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Interest Rates Research 30 May 2013 Global Rates Weekly Regime shift • Broad-based losses in carry trades across asset classes over the past month suggest a perceived regime shift in policy. Views on a Page 5 Trade Portfolio Update 43 • The market continues to re-price to a hawkish shift in the Fed’s tone, as evidenced by a further rise in long-term real rates and a tightening of Global Supply Calendar 56 breakevens. Given the uncertain market perception of the Fed's reaction Global Bond Yield Forecasts 57 function, we remain neutral on duration and maintain our long gamma view. • We maintain our US 7s30s/10s30s curve flattener view, as the curve looks steep, United States given modest inflation expectations. We also recommend bear flatteners to TIPS: 10s30s breakeven flatteners now position for a further sell-off and bull spread tighteners for a reversal. attractive 14 Money Markets: Heading east 17 Global Regime shift 2 Europe We are neutral on duration in developed rates and long US gamma, given our belief that Sovereign Spreads: Taper talk – in core EGB markets are likely to remain volatile and sensitive to US labor metrics over the summer. markets 23 We maintain our US 7s30s curve flattener view, given the drop in inflation expectations. Money Markets: ECB – no rush on policy rates 26 United States SSA: European support structures – familiar territory 34 Tread with caution 6 The market continues to re-price to a hawkish shift in the Fed’s tone, as evidenced by a Scandinavia: Prospect of Riksbank rate cut despite headline GDP surprise 35 further rise in long-term real rates and a tightening of breakevens. At current levels, curve flatteners continue to offer better risk-reward than outright duration views, given UK Inflation-Linked: Watch out for the overhang 37 the high uncertainty about the Fed’s reaction function. In options, we recommend bear flatteners to position for a further sell-off and bull spread tighteners for a reversal. Special Topic: EGBs – Back to trading like a rate product 38 Euro Area www.barclays.com Sharp sell-off in euro rates – do not fade it 20 European rates have not been immune to the recent volatility in global markets. We were expecting rates to gradually move higher: even though our end-Q2 targets have been reached, we maintain our neutral-to-negative view on rates. UK Steeper and cheaper 30 The DMO plans to launch a new “super long” 50-60y maturity nominal gilt next month. There is some natural demand for a super long issue: the ultra long end needs to cheapen and steepen for supply to be absorbed. We favour 2052/2060 steepeners. Japan Tug of war in JPY/USD cross-currency basis 41 10y USD/JPY Xccy basis is now as negative as it was in May 2012. Given the gradual tightening of loan spreads, spreads on new loans are likely to be much tighter and may eventually become a disincentive for banks to bear more basis cost. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 58 Barclays | Global Rates Weekly GLOBAL THEMES Regime shift Rajiv Setia We are neutral on duration in developed rates and long US gamma, given our belief that +1 212 412 5507 markets are likely to remain volatile and sensitive to US labor metrics over the summer. firstname.lastname@example.org We maintain our US 7s30s curve flattener view, given the drop in inflation expectations. Global rates endured another week of high volatility. 10y Treasuries sold off 9bp through Laurent Fransolet Thursday, but this masks the intraday volatility that characterized much of the week, on +44 (0)20 7773 8385 little fundamental news. It remains clear that the market believes that US monetary policy email@example.com has taken a hawkish turn, while the increase in volatility in the bond and stock markets in Japan has market participants questioning the efficacy of the BoJ’s monetary expansion. Amrut Nashikkar Meanwhile, inflation expectations in the US have continued to decline through the rate sell- +1 212 412 1848 off, and real rates have to risen to levels not reached since early 2012, even as the incoming firstname.lastname@example.org data have remained decidedly mixed (Figure 1). It is not just the level of real rates that suggests that there has been a policy change in the market’s mind; a look at carry trades in several other markets corroborates such a belief. By definition, an investor in a carry trade looks to earn a risk premium with a view that markets will remain range-bound; ie, forward prices are not realized, but roll to spot prices instead. The fact that carry-trades across asset classes performed poorly over the past month suggests that the market perceives such a regime shift. Carry trades across asset In Figure 2, we have chosen a few carry trades that were popular at the end of April. Some classes were likely stopped out of these are rates trades, such as receiving 3y1y rates, long the belly of the curve, 7s30s in May, suggesting that a steepeners, short 1y10y straddles and long 10y JGBs. Others are non-rates trades such as reversal may be slow in long AUD and long agency mortgage REITs. With the exception of the 7s-30s steepener and coming. selling rates vol, the other trades have given up more than a year’s worth of carry. Clearly, the past month has been brutal for carry trades; we did not see such broad-based losses in carry trades across asset classes in the January rate sell-off. Faced with large losses, leveraged money will likely be hesitant to position for a reversal anytime soon. FIGURE 1 FIGURE 2 Sell-off in rates continues to be real yield driven, while With the exception of 7s30s curve steepeners, popular carry inflation expectations are falling trades have severely underperformed over the past month 120 1y expected Carry/ Months of carry 100 Trade carry , 30-Apr vol lost in May 80 Receive 3y1y 50 bp 1.05 14 Receive 7s 38 bp 0.91 13 60 7s30s steepener 26 bp 0.64 1.5 40 Short 1y10y 270 - 5 straddle (cnts) 20 Long AUD (cnts) 2.6 0.27 32 0 Long agency 1.73 0.75 12 -20 REIT ETFs ($) Oct-Dec 10 Oct 11 Mar 12 July-Aug 12 May 13 Buy 10y JGB 15 bp 0.23 25 Change in real yields, bp Change in breakevens, bp Source: Barclays Research Source: Barclays Research 30 May 2013 2 Barclays | Global Rates Weekly Adding fuel to the fire, there are emerging signs of instability in Japanese markets, potentially signalling the constraints of unconventional monetary policy at the zero lower bound. Despite the BoJ’s stated intention to lower long-term interest rates, 10y JGBs now trade nearly 35bp higher than they did before the BoJ’s QQE announcement. The Nikkei has been extremely volatile, already having lost over 2,000 points after rising to a local peak of 15,627. This rise in volatility, along with the increase in rates, means that financial conditions in Japan have tightened over the past few days, quite the opposite of the BoJ’s intention. Volatility in Japanese equity As our Japanese economists have argued, it will be extremely difficult for the BoJ to meet its and rates markets means that stated inflation target of 2% (see Long and winding road to inflation, April 25, 2013). This is it may be difficult for investors compounded by the fact that wealth effects, if any, from the rise in the stock market are to position for a rally likely to be small, given the low levels of stock ownership in Japan (only 7% in Japan, vs 33% in the US, Figure 3). Further, Japanese depository institutions hold over JPY300trn of government bonds, which means that any large rises in interest rates could also lead to losses on their holdings; capital losses could crimp credit creation, implying an indirect tightening of policy. Our Japanese strategists believe that 0.8% on 10y JGBs is an attractive level for the long term. But it is unclear how the BoJ, which has already announced a massive bond purchase program, could push rates lower in the face of rising volatility. This leads us to take a cautious stance on outright duration in Japan. Volatility is likely to remain elevated In the US, we are neutral on We are neutral on duration in developed markets. Over the past few years, we have duration, but maintain our long consistently viewed every inordinate rate sell-off in the US as an opportunity to “buy the gamma and curve flattener dip.” We are no longer in that camp. Our base view has always been that rates would start views. to rise on a sustainable basis, as growth accelerated to above trend, most likely in 2014. While we still expect this to be the case, our change of stance on duration to neutral last week (see Unusually uncertain, May 23, 2013) was not driven by a fundamental shift in our economic outlook. Rather, it was driven purely by our view that the market’s perception of the Fed’s reaction function has shifted dramatically following mixed messages from Fed leadership. Specifically, unless Fed speakers clarify what metrics they are looking at to gauge the appropriate timing of the withdrawal of stimulus, volatility is likely to remain elevated in the months ahead. In the US Rates Strategy section of this publication, we argue that while the Fed has typically tended to overestimate growth, it has underestimated the FIGURE 3 FIGURE 4 Equity ownership by households in Japan is much lower than The Fed has typically turned dovish whenever the in the US or even Europe unemployment rate has stalled 100% 0.4 Dovish 80% 0.2 0.0 60% -0.2 40% -0.4 20% -0.6 0% -0.8 Japan United States Euro Area Hawkish Currency & Deposits Bonds -1.0 Investment Trusts Shares and equities Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Insurance andPension Reserves Others Change in Unemployment Rate, 6 months Source: Bank of Japan Source: Barclays Research 30 May 2013 3 Barclays | Global Rates Weekly drop in the unemployment rate. With the market already pricing in the first hike in mid- 2015, there is probably some more room for expectations to be pulled forward to early 2015 if the unemployment rate continues to drop because of modest job growth and a fall in the participation rate. Such a scenario would imply 10s trading at 2.25% in the near term. On the other hand, if the decline in the unemployment rate stalls (Figure 4), the Fed could turn increasingly dovish. This leads us to be neutral on duration unless the Fed clarifies otherwise. We are also maintaining our long gamma and 7s30s flattener views going into payrolls. For a list of trade ideas to implement our views or to position for either a continuation of the sell-off or for a reversal, please refer to the US Rates Strategy section. Our European rates strategists believe that rates in core European countries are likely to be driven largely by US rate moves over the near term. Given the recent stabilization in European data, in the Euro Rates Strategy section of this publication we suggest that the recent sell-off in core European rates should not be faded. 30 May 2013 4 Barclays | Global Rates Weekly VIEWS ON A PAGE US EUROPE JAPAN Direction • Economic data in the US remain modest, with the fiscal deal and • Developments in the US are likely to continue to drive euro • Investors appear to have grown cautious about buying on the sequester likely to exert significant drags. rates next week. Therefore the focus is on the NFP report, weakness in the face of the rising volatility in the markets this • The market has overreacted to concerns about tapering, but which should affect market expectations on the possibility month. We believe this situation will continue for now given the uncertainty about the Fed’s reaction function has also increased. of Fed tapering QE. In the Eurozone all eyes will be on the low likelihood of any rapid retreat in yields. Nevertheless, we see ECB, which is expected to remain on hold at its June 10y and 5y JGB yields of 0.8% and 0.3%, respectively, as attractive • We maintain our neutral view on duration. meeting. With the liquidity surplus well below €300bn, from a long-term viewpoint in light of the negative economic markets will pay a lot of attention on the 3y LTROs payback factors worldwide, such as Chinese economic trends. A Fed exit announcement. strategy stands as the one real upside risk for JGB yields, but at present levels we would recommend maintaining a long position. Curve/ • We maintain 10s30s flatteners, as the curve looks too steep, given • Hold on to receive EUR 5y5y/5y10y/5y15y fwds. • 1s3s5s short vs 3s5s7s long. curvature inflation expectations. • Hold onto pay EUR 5y10y/5y15y/5y20y fwds. • We maintain our long front-end Tsy vs. OIS view, given improving • UK: Longer-dated nominal gilt yields remain rich, financing conditions. The 2y sector looks cheap. underpinned by low real rates. Reset Gilt 5/30s or Gilt • We maintain a short view on a weighted 5s10s20s fly to position 10/30s steepeners into Q2 13 supply. Declining realised for a decline in the term premium. volatility supports carry-and-roll structures – carry: vol • Shorten on the Cs STRIPS curve into the 10-12y area; switch out ratios are at their cheapest in the 10-15y part of the curve. of rich 20y Tsy P STRIPS to 20y REFCO P STRIPS. • Into super long supply in June , hold 2052/2060 steepeners Swap • Neutral on 30y spread wideners, considering risks from risky asset • EUR: Take profit on short Bobl ASW on Ger 5s/30s ASW • 20s30s box (20y long). spreads underperformance. box. • Short 10y and 5y. • 1y1y Libor-OIS tightener hedged with 1y1y 3s1s widener. • GBP: While short-dated asset swaps can remain well • 10s30s spread curve flattener to benefit from possible convexity supported between now and end-June, we see 30y ASW paying. vulnerable both outright and on the ASW curve into May and June’s supply. Other • We continue to favor long-end agency-Treasury spread tighteners • SEK: Hold SEK/EUR 10y tighteners in swaps and longs in • Pay USD/JPY 1yx1y basis. spread but find the most upside potential only in the super-long end. 7s SEK Sep ‘13 3m FRA. sectors • Pay USD/JPY 4y basis. have underperformed along the curve and now offer more than • Hold Spain and Italy 2s/5s/10s. 20bp of spread pick-up to Treasuries; shorten duration to 10s with • Hold Spain 5s/10s/30s. no spread give-up. • Hold onto short Spain 10s/15s/30s. • We remain constructive on Canadian covered bonds, given their relative isolation from Europe and continued significant spread • Long 5-8y Netherlands and Finland versus France. pick-up to agencies. Pockets of value persist in USD SSA space. • Long FRTR Oct ‘19/Oct ‘22/Apr ‘26 fly. Inflation • 10s30s breakeven flatteners given already steep levels and the • Short 10y euro HICPx swap versus long in OAT€i18 • Breakevens have started to rise even with negative carry intact, and upcoming 30y reopening supply. breakeven. we expect this trend to continue for now. Over the short term, • Neutral on real rates. Long TIIJan17 versus TIIJan18 on ASW. • UKTI Mar ’24 no longer cheap in relative value, risks of there is probably an opportunity for capital gains. However, it is • The short end may remain under tactical pressure in the overhang post upcoming reopening. difficult to determine where levels will settle over the medium to upcoming switch from positive to negative carry. long term. In establishing long positions over such a horizon, we recommend paying attention to levels. Volatility • Buy 1m*7y straddles, as uncertainty about the Fed’s policy action • Buy EUR1y*30y 100bp wide risk reversal (long receivers) to could persist for the next few weeks. hedge a risk flare in the eurozone. • Initiate 1m*5y vs 1m*15 bear flattener to position for strong • Buy 1y*5y receivers funded with 1y SL 5-30y curve cap to payroll/Fed taper in the near term. Long 3x13 Libor cap-floor vs benefit from EUR rates staying low for long. 3y10y swaption straddle to position for steepening of the vol • Buy EUR 6y*5y versus 1y*(5y5y) to position for steepening surface. of the vol surface and monetise the range in rates. Source: Barclays Research 30 May 2013 5 Barclays | Global Rates Weekly UNITED STATES: RATES STRATEGY Tread with caution Rajiv Setia The market continues to re-price to a hawkish shift in the Fed’s tone, as evidenced by a +1 212 412 5507 further rise in long-term real rates and a tightening of breakevens. At current levels, email@example.com curve flatteners continue to offer better risk-reward than outright duration views, given the high uncertainty about the Fed’s reaction function. In options, we recommend bear Anshul Pradhan flatteners to position for a further sell-off and bull spread tighteners for a reversal. +1 212 412 3681 Over the past few years, we have consistently viewed every inordinate rate sell-off as an firstname.lastname@example.org opportunity to “buy the dip.” We are no longer in that camp. Our base view has always been that rates would start to rise on a sustainable basis, as growth accelerated to above trend, Amrut Nashikkar most likely in 2014. While we still expect this to be the case, our change of stance on +1 212 412 1848 duration to neutral last week (see Unusually uncertain, May 23, 2013) was not driven by a email@example.com fundamental shift in our economic outlook. Rather, it was driven purely by our view that the market’s perception of the Fed’s reaction function has shifted quite dramatically following Piyush Goyal mixed messages from Fed leadership. Specifically, unless Fed speakers clarify what metrics +1 212 412 6793 they are looking at to gauge the appropriate timing of the withdrawal of stimulus, volatility firstname.lastname@example.org is likely to remain elevated in the months ahead. Vivek Shukla Over the past week, the violent sell-off has caused carry trades of all flavors to be punished +1 212 412 2532 (see Global Themes elsewhere in this publication). Given current rate levels, we are getting email@example.com close to where it might be worth outright longs on a tactical basis. From our vantage point, longer-term forwards already reflect any likely taper. The only question is how much more the hiking cycle can be pulled forward. With the market still pricing in the first Fed hike in mid-2015, the market can “reasonably” price to early 2015 (after all, the unemployment rate could be at 6.5% by late 2014 if recent trends continue). This could push 10y rates to ~2.25% in the near term. We therefore maintain our neutral duration view for now. On the other hand, if consumption data surprise to the downside and payrolls disappoint, 10y rates could rally to 1.8-1.9% as hike expectations are pushed out and the term premium declines. Given the possibility of large moves in either direction, we continue to recommend being long gamma on mid-tails. We also maintain our 7s30s/10s30s curve flattener view. While the 10s30s curve has flattened since mid-May, when concerns about tapering were picking up, FIGURE 1 FIGURE 2 Unlike in the past sell-off, breakevens have actually The Fed has consistently overestimated growth but tightened, suggesting the sell-off was driven by hawkish Fed underestimated the drop in the unemployment rate 120 2010 2011 2012 2013* 100 Real GDP, 1y ahead Fed 80 forecast, % 3.0 3.3 2.7 2.55 Realized Real GDP, Q4/Q4, % 2.4 2.0 1.7 -- 60 40 Unemp Rate , 1y ahead Fed forecast, % 9.5 9.0 8.6 7.4 20 Realized Unemp Rate, Avg 0 Q4, % 9.5 8.7 7.8 -- -20 Oct-Dec 10 Oct 11 Mar 12 July-Aug 12 May 13 Change in real yields, bp Change in breakevens, bp Note: We use Fed CMT data for all the episodes, with the exception of the most Note:*The latest, not from a year ago. Source: Federal Reserve, Barclays Research recent one, where we use OTRs. Source: Federal Reserve, Barclays Research 30 May 2013 6 Barclays | Global Rates Weekly we believe curve flatteners still offer attractive risk-reward. In our view, the curve continues to look too steep, given modest inflation