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HSBC - Its Not about the money


									Global Fixed Income Strategy                                                                      abc
Special                                                                                           Global Research

                                                              Our non-consensus view is that QE3
                                                               will drive US Treasury yields to new
It’s not about the                                             lows

money                                                         The impact of the Fed’s trillions is
                                                               passed onto assets in five ways, which
                                                               we identify and use to create a QE
Fed’s trillions are bullish for bonds

                                                              Our QE Scorecard implies that QE3 is
                                                               bullish for Treasuries, credit, EM debt
                                                               and equities, but bearish for mortgage
                                                               and inflation-linked bonds

                                                             The Fed’s QE trillions are not ‘printing’ money
                                                             The Federal Reserve’s new wave of quantitative easing
                                                             (QE3) follows similar large-scale asset purchase policies
                                                             adopted in November 2008 (QE1) and November 2010
                                                             (QE2). Each step of the Fed’s unconventional policy
                                                             response – which will soon add up to close to USD2 trillion
                                                             – has been met with controversy. Opposition comes from
                                                             those who think QE has no real economic impact, to those
                                                             who believe the policy will be inflationary. But it’s not about
                                                             the money, rather about where it goes and how it is used.
27 September 2012
                                                             We assess the impact of the Fed’s trillions by tracing where
Steven Major, CFA
                                                             the money went, and where the cash received by investors
                                                             selling assets to the Fed was invested. By following the
HSBC Bank plc
                                                             money, we identify five ways Fed purchases are felt by
+44 20 7991 5980
                                                             markets and the wider economy: 1) yields on assets targeted
Lawrence Dyer                                                by the Fed; 2) use of cash by investors selling to the Fed;
                                                             3) bank reserves; 4) economic expectations; and 5) policy
HSBC Securities (USA) Inc.
                                                             expectations. There is no printing of money analogous to
+1 212 525 0924
                                                             1920s Germany: the Fed is effectively funding its purchase
                                                             of assets by steering reserves in the banking system in
                                                             certain directions.

                                                             We used these insights to create a QE Scorecard to assess
                                                             the potential impact of QE3 on Treasuries, mortgage bonds,
View HSBC Global Research at:   inflation-linked debt, credit, EM debt and equities. Our
                                                             conclusion is the opposite of the consensus view that QE3
Issuer of report: HSBC Bank plc                              will be inflationary and push US Treasury yields higher, and
                                                             our target is for 10-year Treasury yields to test the 1.4% low
Disclaimer & Disclosures                                     point in the coming months.
This report must be read with the
disclosures and the analyst certifications
in the Disclosure appendix, and with the
Disclaimer, which forms part of it
    Global Fixed Income Strategy
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    27 September 2012

Where will the Fed’s billions                        Appendix 1              16
be felt the most?                                3   Agency holdings         16
More QE from the Fed                             3

QE Transmission Mechanism Scorecard              3   Appendix 2              18
                                                     Corporate holdings      18
Non-consensus view – lower US Treasury yields    4

US Treasuries                                    4
                                                     Appendix 3              20
Inflation-linked bonds                           6   Treasury holdings       20

Mortgage bonds                                   6

Corporate bonds                                  7   Appendix 4              22
EM bonds                                         8
                                                     Disclosure appendix     25
Equities                                         8
                                                     Disclaimer              27
Where the money went in
QE1 and QE2                                     10
Finding traces of QE                            10

It’s not about the money                        13
Reserves are created by the Fed                 13

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   27 September 2012

Where will the Fed’s
billions be felt the most?
 US Treasuries will receive demand as direct substitutes to the
   mortgage market, which is already expensive
 The corporate bond market and EM bonds will also benefit from
   the need to replace assets the Fed buys
 There is an indirect spill-over effect into equities and commodities

More QE from the Fed                                  Such extrapolation is dangerous, not least because
                                                      the market backdrop is different and the starting
The Federal Reserve stepped up its efforts to
                                                      point for valuations has moved significantly (see
promote growth (13 September FOMC) in the
                                                      Figures 2). However, it is important to understand
persistently sluggish US economy, announcing
                                                      how and where the Fed’s trillions have been felt
another round of asset purchases and quantitative
                                                      the most – and where the transmission
easing – dubbed QE3. Based on USD40bn per
                                                      mechanisms are the most direct – in order to
month of new purchases of mortgage-backed
                                                      understand better the way another round of asset
securities, the policy will increase the amount the
                                                      purchases could feed through to the wider markets
Fed will have bought to USD2 trillion (assuming
                                                      and economic expectations.
one year of buying), making it one of the biggest
investors in the world.                               QE Transmission Mechanism
In this report, we track the impact on the markets
of the USD trillions of purchases so far. By          1   Yield levels of targeted bonds – the extent to
following this trail, we aim to understand the            which the Fed as an investor has influenced
transmission mechanisms of QE and analyse how             prices.
these might evolve under the latest QE3. With this
                                                      2   The use of cash received by investors – those
framework, it is possible to assess the potential
                                                          who have sold assets to the Fed.
impact of QE3 on assets, including US Treasuries,
mortgages, inflation-linked bonds, corporate          3   Reserves created in the banking system – the
bonds, equities and EM.                                   extent to which the Fed’s QE has diverted
                                                          banks’ capital from lending.
Five transmission mechanisms of QE
To estimate the impact of QE3, it is not enough to    4   Investor expectations (eg, inflation) – the
simply look at previous rounds of asset buying            extent to which QE has shifted expectations
and assume the impact will be the same or similar.        of growth and stimulus.

