland: GDP, % q/q                                Q1                      -0.1         1.1          0.1          1.3              -
   07:13     Spain: Services PMI, index                         May                    41.9         46.3         42.1        41.0            41.6
   07:43     Italy: Services PMI, index                         May                    44.1         44.3         42.3        41.5            42.0
   07:48     France: Final services PMI, index                  May                    50.1         45.2      45.2 P         45.2            45.2
   07:53     Germany: Final services PMI, index                 May                    52.1         52.2      52.2 P         52.2            52.2
   07:58     E17: Final composite PMI, index                    May                    49.1         46.7      45.9 P         45.9            45.9
   07:58     E17: Final services PMI, index                     May                    49.2         46.9      46.5 P         46.5            46.5
   09:00     E17: Retail sales, % m/m (y/y)                     Apr               1.1 (-1.1) -0.1 (-2.0)    0.6 (0.4)   0.2 (-0.7)    -0.2 (-1.1)
   10:00     Germany: Factory orders, %m/m (y/y)                Apr              -1.4 (-6.0)  0.6 (-6.0)   2.2 (-1.3)          0.0    -1.0 (-3.8)
   12:30     Chile: Economic activity index, % y/y              Apr                      5.5         6.1          5.2          4.0            4.8
   14:00     US: ISM non-manufacturing, index                   May                    57.3         56.0         53.5        53.0            53.8
   23:01     UK: BRC shop price index                           May                      1.2         1.5          1.3            -              -
   02:00     Japan: 10y JGB Auction                                                                                                   ¥ 2300 bn
   09:30     Belgium: 3m & 6m Bills (20Sep12 & 15Nov12)                                                                       € 0/1.6 - 0/1.6 bn
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.




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Wednesday 06 June                                             Period             Prev 2                         Prev 1          Latest        Forecast      Consensus
    -      Poland: Base rate announcement, %                  Jun                  4.50                          4.50            4.75             4.75           4.75
  11:45    E17: ECB Interest rate announcement, %             Jun                  1.00                          1.00            1.00             1.00           1.00
  12:15    US: Atlanta Fed President Lockhart (FOMC voter) speaks in Florida
  12:30    E17: ECB Press Conference
  18:00    US: Fed Beige Book report released
  19:30    US: San Francisco Fed President Williams (FOMC voter) speaks in Washington
  23:00    US: Fed Governor Yellen (FOMC voter) speaks in Massachusetts
    -      Ukraine: CPI, % y/y (to 7/06)                      May                    3.0                            1.9             0.6             0.3               0.1
  00:00    Colombia: CPI, % m/m                               May                  0.61                            0.12            0.14           0.30               0.21
  01:00    New Zealand : Value of all buildings, % q/q        Q1                    -6.1                           -1.6             2.9               -               2.5
  01:30    Australia: GDP, % q/q (y/y)                        Q1               1.4 (2.0)                      0.8 (2.6)       0.4 (2.3)       0.8 (3.4)         0.5 (3.2)
  04:01    Malaysia: Exports, % y/y                           Apr                    0.4                           14.5            -0.1             3.0               3.1
  07:00    UK: Halifax house price index, % m/m (3m/y) (to 8/0May            -0.4 (-1.9)                     2.2 (-0.6)     -2.4 (-0.5)               -        0.5 (-0.1)
  07:00    Spain: Industrial production (wda), % y/y          Apr                   -4.4                           -5.3            -7.5               -              -3.8
  08:30    UK: Construction PMI, index                        May                  54.3                            56.7            55.8           54.0               54.6
  09:00    E17: GDP 2nd release, % q/q                        Q1                     0.1                           -0.3           0.0 P             0.0               0.0
  10:00    Germany: Industrial production, % m/m (y/y)        Apr              1.2 (1.3)                     -0.3 (0.0)       2.8 (1.6)            -0.5        -1.0 (0.8)
  11:00    Brazil: IGP-DI inflation, % m/m                    May                  0.07                            0.56            1.02           0.95               0.96
  12:00    Brazil: IPCA inflation, % m/m                      May                  0.45                            0.21            0.64           0.40               0.43
  12:30    US: Final non-farm productivity, % q/q             Q1                     1.8                            1.2          -0.5 P            -0.8              -0.6
  12:30    US: Final unit labor cost, % q/q                   Q1                     3.9                            2.7           2.0 P             2.3               2.2
  13:00    Belgium: Final GDP, % q/q                          Q1                     0.0                           -0.1           0.3 P             0.3                 -
  23:00    Korea: Final GDP, % y/y                            Q1                     3.6                            3.3             2.8             3.0                 -
  23:01    UK: BRC total sales, % y/y                         May                    2.3                            3.6            -1.0               -                 -
  09:30    Germany: 5y OBL Auction                                                                                                                                € 5 bn
  09:30    Portugal: BT 21Dec12 & 21Jun13                                                                                                                 € 1.25/1.5 bn

