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					Fixed Income

                              10 December 2010

                              Fixed Income Outlook 2011                                                                Special Report
                                                                                                                        Table of Contents

                              How much is too much?                                                                    Executive Summary.......................................... Page 03
                                                                                                                       Bond Market Strategy ...................................... Page 04
Global Markets Research

                                                                                                                       US ..................................................................... Page 15
                                                                                                                       Euroland............................................................ Page 40
                                                                                                                       UK Outlook ....................................................... Page 78
                                                                                                                       Japan ................................................................ Page 82
                                                                                                                       EM ................................................................... Page 90
                                                                                                                       Dollar Bloc Strategy........................................ Page 105
                                                                                                                       Linkers ........................................................... Page 112

                                                                                                                        Research Team
Fixed Income Relative Value

                                                                                                                       Dominic Konstam
                                                                                                                       Research Analyst
                                                                                                                       (+1) 212 250-9753

                                                                                                                       Mustafa Chowdhury
                                                                                                                       Research Analyst
                                                                                                                       (+1) 212 250-7540

                                                                                                                       Francis Yared
                                                                                                                       (+44) 020 754-54017

                              Deutsche Bank AG/London
                              All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
                              exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche
                              Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm
                              may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
                              factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.
                              MICA(P) 007/05/2010
10 December 2010    Fixed Income Outlook 2011

                               Executive Summary
                                   We expect the normalisation of risk premia in the US bond market that resumed in
                                   November of this year to continue into Q1 of next year. The risks of deflation have
                                   receded further, especially after the additional rounds of QE and tax cuts. The
                                   fiscal stimulus should trigger some improvements in the job market and
                                   consolidate the rebound in inflation we are expecting. Under such conditions, the
                                   Fed is unlikely to extend QE unless it is forced to do so by the bond market

                                   However, beyond the first half of 2011, the outlook remains contingent on data as
                                   the economy works its way through many headwinds. Stretched US household
                                   balance sheets, impaired credit markets, elevated unemployment as well risk
                                   aversion stemming from Europe could all support US fixed income markets

                                   The dynamics of Euro Area in 2010 has been a reflection of wasted opportunities
                                   to deal with the problems of a 16 country monetary union combined with a 16-
                                   country fiscal dis-union. Political differences, a reactive rather than pro-active
                                   policy response function and a missed opportunity in terms of bank stress tests
                                   have compounded peripheral woes and reduced the effectiveness of various
                                   rescue measures announced so far

                                   Our outlook for Europe in 2011 is characterized by a muddle through approach but
                                   with contained systemic risks. A convincing solution to Euro Area problems is
                                   unlikely in 2011: Political and legal risks make a full fiscal union or Euro-bonds
                                   practically unviable, restructuring of either the sovereign or senior bond holders is
                                   fraught with contagion risks and there is little incentive for either a strong or a
                                   weaker country to leave the Euro Area

                                   The key differentiator between a near term uncertain outlook and a medium term
                                   ‘systemic risks contained’ view is Spain. Given the low debt to GDP levels, the
                                   Spanish debt trajectory remains sustainable even after accounting for capital
                                   injections in the banking sector

                                   The ECB’s reaction function is likely to reflect the growing divergence between
                                   core and non core economies. While liquidity measures are required for the
                                   weaker peripherals, rates appear too low for core countries. We expect the ECB to
                                   start hiking rates June 2011, while maintaining the safety net of unlimited 1W

                                   In the US, a 2Y10Y steepener and long front end breakevens are our strongest
                                   conviction calls for Q1 2011. In Europe, we favour a EUR 2Y10Y swap flattener,
                                   short France vs Germany and on ASW, short Portugal vs Ireland and Spain, short
                                   front end Euribors, long breakevens and long gamma positions in the 5Y sector

                                   In the UK, we expect an unwind of the risk premium built into the curve with the
                                   long end outperforming. The fiscal consolidation measures enacted in the UK
                                   should also result in the outperformance of UK rates versus both the US and core
                                   European countries. In addition, we favour long breakevens in the 5Y sector

                                   In EM, differentiation between countries forms the main investment theme. We
                                   favour long/neutral positions in LatAm versus short positions in Asia rates.
                                   Inflation risks in Asian economies should remain manageable with the possible
                                   exception of China where aggressive policy action in response to inflation risks
                                   could result in a hard landing of the economy

                               The next regular Fixed Income Weekly would be published on 7th January. We wish all
                                                           our readers Happy Holidays!

Deutsche Bank AG/London                                                                                           Page 3
10 December 2010    Fixed Income Outlook 2011

Bond Market Strategy
    In our 2010 outlook, we expected a repricing of             We are constructive on breakevens globally,
    sovereign risk for twin deficits countries and              particularly at the front end as short term
    receding deflation concerns in the US and the UK.           deflation risks should be priced out in the US and
    One year on, the issues and uncertainties                   the UK as well as in core euro-area countries
    weighing on financial markets are essentially the
    same                                                    Back to square one
    We expect Europe to continue to muddle through.
                                                            In our 2010 outlook, we expected sovereign risk to move
    A convincing solution to the euro area problems is
                                                            into focus and the risk premium for twin deficits countries
    unlikely in 2011: We believe political and legal
                                                            to reprice. We also expected deflation concerns to recede
    risks make a full fiscal union or Euro-bonds
                                                            in the US and the UK on the back of a decent recovery
    practically unviable, restructuring of either the
                                                            and a strong anti-deflation policy bias. In Europe, amongst
    sovereign or senior bank debt is fraught with
                                                            the high risk countries, we expected Greece, Ireland,
    contagion risks and there is little incentive for
                                                            Portugal and Spain to underperform (in that order) and
    either a strong or a weaker country to leave the
                                                            France to underperform amongst the AAA countries. We
    euro area
                                                            also expected some normalisation of the risk premium in
    We recommend short France vs. swaps and short           the rates market with higher rates and steeper curves,
    Portugal vs. Ireland and Spain as twin deficit          especially in the US and UK.
    countries are expected to remain under pressure
                                                            This scenario played out in Q1 2010 with the Greek crisis
    The divergence in performance between the
                                                            forcing the repricing of peripheral spreads and fiscal
    German block and the periphery could force the
                                                            consolidation in Europe, while the risk premium in the
    ECB to adapt its monetary policy, raising the
                                                            Treasury and Gilt curves were rising. The repricing of
    policy rate while keeping some of the exceptional
                                                            sovereign risk in Europe persisted throughout the year
    liquidity measures in place. This argues for 2Y-10Y
                                                            broadly in line with our twin deficits metric. However, in
    flatteners in EUR. The near term environment of
                                                            Q2, the rates outlook shifted in the UK and the US. In the
    heightened uncertainty favours long gamma
                                                            UK, the fear of a Greece-type outcome and a favourable
    positions on 5Y tenor
                                                            political cycle, led to a significant shift in fiscal policy
    In the US, notwithstanding the current low level        which was tightened pre-emptively. In the US, the political
    of core inflation, the risks of deflation have          environment led to a fiscal stalemate that lasted until after
    receded further, especially after the additional        the mid-term elections. The resulting fiscal tightening
    rounds of QE and tax cuts. We, therefore, expect        unveiled some fragility in the recovery which had to be
    the recent normalisation of risk premia in the          compensated by more aggressive monetary policy and
    bond market to continue early into next year            the delivery of additional QE from the Fed exacerbating
                                                            the rally in yields.
    Beyond H1 2011, the outlook is more uncertain
    and likely will ultimately depend upon the
                                                            One year on, the issues and uncertainties that are
    strength of the recovery and the policy mix.
                                                            weighing on financial markets are essentially the same.
    Deflation is neither politically nor economically       The concerns about sovereign risk in Europe remain as
    attractive for a current account deficit country like   the design flaws of the European project (monetary union
    the US and the strong anti-deflation policy bias        without fiscal union) are laid bare without being
    will likely prevail. Given that the Fed remains         convincingly addressed by the EU. These concerns are
    firmly anchored, a 2Y-10Y steepener is our highest      further compounded by the reluctance of the ECB to
    conviction trade in the US for now                      implement sizable credit easing and the missed
                                                            opportunity for EU sovereigns to properly and credibly
    The situation in the UK compares favourably with
                                                            recapitalise the European banking system. The strength
    the US and Europe. The UK has the “benefit” of a
                                                            and resilience of the US recovery remains debated, and
    high level of inflation while it has initiated a
                                                            deflation remains a concern for some, with core inflation
    credible fiscal tightening effort. We expect the
                                                            at multi-decade lows.
    long end of the Gilt market to outperform core
    Europe and the Gilt curve to flatten

Page 4                                                                                         Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