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5               Speculation on the impact of the policy – the                                          Our view is that Treasury yields are likely to fall
                extent to which QE has shifted expectations                                            as a result of the Fed’s policy of buying mortgage
                of what the Fed will do next.                                                          bonds. A re-test of the lower end of the recent
                                                                                                       range for 10-year Treasury yields (1.40%) is
There appears to be much more commentary                                                               likely as a result of QE3.
about the last two and not enough analysis of the
first three, in our opinion. The first three factors,                                                  When QE3 was announced 10-year yields
                                                                                                       temporarily broke out of the upper end of the 1.4-
according to our analysis, are most important for
                                                                                                       1.8% trading range (see Figure A14), which
determining the price of Treasuries and mortgages,
                                                                                                       contributed to the consensus forecasts for higher
whilst the latter could be better at explaining what’s
                                                                                                       yields. We do not share this consensus view, as this
going on with other assets.
                                                                                                       presupposes that the recent move higher in yields is
Non-consensus view – lower US                                                                          purely to do with the Fed’s policy. Appendix 3
Treasury yields                                                                                        shows that investors’ Treasury positions can shift
                                                                                                       dramatically as they react to risks in other markets,
The QE3 Scorecard incorporates five transmission
                                                                                                       as occurred around QE1.
mechanisms and applies these to US Treasuries.

US Treasuries
Scorecard is bullish
                                                                                                        Figure 1. US 10yr Treasury yields lower because of QE
1. Neutral impact as not targeted
                                                                                                                                                       QE1                 QE2           QE3
2. Bullish for Treasuries as cash from mortgage                                                                                    4.0
                                                                                                        10yr Treasury yield (%)

   bonds reinvested in UST                                                                                                         3.5

3. Bullish because it means further slowing of
   bank loan expansion
4. Bullish for UST if low growth limits inflation                                                                                  1.5
   expectations                                                                                                                    1.0
                                                                                                                                        Aug 08        Jun 09    Apr 10    Feb 11    Dec 11   Sep 12
5. Neutral for US yields as low for longer
   persists                                                                                             Source: HSBC, Federal Reserve, Bloomberg

    Figure 2. All types of bonds have done well from QE, levels and spreads are close to historical lows

                10                                                                                                                       30
                                30 Mar 2008                                                                                                           31 Mar 2008
                 8              21 Sep 2012                                                                                              25           21 Sep 2012

                 6                                                                                                                       20
                                                                                                                            Yield (%)
    Yield (%)

                 4                                                                                                                       15

                 2                                                                                                                       10

                 0                                                                                                                       5
                                            US                           EUR 5yr           5yr BEs                                                                   Credit             EM
                 -2                                                                                                                      0

                                                                                                                                                                                             Local Mkts
                      3mth CP







                                  5yr Tsy

                                            30yr Tsy




    Note: US Mortgage rate uses consists of the 30 year FNMA current coupon as generated by MCCN. Credits buckets are comprised of all maturities. US Breakeven data goes only goes back
    to 10/12/2008. Source: HSBC, Bloomberg, Markit, Thomson Reuters Datastream

           Global Fixed Income Strategy
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In fact the opposite might be true. US Treasury                                                The main bullish points for Treasuries are:
yields are still towards the bottom of the longer-
                                                                                                The Fed is most unlikely to allow yields to rise
term trading range and are lower than when QE
                                                                                                 significantly as a result of the policy, potentially
started in 2008 (see Figure 1). A large proportion
                                                                                                 capping 10 year yields around 2.0%.
of the upward move in yields that occurred since
late July can be associated with the policy moves                                               Treasuries are likely to be bought out of the
of the ECB, including the announcement of OMT                                                    proceeds of mortgage bond sales and/or
(outright market transactions), which has been                                                   prepayment flows.
seen as a step on the path to a more durable
                                                                                                The Fed’s policy of using reserves to fund
solution to the eurozone crisis (see The ECB’s
                                                                                                 purchases means the composition of bank
game changer, 21 August 2012). US Treasury
                                                                                                 balance sheets is changing so that there are a
yields have been moving inversely to those of the
                                                                                                 lower proportion of loans than before. This
eurozone periphery (see Figure 3), with the
                                                                                                 may become a constraint on US growth.
decline in Spanish yields mirroring the upward
shift in Treasuries, for example.                                                               Generating inflation expectations may have
                                                                                                 become a goal of policy, but it is already
                                                                                                 implied in negative real yields and higher
  Figure 3. Influence of the eurozone on US rates
                                                                                                 inflation break-evens.
                                                                        7.6                     Future policy is difficult to predict, but more
                   2.2                                                                           QE and the ‘low for longer’ Fed funds
                                                                              10yr yield (%)
  10yr yield (%)

                                                                                                 outlook is likely to result in support for
                   1.9                                                  6.4
                                                                                                 Treasuries and yield compression.

                   1.6                                                  5.6
                   1.3                                                  4.8
                     Oct 11     Dec 11    Mar 12     Jun 12     Sep 12
                              US (LHS)                        Spain (RHS)

  Source: HSBC, Bloomberg

Table 1. QE Transmission Mechanism Scorecard
                                   10yr Treasuries         Mortgage bonds                      Inflation-linked &     Corporates       EM bonds Equities

Yield levels of                    n/a                      Spreads have already               n/a                    n/a              n/a       n/a
targeted bonds                                              tightened significantly
The use of the cash                Bullish, attracts        Bearish as substitutes             Neutral                Bullish          Bullish   Neutral
received                           investment               attractive
Reserves created in                Bullish, less balance Bearish as banks reduce               Neutral                Neutral          Neutral   Neutral
banking system                     sheet for loans          rich asset holdings
Investor expectation               Bullish if growth limits Bullish whilst Fed a large         Break-evens have      Modest bullish on Bullish   Bullish
(eg inflation)                     inflation                buyer                              already risen         equities
Speculation on policy              Bullish as 'low for      Neutral, wait for economy          Previous episodes saw Neutral           Varied    Bullish
impact                             longer'                                                     QE-based rallies
Source: HSBC