and inflation expectations. We also recommend conditional bear flatteners to position for a further sell-off and conditional bull spread tighteners to position for a reversal. With the market re-pricing expectations higher even for 2014, we recommend going long front-end EDs (please see the trade section at the end of the article for details). What has changed? Not the economic outlook The rate sell-off has not been Has the sell-off been driven by expectations of a better economic outlook? We do not think driven by an improvement in so. While consumer confidence has been higher than expected, manufacturing surveys and economic outlook industrial production have surprised to the downside. Our economists’ tracking estimate of Q2 real GDP growth has actually fallen from 1.7% in mid-May to 1.4%. Similarly, consensus and Barclays forecasts for H2 real GDP growth have barely budged at 2.4% and 2%, respectively. Inflation data have also surprised to the downside, and market expectations of CPI inflation 1y and 2y ahead are at the lower end of the range. Hence, it does not seem that expectations for the economy have suddenly shifted to justify the rate move. In past sell-offs, which have resulted from improving fundamentals, real yields and breakevens have participated. In the recent move, only real yields have moved higher (Figure 1); breakevens have actually tightened. This is another sign that the move is not a reflection of a better economic outlook, but rather a hawkish Fed. Mainly the perception of the Fed’s reaction function Market’s perception of the So what changed? In our view, it was the market’s perception of the Fed’s reaction function, Fed’s reaction function has given mixed messages from key Fed officials. New York Fed President Dudley noted that he changed would wait for 3-4 months to decide whether to taper; St. Louis Fed President Bullard noted that he wanted to wait for inflation to rise before tapering; and the May FOMC minutes showed that “views differed about what evidence would be necessary” to gauge substantial progress and, hence, to commence tapering. At the same time, Chairman Bernanke said the Fed may begin to taper at the next few meetings and also did not rule out the possibility before Labor Day, ie, at the June or July meeting. The exact timing of the taper should not have much of an effect on the term premium at the long end of the curve, especially if the taper is gradual and halting, as the stock of Fed purchases may not end up being different than what the market was expecting prior to the recent Fedspeak. However, the conditions under which the Fed will begin to taper convey what metrics it is looking at to judge the appropriateness of monetary policy and, therefore, its reaction function. This should have significant implications for the hiking cycle. Were the Fed to convey it is Until a few weeks ago, we assumed that the Fed would look at not only the partial progress focused on the unemployment made in the labor market since the launch of QE3, but also the modest growth and inflation rate, then the hiking cycle backdrop. This is where there has been a change in market perception. For instance, were the could be pulled forward to Fed to begin tapering at one of the next few meetings despite data that only match consensus early 2015 (eg, modest growth in Q2/Q3, a slowdown in payroll growth vs. the past six months, below- target inflation), that could convey that the Fed is focused on the unemployment rate. This is relevant because the forward guidance is explicitly linked to the unemployment rate, which has been steadily falling faster than Fed’s forecast despite growth being consistently lower than its forecast (Figure 2). Were the unemployment rate to keep dropping at the current pace (driven by modest job gains/a continued decline in LFPR), it could get to 6.5% by the end of 2014, and investors would price in a high chance of a Fed hike in early 2015. 30 May 2013 7 Barclays | Global Rates Weekly While the Fed has stressed that 6.5% is a threshold, not a trigger, it has also been non- committal on how it views declines in the unemployment rate to the extent they are driven by a drop in the LFPR. At the March FOMC press conference, Chairman Bernanke noted that the drop was mostly structural, but at the latest testimony, he characterized that as a sign of a weak labor market. Hence, there is now considerable confusion on how investors are supposed to judge the progress in the economy in the context of the outlook for monetary policy. Could the Fed reverse course? Fedspeak has shifted from Since the sell-off has been driven primarily by shifting perceptions of the Fed’s reaction being hawkish to dovish in the function, there is the potential for a large rally if Fedspeak suddenly turns more dovish. This past is certainly something that has happened in the past. For instance, in March 2012, the FOMC statement mentioned that the unemployment rate had dropped notably and the minutes from that meeting showed that only a couple of members thought that additional stimulus would be necessary even if the economy lost momentum. This was perceived as very hawkish, and 10y yields rose from 2% to 2.4% in a matter of days. Fast forward to June 2012, and the Fed extended the maturity extension program to the end of 2012 and said that it was prepared to take more action (ie, launch QE3). What prompted the turnaround in 2012 were the data. Similarly, the Fed’s tone could reverse if the unemployment rate stalls, or medium-term inflation forecasts/longer term breakevens fall, or financial conditions continue to tighten. However, with the unemployment rate closer to the 6.5% threshold, the bar to force a reversal may be higher this time. Stalling of the unemployment To highlight the evolution of Fedspeak, in Figure 3, we plot the 6m change in the rate may cause a reversal in unemployment rate. The Fed has typically sounded hawkish after sharp drops in the the recent hawkish tone unemployment rate and dovish after the unemployment rate stalls. For instance, heading into Q3 10 and Q3 11, the unemployment rate had stalled and the Fed launched QE2 and Operation Twist, respectively. However, by the March 2012 FOMC meeting, the rate had dropped 0.8%, leading to Fed to shift its tone. But by the middle of the year, it stalled again and the Fed extended Operation Twist. With the unemployment rate now much closer to the desired level than it was in 2010 or 2011, the Fed’s tolerance for an unchanged rate may be higher. In addition, over the past few years, tail risks have diminished greatly; household and bank balance sheets are in better shape, and euro area stability concerns have subsided. FIGURE 3 FIGURE 4 A stalling of the unemployment rate may cause the Fed to … or a decline in longer-term inflation expectations could reverse its recent stance… force a dovish shift 0.4 4.0 Dovish 0.2 3.0 0.0 2.0 -0.2 -0.4 1.0 -0.6 0.0 -0.8 May-08 May-09 May-10 May-11 May-12 May-13 Hawkish Fed's medium term core PCE inflation forecast -1.0 yoy core PCE, % Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 5y5y OTR cash breakevens Change in Unemployment Rate, 6 months 5y5y cpi swaps Source: Haver Analytics, Barclays Research Source: Haver Analytics, Barclays Research 30 May 2013 8 Barclays | Global Rates Weekly Separately, while the Fed has overlooked the recent decline in inflation, Figure 4 shows it is mainly because its own medium-term inflation forecasts remain close to their target. Also, market expectations of longer-term inflation (5y5y cash breakevens or CPI swaps) are still “well anchored”. When the Fed was worried about low inflation in mid-2010, both of these metrics were well below current levels. Hence, it seems that for a reversal in Fedspeak, either the unemployment rate has to stall or long-term breakevens (and the Fed’s medium-term inflation forecasts) need to fall further. Obviously, a sharp tightening in financial conditions could force a reversal as well, ie, a large decline in equity indices, or a continued rise in mortgage and corporate rates, or a strengthening of the USD. As Figure 5 shows, with the exception of the equity market, the other metrics show that financial conditions have tightened over the past month. Convexity hedging Convexity hedging flows are With the sharp rise in mortgage rates, we have received multiple queries on whether the unlikely to exacerbate the sell-off could be exacerbated by mortgage convexity hedging flows. As we have discussed sell-off (Refi Wave: Only a “wavelet” in rates, October 5, 2011), the fraction of the mortgage universe held by hedgers is much lower than it was in prior convexity episodes. In addition, mortgage investors are likely better hedged than they have been. In summary, we do not believe mortgage hedging flows are likely to worsen the sell-off. We do not believe that there is a specific level at which mortgage convexity hedging flows are triggered. In addition, flows from mortgage “hedgers” are not necessarily convexity related. Thus, some of the duration shedding from mortgage accounts over the past few days may be driven by the fact that they were only partially hedging duration; other accounts may simply have been lightening up on MBS if they view the carry trade in MBS to be nearing its end. For context, we have had a nearly 70bp increase in the current coupon rate since the lows at the beginning of May. The duration of the mortgage index has extended nearly a year, which translates to roughly $510bn in 10y equivalents for the entire universe (4,600 *1/9=510). However, in our view, only 10-15% of the mortgage market is hedged (vs ~40% a decade ago). Based on 15% of the index being hedged, this means that roughly $80bn in mortgage-related hedging needs should theoretically have been triggered since early May. The actual hedging-related flows will likely have been far smaller, as many hedgers were likely pre-hedged for convexity. Consider the main sources of potential mortgage hedging: GSES, REITs, servicers, and pipeline hedgers. . FIGURE 5 Have financial conditions tightened enough? 3.5 130 3.3 125 3.1 120 2.9 2.7 115 2.5 110 2.3 105 2.1 100 1.9 1.7 95 1.5 90 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Mtg CC yield IG Index Yield DXY Index, rhs S&P 500, rhs Note: S&P and DXY has been scaled to 100 at the beginning of the period. Source: Bloomberg, Barclays Research 30 May 2013 9 Barclays | Global Rates Weekly • The GSEs have been mandated to shrink their portfolios by 15% per annum. As a result, they have been systematically unwinding their derivatives books. This means that they do not need to actively hedge convexity as much as they did in the past. Also, unlike a decade ago, the duration gap is always kept close to zero. Given this backdrop, the chances of a GSE being caught offside is very low. • Second, based on public information, some agency REITs have also partially pre-hedged their convexity, so their need to rebalance duration hedges may be lower. Many Fed speakers, including Chairman Bernanke and Jeremy Stein, have pointed to the growth in the mortgage REIT universe as a potential source of financial instability (eg, agency REITS are currently ~$350bn vs. less than ~$90bn in 2007). However, from the point of view of the rates market, any forced MBS selling that occurs because of leverage constraints on REITS may not be a duration event in itself, since the associated hedge will also need to be unwound at the same time. • Pipeline hedging should also not be as big a risk as it was in 2003. Mortgage issuance has been smaller than in prior episodes, and originators are not coming off a particularly aggressive lending phase. • As far as servicers are concerned, the question is how much of the convexity was pre- hedged and how tightly various servicers are hedging their books. Our mortgage strategy team believes that the large servicers were fairly well hedged for convexity. Based on our models, an upper bound on servicer hedging should be $50bn in 10y equivalents in a further 50bp sell-off, if they had not pre-hedged for convexity at all. An upper bound on hedging from all other hedgers (GSEs, REITs etc.) should be another $50bn in 10s for a 50bp sell-off. So paying needs of $100bn in 10y equivalents is an upper bound for a further 50bp sell-off under very conservative assumptions. Market implications Duration: Remain neutral 10y rates can still move What is the near-term outlook for rates? We believe volatility is likely to remain high over the significantly in either direction coming weeks. Since it established forward guidance, the Fed has been able to suppress the transmission of economic uncertainty into interest rate volatility. However, with its reaction function becoming uncertain, interest rate volatility should remain elevated, and there could be large moves in either direction. Hence, we remain neutral on duration. The market still expects the first hike around mid-2015. If the Fed intends to focus on the unemployment rate, then the hiking can still be pulled forward. A re-pricing to Q1 15 could result in another 10-15bp rise in 10y rates. This would mainly affect the intermediate sector, as longer-term forward rates have also risen enough to compensate for the smaller-than- expected Fed balance sheet; 10y10y swap rates are already at 4.1%. On the other hand, if labor market data weaken materially or the Fed re-emphasizes the modest growth and inflation backdrop, hikes should be pushed out and the term premium should decline. For instance, Vice Chair Yellen has argued that to compensate for the zero lower bound, the Fed should keep rates on hold until mid-2016, after unemployment has dropped to about 6%. Even if the market were to push out the Fed hikes to, say, Q3 15, 10y rates could decline to early May levels. Curve: Maintain flatteners We maintain our 10s30s curve We maintain our 7s30s/10s30s curve flattener view. While the 10s30s curve has flattened flatteners since mid-May, when concerns about tapering were picking up, we believe curve flatteners still offer attractive risk-reward. Further repricing of the hiking cycle should result in the 30 May 2013 10 Barclays | Global Rates Weekly underperformance of the belly in a sell-off, as falling long-term inflation expectations and the negative reaction of risk assets should support the long end. On the other hand, dovish Fedspeak or weak data should result in a decline in the term premium as well, and the long end may not underperform in a rally. In our view, the curve continues to look too steep, given modest inflation and inflation expectations. Swap Spreads: Maintain spread curve flattener We maintain our long 7s30s We maintain our long 7s30s or 10s30s spread curve flatteners recommendation. As we or10s30s spread curve suggested last week, given the potential for duration shedding by leveraged holders of flatteners recommendation mortgages, we believe that the possibility of a taper should bias swap spreads in the belly of the curve wider, while any potential equity market selloff should bias 30y spreads tighter because of insurance hedging flows. An attractive risk-reward implementation of long end tightening view is selling USU3 invoice spreads have not kept pace with the cheapening in 15y sector in treasuries from potential Fed tapering. Volatility: Maintain long gamma We maintain our long gamma Given that the uncertainty about the Fed’s reaction function is likely to amplify any position economic data surprises, particularly in the upcoming payroll report, we expect volatility to remain high. We had recommended long gamma on mid-tails when 1m7y was trading at 73bpv. Since then, it has richened to 87bpv, which implies 5.5bp in daily delivered vol or a 20bp drift in 7y rate over next one month. With the payroll report likely to be the key driver of both when tapering, we believe gamma should stay elevated next week. Trade Ideas Outright Trades Long front EDs (EDZ3 to EDU4) and FFZ4 In this selloff, market expectations of short rates have changed even for 2014, with which we disagree. For instance, EDZ3 is pricing in 3m Libor to rise from the current 27.5bp to 36bp by the end of the year. We believe this increase is unlikely to materialize, especially given reduced USD funding needs from European banks. In addition, the market is now pricing in a significant chance of the first hike in 2014. FFZ4 is implying an effective fed funds rate of 32.5bp; in other words, a 30% chance of a hike to 50bp is priced in (assuming either 25bp or 50bp; allowing for effective to remain below 25bp would lead to even a higher probability of 50bp). We believe that is excessive. Even if the unemployment rate were to decline to 6.5% by late 2014, the Fed will likely refrain from hiking that much sooner than the earlier mid-2015 guidance. We recommend going long FFZ4 and EDU4 as well. Sell USU3 invoice spread We also continue to recommend USU3 invoice spread narrowers (sell USU3 and receive equivalent DV01 in Sep 2013 forward starting swap maturing in Nov 2028): • The Nov 28s (CTD of USU3) swap spread is still close to the wides reached in April; it has also widened over the past few days from swap paying flows in lower tenors. • However, the market is pricing in a tapering of Fed purchases, resulting in a cheapening of the 15y sector in Treasuries. This can be seen from the 10s-Nov28s-30s yield fly. • Tapering also means a greater illiquidity discount when the CTD rolls off, which should start to get reflected in the invoice spread. Typically, the spread to the swap curve of Nov 28s (CTD for USU3) moves with the 10s-US-30s yield fly, but the relationship has broken down recently. 30 May 2013 11 Barclays | Global Rates Weekly • Favorable risk reward: If the Fedspeak reverses, the invoice spread should be biased tighter because mortgage underperformance should reverse. On the other hand, if the Fed tapers, as futures expiry in September approaches, the invoice spread should tighten because the CTD cheapens. The primary risk to the trade is a mortgage convexity event that would push the invoice spread wider. We target a tightening of 5bp in the USU3 invoice spread, with a stop at 17bp. Conditional Trade for a continuation of the sell-off 1m*5y vs. 1m*15y bear flattener We continue to like bear flattener to position for further selloff. However, the yield curve and gamma has already re-priced to some extent; for example, the 7-30y swap curve has flattened 12bp and gamma on mid-tails has richened relative to long tails since concerns about tapering picked up, so one needs to pick points on the yield curve carefully. We evaluated a variety of premium neutral bear flatteners for curve entry levels in the recent past, as well as the last three-year history. Our conclusion: 1m*5y vs. 1m*15y is optimal. This part of the yield curve has steepened in the recent sell-off, so gamma on 5y tails is still cheaper to 15y tails. Due to the lower vol on 5y tails, a premium neutral bear flattener can be initiated at better than spot and forward levels. A material sell-off, as shown in Figure 6, would likely flatten the curve, or at least move the curve in parallel. As a result, a slightly out-of-the-money bear flattener, such as the following, is appropriate: • Long $260mn 1m*5y 20bp high-strike payer (=1.42%) • Short $100mn 1m*15y 22bp high-strike payer (=3.04%) • Premium neutral, as of May 30, 2013 This is effectively a 5-15y flattener at 162bp when spot is 161bp and the forward is 160bp. As shown in Figure 6, the curve has been 135-175bp range at about 25bp higher rates, implying an attractive risk-reward for the trade. FIGURE 6 FIGURE 7 5-15y curve will likely start to flatten in a further rate sell-off Swaptions are cheaper to TY options even though swaps are delivering more volatility 5-15y 1.4 curve, bp 1.3 195 current, 1.2 175 2.02 , 162 1.1 1.02 155 1.0 0.96 135 0.9 115 0.8 95 0.7 Jul-04 Jul-06 Jul-08 Jul-10 Jul-12 75 swaption/ TY implied vol ratio 1.0 1.5 2.0 2.5 3.0 3.5 20d del vol ratio avg (5y,15y) Note: Last data point as of May 29. Source: Barclays Research Source: Barclays Research 30 May 2013 12 Barclays | Global Rates Weekly Conditional Trade for a reversal of the sell-off Buying swaption vs TY options We recommend buying swaptions vs TY options. Short-dated Treasury future options are trading at a premium to OTC swaptions, even though swaps in the belly are delivering more vol. For example, as of May 30, TYN3 straddles are pricing 93bp/y, while matched-expiry swaptions on 7y tails are priced for about 89bp/y, implying the latter is at about a 4% premium to swaption vol. Swaptions trading at a discount to exchange options is not unusual for the past few years (Figure 7). However, as the recent price action has indicated – where 7y swaps have moved more than the 7y Treasury or 7y spreads have widened in the rate sell-off – swaptions could deliver more vol in a rate reversal as well. As a result, we recommend two trades, as follows: • Short 1000 TYN3 call 130 (underlying TYU3 = 129.64) • Long $122mn 6/21 -> 7y receiver 1.69% (forward = 1.74%) This is a premium neutral bull spread tightener, initiated at a better spread level than forwards due to lower vol for swaptions. The second trade combines the bull spread tightener with a bearish spread widener, as follows: • Short 1000 TYN3 strangles 129.5/ 130 • Long $122mn 6/21 ->7y strangles 1.71/1.76% This structure requires no premium outlay and would benefit if rates rally significantly, leading to tighter spreads in the belly. 