We expect Europe to continue to muddle through, with            the bond market which is likely to test 3.50% as the
liquidity being provided by the ECB and the EFSF/IMF. As        market prices higher deficits and less QE. Given that the
long as Spanish finances are deemed to be sustainable,          Fed remains firmly anchored, a 2Y-10Y steepener is our
the economic cost benefit analysis argues for the               highest conviction trade in the US for now.
provision of further cross-support, the contour of which
still needs to be defined. In the meantime, the market is       The twin deficits position of the US is underpriced 1
likely to test the resolve of Europe and force the ECB to
                                                                   30%                      B o nd index
provide enough credit and liquidity support to contain                                      returns in USD
                                                                   25%                                                                           US
systemic risk. Given the divergence in performance
                                                                   20%                                                      FR
between the German block and the periphery, the ECB is                                                   EU
likely to have to adapt it monetary policy and raise the
policy rate while keeping some of the exceptional liquidity        10%

measures in place. We expect the euro curve to bear                 5%                                                 UK

flatten, and see France and Portugal as rich vs. other              0%
European credit.                                                   -5%                       y = -0.03x + 0.23
                                                                                                 R 2 = 0.69
We expect the normalisation of risk premia in the bond             -15%
market that resumed in November of this year to continue                                                                             Twin deficit metric
early into next year. Notwithstanding the low level of core               -2            0            2             4             6           8             10
inflation today, the risks of deflation have receded further,
                                                                Source: Deutsche Bank, IMF, Bloomberg Finance LP
especially after the additional rounds of QE and tax cuts.
Indeed, referring back to Bernanke’s seminal 2002               In contrast to last year, the situation in the UK today
deflation speech, the combination of QE and tax cuts have       compares favourably with the US and Europe. The UK has
reproduced a little less than USD1trn of Friedman’s             the “benefit” of a high level of inflation while it has
“helicopter drop” of money. Second, prior to accounting         initiated a credible fiscal tightening effort. Moreover its
for the impact of the new fiscal stimulus, the general          currency has already significantly adjusted providing
improvement in the US data was consistent with 2.5-3%           further support for the economy. We expect the long end
GDP growth in 2011, enough to stabilise unemployment            of the Gilt market to outperform and the Gilt curve to
and core inflation. The fiscal stimulus should trigger some     flatten.
improvements in the job market and consolidate the
rebound in inflation we are expecting. Under such
conditions, and given the internal and external opposition      More Deficits Less QE = Steeper curve
to QE2, the Fed is unlikely to extend QE beyond June.           Looking through the new stimulus measures (which are
                                                                temporary in nature), the US economy was seemingly on
Beyond H1 2011, the outlook looks more uncertain and            track for a slow rebalancing from an inventory/fiscal
likely will ultimately depend upon the strength of the          stimulus led growth to a private demand led growth. The
recovery and the policy mix. The reality is that despite the    rapid pace of deleveraging highlighted in last year’s
recent rates sell-off, the US are still benefiting from the     outlook enabled the private sector to de-lever more slowly
USD status as a reserve currency as neither the USD nor         in 2010. As argued by our economists, a slower pace of
US rates are pricing a risk premium consistent with the         deleveraging is what matters to GDP growth and the pick
level of twin deficits in the US (see graph below).             up in the credit impulse (which measures the pace of
Something will have to adjust, fiscal policy, the USD or        change in net new lending) has delivered real private
interest rates? Fiscal policy is rarely pre-emptive, but the    demand of about 4-5% in Q2 and Q3.
expiry of stimulus measures implies a negative fiscal
impulse of about 3.0% in 2012 and it is as yet unclear to
what extent private demand will be able to compensate
for that. The twin deficits mix and the monetary policy
bias justify a higher risk premium than is currently priced.
However, this repricing may be limited by the continued
uncertainty in Europe.

Longer term, we continue to believe that deflation is
                                                                  The twin deficit metric is the simple average of the required fiscal
neither politically nor economically attractive for a current
                                                                adjustment as mentioned by the IMF in its Nov 2010 Fiscal Monitor and
account deficit country and that the strong anti-deflation      the 10Y average of current account balances. The bond index returns are
policy bias will prevail. For now, the ball is in the camp of   since calculated since July 2007 adjusted for changes in the FX

Deutsche Bank AG/London                                                                                                                               Page 5
10 December 2010                   Fixed Income Outlook 2011

Slower pace of deleveraging is consistent with 4-5%                                         deliver 4.25% nominal GDP, with upside risks from
real private demand                                                                         headline inflation, and prospects for some improvements
                                                                                            as the deleveraging process runs its course.
               % of GDP                   United States              % yoy            12
                                                                                            Against this backdrop, rates were too low relative to
    4                                                                                       fundamentals. This in itself is not surprising, as the whole
                                                                                      4     point of QE is to push government bonds above fair
    0                                                                                       valuation to crowd out private investors towards more
                                                                                      0     risky assets. The richness of the rates market can be
                                                                                            summarised in many ways. First, from a long term
   -8                                                                                 -4    perspective, the bond risk premium (10Y nominal yields
                     Quarterly credit impulse (lhs)                                         minus long term growth and inflation expectations) was at
  -12                                                                                 -8
                     Real consumption + investment (rhs)                                    historically low levels.
  -16                                                                                 -12
     1974 1978 1982 1986 1990 1994 1998 2002 2006 2010                                      The bond risk premium reached extremely low levels
                                                                                              2.5                                                                                 -4.5
Source: Deutsche Bank, Bloomberg Finance LP                                                                     USD B RP
                                                                                              2.0               Subsequent 1               0Y
                                                                                                                            8M change o f 1 UST yield (rhs, inverted)             -3.5
This level of private demand has enabled the US economy                                        1.5                                                                                -3.0
to grow at around 2.5%-3.0%, which is just about the                                                                                                                              -2.5
                                                                                               1.0                                                                                -2.0
level necessary to generate some mild job creation.
                                                                                              0.5                                                                                 -1.0
Level of growth just enough to generate mild job                                              0.0                                                                                 -0.5
creation                                                                                      -0.5                                                                                0.5
   900                       Change in P rivate P ayro lls (3M M A , lhs)                     -1.0
                                                                                      12                                                                                          1.5
   750                       US real GDP Qo Q (2Q M A rhs, in %)                                                                                                                  2.0
                                                                                      10      -1.5
   600                                                                                                                                                                            2.5
   450                                                                                        -2.0                                                                                3.0
                                                                                      6              00    01     02     03     04        05   06     07       08   09   10
   150                                                                                      Source: Deutsche Bank, Bloomberg Finance LP, Consensus Economics
      0                                                                               2

  -150                                                                                0
                                                                                            Second, from a shorter-term perspective, the richness of
  -300                                                                                -2
                                                                                            the rates market vs. fundamentals is evidenced by the
  -450                                                                                -4
                                                                                            disconnection between US economic surprises and the
  -750                                                                                -8
                                                                                            level of 10Y yields that was present until a few weeks ago
  -900                                                                                -10   (see chart below).
          75   78    81    84     87    90    93   96   99    02   05       08   11

Source: Deutsche Bank, Bloomberg Finance LP                                                 Rates were too low relative to fundamentals
                                                                                              6.5                                                                                   1
Notwithstanding the low level of core inflation, deflation
                                                                                                6                                                                                  100
risks have receded further. Both a bottom up and top
down analysis suggest that core inflation is likely to                                                                                                                             90
rebound from current depressed levels to end 2011 above                                         5
1.5% on y-o-y basis. More importantly, the combination of                                     4.5
tax cuts and additional QE has de-facto replicated close to                                                                                                                        70
USD 1trn of a “helicopter drop of money”, the ultimate                                                                                                                             60
tool to fight deflation. This increases the confidence that
inflation expectations should remain well anchored and                                          3
                                                                                                                        US 1 swap rate (lhs)
further reduce deflation risks. This assessment is now                                        2.5                       US Surprise Index
generally well reflected in the inflation market, where the                                     2                                                                                  30
inflation risk premium has normalized (see Global Linkers                                      M ay-02      Sep-03       Jan-05      Jun-06         Oct-07     M ar-09   Jul-10
for more details).                                                                          Source: Deutsche Bank, Bloomberg Finance LP

Thus, prior to the announcement of the new tax                                              The announcement of a compromise on the tax cut
measures, the US economy appeared to be on track to                                         extensions has precipitated some normalisation in the risk

Page 6                                                                                                                                               Deutsche Bank AG/London
10 December 2010                  Fixed Income Outlook 2011

premium in early December. The normalisation in the risk                          2Y-10Y forward curve is too flat
premium is particularly apparent in the long-end of the
                                                                                     100                                                     Out o f sample
curve, where the 5Y5Y bond risk premium (i.e. the 5Y5Y                                       Excess steepness
vs. the corresponding growth and inflation expectations),                                                                           Yield
is now back in line with the historical average since 1999.                                                                     co nundrum