Thursday 07 June                                                Period               Prev 2        Prev 1                       Latest        Forecast      Consensus
     -       Serbia: Repo rate, %                               Jun                     9.50         9.50                        9.50             9.50              -
   08:30    Italy: PM Monti at National Congress of Italian Cooperative Banks Association in Palermo
   11:00     UK: BoE asset purchase decision                    Jun                     325           325                         325              325             325
   11:00     UK: BoE Bank rate decision, %                      Jun                     0.50         0.50                         0.50            0.50             0.50
   14:00     US: Fed Chairman Bernanke (FOMC voter) speaks in Washington
   16:10    US: Atlanta Fed President Lockhart (FOMC voter) speaks in Georgia
   17:15     US: Minneapolis Fed President Kocherlakota (FOMC non-voter) speaks in Minnesota
   19:30    US: Dallas Fed President Fisher (FOMC non-voter) speaks in California
   23:00    Peru: Reference rate, %                             Jun                     4.25         4.25                          4.25          4.25              4.25
   01:30    Australia: Employment change, k                     May                    -15.1          37.6                         15.5            5.0              0.0
   01:30    Australia: Participation rate, %                    May                     65.2          65.3                         65.2          65.3              65.2
   01:30     Australia: Unemployment rate, %                    May                      5.2           5.2                          4.9            5.1              5.1
   05:30     France: ILO Unemployment rate                      Q1                       9.5           9.7                          9.8              -              9.9
   05:45    Swi: Unemployment rate (adj), %                     May                      3.1           3.0                          3.1              -              3.2
   07:15    Swi: CPI, % m/m (y/y)                               May               0.3 (-0.9)    0.6 (-1.0)                   0.1 (-1.0)              -       0.0 (-1.0)
   07:30     Neth: HICP, % m/m (y/y)                            May                1.0 (2.9)     1.4 (2.9)                    0.5 (2.8)     -0.2 (2.5)                -
   08:00    Norway: Manufacturing production, % m/m (y/y) Apr                      1.1 (1.6)    -0.7 (0.7)                  -0.5 (-0.8)              -                -
   08:00    Taiwan: Exports, % y/y                              May                     10.3          -3.2                         -6.4           -4.0             -5.2
   08:28     UK: Services PMI, index                            May                     53.8          55.3                         53.3          51.5              52.5
   10:00     Ireland: HICP, % m/m (y/y)                         May                1.1 (1.6)     1.0 (2.2)                    0.0 (1.9)      0.1 (2.0)                -
   12:30     US: Initial jobless claims, k (4wma)               Jun-02           372 (376)      373 (371)                   383 (375)       375 (376)                 -
   13:00     Mexico: CPI, % m/m                                 May                     0.20          0.06                        -0.31         -0.34                 -
   19:00     US: Consumer credit, chg, $ bn                     Apr                     17.5           9.3                         21.4          14.0              10.0
   23:50     Japan: Real GDP, % q/q saar                        Q1                       7.6           0.1                          4.1            5.0              4.5
   23:50     Japan: Bank lending, including shinkin (% y/y)     May                      0.6           0.8                          0.3            0.3                -
   23:50     Japan: Current account, JPY bn                     Apr                  -437.3        1177.8                      1589.4           750.3            440.8
   02:00     Japan: 30y JGB Auction                                                                                                                           ¥ 700 bn
   04:00    Malaysia: 15y Bonds Auction                                                                                                                      MYR 3 bn
   04:00    Malaysia: 91d Bills Auction                                                                                                                     MYR 0.8 bn
   08:30    Spain: 2y, 4y & 10y SPGB Auctions                                                                                                                    € 3 bn
   08:50     France: 7y,10y,15y & 50y OAT Auctions                                                                                                               € 8 bn
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.