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Inflation-linked bonds                                                  the ultra-long segment, providing a further incentive
                                                                        for investors to buy and hold the linkers.
Scorecard is bearish
                                                                        One of the conundrums of the past few years has
Past experience of QE would suggest higher BEs
                                                                        been the collapse in the velocity of money even
could follow the QE, but valuations suggest this is
                                                                        while some measures of risk appetite and inflation
not the same trade as in 2008-09. The assertion
                                                                        have been rising (see Figure 5). The Fed has
often made is that the increase in the size of the
                                                                        expanded the reserves in the banking system, but
central bank’s balance sheet will result in higher
                                                                        this has not resulted in a rise in the broader
inflation and that this should be reflected in a rise in
                                                                        measures of money supply, reflecting the weak state
inflation expectations. In fact US BEs (break-evens)
                                                                        of the economy and continued deleveraging. The
have already risen since the announcement of QE3
                                                                        current environment is a challenge to those who
and are significantly higher than at the start of QE in
                                                                        believe increased money supply results in
2009, when sub-zero levels were implying
                                                                        higher inflation.
deflation. The most recent increase in BEs (see
Figure A16) shows that markets have been quick to                       Understanding that ‘it’s not about the money’ and
price in additional inflation expectations and risk                     that with growth (and employment) so weak that
premium. But if the Fed’s policies fail to show                         wages are unlikely to rise makes it possible to look
tangible evidence of real GDP growth, then long                         through the recent rise in inflation expectations.
TIPs positions would require real yields to go even
more negative (see Figure 4) than they are.                              Figure 5. Velocity of money falling whilst risk assets rise

                                                                                  1600                                                 2.2
    Figure 4. US 10yr real yields have been negative for some time                1400                                                 2.1
                         4                                                        1200
                                                                         I ndex


                                                                                   800                                                 1.9
    Real swap rate (%)

                         2                                                         600                                                 1.8
                         1                                                         400
                                                                                     0                                                 1.6
                         -1                                                              86 88 90 92 94 96 98 00 02 04 06 08 10 12
                         -2        EUR                                               S&P 500 (LHS)                    CRB Rind (LHS)
                                   USD                                               US M2 Vel oci ty (RHS)
                                                                         Source: HSBC, Bloomberg
                          Oct 07    Dec 08   Mar 10   Jun 11   Sep 12

    Source: HSBC, Bloomberg
                                                                        Mortgage bonds
Negative real yields have been observed before and                      Scorecard is bearish
already exist across most of the developed market
                                                                        Mortgage bonds are expensive by historical
yield curves, except for the ultra-long segments.
                                                                        standards and with the Fed’s actions likely to
And it would be a logical outcome for the entire real
                                                                        spark new supply from refinancing over time, the
yield curve to move lower from a scenario which
                                                                        main beneficiaries from the Fed’s actions will be
involved the economy staying weak and the Fed’s
                                                                        other categories of fixed income. Initial
purchases serving to contain nominal bond yields.
                                                                        conditions, the current coupon 30-year mortgage
Asset-swaps on inflation-linked bonds are generally
                                                                        spread of 10bp over the 10-year Treasury
higher than conventional equivalents, especially in
                                                                        (Figure A15), are quite different from those

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before the Fed’s QE1 mortgage purchases, when           already owns USD80bn of these coupons in its
the spread was as much as 200bp, because of             USD1trn mortgage portfolio). However, many
active selling by foreign investors and households.     more will be made as existing mortgages
Spreads are way below their historical norms at         are refinanced.
present and the most likely scenario is that the Fed
                                                        The Fed’s QE3 announcement caused the spread
buying will contain yield spreads in the near term,
                                                        of the current coupon 30-year mortgages to
not drive them much lower.
                                                        narrow from 80bp over the 10-year T.Note to
In fact the risk is that today’s very rich levels may   10bp, as investors bought ahead of the Fed (see
not be sustained if the pace of refinancing and         Figure A14). Adjusted for the mortgages’ curve
creation of new bonds, likely to run at USD1.2trn       and convexity risk (option-adjusted spread), low-
per year or more over time, moves too far ahead         coupon mortgage yields are 20-30bp through the
of the Fed’s pace of buying (currently set at           Treasury curve, which should attract willing
USD480bn per year). A second concern is that the        sellers into ‘risk free’ Treasuries at these levels.
real economy will only benefit if today’s low           Furthermore, assuming the economy is still weak;
market rates are passed on to borrowers. So far,        the Fed itself may restart a traditional QE
that has not been the case.                             programme to buy Treasuries if the yield was to
                                                        rise. A cap could be 2.0% for 10 years.
The Fed is likely to target low-coupon mortgages,
created either from a new home purchase or              Corporate bonds
refinancing of an existing high-coupon mortgage.
                                                        Scorecard is bullish
Buying low coupons does the most to reduce new
mortgage rates for consumers and thus to increase       Understanding what current mortgage holders will
consumption (as refinancing lowers mortgage             buy is the key to understanding the outlook for US
expenses) and increase home demand (as                  corporates. The largest holders of agency
mortgage costs fall).                                   mortgages and debt – banks, mutual funds and
                                                        foreign investors – should see the largest
Existing mortgages are held by banks, foreign
                                                        prepayments. These are professional investors
investors and mutual funds (as shown in
                                                        with intermediate to long-term horizons.
Appendix 1). As these mortgages are refinanced,
                                                        Therefore, they are unlikely to find the current
investors receive principal payments and must
                                                        rich value of new production mortgages attractive
decide how to invest them. These investors may
                                                        and will be looking for substitutes in the credit
compete with the Fed in buying the new, richly
                                                        markets. Appendix 2 reviews the behaviour of
priced, low-coupon mortgages or they may direct
                                                        corporate bond investors as reviled by their
the prepayment into another investment sector.
                                                        investment flows.
The vast majority of these principal payments
should be redirected into fixed-income                  Mutual funds and pension managers are short-
investments, but the question is which ones.            term performance driven, as they are evaluated
                                                        versus bond indices, so they should see value in
The limited supply of low-coupon mortgages has
                                                        corporate bonds, even after the recent spread
contributed to their large spread tightening. There
                                                        tightening, as well as Treasuries. Their
are only USD47bn of 30-year 3% mortgages and
                                                        performance benchmarks would continue to hold
USD311bn of 30-year 3.5% mortgages currently
                                                        mortgage securities, so there may be some
available for the Fed to purchase today (the Fed
                                                        demand for rich mortgages to limit tracking errors