The 5Y5Y bond risk premium has normalized towards
its historical averages since 1999                                                                                                                            -35bp
                                   Centered UST 5Y5Y B RP
   1.5%                                                                             -100
                                                                                    -125                 0Y
                                                                                                     2Y-1 vs. Fed Fund rate
                                                                                                     2Y-1 vs. Real Fed Fund rate and Deficit
                                                                                           97 98 99 00 01 02 03 04 05 06 07 08 09 10                     11
  0.0%                                                                            Source: Deutsche Bank, Bloomberg Finance LP


                                                                                  No fiscal union no systemic crisis =
                                                                                  muddle through and flatter curve in
          99   00     01    02    03     04    05    06     07     08   09   10   The cost of fiscal dis-union
Source: Deutsche Bank, Bloomberg Finance LP, Consensus Economics                  The dynamics in the Euro area is a reflection of a 16
                                                                                  country monetary union but a 16-country fiscal dis-union.
As evidenced by the 5Y5Y graph above, the bond risk                               Political differences, a reactive rather than pro-active
premium beyond the monetary policy horizon has mostly                             policy response function and a missed opportunity in
normalized. The twin deficits position of the US could very                       terms of bank stress tests have compounded peripheral
easily justify an above average risk premium and the 5Y5Y                         woes and reduced the effectiveness of the various rescue
yield remains about 40bp lower than long term                                     measures announced so far.
expectations of nominal growth in the US in absolute
terms. However, as discussed in the next section, the lack                        In aggregate, the euro area does not have a solvency
of decisive breakthrough in Europe should limit the extent                        issue. The euro-area 2011 budget deficit is expected to be
of such repricing.                                                                below 5% of GDP, vs. more than 9% in the US and 7% in
                                                                                  the UK. The euro area is expected to run a slight current
On the other hand, if the Fed is unlikely to extend QE, it                        account surplus in 2011 vs. a deficit of 4% in the US and
should not be inclined to signal any normalization of the                         0.7% in the UK. Unlike the US, the Eurozone has already
policy rates for now with core inflation only starting to                         embarked in a significant fiscal tightening effort.
normalize and significant fiscal deficit reductions ahead.
For reference, the Bank of England has tolerated core                             Clearly, we think the crisis could be resolved with a more
inflation above 2% and rising inflation expectations for                          explicit form of fiscal union. However, a fiscal union is
more than a year without tightening monetary policy.                              politically very difficult. The market is pricing these
                                                                                  political constraints, as the sum-of-the-part in Europe is
We expect 10Y UST to test 3.5% and potentially more if                            perceived as being significantly more risky than the whole.
the risk premium better reflects the current twin deficit                         The GDP-weighted 5Y CDS of the Eurozone which
mix. However, at current yield levels, we find it more                            currently stands at 170bp is more than 2.5x the CDS of
attractive to enter the year with 2Y-10Y steepeners on.                           the UK and 4x the CDS of the US. The 130bp difference
We think this trade will have a bearish bias, carry                               with the CDS of the US reflects the cost of the fiscal dis-
positively and should benefit from the gradual pricing out                        union.
of QE2 and an eventual repricing of the longer-term risk
premium. Moreover a model relating the slope of the                               Muddling through, the least bad option
curve to the level of deficits and real policy rate suggests                      If the fiscal union is difficult to envisage at this stage what
that the 1-year forward curve is about 35bp too flat.                             are the alternatives? One possibility would be for the ECB
                                                                                  to implement aggressive and large scale credit easing, if
                                                                                  not outright debt monetization. Another alternative would
                                                                                  see liquidity extended to the weaker countries, with the
                                                                                  hope that fiscal tightening and structural reforms will set

Deutsche Bank AG/London                                                                                                                                       Page 7
10 December 2010      Fixed Income Outlook 2011

them back on the path to fiscal sustainability. More drastic   at 1.50, and it is easily conceivable that the currency of
alternatives would see the countries that suffer a solvency    core countries would appreciate by at least 10% above
issue immediately restructure their debt, the ones             that level, if they chose to exit the euro-zone, especially in
suffering both a solvency and competitiveness issues           light of the policy mix implemented across the Atlantic.
restructuring their debt and exiting the monetary union,       This cost benefit analysis would change if Spain is
and countries suffering from a liquidity crisis being          deemed to suffer from a solvency rather than liquidity
extended large and credible lines of credit to bridge over     crisis.
their structural adjustments.
                                                               Third, the decision of restructuring debt is also based on a
The various solutions to the crisis that have been             cost benefit analysis. From a pure economics standpoint,
proposed so far span the range of possibilities discussed      it is unlikely that a restructuring will be chosen as long as
above: a joint bond issuance, an increase of the capacity      it threatens the contagion risks to other sovereigns, the
of the EFSF, subordinating the EFSF to existing                European banking system, and the ECB. This will likely be
bondholders, changing the mandate of the EFSF, orderly         difficult to achieve given the large cross border exposures
restructuring, voluntary default, full fiscal union, euro      in Europe.
break-up with either the weaker or stronger countries
leaving, more aggressive credit easing from the ECB,           Cross border exposure of banking system in
aggressive implementation of reforms and tightening of         Eurozone2
fiscal policy to name but a few.
                                                                 350                B anking system expo sure to Greece, Ireland,        25%
                                                                                    P o rtugal and Spain (USD bn)
The uncertainty around the form of the final resolution is                          A s % o f GDP
high as evidenced by the extent of the disagreement
amongst EU politicians aired over the last few weeks.
However, we believe a few guiding principles can help            200
narrow the range of likely outcomes and suggests that the
muddle through scenario in which the ECB and EFSF/IMF             150
provide liquidity to the weaker countries will be followed
for now.
First, any solution involving a major change to the Lisbon
                                                                    0                                                                    0%
treaty will likely carry so much political and
                                                                          AT      BE        FR   DE   GR    IE    IT    NL    PT    ES
implementation risk that it is unlikely to be credible. This
                                                               Source: Deutsche Bank, BIS
includes common bond issuance and full fiscal union (see
Euroland Sovereign Outlook for discussion).
                                                               Fourth, while the ECB is reluctant to maintain its
                                                               extraordinary liquidity operations in place and increase the
Second, as long as the solvency concerns are limited to
                                                               scope of its Securities Market Program, it has, and is likely
Greece, Portugal and Ireland (which together account for
                                                               to continue to choose to do so rather than risk a systemic
less than 7% of the euro-zone GDP), it is unlikely that the
cost associated with providing them with support will
outweigh the costs for the stronger countries of exiting
the euro-area and/or the cost attached to the systemic
nature of a disorderly default. The cost to the stronger
countries of supporting the weaker countries should come
either in the form of higher inflation or in the form of
losses on the loans provided. Inflation is not a concern at
the moment as reflected in the ECB staff’s mid-point of
inflation forecast for 2011 and 2012 at 1.8% and 1.5%
respectively. A 100% loss on the EU share of the total
Greek, Irish and Portugal (assumed to be of similar size to
the Irish package) packages would amount to EUR 170bn
which compares with EUR 347bn earmarked for EU
structural funds and accounts for 1.9% of 2009 Eurozone
                                                                 This is obtained from the BIS data on consolidated claims of reporting
GDP. This cost is comparable to the estimated impact of a
                                                               banks on an ultimate risk basis. For Germany the exposure to Ireland is
20% currency appreciation would have on the Eurozone           reduced to EUR 25bn as according to the Bundesbank the BIS data
GDP over 2 years. Prior to the Greek crisis, the euro was      overstates the exposure due to the location of special purpose vehicles
                                                               and subsidiaries in Ireland.