30 May 2013 13 Barclays | Global Rates Weekly INFLATION-LINKED MARKETS: UNITED STATES 10s30s breakeven flatteners now attractive Michael Pond We find the 10s30s breakeven curve has steepened more than justified by a fair value +1 212 412 5051 model. The recent steepening is reflective of very low near-term inflation expectations firstname.lastname@example.org and market pricing in tapering, in our view. We recommend 10s30s breakeven flatteners ahead of 30y TIPS supply. Chirag Mirani +1 212 412 6819 Relative value trades more favourable given the recent volatility email@example.com Given the increased uncertainty regarding the Fed’s reaction function over the past few weeks, the rates market has become volatile to say the least. This means the economic data uncertainty is likely to translate into more interest rate volatility; as such, we turned neutral on outright duration views last week. Until there is more clarity on economic data and further confirmation on the Fed’s reaction function, we think tactical relative value trades in the TIPS market make more sense. In particular, the recent 10s30s breakeven curve steepening is overdone versus our 10s30s breakeven fair-value model (adjusted for the Fed purchase dummy variable), which, in our view, presents an attractive opportunity to position for a reversal in this move. 10s30s breakeven flattener is particularly attractive Given the increased volatility, We believe the recent 10s30s BE steepening has been a function of falling near-term we find tactical trades such as inflation expectations (now sharply lower versus our forecasts) and the market aggressively 10s30s breakeven flattener pricing in Fed purchase tapering following Chairman Ben Bernanke’s comments that the Fed more attractive to outright may begin to taper at the next few meetings if the data improve significantly. The former breakeven/real rate trades has lead the entire the 2s10s breakeven curve to steepen extensively, which justifies at least some steepening in the 10s30s breakeven curve (Figure 1), in our view. On the latter, judging from our 10s30s breakeven fair-value model (without Fed purchase dummy variable), the TIPS market is pricing in a significant reduction in long-end purchases, which seems aggressive. This is consistent with our findings in Trading the taper, May 16, 2013. We recommend fading the steepening in 10s30s breakeven curve, which has a favourable supply outlook given the 30y reopening TIPS supply in June. Considering the volatility in rates and weaker-than-expected TIPS auctions recently, investors are likely to price in FIGURE 1 10s30s breakeven more than 4bp steeper than justified by a fair value model; we recommend fading this move 80 70 60 50 40 30 20 10 0 -10 Mar 09 Sep 09 Mar 10 Sep 10 Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 10s30s Estimated (w/o Twist Dummy) 10s30s BE 10s30s Estimated (with Dummy Twist) Source: Barclays Research 30 May 2013 14 Barclays | Global Rates Weekly higher concession for the 30y, which should put further flattening pressure on the 10s30s breakeven curve. Next we discuss the details of 10s30s breakeven fair-value models (with and without Fed purchase dummy variables). The 10s30s breakeven curve has over-steepened by 4bp 10s30s breakeven steepening In Be forward looking, look at forwards, May 9 2013 (on page 3), we discussed steepening is coinciding with increased in the 10s30s breakeven curve. Then, we anticipated further steepening in 10s30s chatter about tapering, which breakeven curve based on our fair-value models and upcoming 10y TIPS reopening supply. suggests the Fed purchase Prior to Operation Twist, our 10s30s breakeven fair-value model used the 5y CPI swaps rate, activity likely played a role in 2s10s CPI swap curve and 3m L-OIS as independent variables for the 10s30s BE fair-value flattening 10s30s breakeven estimate. After the Operation Twist announcement, this 10s30s BE fair-value model curve deviated sharply from 10s30s BE market levels. In our view, this was due to the Fed purchasing more long-end nominals (versus nominal 30y issuance) than long-end TIPS (versus TIPS 30y issuance) in both Operation Twist and QE3. Because of this, we adjusted our model with a Fed purchase dummy variable; we now see fair value of the 10s30s breakeven curve at 12bp (figure 1), while the 10s30s breakeven curve is trading at 15.7bp (as of Thursday, May 30). On a residual basis, the 10s30s breakeven curve is about 4bp too steep, similar to pre-Operation Twist levels. In fact, since March 19, the 10s30s BE curve has steepened about +17bp, from the low of -2bp, while both fair-value 10s30s breakeven models (with and without the Fed purchase dummy variable) have steepened only +8bp. The difference between the 10s30s BE steepening (market) versus the fair-value-model-anticipated steepening suggests that the market is reverting to pre-Operation Twist levels and therefore is anticipating Fed purchase tapering. Pre-Operation Twist 10s30s BE model fair value at 25bp The 10s30s BE curve is steeper The 10s30s breakeven curve fair value (not including the Fed purchase dummy variable) is than fair value estimates, at 25bp (Figure 1), reflecting a residual of only about 9bp versus the market. As noted, just a implying a significant amount few months ago (on March 19), the residual was close to 18bp (now at 9bp), the recent of Fed tapering, which should compression in residual versus the original 10s30s breakeven model suggests that the be faded, given low realized market is now pricing in significant reduction in Fed purchases. Also, uncertainty remains inflation and mixed economic about whether the stock of Fed holdings or the flow of Fed purchases matters for this curve. data If the former (which favors the nominal long end relative versus the TIPS long end), the 10s30s BE curve should continue to trade below the 10s30s BE model (without Fed purchase dummy) fair value of 25bp. Additionally, economic data uncertainty remains, and in the context of falling realized inflation, the Fed is likely to start tapering very gradually. In light of these factors, this amount of 10s30s BE steepening seems too much; we recommend 10s30s breakeven flatteners (Entry: 16bp, stop-loss:20bp, Target: 8bp). Outside of the Fed factors, the 2s10s CPI swap curve has likely steepened too much as front-end breakevens are now significantly cheap versus our CPI forecast. Thus, on improving global economic data, the CPI swap curve is likely to flatten. 30y reopening supply should help 10s30s breakeven flattener We think the upcoming 30y reopening supply (our expectations: $7bn; tentative announcement date: Thursday, June 13; tentative auction date: Thursday, June 20) is supportive of the 10s30s breakeven flattener trade for a number of reasons. One reason is that the past few TIPS auctions have been weaker than expected. Second, real rates have been quite volatile over the past month, which should lead market participants to price in a higher-than-normal concession given the very large duration for the 30y. Also, after the 10y TIPS reopening supply in May, TIIJan23s remain fairly cheap on relative ASWs curve, which is supportive of the trade. 30 May 2013 15 Barclays | Global Rates Weekly Negatives for the trade The key risk to the trade is a better-than-expected May payroll report next week. The market may price in even more tapering, which could help the 10s30s breakeven curve steepen further. Separately, a decline in energy/commodity prices may further steepen the breakeven curve in general. The trade carries slightly negatively (-0.4bp) until July 1. 30 May 2013 16 Barclays | Global Rates Weekly UNITED STATES: MONEY MARKETS Heading east Joseph Abate Persistently low interest rates and a diminishing supply of higher yielding bank paper +1 212 412 7459 are encouraging a few money funds to look for alternatives in regions previously firstname.lastname@example.org ignored. One of these is non-Japan Asia. 1 • Money funds have always maintained large non-US asset allocations. But the composition of these holdings appears to be shifting away from core Europe. • Holdings of obligations from non-Japan Asia – while still small as a share of overall money fund assets – have grown four-fold in the past 18 months. • All of this exposure is unsecured, mostly in CP. And relative to other money fund assets, these holdings have fairly lengthy WAMs (at 63d). • As demand for this paper increases, it is getting more expensive. The volume-weighted average yield has fallen 20bp since January 2012. We expect allocations to continue to grow as money funds seek to balance the diminishing supply of bank paper under 3m with their need for more attractive yields. Migration from US holdings The past few weeks have been difficult ones for money market funds. Overnight Treasury collateral rates dipped into the low single digits as net bill supply contracted sharply. As money fund managers have termed out and changed their asset allocations, spill-over effects have pulled some (non-Libor) unsecured funding rates sharply lower. In fact, some institutions have been able to raise 6m financing at rates below 25bp. And although the sample of issuing AA-financial institutions is small, their 3m funding rates have recently drifted below 15bp. The Treasury’s stronger-than-expected tax collections, together with additional (and longer) net bill supply reductions, suggest that all short-term interest rates will hover at these levels or lower at least through July. FIGURE 1 FIGURE 2 Non-government taxable fund allocations (% total assets) Singapore and China exposures ($bn) 1,800 18 1,600 16 1,400 14 1,200 12 1,000 10 800 8 600 6 400 200 4 0 2 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 0 US bank Europe UK Japan Scandi Australia Other Jan-12 Mar-12May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 Note: All taxable money fund balances excluding holdings of Treasuries and Source: imoney.net Agencies. Other includes US non-US primary dealers, Canada, Switzerland, and multinationals. Source: imoney.net 1 We exclude Australia from this analysis. 30 May 2013 17 Barclays | Global Rates Weekly A European focus Money funds have historically Taxable money market fund holdings have always had a fairly sizeable non-US asset had large non-US asset allocation (Figure 1). Before the sovereign debt crisis triggered sizeable prime fund allocations redemptions, money market funds held a significant portion of their assets in the liabilities of banks in core Europe. As investor nervousness increased, money funds reduced their exposures to France, Germany, Belgium and the Netherlands and increased their holdings of paper from Japan, Canada, and Australia. During the crisis (between May 2011 and May 2012), Japanese, Canadian, and Australian exposures increased 110%, 48%, and 18%, respectively. And even though there has been a retour de France and a pickup in core European exposures more generally, money fund exposures to Japan, Canada, and Australia remain higher today than they were a year ago. Going east In addition to these “most favored nations,” money funds have also sharply increased their holdings of obligations from institutions located in China, India, Singapore, and South Korea. Since January 2012, taxable money funds have increased their holdings of paper from these four countries four-fold. However, nearly all of the increase has come from money fund holdings of unsecured obligations from Singaporean and Chinese institutions, which have risen three- and six-fold, respectively (Figure 2). Holdings from Indian and Korean companies are somewhat different. Indian bank exposure is limited to direct pay letters of credit from a US bank, and the Korean holdings are from quasi-government institutions. Issuers from Singapore and China include a mixture of large industrial companies and banks with increasingly global reach. Holdings from Singapore Although money market paper from China and Singapore accounts for just under $20bn (or and China have 0.7% of total taxable money fund assets), its rapid growth is impressive, especially relative increased dramatically to the holdings of Japanese obligations, which have risen 33% over the period. And unlike their Japanese exposures, none of the Singaporean or Chinese money fund holdings is secured or in repo. Instead, all of the exposure is in either commercial paper or bank deposits. More significantly, the tenors of these borrowings are at an average WAM of 63d since January 2012, which is a bit longer than Japanese exposures, which is about 40d (Figure 3). FIGURE 3 FIGURE 4 Money fund WAMs by country (d) Unsecured financing rates (bp) 100 50 90 45 80 40 70 35 60 30 50 25 40 20 30 15 20 10 10 5 0 0 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Singapore China Japan Australia Fin CP, all Non-Japan Source: imoney.net Note: The CP rate is for 2m maturities to match the WAM of the non-Japan exposures more closely. Source: Federal Reserve and imoney.net 30 May 2013 18 Barclays | Global Rates Weekly As demand for Asian paper has risen, it has become progressively more expensive, in both absolute and relative terms. Between January 2012 and April 2013, the volume-weighted average yield has declined from 45bp to 25bp (Figure 4). Over the same period, the rate on similar maturity AA financial CP has traded under 15bp, so that the spread to AA bank paper has also narrowed 20bp. With little let-up in sight to the super-low money market yields, we expect demand for paper from Singaporean and Chinese institutions to increase, especially as fund familiarity with the issuing institutions grows. In turn, these yields should continue to converge on 2m financial rates. 30 May 2013 19 Barclays | Global Rates Weekly EURO AREA: RATES STRATEGY Sharp sell-off in euro rates – do not fade it Laurent Fransolet European rates have not been immune to the recent volatility in global markets. We +44 (0)20 7773 8385 were expecting rates to gradually move higher: even though our end-Q2 targets have email@example.com been reached, we maintain our neutral-to-negative view on rates. Markets have become more volatile in the past few weeks, digesting the implications of a potential shift away from ultra accommodative monetary policies, especially in the US. European rates have not been immune, especially since some European-specific factors have also contributed to push rates higher. In our view, the recent moves have been very much in line with the developments in the economic outlook and the moves in US rates, as we outline below. One of the biggest sell-offs in the past few years, but euro rates are still low Since their lows at the beginning of May, reached on the day of the ECB rate cut, euro rates have broadly sold off, by about 10-15bp at the short end, and 30bp in 10y. Still, this sell-off has just unwound the rally that was triggered by the weaker economic data (hard data and more importantly, surveys like the PMIs) from the beginning of March. In absolute terms, euro area rates have moved back to within the broader range that they have been stuck into since the middle of 2012. This is in contrast to US rates, which are now firmly above the top end of the range they had been in over the past year. Our valuation models suggest that 5y5y fwd rates (and hence 10y rates as well) remain on the expensive side, despite the recent sell-off and the structural decline in medium-term nominal potential growth in the euro area. We remain cautious about over-interpreting these valuation models, and part of the valuation gap can be attributed to a ‘safe-haven’ premium. Still, they indicate a richness for 10y euro yields in the order of 30bp (down from 50bp a few weeks ago). Importantly, we suspect the gradual but continuous decline in medium-term nominal growth expectations has probably come to an end, if only because there is a certain ‘cyclical’ element to it, i.e. it is correlated to near-term growth expectations, which have been bottoming out since mid 2012. Similarly, the safe-haven premium is more likely to decrease from here than increase, as supply and demand factors, as well as the reduced likelihood of a large crisis, are less supportive of safe-havens. FIGURE 1 FIGURE 2 The economy will remain a key driver for bonds Euro 5y5y fwd model vs actual (%) Draghi's speech 7 -1.6 -12.5 -11.0 Barclays -9.5 6 -1.1 Forecasts -8.0 5 -6.5 -0.6 -5.0 4 -3.5 -0.1 -2.0 3 -0.5 2.75% FV for 0.4 1.0 2 2.90% LT 2.5 nominal 0.9 4.0 5.5 1 6mth chg in Bund 10y (%) 99 01 03 05 07 09 11 13 1.4 7.0 6mth chg PMIs (RHS, units) 10 11 12 13 EUR 5yr5yr Model for OIS 5y5y (1999- Apr12) Source: Bloomberg, Barclays Research Source: Barclays Research 30 May 2013 20 Barclays | Global Rates Weekly Hence, both factors are more likely to lead to a gradual and modest increase (say 30-50bp) in the fair value of medium-term yields in coming quarters, rather than a decrease, other things being equal. The European outlook has improved, albeit from low levels In the Euro Area Rates Strategy section of Global Rates Weekly, 16 May, we highlighted that we were expecting hard data and survey data to improve in the near term, from a very depressed level. This has occurred in the past few weeks. In particular, the PMIs have been moving back up towards the January levels (the recent ‘highs’ are still below 50 though). Overall, the recent data releases seem to indicate that the renewed weakness in March, which led to the latest leg of the rally in the Bund, is being unwound. In fact, based on the relationship we identified between 6-month changes in PMIs and 6-month changes in the Bund, the latest data suggest 10y Bunds should have moved by around 30bp, much in line with the actual moves. On its own, even without looking at US moves, the back-up in 10y euro rates thus can be justified by the improved data vs March/April. From here, our leading indicators still suggest improvements in the hard data in the next few months, before a stabilisation in the summer. Our