1 June 2012                                                                                                                                                            76
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Friday 08 June                                                Period                Prev 2       Prev 1        Latest     Forecast                         Consensus
      -      US: Minneapolis Fed President Kocherlakota (FOMC non-voter) speaks in Michigan
    01:00    Korea: South Korea 7-day Repo rate, %            Jun                      3.25        3.25          3.25          3.25                              3.25
    02:15    Australia: RBA Governor Stevens speaks at Chamber of Commerce in Adelaide
    08:00    Austria: CB Governor Nowotny speaks at the Austrian central bank's economic preview press conference in Vienna
    14:00    Mexico: Overnight rate, %                        Jun                      4.50        4.50          4.50          4.50                              4.50
      -      Greece: Final GDP, % q/q (y/y)                   Q1                -0.7 (-5.0)  -5.5 (-7.5) 1.0 (-6.2) P           1.0                                  -
    01:30    Australia: Home loans, % m/m                     Apr                       -1.5        -2.5          0.3             -                                0.0
    01:30    Australia: Investment lending, % m/m             Apr                       -7.7         4.3         -1.0             -                                  -
    01:30    Australia: Trade balance, AUD mn                 Apr                      -843        -754        -1587              -                              -900
    05:00    Japan: Economy watchers' DI                      May                      45.9         51.8         50.9             -                                  -
    05:00    Estonia: Final GDP, % q/q                        Q1                         0.9        -0.2        0.5 P           0.5                                  -
    06:00    Germany: Trade balance sa, € bn                  Apr                      13.2         14.9         17.4             -                              12.8
    06:30    France: BdF industrial business sentiment, index May                        95           95           95             -                                  -
    06:45    France: Budget, year-to date, € bn               Apr                     -12.5       -24.2         -29.4             -                                  -
    06:45    France: Trade balance, €bn                       Apr                       -5.4        -6.3         -5.7          -5.4                               -5.5
    07:30    Sweden: Industrial production, % m/m (y/y)       Apr                 3.4 (1.6)  -5.1 (-7.1)   0.4 (-6.5)    0.1 (-5.5)                                  -
    08:00    Italy: Industrial production, % m/m (y/y)        Apr               -2.5 (-3.9)  -0.7 (-6.0)   0.5 (-5.5)   -0.4 (-6.3)                               -0.5
    08:30    UK: Input prices, % m/m (y/y)                    May                 2.5 (7.9)    1.7 (5.6)   -1.5 (1.2)    -2.1 (0.6)                         -1.2 (1.6)
    08:30    UK: Output prices, % m/m (y/y)                   May                 0.6 (4.1)    0.6 (3.7)    0.7 (3.3)    -0.1 (3.0)                          0.2 (3.3)
    08:30    UK: Core output prices, % m/m (y/y)              May                 0.5 (3.0)    0.1 (2.5)    0.6 (2.3)     0.1 (2.3)                          0.2 (2.3)
    09:00    Greece: HICP, % y/y                              May                        1.7         1.4          1.5           1.7                                  -
    09:00    Cyprus: Final GDP, % q/q                         Q1                        -0.8        -0.1       -0.3 P          -0.3
    09:00    Malta: GDP, % q/q                                Q1                         0.4         0.1         -0.6           0.1                                  -
    10:00    Portugal: Final GDP, % q/q                       Q1                        -0.6        -1.3       -0.1 P          -0.1                               -0.1
    12:00    Chile: CPI, % m/m                                May                        0.4         0.2          0.1           0.1                                0.2
    12:30    US: Trade balance, $ bn                          Apr                     -52.5       -45.4         -51.8         -49.5                              -49.4
    14:00    US: Wholesale inventories, % m/m                 Apr                        0.6         0.9          0.3           0.3                                0.5
    19:00    Argentina: GDP, % y/y                            Q1                         9.1         9.3          7.3             -                                  -

Saturday 9 June                                                          Period                  Prev 2         Prev 1          Latest        Forecast     Consensus
   01:30     China: CPI, % y/y                                           May                        3.2            3.6             3.4               -            3.2
   01:30     China: PPI, % y/y                                           May                        0.0           -0.3            -0.7               -           -1.2
   05:30     China: Industrial production, % y/y                         May                       12.8           11.9             9.3               -            9.8
   05:30     China: Fixed asset investments, YTD % y/y                   May                       21.5           20.9            20.2               -          20.0
   05:30     China: Retail sales, % y/y                                  May                       18.1           15.2            14.1               -          14.3
     -       Malaysia: 3y/7y Bonds Auction (to 30/06)                                                                                                               -
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.