Page 8                                                                                                           Deutsche Bank AG/London
10 December 2010               Fixed Income Outlook 2011

ECB intervenes when systemic risks rises                           As should be apparent from the above discussion, the
                                                                   ultimate outcome for the euro area will likely depend in
  18000                 ECB SM P purchases (EUR mn)         70
                                                                   greater part on Spain. If Spain is suffering a liquidity rather
  16000                 Italy 2Y1 spread slo pe
                                 0Y                         60
                                                                   than solvency crisis (as we believe is the case), the
  14000                                                     50
                                                                   economic cost benefit analysis outlined above should
  12000                                                     40
  10000                                                     30

   8000                                                     20     Concerns over Spain are driven by the banking sector
   6000                                                     10     rather than sovereign woes. One way to quantify the
   4000                                                     0      potential capital injection for the Spanish banking sector is
   2000                                                     -10    to recalibrate the May Euro area bank stress tests using a
       0                                                    -20
                                                                   10.5% core tier1 ratio criteria and stricter revenue
                                                                   assumptions (see Euroland Strategy for details). In the
                                                                   adverse scenario, Spanish banks would require an
                                                                   additional EUR 75bn of capital injection. Given the current
Source: Deutsche Bank
                                                                   low debt/GDP levels (65% estimated for end 2010), the
Fifth, if a weak country were to leave the Eurozone, it            debt trajectory should remain on a sustainable path even
would have to impose capital controls to avoid a bank run          after accounting for bank capital injection and shocks to
and force the conversion of deposits. It would also create         GDP and deficit numbers.
a significant asset liabilities currency mismatch on a large
segment of its corporate sector. Moreover, if one country          A critical first quarter
were to leave, it could precipitate other weak countries in        The market is likely to test the resolve of policymakers in
doing so, as depositors and market participants re-assess          Q1 as significant events loom ahead. Likelihood of
this risk.                                                         Portugal tapping the EFSF facility in January/February,
                                                                   Irish parliamentary elections over a similar time frame and
This effectively leaves the muddle through as the most             a hump in redemption profile for Spain in March-April are
effective option for now, with the EFSF/IMF and the ECB            likely to keep risk aversion on the cards. The table below
providing liquidity. In that context, Portugal is likely to join   outlines the key events to watch for in the near term and
Greece and Ireland under the EFSF/IMF umbrella. A more             the redemption profile for key peripheral countries.
credible framework to provide liquidity to other countries
may have to be implemented. This could involve a reform            Key event risks on the horizon
of the size/structure/mandate of the EFSF, or a more                 End Dec-10               Criteria for second round of stress tests finalised in
                                                                                              Ireland. These could become benchmark for other
credible and transparent commitment from the ECB to                                                            European countries
offer. The ECB could achieve this objective either via                   Jan-11                                EFSF starts issuing bonds
direct bond purchases (as it has done since its last Council
                                                                      Jan/Feb-11                 Likelihood of Portugal tapping the EFSF facility
meeting) and/or by suspending mark-to-market on its repo
                                                                      Jan/Feb-11                             Irish parliamentary elections
operations and/or offering longer term repo operations.
                                                                         Feb-11                Recapitalisation of Irish banks (AIB, BoI and EBS)
The ECB and EFSF liquidity would come at the cost of the
                                                                        Mar-11                  Redemptions of EUR 14bn from Spanish banks
recipient countries agreeing to undertake additional fiscal
and structural measures and, as discussed below,                        Mar-11             Irish bank stress tests using a core tier 1 ratio of 10.5%

possibly some normalisation of the policy rate.                         Mar-11              Review of Irish fiscal performance and next tranche of
                                                                                                           funds provided to Ireland
                                                                         Apr-11          Redemptions of EUR 17bn of Spanish sovereign debt and
We think the muddle through scenario imposes itself                                                       14bn of bank debt
naturally as the least bad option. It nonetheless has some         Source: Deutsche Bank, EFSF, Irish Finance Ministry, Bloomberg Finance LP

advantages and drawbacks. One the positive side, the
muddle through scenario offers significant optionality in
managing the final outcome if a country ultimately proves
to be suffering from a solvency and/or competitiveness
issue. This point is not lost on the market, which prices a
restructuring of Greek debt. On the negative side, political
risk in recipient countries is likely to increase overtime as
the burden of the fiscal tightening weighs on the
population. The political dynamics in Greece suggest that
so far this risk remains limited.

Deutsche Bank AG/London                                                                                                                        Page 9
10 December 2010                        Fixed Income Outlook 2011

Redemption profile for key peripheral sovereigns                                                                     But too restrictive for peripherals
  40                                                                                                                    1.5                                        Spanish sho rt real rate (lhs)               5
           EUR bn                                             35
  35                                                                                                                                                               Spanish unemplo yment                        7
                                                             32              32
            Spain So vereign
  30        Spain B anks                                                                           29
            P o rtugal So vereign                                                                   24
  25        P o rtugal B anks               22                                                                                                                                                                  11
            Ireland So vereign
  20                                                                                                                                                                                                            13
            Ireland B anks
   15                                                                           14                                      0.0
                              9                                10
   10     98              8                                                                                                                                                                                     17
                                            6                                                                          -0.5
                                                                                  5           5              5
               3                  4             3        4         3
    5              22 2               2 2           22                                2                 33                                                                                                      19
                                       1                               12                                        1
    0                                                                                                                   -1.0                                                                                    21
               Jan            Feb               M ar           Q2                 Q3                    Q4                Jan-08          A ug-08       M ar-09         Sep-09       A pr-10          Oct-10
Source: Deutsche Bank, Bloomberg Finance L.P.                                                                        Source: Deutsche Bank, Bloomberg Finance LP

Do not discount ECB rate hikes                                                                                       As the divergence between core and non-core economies
For core countries, real short rates are negative and the                                                            grows, the ECB is likely to draw a sharp distinction
level of the currency looks undervalued relative to                                                                  between its liquidity and rate setting policy. In our view
fundamentals. As a result monetary conditions appear too                                                             the ECB would maintain, at the minimum, the safety net
accommodative for the core which is likely to support                                                                of 1W tenders into 2011. However to balance the ample
further positive performance.                                                                                        liquidity provision and to maintain its inflation fighting
                                                                                                                     credentials, the ECB would shift to a hawkish tone and
Policy stance too accommodative for core economies                                                                   raise rates by the end of Q2 2011. Our economists expect
   3.0                                                                                                       7.4
                                                                                                                     the first rate hike by Jun 2011, with the base rate reaching
                                                    German sho rt real rate (lhs)
                                                                                                                     1.75% by end 2011. This should be supportive of bear
                                                    German Unemplo yment                                     7.5
   2.5                                                                                                               flattener trades in the 2Y-10Y sector. The risks of a policy
   2.0                                                                                                               error from the ECB favours implementing the trade in
                                                                                                                     swap space.
    1.5                                                                                                      7.8

    1.0                                                                                                      7.9     Moreover a model relating the German 2s10s slope to the
   0.5                                                                                                       8       expected level of deficits and to the expected real policy
                                                                                                             8.1     rate (assuming 1.75% by the end of 2011) suggests the 1-
                                                                                                             8.2     year forward curve is about 25bp too steep. This is in
                                                                                                                     sharp contrast with the excess flatness of the US forward
                                                                                                                     slope. As a relative value trade, we would recommend a
   -1.0                                                                                                      8.4
     Jan-08           A ug-08           M ar-09          Sep-09             A pr-10               Oct-10
                                                                                                                     2s10s steepener in the US vs. 2s10s flattener in EUR.
Source: Deutsche Bank, Bloomberg Finance LP
                                                                                                                     US forward 2s10s slope too flat vs. EU forward slope
We note the peripheral economies however face short                                                                      80         Excess steepness                                   0s
                                                                                                                                                                        US vs EU 2s1 slo pe differential
real rates which appear restrictive and the level of euro is                                                             60
                                                                                                                                                                        vs. real sho rt rate differential and
                                                                                                                                                                        deficit differential
overvalued relative to domestic fundamentals. The                                                                        40
restrictive policy stance along with the fiscal consolidation
necessitated by the sovereign spread dynamics implies
that the non-core economies would continue to drag in
2011.                                                                                                                   -20




                                                                                                                       -120         Excess flatness
                                                                                                                               99    00   01    02    03    04     05    06    07    08    09    10      11
                                                                                                                     Source: Deutsche Bank, Bloomberg Finance LP

Page 10                                                                                                                                                                       Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

We argue indeed that the risk premium should increase                               The twin deficit metric
more in the US than in Europe next year. First we believe                             Country           Fiscal        Current        Fiscal        Final             10Y         10Y
European rates are already adequately pricing in sovereign                                               msr.         account        cred.         metric           ASW         ASW
                                                                                                                                                                    level     rich/che
risk, which is not the case in the US. Second, the Fed                                                                                                                        ap (-)/(+)
looks unlikely to expand QE beyond June in a context of                               Germany              1.5           -4.6           2.8           -0.1           -34            -41
higher core inflation even if the unemployment rate falls
                                                                                        France            4.0            3.4           2.2            3.2             2             -157
only marginally. Third the ECB appears more likely to be
                                                                                           Italy          1.5            2.7           2.7            2.3           109              -9
hawkish than the Fed, commanding a lower risk premium
                                                                                        Spain             6.0            3.8           1.1            3.6           183              3
in Europe.
                                                                                    Netherlands           2.3           -6.8           0.1           -1.5            -8             49

Another way to express this view is through being long                                Belgium             3.0           -2.0           0.0            0.3            65             38