economists’ growth outlook is unchanged: they expect a gradual improvement in the survey data as well. This improvement, against very low expectations for the euro area, should reduce the likelihood of further moves by the ECB and should also continue to push longer-end rates higher, in our view. Note that in any case the prospects of negative deposit rates have declined given the recent comments by a number of ECB officials, and additional easing is no longer priced in at the short end of the euro curve. If anything, the spectre of passive tightening due to a decline in the liquidity surplus, currently at €260bn, to below €200bn is resurfacing and this may put, other things being equal, renewed pressure on short rates if the ECB does not counteract it (with a further refi cut, or new LTROs). The US rate outlook remains key for euro rates: we think this time might be different Euro rates are and will remain broadly correlated to US rates. Over any significant period of times, rates in both regions move in tandem, and this is especially the case when there are large moves, as we have had. The typical beta in 10y rates is around 0.75: a 10bp move in 10y US rates translates into a 7.5bp move in 10y euro rates. As such, the recent moves in euro area commensurate with the moves in the US. If anything, they are a bit lower than what could have been expected (50bp in the US vs 30bp in euro area), and this is also reflected in the widening of the 5y5y fwd nominal spread (in swaps) to above 90bp – this looks fairly high given that the spreads in 2y rates are still close to zero. We are reluctant at this stage to position for an outright re-tightening of the 5y5y fwd spread (or the nominal USTs vs Bund spread), since the focus is almost entirely on US rates, but it does suggest that over time, there is more room for the Bund to sell-off in absolute terms. As outlined in the US rates strategy section, we believe the recent sell-off in US rates is different this time than what we have experienced in the past few quarters – we are refraining from tactical long duration positions at this stage, since the sell-off has been driven by a change in the market perception of the Fed reaction function, and the data could trigger large two-way volatility in the coming weeks and months. These potentially further volatile moves in US rates are likely to be reflected as well in the euro area rates outlook. Coupled with the underlying expected small improvement in the economic data, it suggests further potential modest upwards pressure on euro area rates. We are thus comfortable with our view still of a gradual move up in 10y euro area rates, towards 1.70% in 10y Bunds by year-end. 30 May 2013 21 Barclays | Global Rates Weekly The wider implications of Fed tapering: likely a muted impact on peripheral debt Moving away from the pure rate level, recent rate markets gyrations have also been reflected in other financial variables – this is well documented in for example the Global asset allocator ‘Who is vulnerable to Fed Tapering?’ May 24. The general tightening trends seen in core and peripheral markets have come to a (temporary) end in the past few weeks, with even some modest re-widening seen vs Germany. Market participants are arguably nervous about a general change in risk appetite and the impact it could have on peripheral markets at large. As we had highlighted in recent comments, our view was that the bulk of the tightening in Spanish and Italian spreads was behind us – a new period of more gradual (and volatile) tightening was likely to emerge, as valuations were less attractive and positions by non domestic investors were less underweight than before. We are thus not surprised by the recent stabilization in spreads and we do not see it as the precursor of a large renewed sell- off in peripheral spreads. In our view, a number of factors will remain supportive, even if the central bank-induced ‘risk-on’ environment is less favourable. In particular, we would note that following very heavy government bond supply YTD, the remainder of the year will likely register a run rate of gross and net supply of around 30-40% lower in both Spain and Italy, even accounting for the traditional low issuance in the summer. This, and the slow gradual stabilization seen in these economies, along with the lack of big potential headline news, suggest that large sell-offs are unlikely. Over time, we continue to believe the path of least resistance will be towards further tightening in Spain and Italy, across the curve, as a broader set of investors gradually come back to these markets (eg Asian investors less keen on taking outright duration risks in safe-haven countries). The tightening in spreads is more likely to be driven by core rates moving higher than by a large decline in the absolute level of peripheral rates, though. We stay long outright in 3-5y yields and long the belly of the curves vs 2 and 10s in both Spain and Italy (we do not have a strong strategic view on one country vs the other). 30 May 2013 22 Barclays | Global Rates Weekly EUROPE: SOVEREIGN SPREADS Taper talk – in core EGB markets Huw Worthington Selected short positions in France vs. highly rated core issuers offer a low-risk limited +44 (0)20 7773 1307 downside way of positioning against any short-term re-widening, which could occur on firstname.lastname@example.org the back of “taper talk”-type news flow. Since Ben Bernanke’s comments stating that “tapering” bond purchases could be Cagdas Aksu considered at the Fed’s September meeting, outright bond yields have sold off by 8-11bp in +44 (0)20 7773 5788 2-10y bunds. Notably, this has also been accompanied by a re-widening in EGB spreads, email@example.com which had been more resilient in the earlier yield sell-off in the first part of May. Unsurprisingly the moves have been greatest in the larger peripheral markets, with Italy underperforming the German sell-off by an additional 16bp in the front and in 10y, while Spain widened 17bp and 10bp in the same basis (the 5bp differential being accounted for by BTP supply, we think). Elsewhere, Portugal proved resilient broadly mirroring the moves in Spain and Italy, while Ireland is little changed on the week in 10y and managed a further 7bp of outperformance in the front-end. France has been the strongest Underperformance was notable in core issuers as spreads moved off their post-2011tights. core performer since end The strongest performer post the catalyst of the BoJ announcement at end-March had been March France, with tightening, since then up until last week’s comments, of 25bp in 5y and of 35bp in 10y bonds. This compares with outperformance on the same basis of 19bp and 16bp in the Netherlands 17bp and 21bp in Austria and 14bp and 15bp in Finland. France still trade close to YTD Given this performance it would not have been surprising to see France give some of this up tights vs. peers, however in the recent re-widening. However the underperformance of France vs. core has been small with widening of 8bp in the 5-10y area compared to 6bp in the Netherlands and 4-8bp in Austria and 3-6bp in Finland, leaving France still trading close to YTD tights vs. peers. France looks rich in 6y vs NL, The moves have not been consistent across curves amongst all core issuers. The richness of Finland and in 9y vs Austria France in 5y compared with the cheapness of this sector in Finland and the Netherlands leaves spreads particularly tight here. In contrast, while the cheapness of Austria in 9-10y, as illustrated in Figure 1, offers the best value, in our view. FIGURE 1 Selected Core Issuer ASW Structures 25 France Netherlands Austria Finland 15 5 -5 -15 -25 -35 Jan 15 Apr 16 Jul 17 Sep 18 Dec 19 Mar 21 Jun 22 Aug 23 Source: Barclays Research 30 May 2013 23 Barclays | Global Rates Weekly Fundamentally, we still believe France has a weaker credit profile/near-term outlook compared with other core issuers. To a large extent this is already reflected in both credit ratings and, importantly, short market positioning. Indeed the latter seems likely to have been a factor in France’s resilience of late and should remain supportive going forward. However, the recent lowering of French growth expectations alongside the 2y extension given to France to meet deficit targets may be a catalyst for a re-assessment by rating agencies, and in particular by Fitch, which still rates France AAA (with negative outlook), given that it stated in December that “France's fiscal space to absorb further adverse shocks without undermining its 'AAA' status is largely exhausted”. Short France vs. highly rated As we have been highlighting for some time, given the pace of gains thus far since mid core issuers seems a relatively 2012, a consolidation phase now seems likely in EGB spreads. Nonetheless selected attractive low risk way of short positions in France at current very tight levels vs. highly rated core issuers seem a positioning given current levels relatively attractive low-risk way of positioning against any short-term re-widening, which could occur on the back of “taper talk”-type news flow. We expect that any underperformance from France would be modest and limited to moves of 5-10bp, with French core spreads moving closer to Feb/Mar 13 levels as opposed to what was seen earlier in the crisis, while avoiding the greater volatility seen in peripheral spreads (on which we remain constructive for the medium term). FIGURE 2 Finland and Netherlands vs 6y France and 8y Austria vs France 0 9y Austria vs France 6y Finland vs France 6y NL vs France -5 -10 -15 -20 -25 -30 -35 -40 Jan-13 Jan-13 Jan-13 Feb-13 Mar-13 Mar-13 Apr-13 Apr-13 May-13 May-13 Source: Barclays Research Next week’s cash flows Austria auctions 4y and 10y bonds on Tuesday for up to €1.43bn, while Germany on Wednesday will tap the 5y OBL for €4bn. Most interest, however, will be focused on Thursday, when both France and Spain come to the market. Support will come from Italy, which will redeem €17.2bn of bonds and will pay out €1.07bn in coupons. 30 May 2013 24 Barclays | Global Rates Weekly FIGURE 3 Barclays cash flow expectations for week beginning 3 June 2013 Beginning Auction Date Issuance Redemptions Coupons Net Cash Flow 20-May 2.74 Germany 4.00 0.00 0.00 4.00 Weekly 27-May 13.49 France 8.00 0.00 0.00 8.00 Net 03-Jun -0.43 Italy 0.00 17.17 1.07 -18.23 Cash flow 10-Jun -3.78 Spain 4.50 0.00 0.00 4.50 17-Jun 13.90 Belgium 0.00 0.11 0.02 -0.13 Greece 0.00 0.00 0.00 0.00 Net Cash Flow is issuance minus redemptions minus Finland 0.00 0.00 0.00 0.00 coupons. Negative number implies cash returned to Ireland 0.00 0.00 0.00 0.00 the market. Holland 0.00 0.00 0.00 0.00 Austria 1.43 0.00 0.01 1.42 Total issuance 17.93 Portugal 0.00 0.00 0.00 0.00 Total redemptions 17.27 Total 17.93 17.27 1.092 -0.43 Total coupons 1.09 Net cash flow -0.43 Source: Barclays Research 30 May 2013 25 Barclays | Global Rates Weekly EUROPE: MONEY MARKETS ECB: no rush on policy rates Giuseppe Maraffino We do not expect any major announcement at the June ECB press conference. Short +44 (0)20 3134 9938 rates have sold off recently reflecting global factors, but any rally back is likely to be firstname.lastname@example.org limited by the ongoing passive tightening of liquidity conditions. Since the ECB’s May meeting, data in the Eurozone have continued to stabilise somewhat Laurent Fransolet after the worsening economic activity in Q1. The Eurozone “flash” PMIs for May overall +44 (0)20 7773 8385 showed healthy gains after the stabilization posted in April, though they are still below 50. email@example.com May inflation releases for some Eurozone countries suggest a likely increase in “flash” May HICP to 1.4% y/y from 1.2% y/y. Therefore, the prospects of imminent action by the ECB appear minor, although the ECB is likely to remain on alert as growth and inflation data probably remain weak (and the ECB will likely adjust its forecasts on both). Data show economic stabilization, Indeed, we expect the ECB to remain on hold at next week’s meeting and to continue to signal we expect the ECB to remain the possibility of further policy rates cuts if the worsening of the growth/inflation outlook on hold warrants it. Noteworthy, since the May 2 meeting, the rhetoric has continued to focus on the possibility of a negative depo rate, but it has turned more prudent over the last few days as several ECB members, including the Vice President Constancio, highlighted the risks and the negative implications (in terms of an increase in lending rates) that could stem from a negative depo rate. Judging from their latest comments, we would classify, Asmussen, Noyer, Mersch, Nowotny (together with Constancio) in the “less open” camp while Praet, Draghi, Visco have shown more openness. This suggests that there is no clear consensus within the ECB on the benefits of a negative depo rate yet, which makes the chance of imminent action low. The liquidity surplus is gradually Owing to the 3y LTROs repayments and the increase in autonomous factors, the liquidity surplus approaching the €200bn threshold has declined €45bn to €268bn, since the beginning of May. Even if the liquidity is still large, the risk of a passive tightening in liquidity conditions is not negligible, especially if one considers that as ate end-April banks in the core countries still had €145bn of 3y liquidity and banks in the peripheral countries about €570bn. With the former likely to continue to reimburse, we would not rule out the possibility that also peripheral banks, and, in particular the Italian ones that as at end-April repaid only €3.5bn out of €255bn that could have been repaid Government bonds redemptions in the coming weeks (the next is €17.6bn of BTPs on June 1) could allow banks to unwind carry trade positions which are not so attractive anymore, and to repay the ECB. FIGURE 1 FIGURE 2 3y LTROs repayment: cumulative and weekly payback Risks of passive tightening (€bn) 350 160 Liquidity Surplus Cumulative repayment, eur bn, lhs 1,000 €4bn weekly payback till year-end 300 Weekly repayment, eur bn, rhs 140 €4bn weekly payback till June €8bn weekly payback till year end 120 800 250 100 200 600 80 150 60 400 100 40 50 20 200 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 0 Number of repayments Jun-09 Mar-10 Jan-11 Oct-11 Aug-12 May-13 Source: ECB, Barclays Research Source: ECB, Barclays Research 30 May 2013 26 Barclays | Global Rates Weekly The ECB should counteract the We do not expect any suggestion of another very long-term operation at the upcoming ECB passive tightening via policy rate meeting. Our impression is that the ECB is willing to counteract any possible passive and not via another LTRO tightening of liquidity conditions (in the wake of banks’ repayment of the 3y LTROs) via policy rates rather than an injection of liquidity to the system. We think that another long- term liquidity operation would be designed to be more effective in supporting the real economy (and not banks’ funding) via banks, maybe using SME loans (or on SME-backed ABS) as collateral, with attractive features for banks, such as long maturities (3 years+) and possibly, at the prevailing refinancing rate when the LTROs commence, instead of averaging MRO rates over the LTROs’ duration. However, such an announcement is unlikely in June. The recent increase in short rates, In our opinion, the recent increase in euro short rates should not be a source of concern for is not a concern for the ECB the ECB. Indeed the sell-off, not as abrupt as in January (see Figure 4) has mirrored the upward movement of US rates on rising expectations of Fed tapering its QE. In short, it was not the result of endogenous euro area factors like in January, but of global factors – and indeed the impact on exchange rates has been limited. More prudent comments on the negative depo rate and market positioning have probably contributed to exacerbate the upwards move in rates. Furthermore, the EONIA fixing has remained in the 6.5-8.5bp range, despite an increase in daily volatility resulting from the low EONIA volume. The 3m Euribor has stabilized at 20bp, and the 12m euribor has remained broadly unchanged at 48bp. Basically, the pressure has affected the long part of the money market curve (bear steepening), as is usual when global factors are at play. Any correction in short rates The 1y and the 1y1y forward rates moved up, to 8bp and 26bp respectively. At such levels, movement likely to be limited by rates are at the upper bound of our expected trading range given the current monetary the risk of passive tightening policy stance. While a further increase depends on the evolution of US rates (likely dependent on the next data releases like the May NFP, the day after the ECB meeting), the ongoing reduction in the liquidity surplus in the Eurosystem is likely to limit any rally back from the current levels. We are thus not yet scaling back into tactical longs. Negative depo rate: no longer It seems that currently the EONIA forward curve is no longer pricing in a cut in the depo priced in the Eonia forward curve rate. Indeed, the forward on Eonia sees the fixing in the 6-8bp range until the beginning of next year and then gradually moving up to about 28bp by the end of 2014 and at 36bp by March 2015, when the second 3y LTRO expires. Such level would be consistent, in our opinion, with a further decline in the liquidity surplus in the coming months somewhat counteracted by an ECB refi rate cut (no change in the deposit facility). FIGURE 3 FIGURE 4 EONIA forwards: No cut in depo rate is priced anymore (%) Global factors behind the euro short rates sell-off (%) 0.30 0.6 USD -1y1y fwd Eonia 41424 30 -May-13 EUR - 1y1y fwd Eonia 0.25 41417 23 -May-13 0.5 USD - 1y EONIA 02 -May-13 41396 0.20 EUR - 1y Eonia 0.4 0.15 0.3 0.10 0.05 0.2 0.00 0.1 -0.05 0.0 May-13 Sep-13 Jan-14 Jun-14 Oct-14 Feb-15 May-12 Sep-12 Jan-13 May-13 Source: Barclays Research Source: Barclays Research 30 May 2013 27 Barclays | Global Rates Weekly Banks’ exit from the EONIA/Euribor panel An important issue that has surfaced recently is the implication of banks’ exit from the EONIA/Euribor panel on monetary policy implementation. Banks’ exodus from the panel Indeed, two more German banks (LBBW and Helaba) have announced their exit from the continues… panel after May 31. The Euribor panel is currently composed of 36 banks, and those that contribute to it are the same banks that contribute to the EONIA panel. Noteworthy, since last summer 8 banks have left the panel: LandesBank Berlin (1 May 2013), UBS (28 March 2013) Svenska Handelsbanken (20 March 2013), RBI (15 January 2013), Rabobank (3 January 2013), BayernLB (1 January 2013), Deka Bank (30 November 2012) and Citibank (21 September 2012). …with risks of reducing the A side-effect of banks’ exodus from the panel is the reduced credibility of EONIA and Euribor credibility of EONIA and Euribors as indicators of euro area liquidity conditions (in terms of prices and volumes) for the ECB’s as reference rates monetary policy implementation. So far, several ECB members have raised concerns on this important issue. In particular, in his speech at the 17th Global Securities Financing Summit, Luxembourg, 16 January 2013, the ECB executive board member Benoit Coeure’ highlighted the importance of EONIA as the first link in the chain of monetary policy transmission. He pointed out also that “in light of the fundamental importance of money market reference rates, we are closely following the developments taking place as regards the shrinking number of panel members for establishing EURIBOR and EONIA rates. Given the authorities’ commitment to addressing the shortcomings revealed in the rate-setting process, it is in the interest of markets that banks remain in the panel while the regulatory framework is being amended and behave as responsible market participants, thus preventing potential disruption in the functioning of an important financial market segment.” Also, the ECB’s May 2013 Financial Stability Review (published on May 29) highlights in BOX 2 the importance of reference interest rates “as a key orientation or benchmark of the prevailing price of liquidity for financial market participants and help in standardising financial contracts for both wholesale and retail clients (e.g. loans for house purchase)". Different impact on Eonia and In terms of potential effect on the EONIA and Euribor, we believe that the impact from a Euribor due to variance in banks’ exit differs, as both rates have a different calculation method, as we discussed in the calculation methodologies focus section, “Banks’ panel exodus: Eonia has been affected, not Euribor” in the Euro Money Markets Weekly: The final Countdown, 22 January 2013. Marginal Impact on the Euribor fixing The Euribor is a simple average of the rates provided (which are not market rates). Also, in the calculation of the Euribor fixing, the highest and lowest 15% of all quotes collected on a given day are taken out to eliminate the effect of any outlier contribution. The fixing is calculated as an average on the remaining contributions rounded to three decimal places. The contributions from LBBW and Helaba have been about 20bp since the ECB’s May meeting (more precisely, Helaba increased its contribution from 20bp to 21bp yesterday, 29 May, and LBBW has kept its contribution at 20bp). Hence, both contributions are considered in the fixing calculation. As both of these are broadly in line with the current Euribor fixing (20bp), we would not expect a significant impact on the fixing, which is likely to remain unchanged or, at the margin, to move down slightly (all other contributions being equal). Impact on Eonia: decline in volume and probably in the fixing, with higher daily volatility Eonia (Euro OverNight Index Average) is calculated as a “weighted average of all overnight unsecured lending transactions in the interbank market, initiated within the euro area by the Panel Banks (the same as for Euribor)”. Each panel bank “shall report to the ECB the total volume of unsecured lending transactions that day and the weighted average lending rate for these transactions”. 