                               Global Fixed Income Strategy
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while adding yields. Since the total size of the                                                          curve flattening driven by the building up of
corporate bond market has been stable, this                                                               inflation expectations.
incremental demand should be positive and help
                                                                                                          Pablo Goldberg (Strategist, (HSBC Securities USA))
keep spreads on a tightening trend.
    Figure 6. Triple B corporate bond spread and QE
                                                                                                          Scorecard is bullish
    Corporate BBB spread to 10yr Treasury (%)

                                                4.5          QE1        QE2                     QE3       For equities, the most significant aspect of the
                                                                                                          latest QE announcements is that they are open-
                                                                                                          ended commitments. Neither the Fed nor the ECB
                                                2.5                                                       has announced a size or an end-point. This bodes
                                                2.0                                                       well for equities to judge from the previous
                                                1.5                                                       experience of QE.
                                                                                                              Figure 7. QE boosts equities
                                                  Jul 08   May 09   Mar 10    Jan 11   Nov 11    Sep 12
    Source: HSBC, Federal Reserve, Bloomberg                                                                                                    QE1               QE2      LTROs
                                                                                                              World equi ty i ndex

EM bonds

Scorecard is bullish

The effect of QE on emerging markets is both
direct and indirect, and has different implications                                                                                                                                Draghi

by asset class and duration. Further stimulus in the                                                                                 150
                                                                                                                                       Feb 09   Nov 09   Aug 10   May 11    Feb 12 Sep 12
US tends to lead to ‘risk-on’ trades, which is
generally beneficial for EM spreads, while it tends                                                           Source: HSBC, Bloomberg

to lower (or cap) US yields at very low levels.
Renewed search for yield follows, particularly by                                                         There have been essentially two episodes of QE:
investors with guaranteed returns on liabilities                                                          Japan in 2001-04; and the US, Japan, the UK and
that cannot be met by their ordinary investment                                                           the eurozone, to varying degrees, after the
alternatives. Hard currency EM bonds are the first                                                        financial crisis of 2008. We draw the following
to receive the beneficial impacts of QE.                                                                  lessons from these episodes:

In a second order, QE risk-on effects also boost EM                                                       1                          QE did on average have a positive impact on
currencies, leading to gains in local currency bonds.                                                                                stock markets (see Figure 7). Three months
FX gains are the single most important driver of                                                                                     after the announcement of QE, stocks in the
local currency performance and performance                                                                                           US rose by an average 6%, in the UK by 8%
volatility (see Searching for Safety: A new source of                                                                                and in the eurozone by 15%.
demand for EM assets, 25 September). Yet QE tends
                                                                                                          2                          The US and UK saw a more consistent
to translate into higher commodity prices and
                                                                                                                                     impact of QE on stocks than did Europe or
inflation expectations, which pressure the front-end
                                                                                                                                     Japan. This may well be because the quantum
of the local EM curves. While the initial impact
                                                                                                                                     of QE was bigger.
tends to be bullish overall, there is a subsequent

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3    The impact on equities can be negative when
     the central bank stops buying. The end-points
     of Fed QE in May 2009, June 2011 and the
     end of the ECB’s LTRO in March 2012
     highlight the risks.

4    The impact of QE can be short-lived. In
     Japan, stocks had a brief bounce after the first
     announcement of QE in 2001, but fell for the
     following two years despite increases in the
     QE target. QE was also notably ineffective in
     Japan in 2010-11. The first round of QE after
     the global financial crisis in 2008 similarly
     triggered a short-term bounce, but stocks then
     fell until the second (bigger) QE, announced
     for example by the US in March 2009.

We stress that liquidity is only one side of the
coin for equities. Signs of a rebound in economic
growth would greatly increase our confidence that
any rally in equities could be sustained. However,
we believe it is dangerous to be too negative on
equities when the world’s major central banks are
prepared to inject liquidity without specific limits
on size or duration.

Garry Evans (Equity Strategist, (HSBC Bank plc))

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Where the money went in
QE1 and QE2
 The Fed asset purchases grab the headlines, but starting points and
     knock-on effects are important to post-QE performance
 We use our QE Scorecard to show the transmission mechanisms in
     combination with market conditions are key to market performance
 Today's initial conditions -- rich mortgage spreads -- and the
     behaviour of large investors suggests significant rotation from
     mortgage holdings into Treasuries in QE3

Finding traces of QE                                    analysis also shows who currently owns large
                                                        mortgage positions and discusses how these owners
Commentators and many investors speak of the
                                                        are likely to choose between competing with the Fed
Fed’s QE as “printing money”, implying that funds
                                                        to buy mortgages or rotating mortgage positions in
just get thrown into the financial system. But as
                                                        to the Treasury or corporate band markets
USD 1.5trn of excess reserves move through the
economy they leave traces that can be tracked           Our views on the likely performance of markets
through official data.                                  depend upon the QE scorecard and initial
                                                        conditions in the markets. In QE1, the extremely
Excess reserves grew to represent roughly 10% of
                                                        stressed spread levels for mortgages and corporate
GDP and 10% of bank assets. The Flow of Funds
                                                        bonds meant that spreads had room to tighten
report allows us to follow the money created in QE1
and QE2 and helps guide how QE3 will affect the          Figure 8. QE and the impact on MBS and Corporates
markets and the economy.
Appendices 1 to 3 tract the Flow of Funds report                                                                  QE1          QE1
                                                         Spread over 10yr Tsy (%)

                                                                                    4.0                                        expansion
from the Federal Reserves to show the evolution of                                                10yr Corp BBB
investors’ holdings of mortgage, corporate, and                                     3.0           30yr MBS
Treasury bonds, respectively, through the financial
crisis. Investment risk in the mortgage and corporate
market was redistributed from foreign and selected                                  1.0

domestic investors to the Federal reserve and other
domestic investors. Mutual funds and banks added
                                                                                      Jan 07   Jul 07 Jan 08   Jul 08 Jan 09   Jul 09 Jan 10
to their agency security holdings, for example. This
                                                         Source: HSBC, Federal Reserve, Bloomberg