EUR 5Y5Y real yield vs. short US 5Y5Y real yield. Despite                              Austria            2.3           -3.5           1.4            0.1            12              -2

the recent sell-off, the US 5Y5Y real yield (implied by TIPS)                         Portugal            5.0            8.0           5.7            6.2           255             -45
remains expensive by about 50bp against its historical                                  Ireland           12.6          -1.5           4.2            5.1           395             147
average and long term expectations of real GDP growth,                                 Finland            0.0           -1.6           0.0           -0.5            -5              8
suggesting more potential for the normalization of the risk                            Greece             14.0           8.0          18.8           13.6           648              7
premium in real space. On the other hand the EUR 5Y5Y                               Source: Deutsche Bank, EC

real yield (implied by OATei) is already slightly above its                         Notes: Positive current account balance is a negative number as it improves the twin deficit metric

long term average around 2% and is significantly higher
than long term expectations of real GDP growth in                                   Will US equities cap the rates sell-off
Europe. The EUR vs US real yield spread thus remains
high historically. The trade would benefit from the relative                        We argued last year that the low level of real rates was
repricing of risk premia in the US vs. Europe but also from                         supportive for an equity market. This remains very much
specific relative value considerations in real space. In                            the case, and we continue to believe that a sell-off in rates
particular the US 5Y5Y breakeven is already close to fair                           triggering a sell-off in equities remains more likely than an
valuation capturing a significant inflation risk premium,                           equity sell-off triggering a rally in rates.
while it remains cheap in Europe.
                                                                                    Equities can indeed look expensive on some long-term
                                                                                    valuation measures (e.g. on the basis of Shiller’s real
Favour long EUR real yields vs. US real yields
                                                                                    earnings yield calculated using 10-year trailing real
                         EUR vs US 5Y5Y real yield differential
                                                                                    earnings, see chart below). However, this richness of
   0.6%                                                                             equities is mitigated by the low level of real yields.

                                                                                    Shiller’s earnings yield suggests equities are possibly
   0.0%                                                                               14
                                                                                                                                                                 Earning yields (10Y
  -0.2%                                                                                                                                                          trailing earnings)
                                                                                      12                                                                         M edian
                                                                                      10                                                                         A verage

  -0.8%                                                                                8
      Dec-04       Dec-05       Dec-06        Dec-07   Dec-08     Dec-09   Dec-10
Source: Deutsche Bank, Bloomberg Finance LP                                            6

Short France and Portugal
As the market focuses back on fundamentals, the high
twin deficit countries would remain vulnerable relative to                                 62      66    70      74      78     82      86      90      94     98      02      06         10
the fiscally responsible countries. We would thus favour                            Source: Deutsche Bank, Prof. Robert Shiller’s website
short positions in France (on ASW as well as versus
Germany) and Portugal (versus Ireland and Spain). Both                              Indeed, 10Y real rates (approximated as 10Y nominal rate
France and Portugal appear rich on our twin deficit                                 – 10-year rolling average of core CPI YoY or by the 10Y
measure of fiscal and current account deficits.                                     TIPS real yield) are themselves very low (around 1%). As a
                                                                                    result the equity risk premium calculated as the earnings
                                                                                    yield minus the 10Y real rate is slightly cheap relative to

Deutsche Bank AG/London                                                                                                                                                         Page 11
10 December 2010                      Fixed Income Outlook 2011

the long-term average of 3.5% and a median of 2.75%                                              between the change of rates and equity returns (see chart
(using the median as a reference point is appealing as it                                        below).
reduces the impact of both the high inflation period of the
1970s, and of the dotcom bubble).                                                                Low BRP levels should allow a positive correlation
                                                                                                 between higher yields and higher equity prices
But the equity risk premium looks slightly cheap
                                                                                                  -1.0                                                                         3.5
                                                                                                           %                                                    0Y
                                                                                                                                                        SP X - 1 co rrel,
given the low level of real rates                                                                                                                       weekly changes, last   3.0
  14                                                                                                                                                     2M
                                                                                                                                                        1 , lhs, inverted      2.5
                                                                Equity risk premium               -0.6
                                                                (Earnings yield - 1 real rate)
                                                                                   0Y                                                                   US B RP                2.0
  12                                                                                              -0.4
                                                                A verage                                                                                                       1.5
                                                                                                  -0.2                                                                         1.0
  10                                                            M edian
                                                                                                   0.0                                                                         0.5
                                                                                                   0.2                                                                         0.0

   6                                                                                                                                                                           -0.5
   4                                                                                               0.6
                                                                                                   0.8                                                                         -2.0
                                                                                                   1.0                                                                         -2.5
   0                                                                                                                                                               0 1
                                                                                                         91 92 92 93 95 96 96 98 99 00 01 02 03 04 05 06 07 08 09 1 1

  -2                                                                                             Source: Deutsche Bank Bloomberg Finance LP, Consensus Economics

       62    66      70      74     78      82      86     90     94      98   02   06    10
Source: Deutsche Bank, Prof. Robert Shiller’s website                                            For the time being the bond risk premium remains close
                                                                                                 to historically low levels, and bond yields should increase
From a positioning perspective, bonds also appear more                                           together with equity prices. Using this framework, we find
vulnerable than equities as data on inflows into mutual                                          that the 10Y yield could reach 4% before the correlation
funds suggests that investors have continued to favour                                           starts to change sign.
the bond market relative to equities.
                                                                                                 Finally we take note that our market sentiment index has
Inflows out of money market funds have                                                           turned south sharply - driven by a massive jump in equity
disproportionately benefited bond funds                                                          issuance - about 4 times that of October. The sentiment
                                                                                                 index now points to flat S&P (+0.5%) over the next 6M.
                      Inflo ws into mutual funds (as a % o f o utstandings A UM )                Last time a similar drop occurred was in April 2010.

   2.0%                                                                                          Market sentiment index sends a neutral signal

   0.0%                                                                                             10%

   -1.0%                                                                                             5%

  -3.0%                                          Hybrid
                                                 B o nds
        Jan-90                Jun-95                Dec-00                Jun-06                   -10%

Source: Deutsche Bank, ICI
                                                                                                   -15%                               Sentiment Index (lhs)
                                                                                                                                      -0.75 Z-sco re
At some point however, higher real rates should have a                                             -20%                               0.75 Z-sco re
negative impact on equities leading to a negative                                                        Jan-01             Sep-03               Jun-06            M ar-09
correlation between yield changes and equity returns (i.e.                                       Source: Deutsche Bank

a positive correlation between bond returns and equity
returns). We find a good relationship between the
bond/equity correlation and the bond risk premium
(defined as the 10-year nominal yield minus long term
expectations of growth and inflation from consensus
economics forecasts). Historically, low levels of bond risk
premium have been associated with a positive correlation

Page 12                                                                                                                                                 Deutsche Bank AG/London
10 December 2010       Fixed Income Outlook 2011

The Trades                                                        In Europe, 5Y breakevens are trading close to 1.5%,
                                                                  relative to our forecast of average inflation of 1.8% over a
Duration: Improving economic data, fiscal stimulus and            five year horizon, supporting long breakeven positions in
unwind of QE premium in the US leads us to expect 10Y             the 5Y sector.
UST to test 3.50% in Q1. Beyond H1, our US colleagues
expect rates to rally back, while we are more concerned           Volatility: Near term uncertainty, both over peripheral
about the risk of fuller repricing of the twin deficits risk in   Europe as well as economic developments in the US
the US. In Europe, robust economic data and increasing            should be characterized by heightened volatility levels. We
contingent liabilities of the core Eurozone countries along       recommend long gamma positions in the US, Euroland
with the differentiation between monetary and liquidity           and the UK.
policy by the ECB should result in a bearish pressure for
EUR rates. We target 3.25% for 10Y Bunds by Q1 but                In Europe, we particularly favour gamma positions in the
prefer to express a short position via front end trades and       5Y sector as well as long 20Y and 30Y tail vega. The 5Y
a 2Y10Y flattener. We are also short EUR rates vs. UK             volatility would be supported as a resolution to the
rates in the long end which arguably has the best fiscal          European crisis remains elusive while peripheral crisis as
and monetary policy mix. We would favor long positions            well as regulation changes would support long tail vega
in EUR 5Y5Y or 10Y real yields relative to US real yields.        demand.