30 May 2013 28 Barclays | Global Rates Weekly The impact is likely to be higher on EONIA because apparently German banks are quite important for the calculation of EONIA in terms of reported volumes and fixing, as suggested by the drop in volumes and the increase in volatility in the fixing when German markets close for public holidays (meaning there are no contributions by the German banks in the panel). This is probably because some German banks currently in the EONIA panel are very active in the overnight unsecured liquidity market, with many transactions, especially with small banks, closed at rates higher than the market average. Due to the lack of detailed data, it is difficult to understand the contributions of Helaba and LBBW within the group of German banks. We would guess that their exit is likely to bring the reported volume into the €10-15bn range from €15-20bn currently, with the EONIA fixing likely to creep down (because of the reduction in reported transactions closed at high rates). Importantly, the daily volatility for EONIA is likely to remain high, as in a context of small EONIA (reported) volume, the fixing becomes more sensitive to any particular transactions reported by panel banks at higher/lower rates. 30 May 2013 29 Barclays | Global Rates Weekly UNITED KINGDOM: RATES STRATEGY Steeper and cheaper Moyeen Islam The DMO plans to launch a new “super long” 50-60y maturity nominal gilt next month. +44 (0)20 7773 4675 There is some natural demand for a super long issue: the ultra long end needs to firstname.lastname@example.org cheapen and steepen for supply to be absorbed. We favour 2052/2060 steepeners. The DMO plans to issue a new With the market being led by the sell-off in USTs, the ongoing discussion about tapering Fed conventional gilt of 50-60y purchases and the volatility in Japanese assets, the ultra-long end of the UK curve seems maturity in June very far removed for the broader macro themes that we see in the fixed income universe. Nonetheless, there will be a significant event next month: the DMO will announce further details of its planned super-long gilt issuance at the end of June. This will be for a maturity in the 50-60y area of the nominal curve, thus extending it beyond its traditional 50y maximum maturity point. The decision to do so was arrived at ahead of the Budget and some discussion of how the government could take advantage of record-low gilt yields. While the market response to the initial idea of a 100y maturity was lukewarm, there was enough interest and perceived demand for hedging of the longest-dated liabilities to suggest that an opportunity now exists for the DMO to open up a new part of the curve. There is some natural demand How much demand would there be for a new super long? Figure 1 shows the liability profile from DB schemes looking to for a typical defined benefit (DB) pension scheme. The significant drop in liabilities after hedge their tail liabilities 2060 is largely a function of the dwindling number of open DB schemes that are actively adding to their liability stocks. The most recent National Statistics survey of pension schemes estimated there were only 1 million workers in open DB schemes and only 2.4 million workers in private sector DB schemes in total. So while there is some demand from liability hedgers, it is by no means significant. Our Pension and Insurance Solutions group estimates there are no more than 5% of total liabilities in the ultra-long maturities. With overall pension liabilities about £1.3trn, this would mean there is, in theory, £60-65bn of liability hedging demand. However, some of this will have already been hedged in the past decade when there was issuance to fund utility buyouts by the private equity industry. FIGURE 1 Projected liability structure of a typical UK DB scheme (£mn) 50 Pensioner Liabilities Active Liabilities 40 Deferred Liabilities 30 20 10 0 2012 2022 2032 2042 2052 2062 2072 2082 2092 2102 Source: Barclays Pension and Insurance Solutions Group 30 May 2013 30 Barclays | Global Rates Weekly FIGURE 2 The longest end of the gilt curve trades structurally rich 3.40 2044 and 2052 gilts are cheap 3.35 3.30 3.25 3.20 29 32 35 38 41 44 47 50 years to maturity Source: Barclays Research Bucketing of cash flows in LDI The structure of liability hedging through LDI structures has focused on the cash flow strategies means that the profiles of liabilities and looks to immunise liabilities via matching cash flows. The lack of longest liabilities are partially hedging instruments at the longest maturities has meant the longest-dated liabilities are hedged with the longest aggregated together and the longest available duration instruments are used to hedge available instrument them. This results in the longest-dated gilts trading structurally rich to the curve (Figure 2). We expect any new super long issue to pick up a similar “hedging premium” and trade rich. By extension, this means the 2055 and 2060 issues will lose some of their lustre and should underperform in RV versus other post 30y maturities. The curve has been steady but The longer end of the curve remains relatively directional to the market. Figure 3 shows that is directional to the level of the the 2022/2042 spread versus 2022s yield has been as consistent as the relationship between market; we would expect a the 2042/2060 and 2022/2042 spread (Figure 4). The latter has been steepening steadily further back-up in forward since the middle of last year, so it has rarely been positive, supporting our view that the longer rates into supply, with the 20y end of the curve has traded structurally rich. Gilt forward rates remain at the cheaper end of sector underperforming as QE their recent range, with Gilt 10y10y fwd and Gilt 15y15y fwd comfortably higher above 4.25%, expectations fade having backed up some 20-30bp since the beginning of May. While forward rates have been FIGURE 3 FIGURE 4 2022/2042 spread vs 2022 yield 2022/2042 spread vs 2042/2060 spread 180 160 0 160 150 -1 140 y = -43.104x + 210.72 140 -2 R² = 0.7648 120 130 -3 100 120 -4 80 110 -5 60 100 -6 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 40 U42022/4H2042 spread (lhs) 1.25 1.75 2.25 2.75 3.25 3.75 4H2042/U42060 spread (rhs) Source: Barclays Research Source: Barclays Research 30 May 2013 31 Barclays | Global Rates Weekly higher, we expect more of a concession to develop over the next month so expect the 20y sector to underperform since the “natural” support of QE that it had enjoyed will likely be diminished, as further asset purchases seem unlikely in the next few months. We assume a 2068 maturity To model a new issue in asset swap space, we assume that the new issue is a 3.25% coupon with a 3.25% coupon, a January 2068. In the DMO’s quarterly consultation meeting, the discussion with end investors compromise between the end- and market markers saw the former looking for a longer extension but the latter favouring a users looking for a longest more modest extension into the 55-year sector. While we have no more insight into maturity possible maturity and the choice, in our opinion, a 2068 is a something of a “compromise” between the desires of the market-makers seeing no two groups: it extends the curve by eight years, while extending duration by about 2.5 years material need to extend the from the Jan 2060s. Figure 5 shows the relationship in the ultra long end between duration curve aggressively and yield. An extension of duration by 2.5 years would be consistent with a yield pick-up of about 15bp, given the relationship between yield and duration. However, Figure 6 suggests the convexity/duration relationship, which has been very tight, would say that duration of about 25 years implies a convexity pick-up of about 1.6, so the current estimated increase in convexity of about 2.02 is too high – consistent with our view that the ultra/super long end of the curve is too flat. We see fair value for a 2068 issue at about 2060s +5bp. Pricing the convexity of an One of the most common questions regarding ultra long-dated instruments is how to value ultra-long issue is not the convexity of an issue. More convex securities are prized by investors as they will straightforward and somewhat outperform in both bull and bear scenarios, and low coupon, long maturity issues tend to theoretical as it not easy to have higher convexity than their peers. All of this tells us that the 2068s should see some monetize fully support from convexity buyers, but how much is that convexity worth? Translating the value of convexity into the yield curve is not straightforward. Mathematically, the basis point value of convexity is a function of the instrument’s convexity and its normalised implied volatility. If we make the assumption of ignoring transaction costs, to monetise this gain, one would have to assume that any two instruments (convexity is a relative measure after all) would both be held to the maturity By constantly holding one versus the other, the While convexity is understood, convexity gain could be treated as an annuity. If this was summed over the life of the other factors will underpin the instruments being compared, the difference in the annuity values of convexity should curve shape more such as flow translate into the yield difference between the instruments and the curve being flatter at the and positioning longer maturities, so counteracting the term premium in the curve – but by how much? FIGURE 5 FIGURE 6 Yield vs duration for long gilts (2042-2055) Duration vs convexity for long gilts Convexity Duration 8.00 22 y = 0.6981x - 8.1841 7.50 R² = 0.9902 21 7.00 y = 25.784x - 65.954 R² = 0.8568 6.50 20 6.00 5.50 19 5.00 4.50 18 4.00 3.50 17 16.00 17.00 18.00 19.00 20.00 21.00 22.00 23.00 3.20 3.25 3.30 3.35 3.40 yield duration Source: Barclays Research Source: Barclays Research 30 May 2013 32 Barclays | Global Rates Weekly In CMS space, the convexity The CMS swap market gives some idea as to where this adjustment would be done in adjustment is worth about forward space. The CMS GBP 10y20y fwd versus 30y20y fwd spread is about -25bp – in 25bp, ie, the curve should be vanilla swaps, the same spread is about -20bp. This suggests that the swaps market does 25bp flatter in ultra-longs price convexity in some form. Though bonds and swaps differ, the historical realised versus 30y volatility of the 2060 gilt and 50y swap have tended to be closely linked (Figure 7), suggesting the implied volatility would likely be similar. However, to expect the new issue to come 20bp through the 2060 seems highly unlikely. More importantly, the convexity, while understood by the market, is not the only factor to consider in pricing. For example, in linear GBP swaps, GBP 40/50s are about a basis point flatter than GBP 50/60s. This is largely a function of the relative richness of the 50y point on the curve (GBP 10y40y fwd is notably rich in swap RV), which itself is a function of residual positioning and supply and demand. So while the convexity is an important concept and is an attractive feature of the new issue, whether its “mispricing” can be monetised is a moot point, in our view. We need to see asset swaps In the ultra-long end, the gilts curve is more inverted than the swap curve, leaving asset cheapen to attract outright swap valuations interesting (Figure 8). On a matched-maturity basis (vs 6mL), the new buyers issue would be slightly cheap. However, on a par/par measure, its lower coupon leaves it rich relative to surrounding issues, while on the z-spread measure, a new 2068 would be We need to see a bear slightly cheap to the 2060s. All told, we would expect some cheapening in asset swap back steepening in 2052/2060s towards L+30bp before there is outright asset swap demand for the issue but there may be ahead of supply some interest in switches out of expensive bonds. All told, the outright level There should be some demand from the issue from index-sensitive accounts. We estimate needs to cheapen and the that the +15y Index extends by +0.013yrs per £1bn of the issue and the All Stock Index by ultra-long end bear steepen +0.02yrs per £1bn of the issue. All told, we expect the current level of ultra long yields to be into June’s supply too rich for outright buyers, while the ultra long end is too flat ahead of supply. This suggests that most of the demand for the issue will come from extension trades in the 2055/2060 part of the curve, meaning the curve should come under steepening pressure into supply. Thus, we favour being long the cheaper 2052 issue relative to longer parts of the curve as a structural trade into supply. FIGURE 7 FIGURE 8 Gilt 2060 vs 50y swap historical volatility Long gilt asset swap measures (bp) 2.00 Historical volatility in 50yr swap bp vs 6mL par/par z-spread 1.80 Historical volatility of 2060 gilt 30 1.60 28 26 1.40 24 1.20 22 1.00 20 0.80 18 0.60 16 14 0.40 12 0.20 10 0.00 Dec Dec Jan Dec Dec Jul Dec Jan Jan-68 May-10 Nov-10 May-11 Nov-11 May-12 Nov-12 2040 2042 2044 2046 2049 2052 2055 2060 Source: Barclays Research Source: Barclays Research 30 May 2013 33 Barclays | Global Rates Weekly SUPRANATIONAL, SUB-SOVEREIGN & AGENCIES European support structures – familiar territory (This is an edited extract from The AAA Investor, published 30 May 2013) Fritz Engelhard In this week’s The AAA Investor publication we review the events since 2009 leading up +49 69 7161 1725 to the sovereign crisis and also assess the current situation for European support email@example.com structures and the respective relative value from a capital markets perspective. May 2013 marked the third anniversary of the implementation of the first sovereign Michaela Seimen support programme for Greece and the creation of the European Financial Stability Facility. +44 (0)20 3134 0134 In line with the evolution of the European sovereign crisis, European support structures firstname.lastname@example.org have been adjusted according to changing requirements. Furthermore, the overall situation has been a learning process for politicians and market participants alike as a crisis with this Jussi Harju, CFA global scale and impact has been rarely experienced. In line with the more recent track +49 69 7161 1781 record of the eurozone as a union, weaknesses of the system have been exposed and email@example.com needed to be addressed. In this week’s publication we review the events since 2009 leading up to the sovereign crisis and also assess the current situation for European support structures and the respective relative value from a capital market perspective. FIGURE 1 Timeline of events for the establishment of sovereign financial backstop facilities EFSF and ESM Year Date Key events for the establishment of EFSF and ESM financial backstops 7 June European Financial Stability Facility (EFSF) was created 2010 28 November Agreement of financial assistance programme for Ireland (€85bn) 17 May Agreement of financial assistance programme for Portugal (€78bn) Agreement by eurozone and EU finance ministers to increase EFSF's 20 June effective lending capacity, widen scope of mandate and finalise terms of permanent stability mechanism, the European Stability Mechanism (ESM) 2011 Eurozone summit, second support package for Greece and increased scope 21 July for EFSF / ESM EU summit - ESM brought forward, EFSF will continue as scheduled until 9 December end June 2013 2 February ESM Treaty signed 14 March Second Greek programme formally approved by Euro Working Group 2012 30 March Eurogroup decides EFSF / ESM to run in parallel 20 July Eurogroup grants financial assistance to Spain's banking sector 8 October ESM inauguration 2013 8 January ESM launches its short-term programme with its first bill auction Source: Barclays Research 30 May 2013 34 Barclays | Global Rates Weekly SCANDINAVIA: RATES STRATEGY Prospect of Riksbank rate cut despite headline GDP surprise Mikael Nilsson Rosell Sweden’s headline Q1 GDP number surprised to the upside but the weak composition +44 (0)20 7773 6057 does not bode well for the coming quarters. Therefore, we retain our longs in the very firstname.lastname@example.org front-end and receive 10y swaps versus EUR, given the very benign inflation outlook. Swedish swap rates underperformed EUR by c.4.5bp across the curve after the surprisingly strong GDP report. However, the weak composition of growth does not bode well for the coming quarters and the very benign inflation outlook still suggests room for rate cuts, in our view. Hence, we continue to see value in holding longs in the very front-end (Sept ’13 3m FRAs) and cross-market tighteners versus EUR in 10y swap rates. Swedish GDP increased by 0.6% q/q (1.7% y/y) in Q1, significantly stronger than our estimate (0.1% q/q 1.1% y/y) and, more importantly, the Riksbank’s latest forecast (0.3% q/q; 1.5% y/y). However, the composition of GDP growth was not particularly convincing, in our view, with inventories leaving a significant positive contribution to GDP compared to Q1 last year (0.7 percentage points). This will likely reverse and weigh negatively on growth in the coming quarters. In addition, it is notable that net exports left a significant positive contribution (0.6% percentage points), despite surprisingly weak exports (-2.9% y/y). Hence, the positive contribution was instead driven by even weaker imports (-4.7%). Furthermore, while