1 June 2012                                                                                                                                                         77
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GLOBAL KEY EVENTS

                              Jun-12 Jul-12 Aug-12             Sep-12     Oct-12     Nov-12     Dec-12     Jan-13   Feb-13 Mar-13 Apr-13   May-13
Forthcoming central bank announcement dates
North America
FOMC meeting                   19-20   31      -                  12       23-24        -            11     n/a      n/a    n/a    n/a      n/a
FOMC minutes                     -     11     21                   -         3         14             -     n/a      n/a    n/a    n/a      n/a
Congressional testimony          -     Jul     -                   -         -          -             -     n/a      n/a    n/a    n/a      n/a
Fed's Beige Book                 6     18     30                   -        10         28             -     n/a      n/a    n/a    n/a      n/a
Bank of Canada                   5     17      -                   5        23          -            4      n/a      n/a    n/a    n/a      n/a
Europe
ECB "policy" meeting             6      5      2                  6          4          8             6     10        7      7      4         2
ECB monthly bulletin            13     12     9                  13         11         15            13     17       14     14     11        9
ECB "non-policy" meeting        21     19      -                 20         18         22            20     24       21     21     18        16
Bank of England                 6-7   4-5    1-2                 5-6        3-4        7-8           5-6   11-12     8-9    7-8    4-5      9-10
BoE Inflation Report             -      -     8                   -          -         14             -      -       15      -      -        16
BoE minutes                     20     18     15                 19         17         21            19     25       22     21     18        23
Riksbank                         -      4      -                  6         25         29            18     n/a      n/a    n/a    n/a      n/a
SNB                             14      -      -                 13          -          -            13     n/a      n/a    n/a    n/a      n/a
Norges Bank                     20      -     29                  -         31          -            19     n/a      n/a    n/a    n/a      n/a
Asia/RoW
Bank of Japan                  14-15 11-12   8-9                18-19     4-5, 30     19-20     19-20       n/a      n/a    n/a    n/a      n/a
BoJ minutes                     20     18     14                 24         11         2,28      26         n/a      n/a    n/a    n/a      n/a
Reserve Bank of Australia        5      3      7                  4          2          6         4         n/a      n/a    n/a    n/a      n/a
RBNZ                            14      -      -                 13          -           -        6          -        -     14      -        -
Key international meetings
ECOFIN                          22    n/a    n/a                 n/a        n/a        n/a       n/a        n/a      n/a    n/a    n/a      n/a
G20                            15-17    -      -                13-14       n/a        n/a       n/a        n/a      n/a    n/a    n/a      n/a
Elections
France (Presidential)            -      -      -                  -          -          -             -      -        -      -      -        -
Greece (Parliamentary)          17      -      -                  -          -          -             -      -        -      -      -        -
France (Legislative)           10-17    -      -                  -          -          -             -      -        -      -      -        -
India (Presidential)             -     Jul     -                  -          -          -             -      -        -      -      -        -
Mexico (Presidential/Legisla     -      1      -                  -          -          -             -      -        -      -      -        -
Hong-Kong (Legislative)          -      -      -                 Sep         -          -             -      -        -      -      -        -
US (Presidential/Legislative)    -      -      -                  -          -          6             -      -        -      -      -        -
Source: Central banks, IMF, European Commission, Reuters, Bloomberg, Market News, Barclays Capital