Curve: The ECB will likely find it necessary to distinguish
                                                                  Hedges to the portfolio
between monetary policy and liquidity policy to
accommodate the divergent core and peripheral                     The range of rate risks facing borrowers and investors in
economies in Eurozone. This should be supportive of               2011 is wide. While there are some historical precedent
2Y10Y flatteners in EUR. In contrast, the US front end            to the financial shock that the global economy had to
remains anchored and bearish pressures should manifest            suffer (e.g. Japan and the Great Depression), the policy
via the 10Y sector. We favour 2Y10Y steepeners in the             reaction function has been markedly different and its
US. As a relative value play, we recommend 2Y10Y                  impact on the real economy is highly uncertain. This
steepeners in the US vs flatteners in Europe.                     uncertainty is compounded by the threat posed to the
                                                                  euro-zone by diverging economies and the need to
Peripheral Europe: The pressures on the peripheral                rebalance the global economy. Some of the key risks to
Eurozone countries are likely to persist as none of the           consider are:
proposed mechanisms provide a credible resolution of the
problem. Stop gap measures to avoid systemic risks are            Extreme euro tensions
however expected to remain. We note France remains the
most vulnerable of the AAA rated countries while Portugal         Our base case scenario is one where Spain withstands
has benefited the most from ECB’s purchases. We                   the market pressure which is likely to persist until the
recommend being short France vs. swaps and short                  Spanish banking system is more convincingly
Portugal vs. Ireland and Spain.                                   recapitalised. However, the risks of a self-fulfilling rise in
                                                                  borrowing costs and/or significantly higher recapitalisation
Spreads: Swap spreads in Europe appear elevated driven            costs remain. The EFSF together with the EFSM and the
by safe haven demand for German bonds as well as                  IMF could lend up to EUR480bn, which would leave
relative lack of issuance from the financial sector.              EUR350bn to support Spain if both Portugal and Ireland
Increasing contingent liabilities of the core Eurozone            require EUR65bn each. However, even if the EFSF could
countries should lead an underperformance of core bonds           technically support Spain, the political and economic
on ASW basis. We recommend 10Y ASW tighteners in                  implication of a Spanish bailout would significantly raise
Europe.                                                           the risk of a euro break-up. The more obvious way to
                                                                  hedge against this risk is to buy protection on the euro, as
Inflation: We are constructive on breakevens globally,            any breakup is likely to occur with the stronger countries
particularly at the front end as deflation risks should be        leaving the euro-zone. We would also implement
priced out in the US and the UK as well as in the core            wideners on the EUR/USD cross-currency basis and on
European countries. In the US, we expect both core and           the Euribor/Eonias basis in order to capture a flight to
headline inflation to rebound in 2011 CPI YoY reaching 2%         quality towards the US dollar and growing tensions in the
by the end of the year. We recommend long front end               European banking system.
breakevens in the US

Deutsche Bank AG/London                                                                                                 Page 13
10 December 2010      Fixed Income Outlook 2011

Deflation in the US

The underlying dynamics of the subcomponents of core
inflation suggest that US inflation should stabilise and rise
modestly in 2011. However, the sustainability of this
rebound crucially depends on real growth in the US
staying above 2% and the current output gap not
weighing on inflation expectations. This risk will rise if the
US tighten fiscal policy prematurely, which is possible
given the recent shift in Congress. To hedge against this
scenario we would recommend out-of- the-money
receivers on the long- end to protect against an extended
period of low rates. We also recommend purchasing 5Y
deflation floors, financed by selling 10Y deflation floors.
Despite a higher risk of experiencing subdued inflation
levels or a deflation in the next few years, rather than over
the next 10 years, the trade generates a positive premium
take out.

The key risk to our trades are (1) deflationary risks
emerging in the US and (2) systemic risks in the euro-area
because of sovereign and / or senior bank debt

                        Francis Yared, (44) 20 754 54017
                         Mohit Kumar, (44) 20 7545 2776
                   Jerome Saragoussi, (33) 1 44 95 64 08
                   Abhishek Singhania, (44) 20 7547 4458

Page 14                                                          Deutsche Bank AG/London
10 December 2010     Fixed Income Outlook 2011


2011 Outlook – Higher Yields Are Not                          stable. Although this doesn’t mean growth will accelerate
                                                              it does mean that a double dip is unlikely.
    2010 was a story of expecting low rates, for a long       Still a key concern is that, because inflation has fallen so
    time. We think 2011 will be divided into two              far, the usual cyclical buffers aren’t working so efficiently.
    halves. The first half represents a test of the low       Companies are reluctant to make the switch from
    for long view. Is the economy gaining sufficient          productivity led to employment led output gains for fear
    traction that rates can begin some kind of steady         that profits will be compromised given weak pricing
    normalization? The second half will be the                power.
    answer. We think that answer is a resounding no
    – low for long will come back into vogue. The             If underlying demand growth is only 2-3 percent, it is hard
    market will re rally and once again disappoint the        to see how an output gap, loosely measured at around 6
    economy optimists.                                        percent can close quickly if underlying potential growth is
                                                              2 percent. Over time capacity may become redundant so
    It is not that the economy isn’t getting better – it
                                                              that with hindsight the output gap will appear to have
    is. Instead it is that there are so many headwinds
                                                              been over estimated. However in the meantime a
    to work through, that recovery is not consistent
                                                              reasonable worry will be that the persistence of the
    with premature monetary tightening by either the
                                                              output gap will dampen further inflation.
    Fed or the markets. Fiscal stimulus buys time in
    2011 but little else. Ironically the stronger growth
                                                              Policymakers seem well attuned to these risks. The Fed’s
    looks, the more likely fiscal tightening will come
                                                              QE program is designed to cut through a potentially
    into play sooner keeping the recovery on a
                                                              negative dynamic of expecting falling inflation that feeds
                                                              into further falls in actual inflation. The proposed new
    We are closing our 10s30s pain trade flattener. It        fiscal stimulus and delayed fiscal tightening recognizes
    worked well to protect against a post QE Fed              the lack of demand stimulators.
    disappointment trade. We feel that this
    disappointment trade may have a little further to         While QE is experimental, there is no certainty that it will
    run but the bulk of the move is behind us. We             shock inflation higher. The way QE is being executed also
    think it is too early to go long duration again but       runs the risk of derailing its effectiveness. In trying to raise
    expect to build a new long upwards from 3.35              inflation expectations, bond markets have priced yields
    percent.                                                  higher and monetary policy appears to have tightened.
    We are also closing our long swap spread trade.           Defenders of QE hope that yields may anyway have been
    This has benefited also from the pain trade and           rising, so net it remains stimulatory but this is open to
    convexity paying. Prospective corporate issuance          debate. The only thing for sure is that equities remain
    in early 2011 as well as the surprise fiscal stimulus     higher post QE than pre QE announcement, suggesting
    bodes well for some re narrowing.                         some net benefit.
    TIPS offer value in the front end out to five years.
    This is as much due to the fact that breakevens           There is always the chance that the Fed shifts gears on
    are very low and near term technical factors that         QE. If yields rise too much, it may take a more proactive
    can elevate CPI, at least temporarily.                    stance and use QE to steer yields lower. Either by focuses
                                                              on implicit yield targeting or by purchasing more longer
Our view has been that the economic recovery will take
                                                              dated issues. It could also threaten to increase purchases.
time to gain traction. The main restraint is the absence of
                                                              We think none of these lucky as long as equities and the
obvious external demand stimulators. There is a limit to
                                                              economy seem to be on track for some kind of recovery.
fiscal stimulus, the household sector is still deleveraging
                                                              We think it is unlikely that the Fed will fall short of the
and the corporate sector seems somewhat reluctant to
                                                              $600 billion it intends to purchase even though market
invest given an uncertain demand environment and a
                                                              speculation as to that possibility will be rife in 2010h1.
sizeable output gap. The good news is that the pace of
deleveraging is slowing so that the savings rate should be

Deutsche Bank AG/London                                                                                              Page 15
10 December 2010      Fixed Income Outlook 2011

Fiscal policy should raise GDP by at least ¾ percent in         exchange rate appreciation or slam on the growth brakes
2011, assuming the payroll tax reduction is all spent.          at home. Absent inflation, while there will be complaints
However, in our view, at best this buys some time for           about the lack of fiscal rectitude, the choice is unilateral
recovery. The deficit is huge and meaningful fiscal             forex diversification and faster exchange appreciation that
tightening is not far behind. Even if we dodge the              slows growth or continuing to acquire dollar (fixed
Ricardian bullet of equivalence in 2011, there is at least 1    income) assets. Note that even if there is a sharp jump in
if not 2 percent of fiscal tightening slated for 2012. If       risk premium associated with concerns for easy fiscal
underlying economic growth remains in the 2-3 percent           policy, the Fed has the option to contain it through QE. At
range, there is a sharp slowing implied for 2012.               this point lower yields may well be achieved at the
                                                                expense of a weaker dollar -- bringing to a head the very
Most market participants recognize the disappointment in        fears that overseas investors may currently have anyway.
the economic recovery. Yet there is quite a diversity of        The US lack of fiscal discipline and Asia’s quest for growth
opinions as to what should be done. Our own economists          make them brothers in crime.
have remained confident that it is only a matter of time
before corporates have the confidence to ramp up                Equities versus Bonds
employment. QE is unnecessary and potentially                   We still appear to be in a world where equities and bonds
dangerous for raising inflation expectations excessively.       are negatively correlated. A world that has persisted since
While they have scaled back the timing of Fed tightening        2000 as yields dropped sustainably below 6 percent. As
they still think it is much sooner than the market currently    deflation risk wanes, bond yields are supposed to rise as
expects. They interpret the recent sell off in Treasuries as    equity valuations improve.
growing confidence in the economic recovery story. The
fiscal stimulus, while not expected, adds icing to the          Nominal Growth vs Nominal Yields
recovery cake. The fact that real yields have risen 35 basis       16
points for 10s in less than 5 days is consistent with this         14
view. Breakevens have been broadly unchanged. Our
European strategists are more skeptical about the
recovery and more concerned about appropriate risk
premium in the Treasury market. This reflects the poor              8
score the US attains on a twin deficit monitor. For sure, it        6
is somewhat incongruous that Ireland has to introduce               4
new tax rates for the lowest incomes while the US moves
to extend tax breaks for the highest incomes. They                                                Nominal Growth
conclude that the dollar and yields can’t both be right.                                          10 Year Nominal Yields yoy
Either yields need to be higher or the dollar weaker to            -2
reduce the sovereign risk premium.                                 -4
                                                                    19532      19604    19682   19754   19832   19904     19982   20054
While these are legitimate concern for the market, we           Source: Deutsche Bank