consumption growth was slightly stronger than expected at 1.5% y/y and left a positive contribution to growth (0.7 percentage points), it is, in our view, more notable that fixed investments plunged (-7.2% y/y) and left a surprisingly large negative contribution than anticipated (-1.3 percentage points). On a more detailed, and perhaps slightly abstract, level it is also notable, in our view, that Statistic Sweden’s internal calibration shows an unusually large discrepancy between GDP estimates based on demand-side data (1.4% y/y) and production data (-0.3% y/y). All in all, we leave our 2014 GDP forecast unchanged (1.4%) given that the Q1 GDP surprise, in our view, was mainly driven by temporary factors which will reverse in the coming quarters (for a more detailed account, see Slightly better days ahead, 10 April FIGURE 1 FIGURE 2 GDP surprises to the upside but growth composition is weak Downside risk to the Riksbank’s CPIF forecast % 4.0 y/y 2.5 3.5 2.0 1.5 3.0 1.0 2.5 0.5 0.0 2.0 -0.5 1.5 -1.0 1.0 Forecast -1.5 -2.0 0.5 Jun-12 Sep-12 Dec-12 Mar-13 0.0 Household consumption Public consumption 06 07 08 09 10 11 12 13 14 Fixed investments Inventories CPIF CPIF, RB Net exports GDP (y/y) Source: Statistic Sweden, Barclays Research Source: Riksbank, Barclays Research 30 May 2013 35 Barclays | Global Rates Weekly 2013). More importantly, we don’t believe the Q1 GDP numbers will trigger any significant revision of the Riksbank’s forecast going into the 3 July meeting. Indeed, the weak composition of growth and recent downside surprises in leading indicators will probably, if anything, raise concerns about the underlying growth momentum (Sweden Economic Tendency Indicator: Clearly surprises to the downside in May, 24 May 2013). More importantly, the benign inflation outlook and modest resource utilisation clearly suggest room for further policy rate cuts, in our view. We continue to see substantial downside risk to the Riksbank’s inflation forecast (Figure 2). Indeed, according to statistics released earlier this week the producer price index (PPI) posted its largest y/y decline on record, underscoring the very benign near-term inflation outlook (Figure 3). While, the part of PPI that covers consumer goods hasn’t posted as dramatic a decline as the headline PPI it nevertheless suggests some near-term downside risk to our already benign CPI forecast. While the Riksbank does not have a single preferred resource utilisation measure, notably, in our view, one of its preferred measures, the RU-indicator (summarising information in survey and labour market data), reached its lowest level since mid-2009 in Q1 13 (Figure 4), providing a fairly dramatic contrast to the headline numbers in the Q1 GDP release. Hence, both the inflation outlook and resource utilisation continue to suggest room for further rate cuts, in our view. That said, in retrospect we are also a bit surprised that the Riksbank’s pronounced downward revisions to its inflation forecast in April did not trigger an immediate rate cut, possibly suggesting that the Riksbank’s reaction function has changed more materially than even we had anticipated due to concerns (from the majority) that a “too low policy rate for too long” might nourish potential medium-term systemic risks. However, while the Riksbank continued to stress potential structural weakness in its recently released financial stability report (Swedish bank are financially strong, but the Riksbank continues to stress potential structural weaknesses, 27 May 2013), we believe that the FSA decision to introduce a 15% minimum risk weight floor on mortgages earlier this week might have alleviated some of these concerns. With the short-end discounting a 40% probability of a 25bp cut at the forthcoming meeting we continue to see vale in holding longs in the very front end (Sep ’13 3m FRAs). Given the prospects for further cuts and the benign inflation outlook we also continue to see value in receiving 10y swaps versus EUR. FIGURE 3 FIGURE 4 PPI posts its largest decline (-5.3% y/y) on record in April Resource utilization (RU-indicator) close to mid-2009 levels % % 12 2.50 10 2.00 8 1.50 6 1.00 4 0.50 2 0.00 0 -0.50 -2 -1.00 -4 -1.50 -6 -2.00 -8 -2.50 Jan 91 Jul 93 Jan 96 Jul 98 Jan 01 Jul 03 Jan 06 Jul 08 Jan 11 Mar 96 Nov 98 Jul 01 Mar 04 Nov 06 Jul 09 Mar 12 PPI (y/y) Riksbank's RU-indicator Source: Reuter EcoWin, Barclays Research Source: Riksbank, Barclays Research 30 May 2013 36 Barclays | Global Rates Weekly INFLATION-LINKED MARKETS: UNITED KINGDOM Watch out for the overhang Henry Skeoch The IL Mar ‘24 offers value only in breakeven before its impending auction. The bond is +44 (0)20 7773 7917 no longer cheap on the curve or versus the IL22. The auction itself should be fairly email@example.com routine assuming further concession, but we see risks of a post auction overhang. The DMO will auction the new IL24 for £1.6bn notional on Tuesday, 4 June, equivalent to a £1.8bn cash size and £2mn/bp of risk. The bond was last auctioned for the same notional amount on 11 April, which drew a fairly strong reception with the bond performing well after the auction. We think a repetition of this is unlikely on this occasion. Although the new IL24 is now 15bp cheaper in breakeven relative to the last auction date, it has corrected much of its cheapness both on the real yield curve and relative to the IL22. One positive for the supply is the marked cheapening in real yields since the start of April, with the new IL24 cheapening almost 40bp. This cheapening initially was driven by concerns about a potential disinflationary environment and latterly by the global nominal sell-off, which has been driven in large part by expectations of the Fed tapering its asset purchase programme. We still think that 5-10y breakevens offer attractive value relative to the BoE inflation target, but breakeven demand alone is rarely sufficient to absorb UK linker supply. 10y linkers are also now not notably cheap versus nominal asset swaps. While this likely reflects diminished expectations of further QE nominal purchases, it may also limit ASW interest for the auction. New IL24 has unwound its The new IL24 has exhibited significant volatility in relative value since it was launched last hitherto attractive cheapness October. The launch of the bond drew very strong demand, as did its £1.1bn notional 13 in relative value December reopening with the issue performing well after both auctions. However, it notably lagged the IL22 following the National Statistician’s recommendation not to alter the RPI aggregation formulae on 10 January. The two subsequent reopenings of the new IL24 on 5 February and 11 April saw a marked underperformance of the bond on the real yield curve ahead of the two auctions (Figure 2), with the bond extending its underperformance after the February reopening. Even after Tuesday’s auction, the new IL24 will still be markedly smaller than neighbouring bonds, suggesting it is likely to be frequently reopened in the coming quarters. Therefore, we see little compelling value in the bond at current levels, except versus 10y nominals given the structural value offered by breakevens. The supply has a shortening effect of 0.03y and 0.05y on all-linkers and over-5y indices, respectively. FIGURE 1 FIGURE 2 10y breakevens value outright, no longer cheap vs RPI swaps New IL24 now only marginally cheap on curve 3.4 10 55 New IL24 vs IL17+IL29 real yield barbell 12 3.3 50 New IL24 vs IL22 real yield spread 14 16 3.2 45 18 3.1 20 40 22 3.0 35 24 26 2.9 New IL24 breakeven (%) 30 New IL24 relative z-spd asw (RHS inv, bp) 28 2.8 30 25 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Oct-12 Dec-12 Feb-13 Apr-13 Source: Barclays Research Source: Barclays Research Note: Vertical lines denote reopening auction date 30 May 2013 37 Barclays | Global Rates Weekly EUROPE: SPECIAL TOPIC EGBs: Back to trading like a rate product Cagdas Aksu ECB and other developed market central banks’ notable monetary expansions and +44 (0)20 7773 5788 institutional changes in the eurozone have helped most EGBs trade more like a rate firstname.lastname@example.org product once again. While core countries are pretty advanced in this process, Italian and Spanish bonds are still in transition from trading like a credit to rate product in our view. During the credit and eurozone debt crisis that we have been living through since 2007, sovereign spreads in the euro area have widened substantially in peripheral as well as core European government bonds (EGBs). As a result, correlation behaviour within the EGB market and also versus swaps has been changing notably. As peripheral/core bonds have started pricing in more credit and liquidity risks, they have traded more like credit products than rate products. Indeed, this has ended up being a problem not just for the sovereigns but also for the ECB, due to high financial market fragmentation making it difficult for the central bank to have a relatively even transmission of monetary policy in rates across the eurozone. Indeed, it has been this substantial credit/liquidity premium in peripheral bonds and financial Peripheral and core bonds market fragmentation that has pushed the ECB into taking bolder action in the past two years traded more like credit than (eg, LTROs and OMT program announcement). Thanks to these actions from the ECB, other rate products during the crisis developed market central banks’ significant monetary policy expansions and the institutional changes in the eurozone, core EGBs are once again pretty much all behaving like a pure rates market. While Italian and Spanish bonds have not yet fully become like rate products, we find that they are currently in transition. In order to illustrate this, we looked at rolling correlations of daily yield changes in 5y core and peripheral countries versus 5y German bond yield changes. As Figure 1 shows, before 2007 the correlations on yield changes in Belgium, France and the Netherlands were all very close to one versus Germany. These correlations fell to zero (in France and Belgium, less so in the Netherlands) at the end of 2011/early 2012 as contagion spilled over from periphery to core countries. Since then, a number of factors, including global monetary expansion, have led to yield grab and as a result core spreads across the board, including France, are not far from pre-crisis levels. As such, the correlations of yield changes are now back to around one and all of these curves are trading similar to Germany like a rate product: ie these core bonds are moving more on the back of macro rate moves than credit and liquidity risk premiums. FIGURE 1 FIGURE 2 3m rolling correlation of daily yield changes in 5y core and 3m rolling correlation of daily yield changes in 5y core German bonds periphery and German bonds 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 Italy France -0.5 Belgium Spain -1.0 Holland -1.0 -1.5 Jan-07 Jul-08 Jan-10 Jul-11 Jan-13 Jan-07 Jan-09 Jan-11 Jan-13 Source: Barclays Research Source: Barclays Research 30 May 2013 38 Barclays | Global Rates Weekly FIGURE 3 FIGURE 4 1m rolling correlation of daily yield changes in 5y periphery Swaps have been a good hedge for Germany with and German bonds correlations only dropping notably during times of large structural ASW moves 1.0 1.5 0 -20 Italy 1.0 0.5 Spain -40 0.5 0.0 -60 0.0 -80 -0.5 -0.5 6m rolling correlation with 5y Ger and swaps -100 5y Ger ASW -1.0 -1.0 -120 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Source: Barclays Research Source: Barclays Research Core countries are pretty When we look at the same correlations in 5y Italian and Spanish daily yield changes versus advanced in trading like a rate Germany, it is still early to say whether these bond markets are trading like rate products. product once again; peripheral During the crisis, correlations fell very quickly into negative territory and stayed there for bonds are still catching up quite a long time. However, it is worth nothing that these correlations are gradually edging up in the positive territory. We can see this more clearly when we look at correlations over a shorter time period (Figure 3). Apart from the correlation of yield changes within the EGBs, it is also interesting to look at the correlation of all EGBs, including Germany, against swaps to see how much of a good hedge swaps have been to EGBs before and after the crisis. As Figure 4 shows, German yield levels demonstrate very good correlation with swaps in general, with the correlation having fallen notably only during times of large structural tightening/widening moves in ASWs. While swaps would be a good hedge also for core issuers such as Belgium, France and the Netherlands before the crisis, this changed during the crisis. However, as highlighted above FIGURE 5 FIGURE 6 Swaps have become a good hedge once again for core EGBs … however, swaps would still not be an effective hedge for (all in 5y maturities)… Italy and Spain (all in 5y maturities) 1.5 1.5 1.0 1.0 0.5 Italy Spain 0.5 Ger 0.0 France Belgium Holland -0.5 0.0 -1.0 -0.5 -1.5 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Source: Barclays Research Source: Barclays Research 30 May 2013 39 Barclays | Global Rates Weekly with these core issuers trading like rate products now, swaps have once more become a good hedge/benchmark in their trading. As Figure 6 shows, given the volatility of change in the sign of correlations, swaps would still not be an effective hedge for Italy and Spain. Swaps are also becoming an Overall, our analysis shows that most EGB bonds are once again trading more like rate effective hedge for most of the products. While core countries like Belgium, France and the Netherlands are pretty EGB market advanced in this process, Italian and Spanish bonds are still in transition from trading like a credit to rate product. As such, swaps once again are becoming an effective hedge for most of the EGB market. We expect this process to continue to evolve in this direction, also helping liquidity in the EGB and swaps market. 30 May 2013 40 Barclays | Global Rates Weekly JAPAN: RATES STRATEGY Tug of war in JPY/USD cross-currency basis Reiko Tokukatsu, CFA 10y USD/JPY Xccy basis is now as negative as it was in May 2012. Given the gradual +81 3 4530 1532 tightening of loan spreads, spreads on new loans are likely to be much tighter and may email@example.com eventually become a disincentive for banks to bear more basis cost. The demand for USD funding is still pressuring JPY/USD Xccy basis in a negative direction, Chotaro Morita especially in the above-5y sector. As a result, the 10y basis is close to the historical low +81 3 4530 1717 recorded in 2012 (-74bp), and 5s10s flattened to a historical low of about -12bp. Strong firstname.lastname@example.org demand for USD funding is backed by the consistent increase in Japanese banks’ overseas loans, where the outstanding amount exceeds the pre-Lehman level but funding via Noriatsu Tanji deposits is not catching up (Figure 2). We examine the following factors to see whether +81 3 4530 1346 there is room for USD/JPY Xccy basis to become more negative. email@example.com 1. For an immediate move for positive direction, we need institutions that could take advantage of the negative Xccy basis – typically a Japanese borrower issuing debt in USD and converting the proceeds into JPY. However, for Japanese borrowers, the benefit of negative Xccy basis is often reduced by the wider credit spread they have to pay outside Japan. As credit spread is wider at longer maturities, it is difficult to find a Japanese issuer for 10y USD debt. Although there are issuers of 5y paper, a recent USD500mn 5y note from a Japanese local authority did not appear to achieve cheaper funding compared with its 5y USD issue in May 2012 (JPY Libor-15bp, or JGB flat) or its funding in JPY. Therefore, we think it is unlikely that other issuers will follow soon. 2. On the other hand, samurai issuers appear to have some advantage currently, though marginal. A couple of European companies issued samurai bonds in May. While credit spreads recently stopped tightening in Europe, samurai spreads have not (Figure 3). 3. More negative 10y basis than 5y can be explained that 5y because longer-maturity loans tend to be for project finance and generally offer wider spreads. Therefore, banks can afford to pay more basis cost. According to the BoJ October 2012 system report, project finance spreads typically are about 80bp wider, on average, than spreads on loans for capital investment. In addition, increased usage of subsidized funding via the Japan Bank for International Cooperation at USD 6m Libor flat (effectively 3m Libor+14bp for now), may actually allow banks to bear more basis cost. FIGURE 1 FIGURE 2 5y and 10y USD/JPY Xccy basis spread and spread (bp) Overseas loans and amount funded by deposit -40 15 45 130% 120% -50 10 40 110% 35 -60 5 100% 30 90% -70 0 25 80% -80 -5 70% 20 60% -90 -10 15 50% -100 -15 10 40% 10-May 10-Aug 10-Nov 10-Feb 10-May Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 5Y 10Y 5s10s (bp, RHS) Loan (Mega bank, JPY tn) Deposit as % of loan Source: Barclays Research Source: Barclays Research 30 May 2013 41 Barclays | Global Rates Weekly FIGURE 3 FIGURE 4 European spread and samurai spread (bp) Average spread for IG syndicated loan (5y) 130 80 300 125 75 280 120 260 70 115 240 110 65 220 105 60 200 100 55 180 95 50 160 90 85 45 140 80 40 120 21-Nov 21-Jan 21-Mar 21-May 100 Itrx Europe (bp, LHS) 19-Jul 19-Sep 19-Nov 19-Jan 19-Mar 19-May Samurai average swap spread (bp, RHS) Syndicated loan spread(bp) Source: Barclays Research Source: Bloomberg, Barclays Research At the same time, we also note that, overall, loan spreads are likely to tighten gradually. Although we have limited data, Figure 4 shows an average spread for syndicated 5y loans based on Markit prices (data for 10y loans are not available). If the spread on loan tightens to 150bp from 200bp but funding costs stay the same, banks have to accept much less profit. Assuming the spread for overseas loans is about 100bp wider, on average, than domestic loans, the advantage decreases significantly. Of course, the decision to continue to increase overseas loans does not depend only on the spread, but also on loan demand, so domestic banks may still choose to pay the basis cost. It is difficult to determine the breakeven basis cost for banks to continue accumulate overseas asset, but we can say, at least, that banks can now only acquire less yielding assets because they have to pay the same 10y basis spread as in May 2012. In this sense, we think it is reasonable to start paying 10y Xccy basis at around the current level. FIGURE 5 Trade recommendation updates (bp) Year Current end/ Level (incl Weekly Risk Target Entry Entry at last carry) P&L (DV01, (includin date level report or closed (JPY mn) JPY mn) g carry) Stop Horizon Action 1y OIS pay 13-Jul 6.0 5.5 5.5 0.0 100bn face 8.0 5.0 1y Close as O/N has fallen Swap 1s3s5s short vs. 3s5s7s long 25-May -9.0 -9.5 -10.0 -10.0 10.0 -3.0 -12.0 1m remaining (1:3:5:7=1:-3:3:-1) 1s3s5s short 10-15-20 short 17-May 9.8 13.0 13.9 4.5 10.0 16.0 5.0 1m Hold 7s10s box (JB310/JB327) 25-May -5.50 -6.0 -6.0 0.0 5 -2.0 -8.0 1-3m New Swap Short 10y swap spread 19-Apr -15.0 -17.4 -16.4 5.0 5 -10.0 -20.0 1-3m Hold spread (JB327) Short 5 y swap spread (JS109) 19-Apr -15.0 -13.4 -13.2 1.0 5 -10.0 -20.0 1-3m Hold Pay 1yx1y 10-Nov -44.0 -31.0 -31.0 0.0 10 -30.0 -80.0 medium- Hold long Xccy basis Pay 1yx1y 11-Apr -46.0 -41.0 -41.0 0.0 5 -30.0 -80.0 long Hold Pay 4y 7-Mar -51.0 -52.0 -52.0 0.0 5 -40.0 -70.0 medium- Hold long JGB sell JBM3JBU3 calendar 7-Mar 24.0 n/a 24.0 0.0 300 18.0 30.0 2wks New futures spread contract Weekly P&L =0.5; total P&L since 2013: 585.4; balance sheet=27.4. Note: Current levels based on the absolute maturity to capture rolldown correctly; therefore, it is different from the constant-maturity spread. Source: Barclays Research 30 May 2013 42 Barclays | Global Rates Weekly TRADE PORTFOLIO UPDATE Trade portfolio update Piyush Goyal Since the previous publication (May 23, 2013), the portfolio has lost $1.3mn. It has +1 212 412 6793 increased $8.0mn year-to-date and $56.2mn since inception. 