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significantly. Figure 8 shows the wide spreads to                                            showing limited signs of stress. However, the 10-
Treasuries for the current coupon 30-year                                                    year Treasury’s yield had fallen on fears of slower
mortgage and 10-year Triple-B industrial bond                                                economic growth. In this case, the Fed initiated a
sectors around QE1. Other investors joined the                                               USD600bn Treasury buying programme.
Fed’s buying cheap spread assets in this case, as
                                                                                             Spread continued to trade within its recent range.
shown in the appendices.
                                                                                             However, QE2 led to a significant shift up in
                                                                                             Treasury yields (see Figure 10) and TIPS break-
  Figure 9. QE2 was about Treasury purchases…
                                                                                             even spreads. In this case, we believe shifts in the
                             2.0                                                             forward looking factors on the QE scorecard
                                                                                             contributed to the behaviour of spreads.
  Spread over 10yr Tsy (%)

                                                                                                 Figure 10. …..but the market didn’t benefit immediately after
                             1.0                                                                                          4.5
                                                                                                 10yr Tresury yield (%)

                             0.5                                                                                          4.0
                                          10yr Corp BBB
                                          30yr MBS                                                                        3.5
                               Jan 10   Apr 10   Aug 10      Nov 10   Mar 11    Jul 11                                    3.0

  Source HSBC, Federal Reserve, Bloomberg

Table 2 shows our view of how the QE Scorecard                                                                            2.0
would have looked before QE1. The appendices                                                                                Jan 10   Apr 10     Aug 10     Nov 10    Mar 11     Jul 11

show the flows between investors and today’s                                                     Source: HSBC, Federal Reserve, Bloomberg

initial that help determined our views. The
importance of initial conditions in determining
market performances in QE1 and QE2 highlights
the using past performance to predict future
investment results is potentially hazardous.

Initial conditions had changed around QE2. Figure
9 shows that mortgage and corporate spreads were

Table 2. QE1 Transmission Mechanism Scorecard
                                          10yr Treasuries         Mortgage bonds           Inflation-linked &                        Corporates            EM bonds       Equities

Yield levels of                           Bullish as targeted in Bullish targeted asset    n/a                                       n/a                   n/a            n/a
targeted bonds                            second round
The use of the cash                       Bullish as MBS sellers Neutral                   Neutral                                   Bullish               Bullish        Neutral
received                                  bought Tsy
Reserves created in                       Neutral given low base Neutral                   Neutral                                   Neutral               Neutral        Neutral
banking system
Investor expectation                      Bearish as QE           Bullish on Fed demand    Break-evens                               Bullish given initial Bullish        Bullish
(eg, inflation)                           expected to work        and initial conditions   increase as deflation                     conditions
Speculation on policy Initially bullish on Fed Bullish given “all in” Fed                  Expect higher                             Bullish given all in Bullish         Bullish, but
impact                duration buying, then commitment                                     inflation                                 Fed commitment                       financial
                      bearish on expected                                                                                                                                 crisis
                      success of QE                                                                                                                                       dominated
Source: HSBC

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Table 3. QE2 Transmission Mechanism Scorecard

                     10yr Treasuries     Mortgage bonds          Inflation-linked &     Corporates         EM bonds   Equities

Yield levels of      Fed buying          n/a                     n/a                    n/a                n/a        n/a
targeted bonds       reflected in low
The use of the cash Bullish as sellers   Neutral                 Neutral                Bullish            Bullish    Neutral
received             bought more Tsy
Reserves created in Neutral given        Neutral                 Neutral                Neutral            Neutral    Neutral
banking system       moderate base
Investor expectation Bearish as QE       Neutral given initial   Bullish for Break-even Modestly bullish   Varied     Bullish
(eg inflation)       expected to work    conditions              and commodities        given initial                 given initial
                                                                                        conditions                    conditions
Speculation on policy Bearish as QE      Neutral given initial   Bullish                Neutral            Varied     Bullish
impact                expected to work   conditions
Source: HSBC

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It’s not about the money
 The Fed’s QE buying simultaneously increased its reserves
   (a liability) and the banking system’s reserves (an asset) – which
   are balance sheet events
 QE shifts assets among investors; it does not in create money
   magically as some commentators seem to believe
 If anything the Fed’s actions eventually risk crowding out
   traditional bank lending and act as a break on economic activity
   as the cost of funding for banks is higher than the interest
   received on the reserves

Reserves are created by the Fed                         Figure 11. Bank reserves jump on Fed asset buying

The Fed’s QE creates reserves in the banking
system, which is the funding source for the Fed’s
                                                        Total bank reserves (USDbn)

asset purchases. Excess reserves in the banking                                       1200
system now stand at USD1.5trn (see Figure 11),                                        1000
representing 10% of total assets, a relatively new
development (in 2007 pre crisis this was 0.2%).                                        400
There seems to be a poor understanding that the
reserves created in QE are an asset in the banking                                       Dec 06   Jun 08   Nov 09   Apr 11   Sep 12
system and a liability for the Federal Reserve.
                                                        Source: HSBC, Federal Reserve
Some analysts assume that the reserves “create”
new deposits in the banking system, and so do not
                                                       Don’t say printing, this is balance sheet
affect bank decisions. However, unless the
                                                       There has been no ‘helicopter drop’ and there is
ultimate sellers of assets to the Fed, such as
                                                       certainly no printing of money. Analogies
foreign investors or mutual funds, choose to hold
                                                       between current US monetary policy and 1920s
low yielding bank deposits instead of reinvesting
                                                       Germany miss the point: Printing money is fiscal
in a more substitute asset, this cannot be the case.
                                                       policy and not an option for the Fed or any other
The conventional view assuming the new reserves
                                                       modern central bank. The Fed is buying bonds in
create a new deposit does not have empirical or
                                                       the secondary market. In contrast, during the
theoretical support, based on balance sheet effects
                                                       German hyper-inflation, government tax revenue
and as demonstrated in the Flow of Funds report.
                                                       was as low as 1% of government spending – the