think the outlook for rates in 2011 should also recognize
the time consistency of market repricings given the             Nominal yields are loosely related to nominal growth.
economic backdrop. For example, even if growth does             Since 1953 the average 10 year yield has been 6.3 percent
accelerate into the 3-4 percent on the fiscal stimulus, it is   and the average nominal growth rate year over year was
not clear to us that the market can sustain forward rates       6.7 percent, a 40 bps spread. If we divide the period into
of over 4 percent (3 ½ percent spot) in 10s if fiscal policy    two halves, the first when (inflation) nominal growth was
is likely to tighten in 2012. As it is elevated rates are       rising and the second, from 1980 when it was falling,
choking the housing market again and they may also soon         nominal yields were respectively 5.4 percent and 7.1
interfere with progress in equities.                            percent while growth was 7.6 percent and 5.9 percent.
                                                                The rising inflation world was characterized by yields
Similarly while we recognize the potential for an unsavory      being 2.2 percent below growth on average while the
outcome of higher yields and/or dollar weakness as              falling inflation world, yields were 1.2 percent above
foreign willingness to support US deficits is tested, we        growth. Since 2000 yields and growth have been very
think the near term risk is still that foreign investors have   closely aligned, averaging 4.4 and 4.3 percent on average.
little choice but to continue to support Treasuries. The
breakdown, if it comes, is more likely to be driven by          That suggests that even if we think real growth can center
reckless Fed policies that allow inflation to rise thus         on 3 ½ percent in 2011 and even if we think it is
forcing the hand of Asian policymakers to accept faster         sustainable, with inflation around 1 percent, the most 10s

Page 16                                                                                                      Deutsche Bank AG/London
10 December 2010                Fixed Income Outlook 2011

can rise is around 4 percent (given the forwards would                         We will, however, get confusing interpretations of signals
presumably be pricing 4 ½ percent). Inflation needs to rise                    from credit markets because analysts and market
that much more. More concerning is that it is hard to                          participants have never experienced such a monumental
expect sustainable real growth given subsequent fiscal                         collapse in the past. So it will be difficult to apply past
tightening. Underlying real growth would need to be at                         relationships to the future. We can think of at least three
least 5 percent for fiscal tightening of 2 percent, to be                      likely sources of confusion. Once we clear these three
consistent with 4 percent yields. That seems unlikely                          confusions, we see that the credit outlook for 2011 is
unless the private sector embarks on a re-leveraging up.                       quite bleak, just like the unemployment outlook.

Equity Vaulations vs. Nominal Yield Buckets                                    First, the confusion between change versus level.
    28                                                                         Historically, instead of the level of credit availability, it is
    26                               average equity                            the rate at which credit availability changes are correlated
                                     valuations on trend                       with growth and consumption. In an analytical framework
                                                                               that depends on historical relations and regression
                                                                               analysis; one would likely get some positive signs from
    20                                                     average 17.3        the fact that this rate of change is now positive.
    18                                                                         However, in reality the collapse of credit is so large that
    16                                                                         this collapse matters more that the rate of change in
    14                                                                         credit going forward. This is analogous to the
    12                                                                         unemployment rate versus monthly payroll relationship.
    10                                                                         The absolute number of job losses during the crisis have
                                                                               been so large that a monthly payroll around 150k will
            2     3     4   5    6     7    8     9   10   11   12   13   14   make little dent to the unemployment rate, since it is
Source: Deutsche Bank                                                          merely reaches the level of labor force growth.

 Even if bond yields have been too pessimistic on growth,                      Second is the dichotomy in credit availability of small firms
this suggests a limit not only to how much higher they can                     versus large firms. The large amount of corporate debt
go, but also how well the stock market can do. Right now                       issuance this year has been interpreted as an
bonds still look a little expensive to equity valuations, if                   improvement in the credit environment. However, the
equity valuations are “correct”, yields would normally be                      availability of credit to small firms has gradually been
about 30 basis points higher. Of course if yields are                          shrinking. If one adds the fact that small firms in the US
“right” equity valuations should be closer to 15 times not                     generate the majority of jobs, the outlook does not appear
17 times earnings. Bond yields at 3 ½ to 4 percent                             as good. The charts below show the plight of the small
warrant equity valuations around 17-18 times. A push to                        business clearly. In the NFIB survey of small businesses,
1300 for the SPX is consistent with around 19 times                            the two reasons identified for the lack of hiring is first
(trend) earnings but that would imply sustainable ten year                     weak sales forecast and credit availability. In our opinion,
bond yields close to 4 percent. So unless inflation really is                  this dichotomy is a symptom of credit weakness.
moving back towards 2 percent, while 5 percent upside
for equities seems quite plausible, a 10+ percent move                         Small business hampered by poor sales and credit
soon seems more of a stretch. That’s not to say that                           conditions:
eventually equities can’t move higher, but it requires more
                                                                                 40                                                            0
confidence that there is traction in real growth as well as a
turnaround in the inflation outlook.                                             35                                                            -5

                                                                                                               Pct most important              -10
Credit environment and spread markets                                            25                            problem poor sales (lhs)
                                                                                                               Pct firms expecting credit      -15
Macro Credit Environment likely to be very weak in                               20                            conditions to ease (rhs)
2011.                                                                                                                                          -20
The credit environment will likely remain impaired during                        10

2011 as it has been during the last three years. Balance                          5                                                            -30
sheets across the economy will be more focused on
                                                                                  0                                                            -35
being repaired as opposed to adding to leverage. This
                                                                                      80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
includes the balance sheets of households, banks, the
                                                                               Source: Deutsche Bank, NFIB
GSEs, etc.

Deutsche Bank AG/London                                                                                                                     Page 17
10 December 2010                       Fixed Income Outlook 2011

Third, the Fed’s senior loan officer survey indicates                                homes is weak: The MBA purchase index reflects
significant eagerness on the part of banks to lend. At the                           extremely weak housing market. The halting of
same time the aggregate size of bank loans in the US is                              foreclosures has introduced much uncertainty into the
continually shrinking. The loan officer survey no longer                             housing market, and the continued legal battles over
has the amount of information content as it did in the                               mortgage put-backs will continue to overhang bank
past. It is less relevant when the demand for credit is                              balance sheets. We also don’t expect much help for
constrained.                                                                         homeowners from government efforts such as HAMP and
                                                                                     the various refi initiatives. In the end, households will have
Fed Senior Loan Officer survey: Pct of C&I borrowers                                 a long hard road to regain previous net worth levels in the
reporting tighter standards                                                          balance sheet.

                                                                                     Banks will also contribute little to the improvement in
                                                                                     credit during 2011. The aggregate balance sheet of the
                                                                                     banking system will have several trends, all pointing to
   60                                                                                tightening credit conditions. First, the size of the
                                                                                     residential real estate loan portfolio will keep shrinking.
   40                                                                                The primary reason for this is the declining value of the
                                                                                     nation’s housing stock. Also, loans are more capital
   20                                                                                consuming than securities, so banks will replace loans by
                                                                                     securities as they gradually run off.