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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
   06-Jun-12     Germany                           5y OBL Auction          0.50%    07-Apr-17      5.00                   500.00                500.00
   07-Jun-12       Spain                         10y SPGB Auction          5.85%    31-Jan-22      1.00       541.8        2.01      477.0        2.15
   07-Jun-12       Spain                         4y SPGB Auction           4.25%    31-Oct-16      1.00       577.1         2.17     475.4        2.22
   07-Jun-12       Spain                         2y SPGB Auction           3.30%    31-Oct-14      1.00       509.0         2.26     416.0        2.31
   07-Jun-12      France                    7yr OAT (tot range €7-8bn)     4.25%    25-Apr-19      1.50       106.9        -0.74      43.7       -1.51
   07-Jun-12      France                    10yr OAT (tot range €7-8bn)    3.00%    25-Apr-22      4.00       115.1        -0.19      71.2       -0.53
   07-Jun-12      France                    15yr OAT (tot range €7-8bn)    3.50%    25-Apr-26      1.50       112.8         0.34      98.6        0.33
   07-Jun-12      France                   50yr OAT (tot range €7-8bn)     4.00%    25-Apr-60      1.00       137.2        1.60      150.2       -0.07
   11-Jun-12      Finland                         5y RFGB Auction          1.88%    15-Apr-17      1.00        34.7        -2.06     -43.0       -2.42
   12-Jun-12     Holland                   20y DSL Auction (€1.5-2.5bn)    2.50%    15-Jan-33      2.50        13.9        -0.71      15.1       -0.88
   12-Jun-12      Austria                        10y RAGB Auction          3.50%    25-Sep-21      0.60        93.2        -0.86      47.1       -1.71
   12-Jun-12      Austria                         5y RAGB Auction          4.30%    15-Sep-17      0.60        91.0        -1.14      18.4       -2.28
   13-Jun-12     Germany                         10y Bund Auction          1.75%     04-Jul-22     5.00                   500.00                500.00
   14-Jun-12        Italy                         3yr BTP Auction          2.50%    01-Mar-15      3.00       494.0        2.58      387.1        2.68
   14-Jun-12        Italy                        15yr BTP Auction          4.50%    01-Mar-26      1.00       454.9         2.29     378.5        2.48
   20-Jun-12     Germany                         2y Schatz Auction                  13-Jun-14      5.00                   500.00                500.00
   21-Jun-12       Spain                         7y SPGB Auction           4.30%    30-Oct-19      1.00       553.9         2.04     450.7        2.15
   21-Jun-12       Spain                         8y SPGB Auction           4.00%    30-Apr-20      1.00       544.4        2.01      437.5        2.13
   21-Jun-12       Spain                         10y SPGB Auction          5.85%    31-Jan-22      1.00       541.8        2.01      477.0        2.15
   21-Jun-12      France                              2yr BTAN             0.75%    25-Sep-14      4.00                   500.00                500.00
   21-Jun-12      France                              3yr BTAN             2.50%    15-Jan-15      1.50        47.7        -1.45      -33.3      -2.31
   21-Jun-12      France                              5yr BTAN             2.25%    25-Feb-17      2.50        89.3        -0.94       10.2      -1.88
   21-Jun-12      France                           OATei Auction                                   1.50                   500.00                500.00
   25-Jun-12     Belgium                           7y BGB Auction          4.00%    28-Mar-19      0.75       175.0        0.41      112.2        0.30
   25-Jun-12     Belgium                          10y BGB Auction          4.25%    28-Sep-22      1.50       184.2         0.79     149.5        1.00
   25-Jun-12     Belgium                          15y BGB Auction          4.50%    28-Mar-26      0.75       165.4        1.31      156.6        1.48
   26-Jun-12     Holland                  10y DSL Auction (Range €2-3bn)   2.25%     15-Jul-22     2.50        35.8        -1.10      -7.4       -2.11
   26-Jun-12        Italy                           CTZ Auction                                    2.50                   500.00                500.00
   26-Jun-12        Italy                      BTPei Linker Auction                                1.00                   500.00                500.00
   28-Jun-12        Italy                           CCT Auction             FRN     15-Apr-28      1.50                   500.00                500.00
   28-Jun-12        Italy                       New 5y BTP Auction                  01-Jun-17      4.50                   500.00                500.00
   28-Jun-12        Italy                         10y BTP Auction          5.50%    01-Sep-22      2.50       489.8        2.18      419.8        2.40
     Japan
   05-Jun-12       Japan                          10y JGB Auction                                 2300
   07-Jun-12       Japan                          30y JGB Auction                                  700
   12-Jun-12       Japan                           5y JGB Auction                                 2500
   14-Jun-12       Japan                          20y JGB Auction                                 1200
   21-Jun-12       Japan                  Liquidity Enhancement Auction                            300
   26-Jun-12       Japan                           2y JGB Auction                                 2800
       UK
   12-Jun-12        UK                            2017 Gilt Tap            1.00%    07-Sep-17      4.00
   14-Jun-12        UK                            2060 Gilt Tap            4.00%    22-Jan-60      2.00
   21-Jun-12        UK                            New 2022 Gilt                     07-Sep-22      3.25
   26-Jun-12        UK                           2029 Linker Tap           0.125%   22-Mar-29      1.25
       US
   12-Jun-12         US                            3y Note Auction                                  32
   13-Jun-12         US                           10y Note Auction                                  21
   14-Jun-12         US                           30y Bond Auction                                  13
   21-Jun-12         US                           30y TIPs Auction                                   8
   26-Jun-12         US                            2y Note Auction                                  35
   27-Jun-12         US                            5y Note Auction                                  35
   28-Jun-12         US                            7y Note Auction                                  29
                Unconfirmed Barclays Capital Estimate
                Rich
                Cheap
Source: Barclays Research