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rest of the spending was done by printing money        QE is unlikely to significantly increase net
with no intent to collect the taxes needed to pay      lending. It may reduce borrowing costs but this
for it. This would imply the Fed’s liabilities         effect is likely to be dwarfed by the financial
increase (currency in circulation) but its assets do   headwinds -- the large debt burden in the US and
not. The USD1.5trn of excess reserves leaves           economic crisis in Europe. On the other hand, if
traces in the form of assets and liabilities.          there were an increase in savings to fund the
Analysis of the Flow of Funds shows the investors      reserves, then consumption must fall to fund the
who sold assets to the Fed in QE1 were primarily       savings, or growth must pick up to create wealth
foreign holders of spread product who reinvested       (unlikely). Banks are not complaining about their
their cash generated by sales into the Treasury        deposits at the Fed today. However, knock on
market. In QE2 the Fed and foreigners bought the       effects likely limit QE’s economic effectiveness
increased Treasury issuance while other investors      and this analysis points out that there is a point
shifted spread asset holdings. The Fed’s               where the costs of QE to banks should outweigh
borrowing shows up as loans on the banks’              its benefits for the Fed. This supports a low for
balance sheets while the currency in circulation       longer rate view.
grew on its trend line.
                                                       Who loses?
Excess reserves crowd out loans by banks               The more QE and the longer the Fed continues it,
Through the quantitative easing, the increased         the larger the Fed’s share of the banking system’s
reserves have been reflected in a change in the        balance sheet. Figure 12 simulates the reserves
composition of bank balance sheets (more               share of the banking system’s balance sheet
reserves, fewer loans) not the total size. Indeed      assuming USD40bn and USD80bn QE
the limited growth in bank balance sheets is           programmes and no increase in bank deposits.
because of shrinkage (deleverage) in other areas,      Excess reserves were negligible in 2007; now they
most likely shadow banking.                            are the fourth-largest asset class in the banking
                                                       system. Twelve months of the mortgage QE3
The average cost of fund to banks is significantly
                                                       would make reserves larger than the banks’
higher than the interest received on the reserves
                                                       current third-largest position – their USD 1.9bn of
from the Fed; according to the Federal Reserve
                                                       agency mortgages. That seems manageable for the
Bank of San Francisco the average cost of funds
                                                       banking system. Twenty-four months of a
was 1.06% in July.
                                                       USD80bn QE would make reserves the second-
Catch 22 for QE                                        largest asset class in the banking system – just
By crowding out other types of assets on the           behind the banks’ current USD4.4trn non-agency
balance sheet, assuming that there has been no         mortgage position. That size risks harm. Banks
increase in savings, the reserve growth is             would have to sell or mature USD480bn to
hampering economic activity. Banks may be less         USD2trn of assets, respectively, for these
able to lend to small businesses and others and the    scenarios. The question is which assets?
Fed’s actions may not help the real economy in
the end.

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What the Fed said on 13 September                         Figure 12. Reserves take over more bank balance sheet for QE

The September FOMC statement committed the Fed

                                                          Reserves as a percent of total bank assets
                                                                                                                  USD80bn/mo QE
to buy USD40bn of agency mortgages each month                                                          25%        USD40bn/mo QE
in its third quantitative easing programme. The
statement links the programme’s length and potential
for additional QE, to the state of the labour market:
“If the outlook for the labour market does not
improve substantially, the Committee will continue
its purchases of agency mortgage-backed securities,                                                    0%
                                                                                                         Dec 06   Dec 08   Dec 10   Dec 12   Dec 14
undertake additional asset purchases, and employ its
other policy tools as appropriate until such              Source: HSBC, Federal Reserve

improvement is achieved in a context of price
stability. In determining the size, pace, and
composition of its asset purchases, the Committee
will, as always, take appropriate account of the likely
efficiency and costs of such purchases.”

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Appendix 1
Agency holdings

Foreigners have been sellers                                               Foreign investors were large buyers of agency
                                                                           securities up to 2008 (see Figure A2). They became
Total agency debt and mortgages outstanding have
                                                                           sellers in the debt crisis, contributing to market stresses.
stabilised at USD7trn (see Figure A1). The limited
                                                                           Households and businesses initially bought agencies,
growth in agencies since the start of the crisis means the
                                                                           but have since liquidated their holdings. The ABS and
Fed’s mortgage purchases will displace current holders.
                                                                           REIT holders sold initially, but have since been buyers.
This section of the Flow of Funds report combines
agency mortgages and debt. Since investors typically
treat the two as close substitutes this does not affect                     Figure A2. Sectors selling since end-2008

our conclusions.                                                                                      2000
                                                                            Agency holdings (USDbn)

 Figure A1. Total agency mortgages and debt

 Total agency holdings (USDbn)

                                 6500                                                                  500

                                                                                                             02   03   04    05   06   07   08   09   10   11   12
                                                                                                        Foreign             Household & business           ABS/REITs
                                                                            Source: HSBC, Federal Reserve
                                        02 03 04 05 06 07 08 09 10 11 12
                                                                           The wide spreads caused by uncertainty and selling
 Source: HSBC, Federal Reserve
                                                                           initially saw buying by mutual funds. Later the Fed
                                                                           started QE1 (see Figure A3). Since mid-2009 banks
Fannie Mae, Freddie Mac and Ginnie Mae fixed-
                                                                           have been consistently increasing their mortgage
coupon mortgages targeted by the Fed total roughly
                                                                           exposure. This was an offset to reducing higher risk-
USD4trn. Various floating-rate agency mortgages total
                                                                           weighted corporate debt (see next section). The Fed’s
over USD1trn. These agencies’ debt plus the Federal
                                                                           holdings fell as it received principal payments until it
Home Loan Bank’s make up the majority of the
                                                                           initiated its mortgage reinvestment programme in 2012.
remaining USD2.2trn in debt.

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Figure A4 shows the current agency holdings for a                                                                            Figure A3. Sectors buying since end-2008
range of investors and their positions in April 2008.