2 firstname.lastname@example.org FIGURE 1 Vivek Shukla Mark-to-market performance of the portfolio – cumulative P&L, $mn +1 212 412 2532 mn email@example.com 70 60 50 $56.2 40 30 20 10 0 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Note: As of May 30, 2013. 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. 2 Since January 2009. 30 May 2013 43 Barclays | Global Rates Weekly TRADE PORTFOLIO New Trades Inception Levels @ Current Net Change (Gain Total Stop Initial Variation Total Theme Trade Weights/Notional Amount Horizon Date Inception Level (+) /Loss (-)) Loss (bp) Margin Margin Margin US TIPS 10s30s breakeven 5/30/2013 Jan-23-Feb43 $25k dv01 15 16 ($25,000) ($200,000) 1m $1,000,000 $25,000 $1,025,000 curve flattener US Swaps / Futures For reversal of sell- 5/30/2013 Long front Eds (EDU4) $50k dv01 53.8bp 54bp ($10,000) ($250,000) 1m $200,000 $10,000 $210,000 off Sell USU3 invoice 5/29/2013 RV $50k dv01 13.2bp 13.5bp ($10,000) ($250,000) 1m $500,000 $10,000 $510,000 spreads JPY Swaps CTD spread is too Sell JBM3JBU3 calendar 5/30/2013 wide relative to 300 24 24 $0 ($150,000) 2w $600,000 $0 $600,000 spread 7s10s US Options 5/30/2013 Delta-hedge to Receive $50mn 6/17/13- $50mn 1.74% 1m7y straddle 7y swap Long $260mn 1m*5y 20bp For continuation of 1m*5y vs. 1m*15y bear 5/30/2013 OTM:Short $100mn 1m*15y 22bp 10000 0 ($10,000) ($250,000) 1m $500,000 $10,000 $510,000 sell-off flattener high strike payer Buy swaptions vs TY Sell 1000 TYN3 130 call: Long For reversal of sell- 5/30/2013 options (bull-spread $122mn 6/21 7y reciever @ 1.69% 10000 0 ($10,000) ($250,000) 1m $500,000 $10,000 $510,000 off tightener) Note: All prices as of May 30, 2013. Source: Barclays Research 30 May 2013 44 Barclays | Global Rates Weekly 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 $8,232,000 Front-end Asset 1/12/2012 Long Jan '14 TIPS ASW $500mn Libor - 13bp Libor -8bp $1,400,000 ($250,000) 1y $2,500,000 ($1,400,000) Swap Tightener Long Core Sell 1% 2y CPI Floors vs. Long CL4 Puts 8/3/2012 ($100mn): +50 ($376,500) ($238,500) $138,000 ($200,000) 1y $800,000 ($138,000) Inflation 65 10/5/2012 Carry Long Jan '15 ASW relative to nominals $100mn 14bp 9bp $91,000 ($300,000) 1y $1,000,000 ($91,000) 10/18/2012 Supply unwind Long Feb 40 Relative ASW $10mn 22bp 32bp ($122,000) ($400,000) 1y $400,000 $122,000 Apr16-Jan22 rel ASWs flattener (20K 3/8/2013 Supply 20k DV01 11bp 11bp $0 ($200,000) 3m $1,250,000 $0 DV01) Low realized CPI 3/27/2013 Sell 3y y/y CPI strangle, energy hedged $100mn 1%-3.5% ($1,400,000) ($1,400,000) $0 ($500,000) 3m $2,000,000 $0 vol Sell the belly of Apr17-Jul20-Jan23 real 4/25/2013 Relative Value $50k DV01 -15.5bp -9.4bp $383,000 ($500,000) Unwound $1,000,000 ($383,000) yield fly 5/8/2013 Dovish Fed Long 5y5y BE $25k dv01 269bp 260bp ($225,000) ($250,000) Stop out $500,000 $225,000 5/9/2013 Cheap front end Long Jul13 breakeven $200mn -60bp +49bp $53,000 ($500,000) 3m $500,000 ($53,000) US Treasury $3,173,000 Improvement in 3/14/2013 funding Long OTR3y versus OIS $100k DV01 8.9 8.2 $122,000 ($500,000) 3m $1,000,000 ($122,000) environment Decline in term $50k DV01 -30.4 -31.7 ($30,000) ($500,000) 1m $750,000 $30,000 4/25/2013 Short 5s10s20s (0.4:1.4:1) premium 5/9/2013 Overweight 3s Long 2s3s5s (2:2:0.5) $50k dv01 -11.6 -10.3 ($65,000) ($500,000) Unwound $750,000 $65,000 5/23/2013 Low inflation $50k dv01 117.4 116.4 $50,000 ($500,000) 1m $750,000 ($50,000) 10s30s flatteners worries Eurozone Sovereign debt $450,000 10/5/2012 UFR positioning Receive 5y5y/5y10y/5y15y fwd $15k dv01 102bp 92bp $150,000 ($375,000) 3-6m $600,000 ($150,000) US Swaps / Futures $1,910,000 1y1y Libor-OIS tightener against 1y1y 3/8/2013 RV $100k DV01 13.6 11.8 $180,000 ($500,000) 1m $1,500,000 ($180,000) 3s1s widener 5/23/2013 RV 10s30s spread curve flattener $100kDV01 -22 -24.1 $210,000 ($500,000) 1m $800,000 ($210,000) JPY Swaps $3,957,000 7/13/2012 Short front-end Pay 1y OIS $160k dv01 6bp 6.55bp $88,000 ($350,000) Unwound $1,600,000 ($88,000) Swap spread 3/13/2013 term structure is Swap spread 10s20s30s long usd 60 k dv01 23 12 $540,000 ($450,000) Unwound $1,500,000 ($540,000) distorted 5y belly too 5/16/2013 1s3s5s short vs. 3s5s7s long $30k DV01 -8 -5 $15,000 ($250,000) Unwound $1,500,000 ($15,000) cheap US Options $18,685,000 7/19/2012 Short vol Short 1y*10y straddles ($20mn) ($1,220,000) ($835,000) $385,000 6m $880,000 ($385,000) 9/7/2012 Short vol Short 1y*10y straddles ($20mn) ($1,242,000) ($872,000) $370,000 6m $880,000 ($370,000) 9/27/2012 Short vol Short 1y*10y straddles ($10mn) ($596,000) ($466,000) $130,000 ($1,000,000) 6m $880,000 ($130,000) 10/5/2012 Short vol Short 1y*10y straddles ($10mn) ($597,000) ($407,000) $190,000 6m $880,000 ($190,000) 11/15/2012 Short vol Short 1y*10y straddles ($10mn) ($570,000) ($570,000) $0 Expiry $880,000 $0 Long 1x11 cap -flr straddles 2% vs 6/14/2012 Relative Value $20mn: ($20mn) $1,964,000 $3,019,000 $1,055,000 ($500,000) 1y $880,000 ($1,055,000) 1y*10y straddles 2% Long risk- Long 1y*30y 100bp wide risk-reversal 8/3/2012 $100mn ($450,000) $600,000 $1,050,000 ($500,000) 6m $725,000 ($1,050,000) reversal (long recr), delta hedged 30 May 2013 45 Barclays | Global Rates Weekly Trades Outstanding (continued) 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 $18,685,000 Long 3y*1y 25bp low-strike recr vs 45bp 8/9/2012 Tactical $200mn:($200mn) 0 $0 $0 ($500,000) 1y $800,000 $0 high-strike payer Short belly of 2y5y - 2y10y - 2y30y payer +$94mn : ($100mn): 8/16/2012 Relative Value ($300,000) ($160,000) $140,000 ($500,000) 1y $2,200,000 ($140,000) fly +$22mn 1/4/2013 Short vol sell 2y*10y straddles @ 2.65% ($50mn) ($4,105,000) ($4,025,000) $80,000 ($500,000) 6m $2,200,000 ($80,000) 1/17/2013 Sell skew Sell 3y*5y 2.5% payer, delta hedged ($100mn):($40mn) ($2,115,000) ($2,365,000) ($250,000) ($500,000) 1y $1,200,000 $250,000 1/24/2013 cheap flattenerlong 2ez3 p 99 vs short 4ez3 p 97.75 +2000: (2000) ($650,000) ($1,125,000) ($475,000) ($500,000) Expiry $500,000 $475,000 short TYM3P 128 vs matched expiry 2/1/2013 put-payer (1000): $129mn ($200,000) $0 $200,000 ($250,000) Expired $500,000 ($200,000) payer 2/14/2013 Calendar spread long 5y30y p 3.6 vs 1y30y p 3.15 +$50mn: ($50mn) $3,320,000 $3,170,000 ($150,000) ($500,000) 1y $1,000,000 $150,000 Long 1y30y recr, Short 1y30y payer, Pay $100mn: $100mn: 2/28/2013 Fade skew ($430,000) ($110,000) $320,000 ($500,000) 6m $725,000 ($320,000) fix 1y30y $50mn 4/11/2013 Steeper Vol Long 3x13 cfs vs 3y10y swaption +$50mn: -$50mn $4,650,000 ($500,000) 1y $1,600,000 $4,210,000 ($440,000) $440,000 Surface straddle Long 6/14/13-30y receiver 2.725% vs 4/18/2013 Bull-flattener +20mn: (500 each) 0 ($25,000) ($25,000) ($500,000) Expiry $1,000,000 $25,000 short 3EM3C 99 and 34EMC 98.375 Buy 1x1x1 4EH4 98.125 – 98.375 – 98.5 5/3/2013 Short Vol 3000 contracts 0 $70,000 $70,000 $500,000 Expiry $1,500,000 ($70,000) CALL LADDER 5/16/2013 Fed Tapering Long 3en3p 98.625 vs 5en3p 97.25 +2000-2000 ($25,000) $150,000 $175,000 ($500,000) Expiry $1,000,000 ($175,000) 5/23/2013 Long Gamma Logn 1m*7y straddles $100mn $995,000 $1,215,000 $220,000 ($250,000) Expiry $1,500,000 ($220,000) EUR Options $4,752,000 EUR 100mn: 9/7/2012 Short vol EUR 1x2 1y5y 1.15 vs 0.9 recr ladder 0 $430,000 $430,000 ($250,000) 6m $1,692,000 ($430,000) (200mn) Long EUR 1y*10y 1x2 payer spread (2.2 (EUR 50mn): EUR 10/5/2012 Long vol 0 ($160,000) ($160,000) ($500,000) 6m $550,000 $160,000 vs 2.6) 100mn Short 3m*4y GBP straddles vs 30bp high- +GBP 100mn: gbp 3/8/2013 RV ($1,040,000) ($340,000) $700,000 ($500,000) Unwound $1,200,000 ($700,000) strike 3m*4y payer 100mn Rangebound Long gbp 50mn 1x11 cfs vs gbp 50mn 4/25/2013 50mn:50mn $5,420,000 $4,940,000 ($480,000) ($500,000) 1y $1,800,000 $480,000 GBP rates 1y10y straddles Cross-currency $580,000 10/11/2012 Carry Pay 1yx1y Xccy basis $40k dv01 -53.5 -33 $820,000 ($400,000) 1y $400,000 ($820,000) Paying demand 3/8/2013 is larger in 4-5y pay 4y Xccy basis usd 40 k dv01 -51 -51 $0 ($400,000) 3m-6m $1,000,000 $0 basis US BMA $2,040,000 Long 3m1y BMA ratio vs short 3y1y Sell Front-end 1/12/2012 ratio; 3m1y matured on 4/12 at 1y ratio $200mn : ($200mn) 54, 84 50, 69 $190,000 ($250,000) 1y $800,000 ($190,000) Ratios = 50, implying p&l -$42k Sell Front-end 5/10/2012 Short 3y ratio $200mn 65.375 60 $110,000 ($250,000) 1y $800,000 ($110,000) Ratios Sell Front-end 6/7/2012 Short 3y ratio $200mn 66.75 62 $60,000 ($250,000) 1y $800,000 ($60,000) Ratios 30 May 2013 46 Barclays | Global Rates Weekly Trades Outstanding (continued) 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 Cash 5/23/2013 5/30/2013 Cash Used as Collateral/ Haircut $43,354,800 $47,144,000 Fed Funds (residual cash) $73,407,354 $68,300,422 Return on Fed Funds $115,638 $117,106 Return on trades $15,327,316 Total $115,444,422 Note: All prices as of May 30, 2013. Source: Barclays Research 30 May 2013 47 Barclays | Global Rates Weekly 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 Tightener Long Jan '12 TIPS ASW $500mn Libor - Libor - 34bp $170,000 ($250,000) Unwound 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) Stop-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 3/29/2012 6/1/2012 Relative Value Long TII Jan 22 Relative Asset Swap 45k dv01 33bp 31bp $10,000 ($500,000) Unwound 4/19/2012 7/6/2012 Eurozone contagion Long Apr '17 vs Jan '17 $50k dv01 6bp -5bp $550,000 ($500,000) Unwound 6/1/2012 7/19/2012 Inflation risk premium Long 10y10y vs 5y5y BE $15k dv01 -19bp -8bp $80,000 ($150,000) Unwound 6/28/2012 7/19/2012 Supply Short belly of Jan '18 - Jan '21 - Jan 26 real $20k dv01 -12bp -9bp $90,000 ($250,000) Unwound yield fly 7/19/2012 8/30/2012 Flattener Jan '14 - Apr '17 breakeven flattener ; energy $15k dv01; (30 67bp, 94.44 52bp, 96.35 ($100,000) ($250,000) Unwound hedged contracts) 8/16/2012 10/18/2012 Supply Trade Apr '17 - Feb '42 breakeven flattener $15k dv01 39bp 35bp $12,000 ($250,000) Unwound 11/2/2011 10/25/2012 Normalization Long Apr' 13 TIPS vs. sell 2% CPI cap and sell $30k dv01; 45 -103bp, - -107bp, 4bp, $1,100,000 $700,000 Unwound XBH3 contracts 36bp, 249.83 275 9/20/2012 11/8/2012 Dovish Fed Receive 2y forward 2y break-even (Jan '14 vs $20k dv01 228bp 215bp ($250,000) ($500,000) Unwound Jan '16) 8/17/2012 11/15/2012 Sell Deflation Floor Long Jan' 17 vs. Apr '17 $50k dv01 0bp -1bp ($50,000) ($100,000) Unwound 9/7/2012 11/29/2012 Carry trade Buying German I/L Apr 2016, asset swapped $100mn 32.3bp 16bp $690,000 ($500,000) Unwound into USD 11/8/2012 1/4/2013 Fiscal Cliff Short Jul17 Breakeven 25k/$56mn 215bp 228bp ($292,344) ($500,000) Unwound 11/29/2012 1/4/2013 Supply Fly: 5s Sell the belly of Jan15-Jan17-Jan19 RY Fly $15K DV01 -21 -18 $60,000 ($200,000) Unwound 11/29/2012 1/4/2013 Risk Premium 10s30s BE steepener ahead of Dec. FOMC 15K DV01 2bp 6.2bp $70,000 ($250,000) Unwound 1/4/2013 2/7/2013 Concession unwind Long Jan15-Apr17-Jan19 RY Fly $15k dv01 -10 0 ($175,000) ($150,000) Stop-out 2/21/2013 1/10/2013 Front-end Underpriced Long $250mn TIIJan14s hedged with sell 100 $250mn -134bp, -226bp, 93.5 $1,003,000 ($600,000) Unwound CLZ4 91.74 1/17/2013 3/14/2013 Long the belly and fade the roll Jan19-Jul22-Jan25 real yield fly $20k dv01 32bp 37bp ($10,000) ($160,000) Unwound 4/18/2013 4/25/2013 Dovish Fed Long 5y5y breakeven (Apr 17-Jul22) fwd BE $25k dv01 266bp 278bp $255,000 ($500,000) Unwound 30 May 2013 48 Barclays | Global Rates Weekly Trades Unwound (continued) Inception Unwound Weights/Notional Levels @ Levels @ Net Change (Gain Total Stop Date Date Theme Trade Amount Inception Unwind (+) /Loss (-)) Loss (bp) Horizon UK Inflation 6/1/2012 6/14/2012 Macro Long IL20 vs. pay match-maturity swap GBP 7mn 280bp 262bp ($515,000) ($500,000) Stop-out 6/22/2012 7/6/2012 Macro Buy IL29 Breakeven (vs. UKT 4.75%) GBP 13mn: (GBP 262bp 263bp $35,700 ($500,000) Unwound 13.3mn)/ $35.7k dv01 6/29/2012 7/26/2012 Real Yield curve flattener Long IL32 vs IL17 $45k dv01 126bp 145bp ($720,000) ($500,000) Stop-out 7/13/2012 9/28/2012 Relative Value Sell IL17 vs IL16, IL22 real yield fly $37.5k dv01 -24bp -24bp $150,000 ($300,000) Unwound 9/14/2012 10/18/2012 Cheap forward real rates Receive 20y20y forward RPI real rate swap $17.2k dv01 36bp 42bp ($103,000) ($500,000) Unwound 9/28/2012 11/29/2012 Real yield flattener IL22 - IL42 real yield flattener $25k dv01 97bp 100bp ($175,000) ($500,000) Unwound 11/16/2012 1/10/2013 UK Linker RV Sell IL22 vs IL17+32 RY barbell 62.5k DV01 0bp 1bp $125,000 ($500,000) Unwound 12/12/2012 1/10/2013 10y UK breakevens rich Sell IL22 Breakeven $25k DV01 250 293 ($1,075,000) ($1,000,000) Stop-out 1/17/2013 2/7/2013 UK 5y5y fwd real yield rich Sell IL22 into IL17 cash for cash $30k DV01 -20 -15 $150,000 ($500,000) 3m 2/21/2013 2/1/2013 UK Linker RV IL24 vs IL17+IL34 real yield barbell $125k dv01 32 37 ($500,000) ($500,000) Stop-out 2/14/2013 3/8/2013 Real Yield IL32-IL55 real yield flatteners $50k dv01 26bp 33bp ($500,000) ($500,000) Stop-out EUR Inflation 6/1/2012 6/22/2012 Macro Receive 5y Euro HICPx Inflation EUR 25mn 1.35% 1.48% $390,000 $390,000 Stop-out 6/29/2012 7/26/2012 Relative Value Sell Bund i23 vs. OBL i18 breakeven $27.2k dv01 47bp 50bp ($106,000) ($300,000) Unwound 8/10/2012 9/7/2012 Short inflation Sell 10y FRCPIx ZC Inflation $37k dv01 2.32% 2.4% $50,000 $100,000 Stop-out 9/14/2012 9/28/2012 Relative Value Sell 10y FRCPIx vs. Euro HICPx $39.5k dv01 27bp 37bp ($388,000) ($400,000) Unwound 11/29/2012 12/14/2012 Real Yield Short BTPi16/19 fwd real yield $5.4k DV01 346bp 360bp $75,000 ($250,000) Stop-out 1/17/2013 2/28/2013 Curve Buy BTP€i41 versus BTP€i21 EUR 10mn 21s vs EUR 77bp 36bp $411,000 $75,000 Unwound 4.5mn 41s ($11k dv01) 1/4/2013 3/14/2013 Unwound EUR21.3mn 23s vs Relative value Buy OATi23 versus OATi22 3.5bp 1bp $105,000 ($75,000) 25mn 22s ($35k dv01) 2/14/2013 3/28/2013 Curve trade Long OBL€i18 vs OAT€i40 BE $50k dv01 95bp 81bp ($100,000) ($500,000) Unwound 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 concession 7y-30y tsy curve flattener $50k dv01 177.75bp 174.75bp $150,000 ($500,000) Unwound 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) 30 May 2013 49 Barclays | Global Rates Weekly Trades Unwound (continued) Inception Unwound Weights/Notional Levels @ Levels @ Net Change (Gain Total Stop Date Date Theme Trade Amount Inception Unwind (+) /Loss (-)) Loss (bp) Horizon US Treasury 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 5/10/2012 6/1/2012 Fading 7yr Short 5yr - 7yr - 10yr $50k dv01 -12.2bp -18.2bp ($325,000) ($300,000) Stop-out 5/10/2012 6/14/2012 Relative Value Short HC Nov '15 Ps vs. HC Feb '15 Ps $50k dv01 6.25bp 8bp $87,500 ($300,000) Unwound 6/7/2012 7/6/2012 Fading Operation Twist Long 3% Sep '16 vs. OIS $50k dv01 16.1bp 13.5bp $130,000 ($250,000) Unwound 6/28/2012 7/19/2012 Dovish Fed/ Relative Value Long 9.25% Feb '16s $40k dv01 0.525% 0.40% $500,000 ($400,000) Unwound 6/14/2012 7/26/2012 Macro Long 10y treasury $25k dv01 1.635% 1.425% $570,000 ($300,000) Unwound 7/12/2012 7/26/2012 Flattener 10y-30y tsy curve flattener $50k dv01 108.4bp 106bp $115,000 ($300,000) Unwound 7/26/2012 8/9/2012 Macro Long 7y tsy $50k dv01 0.94bp 1.045bp ($525,000) ($500,000) Stop-out 9/7/2012 9/13/2012 Steepener 7y-30y steepener $50k dv01 171.5bp 184bp $625,000 ($500,000) Unwound 8/10/2012 9/20/2012 Fed on hold Long 5y $25k dv01 0.694% 0.68% $50,000 ($500,000) Unwound 10/11/2012 11/29/2012 Flattener 7y-30y flattener $50k dv01 177bp 178bp ($45,000) ($500,000) Unwound 9/20/2012 1/10/2013 Low funding rates Long 3y $50k dv01 35.5bp 33.2bp $219,000 ($500,000) Unwound 11/15/2012 1/10/2013 Liquidity Premium Long OTR 10s vs Old 10s $100K DV01 3.8bp 4.7p ($89,000) ($500,000) Unwound 12/13/2012 1/10/2013 Long end Fed purchases 7s30s Tsy curve flattener 25k dv01 175.8 175.7 $5,000 ($500,000) Unwound 2/14/2013 1/24/2013 bond refunding steepener 10s30s $50k dv01 119.7 120.3 $28,000 ($500,000) Unwound 1/10/2013 2/28/2013 Long front end Long 4y $50k DV01 59.4bp 53.3bp $378,000 ($500,000) Unwound 1/17/2013 2/28/2013 Lower growth, higher fiscal risk Long 5s10s30s fly $50k DV01 -9.6bp -12.5bp $194,370 ($500,000) Unwound premium 2/1/2013 2/28/2013 Easy Fed, Fading richness of 7s Long 2s5s7s gross fly $50k DV01 8.6bp 3.6bp $243,700 ($500,000) Unwound 2/14/2013 3/14/2013 Not enough liq premium in OTR Long Feb23s vs Nov22s $100k dv01 2.95bp 2.76 $53,000 ($500,000) Unwound 9/20/2012 3/27/2013 QE underpriced Long 10y $25k dv01 1.78% 1.76% $260,000 ($500,000) Unwound 2/14/2013 3/27/2013 sequester/post auction dynamics 10s30s curve flattener $50k dv01 116.65 124.2 ($414,000) ($500,000) Unwound 2/28/2013 4/5/2013 Fade the curve steepness 7s10s flattener $100k DV01 62.8 61.39 $175,000 ($500,000) Unwound 3/27/2013 4/5/2013 Risk aversion 7s30s flattener $50k DV01 186 175.9 $530,000 ($500,000) Unwound 4/11/2013 4/18/2013 Low front end risk premium 5s10s Flattener (65% dv01 on 10s) $50k dv01 43.5 39.9 $179,000 ($500,000) Unwound 4/18/2013 5/16/2013 Curve too steep given inf exp 7s30s curve flattener $50k DV01 172.2 182.9 ($500,000) ($500,000) Stop out 5/3/2013 5/23/2013 Long duration Long 10y $50k DV01 1.79 1.9 ($530,000) $500,000 Stop-out JGB 6/8/2012 6/21/2012 Fading monetary policy easing 5y-10y flattener $125k dv01 66bp 61.8bp $525,000 ($250,000) Unwound 6/8/2012 6/21/2012 relative value 10y-20y flattener $125k dv01 81bp 84.4bp ($425,000) ($375,000) Stop-out 10/17/2012 10/25/2012 Bear flattener JGB 10y-20y bear flattener $50k dv01 90.5bp 91.5 ($50,000) ($150,000) Unwound 11/8/2012 12/13/2012 Auction Concession Unwind JGB 30s40s flattener 60k DV01 19 16.4 $156,000 ($150,000) Unwound 1/29/2013 Tactical JGB 10s12s flattener $60k dv01 30.2 29.8 $24,000 ($150,000) Unwound 2/21/2013 3/7/2013 JGB 20s30s steepener JGB 20s30s steepener $120K 17.5 14 ($400,000) ($400,000) Stop-out 3/28/2013 Still flattening room for JGB 3/21/2013 JGB 10s20s flattener 60 95 91 $240,000 ($150,000) Unwound 10s20s End of extreme low short end 4/18/2013 5/3/2013 JGB 10s20s flattener $40k dv01 90 90.5 ($20,000) ($300,000) Unwound means flatter curve 30 May 2013 50 Barclays | Global Rates Weekly Trades Unwound (continued) Inception Unwound Weights/Notional Levels @ Levels @ Net Change (Gain Total Stop Date Date Theme Trade Amount Inception Unwind (+) /Loss (-)) Loss (bp) Horizon 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 $12.5k dv01 -37bp -70bp ($425,000) ($350,000) Stop-out 21 9/7/2012 11/21/2012 Front end periphery convergence Long SPGB 4.75% Jul 14 vs BTP 4.25% Jul 14 $10k dv01 60bp 102bp ($420,000) ($350,000) Stop-out 6/15/2012 2/28/2013 Relative Value Short Bobl ASW vs. EONIA long Schatz ASW $15k dv01 -48bp -24bp ($360,000) ($350,000) Stop-out vs. libor 1/10/2013 3/8/2013 Fundamental cheapness Long 5y5y fwd EUR ASW $30k dv01 -4 15 $570,000 ($450,000) Unwound 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 5/18/2012 5/30/2012 Calendar Roll Long TUU2 Short TUM2 2000:(2000) 2.875 (ticks) 1.75 (ticks) $70,313 ($250,000) Unwound 5/18/2012 5/30/2012 Calendar Roll Long TYU2 Short TYM2 2000:(2000) 31.75 (ticks) 30 (ticks) $109,375 ($250,000) Unwound 1/6/2012 6/21/2012 Issuance Sell 30y spreads $50k dv01 -31bp -24bp ($350,000) ($250,000) Stop-out 4/6/2012 7/12/2012 Front-end spd widener March '14 FRA-ois (USFOSC8) widener $50k dv01 38.5bp 33.5bp ($250,000) ($250,000) Stop-out 7/19/2012 8/3/2012 Flattener 4y1y vs 1y1y flattener $50k dv01 109.5bp 120bp ($525,000) ($500,000) Stop-out 6/7/2012 8/30/2012 Relative Value Short 5y - US - 30y spread $50k dv01 13.15bp 8.4bp $237,500 ($250,000) Unwound 10/11/2012 10/18/2012 Long duration Receive 3y1y $50k dv01 103.25bp 116.9bp ($500,000) ($500,000) Stop-out 9/13/2012 11/23/2012 Relative Value Long 11/23/12 -> Aug '19 vs short TYZ2 C "$130mn: (1000) 0 $684,000 $684,000 ($500,000) Expired 133 9/7/2012 1/4/2013 Spread Curve Flattener 5y - 10y spread curve flattener $100k dv01 -7.2bp 263bp ($130,000) ($500,000) Unwound 9/13/2012 1/4/2013 Macro 30y Spread widener $50k dv01 -22.5bp -20.5bp $100,000 ($500,000) Unwound 10/11/2012 1/4/2013 Flattener Pay 3y1y Rec 5y9y $50k dv01 237bp 263bp ($500,000) ($500,000) Stop-out 2/14/2013 2/1/2013 7y auction concession unwind Long dv01 weighted OTR7y TYH3 basis $100mn/820 TYH3 cts -260.1 -260.5 ($9,000) ($500,000) Unwound 2/14/2013 4/5/2013 UK v US steepener UK 10s-30s steepener against US flattener 100K DV01 6bp 16bp $1,000,000 ($500,000) Unwound 4/18/2013 5/3/2013 Cross mkt relative value Sell 10y France vs eq wgt US and Japan $50k dv01 64.8 54.8 ($300,000) ($300,000) Stop out JPY Swaps 2/14/2013 1/24/2013 Pause in one-way steepening in Long 1yx10y straddle vs. 1yx20y straddle $120mn -60 -43 $204,000 ($250,000) Unwound long end 2/5/2013 Volatility and rates are both high Short 1yx8y ATM+10bp payers USD60mn -92 -90 $12,000 ($150,000) Unwound 5/18/2012 5/25/2012 Fade excessive bull-flattening 6x2-8x2 steepener $120k dv01 48.75bp 50.5bp $210,000 ($450,000) Unwound 5/24/2012 6/7/2012 Calendar Roll Short calendar spread (JBM2-JBU2) 100 contracts 20 ticks 18 ticks $26,000 ($12,500) Unwound 5/18/2012 6/21/2012 Good carry trade with stable front 6mx1y pay $60k dv01 -53bp -44bp $540,000 ($420,000) Unwound end. 6/14/2012 6/21/2012 Tactical 5y5y-10y10y flattener $60k dv01 99.5bp 104bp ($270,000) ($120,000) Stop-out 6/7/2012 7/6/2012 Long spreads Long 30y swap spread $30k dv01 19bp 18.8bp ($6,000) ($120,000) Unwound 5/22/2012 7/20/2012 Long spreads Long 20Y swap spread $60kdv01 11.4 12.3 ($54,000) ($400,000) Unwound 30 May 2013 51 Barclays | Global Rates Weekly Trades Unwound (continued) Inception Unwound Weights/Notional Levels @ Levels @ Net Change (Gain Total Stop Date Date Theme Trade Amount Inception Unwind (+) /Loss (-)) Loss (bp) Horizon JPY Swaps 7/13/2012 7/20/2012 Long spreads Reestablish 30Y swap spread $30k dv01 21.2bp 20bp $36,000 ($54,000) Unwound 7/19/2012 7/25/2012 Long spreads Short 20y swap spread vs 10y10y (1:3 ) $60kdv01 84.4bp 86.9bp $150,000 ($200,000) Unwound 6/14/2012 7/26/2012 Tactical Short 7Y (future) swap spread $60k dv01 -9.1bp -8.5bp $36,000 ($144,000) Unwound 7/6/2012 7/26/2012 Carry Long 6Y swap spread $120kdv01 -16.1bp -12.7bp ($408,000) ($300,000) Stop-out 8/3/2012 8/16/2012 Tactical pay 1y1y swap $75k dv01 -26.1bp -29bp $218,000 ($300,000) Unwound 8/9/2012 8/16/2012 Relative Value long 30y swap spread and receive 20yx10y at $100k dv01 123.13 123 $13,000 ($300,000) Unwound 2:1 7/20/2012 9/14/2012 Carry Receive USD/JPY Xccy basis 6yx2y vs. 4yx1y $60kdv01 7 -11.7 $1,120,000 ($360,000) Unwound 8/3/2012 9/28/2012 Tactical long 8y swap spread $120k dv01 -5.75bp -5.2bp ($62,000) ($300,000) Unwound 8/31/2012 10/5/2012 Relative Value short swap 7s10s20s $100k dv01 -42.125 -44.5 ($238,000) ($300,000) Unwound 9/14/2012 10/5/2012 Tactical pay 3yx5y Xccy basis $40k dv01 -83 -57 $1,040,000 ($400,000) Unwound 9/21/2012 10/11/2012 Limited rally in 10s Sell 1mx10y receiver spread $40mn -28cts -32cts ($16,000) ($100,000) Unwound 10/5/2012 11/8/2012 Tactical 10y10y - 20y10y steepener $60k dv01 -26bp -18bp $48,000 ($50,000) Unwound 11/7/2012 11/15/2012 Relative Value Swaps 5s10s flattener 120k DV01 44.75 42 $33,000 ($250,000) Unwound 8/31/2012 11/29/2012 Macro long 30y swap spread $60k dv01 21 15.3 $342,000 ($200,000) Unwound 11/7/2012 12/21/2012 Rate Directionality Pay 5y vs 3m Libor 60k DV01 21.5 21 ($3,000) ($150,000) Unwound 9/28/2012 12/28/2012 hedge to overall portfolio Long receiver fly 3mx10y (0.72-0.77-0.82%) $40mn 8cts 17cts $36,000 ($50,000) Expired 11/1/2012 1/7/2013 Carry Trade Sell 1y1y ATM receiver USD40mn -6 -8 ($8,000) ($100,000) Unwound 12/7/2012 1/7/2013 Hedge to short 1y1y long 30y swap spread $60k dv01 14.3 -1 $918,000 ($200,000) Unwound 1/7/2013 1/17/2013 5s swap spread too rich 5s7s box spread $120k dv01 7.5 6.9 ($60,000) ($400,000) Unwound 1/23/2013 2/28/2013 Pause in easing speculaion Swap 20s30s box (20y long) $80k dv01 -7 -4.6 $232,000 ($500,000) Unwound 1/17/2013 3/8/2013 Carry short 5x5, long 10x10, short 20x10 $60k dv01 -149 -140 $360,000 ($250,000) Unwound 2/5/2013 3/8/2013 Volatility Short 1yx8y ATM+10bp payers $60mn -92 -62 $180,000 ($150,000) Unwound 10/18/2012 3/21/2013 Widener 2y Tibor 6v1 widener $120k dv01 19 19.2 $24,000 ($400,000) Unwound 2/7/2013 3/28/2013 Volatility and Rates Short 1yx8y ATM straddle with 5x2 long $30mn -235 -202 $99,000 ($150,000) Unwound Volatility is high for 20y tail vs. Short 1mx20y (ATM+20bp) payers vs. long 3/28/2013 4/25/2013 100mn -5 0 $50,000 ($200,000) Expired 10y tail 1mx10y (ATM+15bp) payers 4/11/2013 4/25/2013 Swap 5s10s steepner Swap 5s10s steepner $60k dv01 35 37 $120,000 ($450,000) Unwound 4/24/2013 5/16/2013 Dip buying under slowed 2s5s flattener $60k dv01 11.5 25 ($450,000) ($450,000) Stop out economic fundamentals 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 $100mn: (2400) ($100,000) $700,000 $800,000 ($500,000) Unwound short 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 30 May 2013 52 Barclays | Global Rates Weekly Trades Unwound (continued) Inception Unwound Weights/Notional Levels @ Levels @ Net Change (Gain Total Stop Date Date Theme Trade Amount Inception Unwind (+) /Loss (-)) Loss (bp) Horizon US Options 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 11/4/2011 2/6/2012 Sell US Gamma Sell 3m*10y straddles $10mn ($431,000) ($233,000) $198,000 ($250,000) Expired 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 11/17/2011 2/17/2012 Sell US Gamma Sell 3m*10y straddles $10mn ($440,000) ($134,000) $306,000 ($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 12/2/2011 3/2/2012 Sell US Gamma Sell 3m*10y straddles $10mn ($393,000) ($259,000) $134,000 ($250,000) 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 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) 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 3/9/2012 5/17/2012 Sell US Gamma Sell TYM2 straddles 100 ($245,313) ($320,313) ($75,000) ($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 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 1/26/2012 5/25/2012 Cross -currency Long EUR 4m*7y vs TYM2 straddles EUR 10mn: (100) ($20,000) $160,000 $180,000 ($500,000) Expired 4/13/2012 6/1/2012 Higher rates Buy EUR 3m*5y payer 1.55% KO 2.05% EUR 100mn $560,000 $50,000 ($510,000) ($500,000) Stop-out 1/6/2012 6/21/2012 Eurozone Contagion Long 6m1y payer spread vs. short 6m7y payer $490mn: ($100mn) ($340,000) 0 $340,000 ($500,000) Unwound spread 2/17/2011 7/12/2012 Relative Value Buy 3y*10y payer @ 5% Sell 3y SL 10y CMS $50mn: ($350mn) ($100,000) 0 $100,000 ($500,000) Unwound Cap @ 5% 8/18/2011 7/12/2012 Eurozone contagion Long 1y2y payer spread vs 1y10y payer spread $90mn: $20mn ($130,000) $10,000 $140,000 ($500,000) Unwound 2/3/2012 7/12/2012 Eurozone contagion Long 1y1y payer spread (0.55% vs 1.05%) $100mn $105,000 $55,000 ($50,000) ($50,000) Unwound 6/15/2012 7/12/2012 Eurozone contagion 1m*10y vs 1m*30y bull flattener ($116.5mn):$50mn 0 ($510,000) ($510,000) ($500,000) Stop-out 4/20/2012 7/26/2012 Long EUR vs. US gamma Long EUR 4m*7y std vs. TYU2 std EUR 50mn: (750) ($945,000) ($1,495,000) ($550,000) ($500,000) Stop-out 4/26/2012 7/26/2012 Relative Value Long 1y5y straddles vs 3EM2 straddles; sold $100mn:(2000) ($250,000) ($10,000) $240,000 ($500,000) Unwound 3EU2 straddles for $1.75mn 30 May 2013 53 Barclays | Global Rates Weekly Trades Unwound (continued) Inception Unwound Weights/Notional Levels @ Levels @ Net Change (Gain Total Stop Date Date Theme Trade Amount Inception Unwind (+) /Loss (-)) Loss (bp) Horizon US Options 6/28/2012 7/26/2012 Short vol Short 1y*10y straddles ($20mn) ($1,260,000) ($1,560,000) ($300,000) ($250,000) Stop-out 5/18/2012 8/3/2012 Eurozone contagion Buy 1y*30y flr 2.25% vs 3m*30y flr 2.25% $200mn: ($200mn) $350,000 $1,090,000 $740,000 ($250,000) Unwound 7/12/2012 8/3/2012 Eurozone contagion Long USU2 156-157 Call spread (digital floor) 3000 contracts $515,625 $195,625 ($320,000) ($250,000) Stop-out 8/9/2012 9/13/2012 Tactical 3m*10y vs 3m*30y bull steepener $117mn: ($50mn) 0 $725,000 $725,000 ($500,000) Unwound 9/7/2012 9/20/2012 Steepener 1y*7y vs 1y*30y bull steepener $63mn: ($20mn) 0 $90,000 $90,000 ($500,000) Unwound 9/20/2012 11/23/2012 Relative Value Short TYZ2 straddles vs 11/23-12 -> 7y +$100mn: (820 ($250,000) ($70,000) $180,000 ($500,000) Expired swaption straddles contracts) 10/23/2012 11/23/2012 Election Long FVZ2 straddles: strike 124 1000 contracts 671,875 781,875 $110,000 ($200,000) Expired 5/24/2012 11/29/2012 Short vol Short 1y*10y straddles vs. long 1y1y payer ($20mn): $200mn ($1,160,000) ($1,015,000) $145,000 Unwound spread 1- 1.25 6/7/2012 11/29/2012 Short vol Short 1y*10y straddles ($50mn) ($3,250,000) ($2,350,000) $900,000 Unwound 11/15/2012 12/11/2012 unwind fvz2 std Short FVZ2 to hedge the long FVZ2 124 1000 124-25 124-25+ $0 Unwound straddles 1/15/2009 12/13/2012 Longer Rates could Rise Buy 5y*10yr Payr Spd (ATM vs 100 bp high), $100mm: - $100mm ($1,924,000) ($1,910,000) $14,000 ($250,000) Unwound added the short CMS cap @ 5% on 7/2/10 ; sell 6w*10y payer @ 2.75% on Nov 10 '11 2/9/2012 12/13/2012 Hike expectations Long 1y*1y - 1y*3y - 1y*5y payer fly ($300mn): $200mn: ($30,000) ($3,000) $27,000 ($500,000) Unwound ($60mn) 5/25/2012 12/13/2012 Short vol Short 2y*10y straddles ($20mn) ($1,830,000) ($1,465,000) $365,000 Unwound 6/21/2012 12/13/2012 Short vol Short 2y*10y straddles ($20mn) ($1,800,000) ($1,445,000) $355,000 ($1,000,000) Unwound 8/16/2012 12/13/2012 Short vol Short 2y*10y straddles ($10mn) ($935,000) ($805,000) $130,000 Unwound 10/23/2012 1/4/2013 Election volatility Long 220mn 2m*5y ATM payer vs. 50mn 220mn:(50mn) ($580,000) ($725,000) ($145,000) ($200,000) Expired 2m*30y ATM payer 1/4/2013 4/5/2013 Tactical 3m*7y vs 3m*30y bear flattener +$75mn:($25mn) ($110,000) $0 $110,000 ($500,000) Expired -491bp: -330bp: $300,000 3/27/2013 4/11/2013 Front end looks cheap Long Jul13s energy hedged $200mn:65 XBM3 ($500,000) Unwound 308.12 284.39 EUR Options 3/9/2012 12/13/2012 Capped steepener 2y5y vs 2y30y bear steepener, short 2y SL 5y- (EUR 90mn): EUR ($1,597,000) ($2,127,000) ($530,000) ($500,000) Stop-out 30y curve cap @ 75bp 20mn: (EUR 400mn) 6/1/2012 5/3/2013 Short vol EUR 1x2 1y5y 1.25 vs 1 recr ladder EUR 20mn: (40mn) 0 $0 $0 ($250,000) Unwound EUR 100mn: (200mn): 2/1/2013 5/3/2013 Low for long 6m5y 1x2x1 1.3 - 0.95 - 0.7 recr fly $650,000 $1,090,000 $440,000 ($250,000) Unwound 100mn JPY Options 5/30/2012 6/29/2012 Higher rates Sell 1m*20y receiver spread $27mn 41cts 20cts $110,700 ($225,000) Unwound 6/28/2012 7/20/2012 Tactical 1m*10y risk reversal (long payers) $80mn notional 0 cts -38 cts ($304,000) ($160,000) Stop-out 7/6/2012 10/5/2012 Relative Value Long 6mx10y 1x2 payers $80mn notional -26cts 1.8cts $222,000 ($200,000) Unwound 10/25/2012 11/15/2012 Tactical Conditional 10s20s flattener 80mn -8 0 $64,000 ($200,000) Unwound 7/13/2012 12/7/2012 Long vol Long JPY 5y5y OTM recr , delta hedged with $80mn notional 80cts 121cts $328,000 ($160,000) Unwound 10y swap 30 May 2013 54 Barclays | Global Rates Weekly Trades Unwound (continued) Inception Unwound Weights/Notional Levels @ Levels @ Net Change (Gain Total Stop Date Date Theme Trade Amount Inception Unwind (+) /Loss (-)) Loss (bp) Horizon JPY Options 11/29/2012 1/17/2013 Bear flattener ATM+10bp 6mx5y payer long vs. 6mx10y $100mn -10 -7 $30,000 ($200,000) Unwound payer short 1/10/2013 1/24/2013 Low vol sell 1mx10y receiver (0.8% at 20 sen) $80mn -20 -43 ($24,000) ($200,000) Stop-out 1/10/2013 1/24/2013 Low vol sell 3mx20y receiver (1.65% at 74 sen) $50mn -74 120 ($15,000) ($200,000) Stop-out 11/28/2012 3/28/2013 Volsurface is too flat Long 10yx10y straddle vs. 5yx5y straddle $120mm 88 96 $96,000 ($250,000) Unwound Cross-currency 5/4/2012 6/28/2012 Tactical Long EUR 6m*2y payer vs GBP 6m*2y payer EUR 100mn 0 $135,000 $135,000 ($250,000) Unwound :(GBP82mn) 8/17/2012 10/25/2012 Tactical Receive USD/JPY Xccy basis 20yx10y $30k dv01 53bp 29bp $720,000 ($200,000) Unwound 9/21/2012 11/23/2012 US vs EUR gamma Long RXZ2 std vs. TYZ2 std +500: (860) $300,000 $663,000 $363,000 ($500,000) Expired 10/15/2009 12/13/2012 Cross -currency Short 5x10 US caps @ 8% vs Long 5x10 EUR ($75mm): EUR 50mm ($200,000) $65,000 $265,000 ($500,000) Unwound caps @ 5% 2/3/2012 12/13/2012 Cross -currency Long EUR 3y10y P @ 4% vs USD 3y10y P @ EUR 10mn: (13mn) ($90,000) ($80,000) $10,000 ($500,000) Unwound 4% 11/29/2012 2/28/2013 EUR vs US Long RXH3 std 144.5 vs short TYH3 std 133.5 +400: (740) $100,000 ($720,000) ($820,000) ($1,000,000) Stop-out 12/21/2012 3/7/2012 USD funding supplied via MoF Pay 8y Xccy basis $40k dv01 -66.5 -55 $460,000 ($400,000) Unwound program 2/28/2013 3/7/2013 JPY long end is too rich vs. USD short 10yx10y JPY swap vs. USD (beta = 0.4) usd 40 k dv01 107 97 ($400,000) ($400,000) Stop-out Source: Barclays Research 30 May 2013 55 Barclays | Global Rates Weekly GLOBAL SUPPLY CALENDAR Country Bond Coupon Maturity Size - bn Euro Area Jun-13 Spain New 15y 4.00 Jun-13 Belgium New 30y 4.00 04-Jun-13 Austria 4y RAGB 4.30% 15-Sep-17 0.72 04-Jun-13 Austria 10y RAGB 1.95% 20-Oct-23 0.72 05-Jun-13 Germany 5y OBL Auction 0.25% 13-Apr-18 4.000 06-Jun-13 Spain 2y SPGB 2.75% 31-Mar-15 1.50 06-Jun-13 Spain 3y SPGB 3.30% 30-Jul-16 1.50 06-Jun-13 Spain 30y SPGB 4.70% 30-Apr-41 1.00 06-Jun-13 France 10y OAT 1.75% 25-May-23 4.00 06-Jun-13 France 15y OAT 2.75% 25-Oct-27 2.00 06-Jun-13 France 30y OAT 3.25% 25-May-45 1.00 11-Jun-13 Holland 3y DSL Tap (range 2.5-3.5bn) 15-Apr-16 3.50 12-Jun-13 Germany 2y Schatz Auction 12-Jun-15 5.00 13-Jun-13 Italy 3yr BTP Auction 2.25% 15-May-16 3.00 13-Jun-13 Italy 5yr CCT Auction FRN 01-Nov-18 1.00 13-Jun-13 Italy 30y BTP 1.50 18-Jun-13 Ireland 5y IRISH 5.50% 18-Oct-17 0.25 18-Jun-13 Ireland 10y IRISH 3.90% 20-Mar-23 0.25 19-Jun-13 Germany 10y Bund Auction 15-May-23 5.00 20-Jun-13 Spain 5y SPGB 4.50% 31-Jan-18 1.25 20-Jun-13 Spain 10y SPGB 5.40% 31-Jan-23 2.00 20-Jun-13 Spain 15y SPGB 1.00 20-Jun-13 France 5yr BTAN 1.00% 25-May-18 3.50 20-Jun-13 France 2yr BTAN 0.25% 01-Nov-15 3.00 20-Jun-13 France 2yr BTAN 1.00% 25-Oct-16 1.50 20-Jun-13 France OATi/ei auctions 0.25% 25-Jul-27 0.60 24-Jun-13 Belgium BGB Auctions? 27-Jun-13 Italy BTPei Linker Auction 1.00 27-Jun-13 Italy 5yr BTP Auction 3.50% 01-Jun-18 3.00 27-Jun-13 Italy 10yr BTP Auction 4.50% 01-May-23 3.00 Japan 04-Jun-13 Japan 10y JGB Auction 2400 06-Jun-13 Japan 30y JGB Auction 500 12-Jun-13 Japan Liquidity Enhancement Auction 300 14-Jun-13 Japan 5y JGB Auction 2700 18-Jun-13 Japan 20y JGB Auction 1200 25-Jun-13 Japan Liquidity Enhancement Auction 300 27-Jun-13 Japan 2y JGB Auction 2900 UK 04-Jun-13 UK 2024 Linker Auction 1.50 11-Jun-13 UK New 2023 Gilt 3.50 13-Jun-13 UK 2032 Gilt Auction 2.50 Jun-13 UK New 50-60y Syndicated Gilt 4.00 20-Jun-13 UK 2018 Gilt Auction 4.50 US 11-Jun-13 US 3y Note Auction 32 12-Jun-13 US 10y Note Auction 21 13-Jun-13 US 30y Bond Auction 13 20-Jun-13 US 30y TIPs Auction 7 25-Jun-13 US 2y Note Auction 35 26-Jun-13 US 5y Note Auction 35 27-Jun-13 US 7y Note Auction 29 Unconfirmed Barclays Capital Estimate Rich Cheap Source: Barclays Research 30 May 2013 56 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 Q2 13 0.00-0.25 0.25 0.20 0.75 1.80 3.00 -0.75 Q2 13 15 15 10 -15 Q3 13 0.00-0.25 0.25 0.20 0.75 1.80 3.00 -0.80 Q3 13 15 15 10 -10 Q4 13 0.00-0.25 0.20 0.25 0.80 2.00 3.15 -0.65 Q4 13 15 15 10 -5 Q1 14 0.00-0.25 0.20 0.30 0.90 2.00 3.15 -0.75 Q1 14 15 15 10 -5 Euro government (Germany) Euro area swap spreads Refi rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y Q2 13 0.50 0.15 0.00 0.40 1.40 2.20 -0.15 Q2 13 32 35 25 7 Q3 13 0.50 0.15 0.05 0.55 1.60 2.35 -0.10 Q3 13 32 35 25 7 Q4 13 0.50 0.15 0.10 0.60 1.70 2.40 -0.10 Q4 13 32 35 25 7 Q1 14 0.50 0.15 0.20 0.75 1.85 2.50 0 Q1 14 32 35 25 7 UK government UK swap spreads Bank rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y Q2 13 0.50 0.50 0.30 1.00 2.00 3.15 -1.35 Q2 13 40 15 10 -15 Q3 13 0.50 0.50 0.35 1.10 2.10 3.20 -1.30 Q3 13 40 15 10 -15 Q4 13 0.50 0.50 0.40 1.20 2.20 3.30 -1.25 Q4 13 35 10 5 -10 Q1 14 0.50 0.50 0.45 1.30 2.30 3.35 -1.15 Q4 14 35 10 0 -10 Japan government Japan swap spreads Official rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y Q2 13 0.10 0. 23 0.12 0.30 0.80 1.75 0.00 Q2 13 15 12 1 -4 Q3 13 0.10 0. 23 0.12 0.35 0.85 1.80 0.00 Q3 13 15 13 2 -10 Q4 13 0.10 0.23 0.11 0.25 0.70 1.70 0.10 Q4 13 15 13 3 -10 Q1 14 0.10 0.23 0.11 0.20 0.55 1.60 0.10 Q1 14 15 13 3 -10 Source: Barclays Research 30 May 2013 57 Barclays | Global Rates Weekly GLOBAL RATES RESEARCH Global Ajay Rajadhyaksha Co-Head of FICC Research +1 212 412 7669 firstname.lastname@example.org 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 email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org Amrut Nashikkar Michael Pond Anshul Pradhan Rajiv Setia Fixed Income Strategy Head of Global Inflation-Linked Treasury Strategy Head of US Rates Research +1 212 412 1848 Research +1 212 412 3681 +1 212 412 5507 email@example.com +1 212 412 5051 firstname.lastname@example.org email@example.com firstname.lastname@example.org Vivek Shukla Fixed Income Strategy +1 212 412 2532 email@example.com Europe Laurent Fransolet Cagdas Aksu Fritz Engelhard Jussi Harju Head of European FICC Research European Strategy German Head of Strategy European Strategy and European Rates Strategy +44 (0)20 7773 5788 +49 69-7161 1725 +49 69 7161 1781 +44 (0)20 7773 8385 firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com Moyeen Islam Sreekala Kochugovindan Giuseppe Maraffino Mikael Nilsson Fixed Income Strategy Asset Allocation Strategy Fixed Income Strategy Fixed Income Strategy +44 (0)20 777 34675 +44 (0)20 7773 2234 +44 (0)20 313 49938 +44 (0)20 7773 6057 firstname.lastname@example.org sreekala.kochugovindan@ email@example.com firstname.lastname@example.org barclays.com Hitendra Rohra Michaela Seimen Henry Skeoch Khrishnamoorthy Sooben Fixed Income Strategy SSA & Covered Bond Strategy Inflation-Linked Strategy Inflation-Linked Strategy +44 (0)20 7773 4817 +44 (0) 20 3134 0134 +44 (0)20 777 37917 +44 (0)20 7773 7514 email@example.com firstname.lastname@example.org email@example.com khrishnamoorthy.sooben@ barclays.com Huw Worthington European Strategy +44 (0)20 7773 1307 firstname.lastname@example.org Asia Pacific Igor Arsenin Chotaro Morita Reiko Tokukatsu Head of Fixed Income Strategy Head of Fixed Income Strategy Senior Fixed Income Strategist, Research, Emerging Asia Research, Japan Japan +65 6308 2801 +81 3 4530 1717 +81 3 4530 1532 email@example.com firstname.lastname@example.org email@example.com For any questions about Barclays Live for Rates, please contact: Jason Howell Amy Mignosi +1 212 412 6706 +44 (0)20 3134 9774 firstname.lastname@example.org email@example.com 30 May 2013 58 Analyst Certification We, Laurent Fransolet, Amrut Nashikkar, Rajiv Setia, Giuseppe Maraffino, Piyush Goyal, Anshul Pradhan, Vivek Shukla, Chirag Mirani, Michael Pond, Joseph Abate, Cagdas Aksu, Huw Worthington, Moyeen Islam, Fritz Engelhard, Jussi Harju, CFA, Michaela Seimen Howat, Mikael Nilsson Rosell, Henry Skeoch, Chotaro Morita, Noriatsu Tanji and Reiko Tokukatsu, CFA, hereby certify (1) that the views expressed in this research report accurately reflect 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