1 June 2012                                                                                                                                              79
Barclays | 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
  Q3 12        0.00-0.25       0.35           0.30     1.00   2.00     3.40       -0.40   Q3 12     35      30      10     -35
  Q4 12        0.00-0.25       0.35           0.30     1.00   2.00     3.40       -0.35   Q4 12     30      25         5   -40
  Q1 13        0.00-0.25       0.35           0.30     1.00   2.00     3.40       -0.35   Q1 13     30      25         5   -40


                                         Euro government                                          Euro area swap spreads

               Refi rate        3m            2y        5y    10y      30y       10y RY             2y      5y     10y     30y
  Q2 12           1.0          0.65           0.10     0.50   1.45     2.35       -0.15   Q2 12     90      90      70     10
  Q3 12           1.0          0.65           0.20     0.70   1.60     2.40       -0.15   Q3 12     80      80      60     10
  Q4 12           1.0          0.65           0.40     1.00   1.90     2.65         0     Q4 12     70      60      50     5
  Q1 13           1.0          0.80           0.55     1.20   2.10     2.85       0.15    Q1 13     70      60      50     5


                                            UK government                                            UK swap spreads

               Bank rate        3m            2y        5y    10y      30y       10y RY             2y      5y     10y     30y
  Q2 12           0.5          0.95           0.50     1.45   2.50     3.50       -0.50   Q2 12     80      45      15     -15
  Q3 12           0.5          0.95           0.55     1.60   2.70     3.55       -0.30   Q3 12     75      40      10     -15
  Q4 12           0.5          0.95           0.60     1.75   2.90     3.60       -0.10   Q4 12     75      35      10     -10
  Q1 13           0.5          0.95           0.70     1.95   3.10     3.65       0.00    Q1 13     70      30      10     -10


                                         Japan government                                          Japan swap spreads

              Official rate     3m            2y       5y     10y      30y       10y RY             2y      5y     10y     30y
  Q2 12           0.10         0. 20         0.10     0.35    1.10     2.10       0.85    Q2 12     15      15      10     0
  Q3 12           0.10         0. 20         0.10     0.30    1.05     2.00       0.85    Q3 12     15      15      10     0
  Q4 12           0.10         0. 20         0.10     0.30    1.05     2.00       0.85    Q4 12     15      15      10     0
  Q1 13           0.10         0. 20         0.10     0.30    1.00     1.95       0.85    Q1 13     15      15      10     0


                                       Australia government

              Official Rate            3y             5y         10y          AU-US 10y
Q2 12             3.75               3.25            3.55       3.80            1.80
Q3 12             3.75               3.25            3.60       3.90            1.90
Q4 12             3.75               3.50            3.75       4.05            2.05
Q1 13             3.75               3.75            3.95       4.15            2.15
Source: Barclays Research




1 June 2012                                                                                                                      80
Barclays | Global Rates Weekly


GLOBAL RATES RESEARCH

Global
Ajay Rajadhyaksha
Head of Rates and Securitised
Products Strategy
+1 212 412 7669
ajay.rajadhyaksha@barclays.com

US
Joseph Abate                      Piyush Goyal                       James Ma                        Chirag Mirani
Fixed Income Strategy             Fixed Income Strategy              Fixed Income Strategy           Fixed Income Strategy
+1 212 412 6810                   +1 212 412 6793                    +1 212 412 2563                 +1 212 412 6819
joseph.abate@barclays.com         piyush.goyal@barclays.com          james.ma@barclays.com           chirag.mirani@barclays.com