                                                                                                                             Agency holdings (USDbn)
In QE3 the Fed will buy low-coupon issues, so most of                                                                                                  2000
the holders will either have to compete with the Fed to
buy richly priced mortgages or shift into other assets.
The investors most affected will be banks, mutual funds                                                                                                 500
and foreign investors. The next section examines their
behaviour to determine their likely reinvestment
                                                                                                                                                                  02 03 04 05 06 07 08 09 10 11 12
                                                                                                                                                                  Fed               Banks                    Mutual funds

                                                                                                                             Source: HSBC, Federal Reserve

 Figure A4. The Fed will have to buy bonds from the current large domestic holders; banks and funds
 Total agency holdings 2008 (USDbn)

                                               30 June 2012
                                      2000     31 March 2008



                                                                                                             State & local

                                                                                                                                                                                      Mutual funds

                                                       Household &





 Source: HSBC, Federal Reserve

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Appendix 2
Corporate holdings

Mutual funds have been buying                                                            Figure A6. Foreign holders and banks have been main sellers
corporates through the crisis
                                                                                         Holdings of corporate securities (USDbn)

The total amount of corporate debt outstanding has                                                                                  2500
stabilised at USD12trn (see Figure A5). This includes                                                                               2000
long- and short-term investment-grade and high-yield                                                                                1500
debt. It also includes foreign debt issued in USD or that                                                                           1000
held by US residents. The total amount of corporate                                                                                 500
debt initially fell during the debt crisis, likely owing to                                                                           0
a drop in commercial paper outstanding.                                                                                                    02 03 04 05 06 07 08 09 10 11 12

                                                                                                                                      Foreign      Banks     Finance   Household
 Figure A5. Total corporate holdings
                                                                                         Source: HSBC, Federal Reserve
 Total holdings of corp securities (USDbn)

                                                                                        Mutual funds, pensions and insurance companies have
                                             10000                                      been the biggest buyers of corporate debt since the debt
                                             9000                                       crisis started and have tended to add exposure recently
                                             8000                                       (see Figure A7). They are the investors most likely to
                                             7000                                       rotate out of mortgages and into a mix of corporates and
                                                                                        Treasuries because of QE3.
                                                     02 03 04 05 06 07 08 09 10 11 12   Figure A8 shows the total corporate bond holdings

 Source: HSBC, Federal Reserve
                                                                                        across the different investor sectors. The household
                                                                                        sector has a significant corporate holding, but only
Foreign investors were significant buyers of corporate                                  small holdings in agencies (see Figure A4). This means
bonds up to 2008, but they became large sellers, Figure                                 it has no agencies to roll out of. The remaining sectors
A6. Banks began to pare holdings around the same time                                   have had stable or falling exposure to corporates
and have continued to do so, likely because of the shifts                               recently and so seem less likely to add to corporate
in the regulatory environment. The household and                                        positions because of QE3. This set of investors, which
finance sectors were initially buyers of corporate bonds                                includes foreign holders, seems most likely to roll from
during the debt crisis but have tended to reduce                                        any mortgage exposure into Treasuries.
positions since mid-2009.

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Figure A7. Pensions and Mutual funds have been main buyers
Holdings of corporate securities (USDbn)







                                                                      02 03 04      05 06 07 08 09 10 11 12
                                                                 Pensions             Insurance       Mutual funds

Source: HSBC, Federal Reserve

Figure A8. Distribution of corporate bond holders – expect most to add as mortgage holdings fall
                            Total corporate holdings (USDbn)

                                                                                                                                                                    30 June 2012
                                                                                                                                                                    31 March 2008
                                                                                                                                                                         Mutual funds



Source: HSBC, Federal Reserve

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Appendix 3
Treasury holdings

All sectors have been buying                                                            Other Treasury investors’ positions shifted dynamically
Treasuries as the market grew                                                           as the debt crisis unfolded. The Fed initially sold large
                                                                                        amounts of Treasuries to make room on its balance
Figure A9 shows the rapid increase in Treasury debt,
                                                                                        sheet for its emergency lending programmes (Figure
USD5.6trn, after the start of the financial crisis. Thus
                                                                                        A11). Its holdings then jumped owing to the USD900bn
most investor sectors have increased their Treasury
                                                                                        of Treasuries purchases in QE1 and QE2, and the
holdings reflecting the increased supply.
                                                                                        additional mortgage principal reinvestments
 Figure A9. Total treasury holdings                                                     into Treasuries.
 Total Treasury holdings (USDbn)

                                                                                        The mutual fund sector bought Treasuries in 2008 as it
                                   10000                                                reduced spread risk on performance concerns. The
                                    9000                                                household sector, which includes hedge funds, has
                                                                                        actively shifted from buyer to seller since, but was a
                                    6000                                                significant buyer around 2010. Its shifts reflect both its
                                    5000                                                view of other asset classes and the value of Treasuries.
                                                                                         Figure A10. Foreign Treasury holdings
                                           02 03   04   05 06   07 08   09 10   11 12
                                                                                         Total foreign Treasury holdings (USDbn)

 Source: HSBC, Federal Reserve

Foreign holdings in Treasuries dwarf the other investor
sectors, so they are presented separately in Figure A10.                                                                           3000

Part of the jump in their Treasury holdings early in the                                                                           2000

financial crisis reflects their rotation out of spread                                                                             1000
product and into Treasuries, discussed above.
                                                                                                                                          02 03 04   05   06 07 08 09   10 11 12

                                                                                         Source: HSBC, Federal Reserve

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 Figure A11. Other large holders dynamically shifted positions                                                                            Figure A12. Surprisingly, banks have been buyers

                                                         1800                                                                                                               350
  Total Treasury holdings (USDbn)

                                                                                                                                          Total Treasury holdings (USDbn)
                                                         1600                                                                                                                               Insurance
                                                                           Household                                                                                        300             Banks
                                                                           Mutual funds                                                                                     250
                                                         1000                                                                                                               200
                                                         800                                                                                                                150
                                                           0                                                                                                                  0
                                                                02   03 04      05   06 07   08       09 10    11         12                                                      02   03   04      05   06           07   08    09        10   11            12

 Source: HSBC, Federal Reserve                                                                                                            Source: HSBC, Federal Reserve

Figure A12 shows the banking sector has been a buyer
of Treasuries since the start of the financial crisis. The
commonly told story that banks sell Treasuries to the
Fed is not supported by the facts on their balance
sheets. Also, note that banks have modest Treasury
holdings given the nearly USD15trn size of their
balance sheets. The insurance industry initially sold
Treasuries in the crisis to buy spread assets but has
since added Treasuries.