Amrut Nashikkar                   Michael Pond                       Anshul Pradhan                  Rajiv Setia
Fixed Income Strategy             Treasury and Inflation-linked      Treasury and Inflation-linked   Fixed Income Strategy
+1 212 412 1848                   Strategy                           Strategy                        +1 212 412 5507
amrut.nashikkar@barclays.com      +1 212 412 5051                    +1 212 412 3681                 rajiv.setia@barclays.com
                                  michael.pond@barclays.com          anshul.pradhan@barclays.com

Vivek Shukla                      Igor Zoubarev
Fixed Income Strategy             Fixed Income Strategy
+1 212 412 2532                   +1 212 526 5518
vivek.s.shukla@barclays.com       igor.zoubarev@barclays.com

Europe
Laurent Fransolet                 Alan James                         Cagdas Aksu                     Ugofilippo Basellini
Head of European Fixed Income,    Global Inflation-Linked Strategy   European Strategy               Fixed Income Strategy
Commodities and Credit Research   +44 (0)20 7773 2238                +44 (0)20 7773 5788             +44 (0)20 3134 6540
+44 (0)20 7773 8385               alan.james@barclays.com            cagdas.aksu@barclays.com        ugofilippo.basellini@barclays.com
laurent.fransolet@barclays.com

Fritz Engelhard                   Jussi Harju                        Moyeen Islam                    Sreekala Kochugovindan
German Head of Strategy           European Strategy                  Fixed Income Strategy           Asset Allocation Strategy
+49 69-7161 1725                  +49 69 7161 1781                   +44 (0)20 777 34675             +44 (0)20 7773 2234
fritz.engelhard@barclays.com      jussi.harju@barclays.com           moyeen.islam@barclays.com       sreekala.kochugovindan@barclays.com

Giuseppe Maraffino                Mikael Nilsson                     Hitendra Rohra                  Michaela Seimen
Fixed Income Strategy             Fixed Income Strategy              Fixed Income Strategy           SSA & Covered Bond Strategy
+44 (0)20 313 49938               +44 (0)20 7773 6057                +44 (0)20 7773 4817             +44 (0) 20 3134 0134
giuseppe.maraffino@barclays.com   mikael.nilsson@barclays.com        hitendra.rohra@barclays.com     michaela.seimen@barclays.com

Henry Skeoch                      Khrishnamoorthy Sooben             Stuart Urquhart                 Marcus Widen
Inflation-Linked Strategy         Inflation-Linked Strategy          European Strategy               Fixed Income Strategy
+44 (0)20 777 37917               +44 (0)20 7773 7514                +44 (0)20 7773 8410             +44 (0)20 3134 5632
henry.skeoch@barclays.com         khrishnamoorthy.sooben@            stuart.urquhart@barclays.com    marcus.widen@barclays.com
                                  barclays.com
Huw Worthington
European Strategy
+44 (0)20 7773 1307
huw.worthington@barclays.com

Asia Pacific
Chotaro Morita                    Reiko Tokukatsu                    Gavin Stacey
Head of Fixed Income Strategy     Senior Fixed Income Strategist,    Fixed Income Strategist,
Research, Japan                   Japan                              Australia and New Zealand
+81 3 4530 1717                   +81 3 4530 1532                    +61 2 933 46128
chotaro.morita@barclays.com       reiko.tokukatsu@barclays.com       gavin.stacey@barclays.com




1 June 2012                                                                                                                              81
Analyst Certification(s)
We, Laurent Fransolet, Ajay Rajadhyaksha, Vivek Shukla, Anshul Pradhan, James Ma, Rajiv Setia, Joseph Abate, Chirag Mirani, Michael Pond, Piyush Goyal,
Giuseppe Maraffino, Ugofilippo Basellini, Huw Worthington, Moyeen Islam, Mikael Nilsson Rosell, Alan James, Henry Skeoch, Hitendra Rohra, 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 research report and (2) no part of our compensation was, is or will be directly or
indirectly related to the specific recommendations or views expressed in this research report.

Each research report excerpted herein was certified under Reg AC by the analyst primarily responsible for such report as follows: I hereby certify that: 1) the
views expressed in this research report accurately reflect my personal views about any or all of the subject securities referred to in this report and; 2) no part
of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.

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