Figure A13 shows how the Treasury holdings for a
range of investor sectors changed since the start of the
financial crisis.

 Figure A13. Position changes since 2008
                       Total Treasury holdings (USDbn)

                                                          5000                                                                                                                                                                  30 June 2012
                                                          4000                                                                                                                                                                  31 March 2008






 Source: HSBC, Federal Reserve

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Appendix 4
 Figure A14. 10-year T.Note in low for longer range                                                      Figure A15. Current coupon mortgage spread richens to 10-year

                                                                                                         30yr MBS curr cpn spread to 10yr Tsy (bp)
                              2.4                                                                                                                    140
                              2.1                                                                                                                    100
 Yield (%)

                              1.9                                                                                                                     80
                              1.8                                                                                                                     60
                              1.6                                                                                                                     40
                              1.3                                                                                                                      0
                                Mar 12                May 12             Jul 12                 Sep 12                                                 Sep 11    Dec 11   Mar 12   Jun 12    Sep 12

 Source: HSBC, Bloomberg                                                                                 Source: HSBC, Bloomberg

 Figure A16. Inflation expectations already back towards top end                                         Figure A17. Homebuyer mortgage rates lag falling market rates

                             4. 0                                                                                                                     4.5
                             3. 5
 I nflati on swap rate (%)

                             3. 0
                                                                                                         Mortgage rate (%)

                             2. 5
                             2. 0                                                                                                                     3.0

                             1. 5                                                                                                                     2.5
                             1. 0                                                 EUR   2s2s
                                                                                  USD   2s2s                                                          2.0         Primary MBS
                             0. 5                                                 EUR   5s5s                                                                      Secondary MBS
                                                                                  USD   5s5s                                                          1.5
                             0. 0
                                                                                                                                                        Sep 11   Dec 11   Mar 12   Jun 12   Sep 12
                               Feb 07        Mar 08     May 09     Jun 10         Jul 11       Sep 12

 Source: HSBC, Bloomberg                                                                                 Source: HSBC, Bloomberg

 Figure A18. Foreign investors shift into Treasuries

 Foreign holdings (USDbn)





                                        02   03 04     05    06 07      08   09 10         11     12
                                Agency                      Corporate                   Treasury

 Source: HSBC, Bloomberg, Federal reserve

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Disclosure appendix
Analyst Certification
Each analyst whose name appears as author of an individual chapter or individual chapters of this report certifies that the views
about the subject security(ies) or issuer(s) or any other views or forecasts expressed in the chapter(s) of which (s)he is author
accurately reflect his/her personal views and that no part of his/her compensation was, is or will be directly or indirectly related
to the specific recommendation(s) or view(s) contained therein: Steven Major, Lawrence Dyer, Garry Evans and Pablo

Important disclosures
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Rating definitions for long-term investment opportunities
Stock ratings
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*A stock will be classified as volatile if its historical volatility has exceeded 40%, if the stock has been listed for less than 12
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As of 27 September 2012, the distribution of all ratings published is as follows:
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(P) 063/04/2012 and MICA (P) 206/01/2012


Global Fixed Income Research Team
Steven Major, CFA
Global Head of Fixed Income Research
+44 20 7991 5980
Rates                                                  Credit
Europe                                                 Europe
Bert Lourenco                                          Lior Jassur
Head of Rates Research, Europe                         Head of Credit Research, Europe
+44 20 7991 1352           +44 20 7991 5632
Subhrajit Banerjee                                     Dominic Kini
+44 20 7991 6851     +44 20 7991 5599
Theologis Chapsalis                                    Laura Maedler
+44 20 7992 3706     +44 20 7991 1402
Wilson Chin, CFA                                       Remus Negoita, CFA
+44 20 7991 5983            +44 20 7991 5975
Di Luo                                                 Anna Schena
+44 20 7991 6753                 +44 20 7991 5919
Chris Attfield                                         Peng Sun, CFA
+44 20 7991 2133   +44 20 7991 5427
Johannes Rudolph                                       Pavel Simacek, CFA
+49 211 910 2157          +44 20 7992 3714
Sebastian von Koss                                     Raffaele Semonella
+49 211 910 3391          +44 20 7991 3153
Asia                                                   Jayadev Mishra
André de Silva, CFA                                    +971-4-4235509
Head of Rates Research, Asia-Pacific                   Asia
+852 2822 2217          Dilip Shahani
Pin-ru Tan                                             Head of Global Research, Asia-Pacific
+852 2822 4665              +852 2822 4520
Grace Qiu                                              Zhiming Zhang
+852 2822 6569             +852 2822 4523
Himanshu Malik                                         Devendran Mahendran
Associate                                              +852 2822 4521
+852 3941 7006        Philip Wickham
Americas                                               +65 6658 0618
Larry Dyer                                             Keith Chan
+1 212 525 0924       +852 2822 4522
Jae Yang                                               Louisa Lam
+1 212 525 0861              +852 2822 4527
Pablo Goldberg                                         Yi Hu
Head of Global Emerging Markets Research               +852 2996 6539
+1 212 525 8729
                                                       Crystal Zhao
Bertrand Delgado                                       +852 2996 6514
EM Strategist
+1 212 525 0745    Linus Fung
                                                       +852 2822 4687
Gordian Kemen
+1 212 525 2593       Alex Zhang
                                                       +852 2822 3232
Victor Fu
+1 212 525 4219           Americas
                                                       Van Hesser
Alejandro Mártinez-Cruz                                Head of Credit Research, US Financial Institutions
+52 55 5721 2380   +1 212 525 3114
                                                       Robert J Schmieder
                                                       Head of Latam Corporate Credit
                                                       +1 212 525 4829
                                                       Mary Ellen Olson
                                                       +1 212 525 0191
                                                       Sarah R Leshner
                                                       +1 212 525 3231
                                                       Arjun Bowry
                                                       +1 212 525 3119

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