                                                                                     Second, the banking system has taken very little
                                                                                     markdown so far in their commercial loan portfolio. This
     Jan-06              Jan-07          Jan-08         Jan-09        Jan-10
                                                                                     will be a drag on their balance sheet for a longer period of
Source: Deutsche Bank, Federal Reserve
                                                                                     time. This drag will be more prominent for smaller banks,
                                                                                     which tend to have larger commercial loan portfolios.
The Households and the Banks: Long way to a healthy
balance sheet
                                                                                     Third, the share of small businesses in new bank loans
US households will continue to focus on re-building their
                                                                                     has been gradually shrinking and this trend will continue in
balance sheets during the 2011. The path to healthy
                                                                                     2011. This will make the banking systems contribution to
balance sheets will require higher, more stable asset
                                                                                     job creation even less.
prices and savings flows. US households will their
continue focus on rebuilding its net worth
                                                                                     Percentage of loans to small businesses
Household net worth                                                                    44

            70000                                                                      42

            60000                                                                      40

            50000                                                                      38

            40000                                                                      36
     $ bn

            30000                                                                      34

            20000                                                                      32

            10000                                                                      30
                                                                                            95        97           99   01   03      05    07     09
                                                                                     Source: Deutsche Bank, FDIC
                    90    92      94     96   98   00     02     04   06   08   10
Source: Deutsche Bank, Federal Reserve
                                                                                     Fourth, the size of the REO properties and Restructured
                                                                                     loan book of banks continue to skyrocket in the balance
It might take several years to fix US consumer balance
                                                                                     sheets. These will create interesting ALM and capital
sheet. Much depends on the asset side of the ledger.
                                                                                     management issues for banks. These assets have very
Real estate holdings are a big worry. Home prices have
                                                                                     long durations. While as a percentage of total assets
started to take a downturn, and we expect another 5%
                                                                                     these are still small, if they grow at the same rate as they
decline in the housing peak-to-trough. The demand for

Page 18                                                                                                                           Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

have this year, banks will have to have long term funding                       Net Interest Income and Non Interest income of banks
for these.
                                                                                     3.9                                                                          2.4
The book of REO+Restructured mortgage loans are                                      3.7
growing exponentially                                                                3.6                                                                          2.0
            140                                                                                                                                                   1.8

            120                                                                      3.3
            100                                                                      3.1                                                                          1.4
                                                                                                              Net interest margin (lhs)
             80                                                                                               Noninterest income %                                1.2
     $ bn

                                                                                                              of assets (rhs)
                                                                                     2.8                                                                          1.0
                                                                                           05            06            07          08          09          10

             40                                                                 Source: Deutsche Bank, FDIC

                                                                                On addition to above, the banking system will be facing
             0                                                                  additional problematic issues such as changing business
                  03      04          05        06        07    08   09    10   models to comply with new financial reform legislation,
Source: Deutsche Bank, FDIC
                                                                                Basel III capital rules, etc.
                                                                                Shadow Banking: Agency securitization only game in
Fifth, the overall securities portfolio will grow, albeit at a                  town
slow pace. The Treasury and agency portfolios will grow                         Non agency securitization in 2011 is expected to be
because they will consume very little capital. The agency                       negligible. There are factors that helped create the
MBS portfolio of banks will stagnate at the current levels.                     massive non agency market, which will continue to be
The demand for agency CMOs will be robust, only to                              absent for the next few years. First and foremost, home
replace the runoff in the non agency CMOs in their book.                        prices are still declining. Consequently the spread level
                                                                                needed in order to deploy capital in this sector is too large
Bank Treasury holdings set to grow                                              to be meaningful. Second, the two key traditional buyers
                                                                                of non agency mortgage securities, i.e. European banks
                                                                                and US insurance companies are both facing significant
            250                                                                 changes in their investment models and unlikely to come
                                                                                back to this sectors. Government programs like TALF, etc
            200                                                                 will do very little to resuscitate this sector. In addition,
                                                                                risk retention requirements stipulated in both the
     $ bn

            150                                                                 accounting rules changes as well as financial reform
                                                                                legislations killed whatever remaining chance of survival of
                                                                                the non agency mortgage market.
                                                                                GSE Outstanding insured portfolios
                  92    94       96        98        00    02   04   06   08
Source: Deutsche Bank, Federal Reserve                                                     2500

Sixth, and probably most important, the net interest                                       2000
income of banks will decline until the Fed raises interest
                                                                                    $ bn

rates, whenever it may be. Interest income has started to                                  1500
decline faster than interest expenses. This is happening
                                                                                           1000                                               Freddie
because we are in a zero short term rate environment for
a long period and, as a result, the yields on the liabilities
book has less room to decline. This phenomenon is not
reversible until the Fed raises interest rates again, or the                                    0
yield curve steepens further and stays there for a while.                                       Jan-07              Jan-08           Jan-09            Jan-10
In addition to this the non interest income of banks have                       Source: Deutsche Bank
been falling and will continue to falll in 2011.

Deutsche Bank AG/London                                                                                                                                         Page 19
10 December 2010       Fixed Income Outlook 2011

While agency securitization will serve as the only                What to expect from the FHLB system
securitization route, both Freddie Mac and Fannie Mae             In a GSE reform framework, the FHLB debt will also be
have experienced a slight decline from the peak in the            included as well. In the meantime, FHLB will continue to
securitization book of business, and the FHA has taken            face decline in their business: FHLB advances will
over an increasing role. While this has improved the              continue to decline in 2011. First, the advances business
volume and the liquidity of Ginnie Mae securities, it also        is shrinking as the funding need of the banking system is
means that credit risk exposure is gradually being                miniscule. Second, as advances decline the capital
transferred from agencies to the Federal government. A            available to support a mortgage portfolio will also shrink.
variety of government proposals to prop us the housing            Third, their net interest margins will decline, similar to
market will lead to further movement of conforming                commercial banks, as higher yielding assets run off. Thus
mortgages to the FHA portfolio.                                   the FHLB debt market will face shrinkage. 
GSE’s role in government’s agenda in 2011
Note much will happen in 2011; more likely, the next              Treasury Supply Outlook
couple of years will see little movement on the regulatory        The Treasury market has reassessed the supply outlook
front. Legislation requires some action by 2013, so there         for the next couple of years based on the latest tax deals
is a looming deadline that will move Washington to                from Washington. The price tags have ranged between
resolve the GSE question. Eventually we think a                   $700 billion and $900 billion in the media. In our view, the
Privatization/Cooperative structure, which was recently           market expectations of additional Treasury supply only go
suggested in a New York Federal Reserve Working Paper,            up by a fraction of those figures, because most of the
is closest to something realistic. Besides this structure,        Bush tax cuts had already been assumed to be extended.
there has been a dearth of alternative ideas currently            The new “big ticket” items in the news this week were
proposed.                                                         the 2% reduction in Social Security taxes and the
                                                                  extended federal unemployment benefits, which are
The benefits of the cooperative structure are: It reduces         estimated to cost around $180 billion over 2 years, and
the incentive to increase risk as the notional share value        had not been priced in by markets.
stays at par, the structure will be the securitization engine,
and the challenge will remain regarding the portfolio             While more cost details on the deals are still needed, we
business. Another benefit is risk sharing by the                  believe net Treasury issuance will probably be around
government, the cooperative and the originating banks.            $1.42 trillion in calendar year 2011. Prior to the news this
However, there are problems as well: Some of the current          week, we had expected some modest cuts in Treasury
problems of conflict of interest will remain. There is a risk     issuance in 2011, especially in the short to intermediate
that the pricing of the guarantee fee will remain difficult       coupon Treasury notes. We now believe the front end
and the distribution of losses will be difficult to settle        issuance will probably remain relatively stable, due to the
among the participants. Finally, an MPF-like structure will       additional borrowing requirements to fund the tax cuts
be hard to trade, because the delivery options could be           and a still uncertain economic outlook.
too large. It is unlikely that the Government will interfere
with the agency securities until it is sure that this structure
                                                                  Gross coupon Treasury issuance will probably be
will work.
                                                                  around $2.1 trillion in 2011
We think that the securitization business of Freddie Mac
and Fannie Mae will eventually be merged. We think that                           $2,500

the most difficult piece to resolve is the portfolio
                                                                                              Total Gross Coupon Issuance
business. It’s not so easy to privatize it, as suggested by                       $2,000
numerous commentators, because whatever remains will
be the poor-quality mortgages, so no private investor will                        $1,500
                                                                     $ billions

take over the organization. Second, the funding of the
remaining portfolio will be complex – a private buyer                             $1,000
would not be likely to fund it at an affordable level. Thus a
government sponsored funding vehicle will likely have to                           $500
Historically, the portfolio business has allowed the GSEs                           $-
to diversify home prices exposure with interest rates                                      2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

exposure to reduce cost. Taking the portfolio business                                                       Calendar Year

away from them make them riskier, costing the                     Source: Deutsche Bank

homeowners more.

Page 20                                                                                                           Deutsche Bank AG/London
10 December 2010        Fixed Income Outlook 2011

Here are some details of our Treasury supply outlook for           Investor demand for Treasuries
next year based on the currently available information.                                     2009 2010 Q1-Q3      2010 Q4          2011
                                                                   Foreign                   446         562            150        900
       Net Treasury supply will probably be around $1.42           Households                521         319             50        550
       trillion in 2011. This of course relies on the passage of
                                                                   Banks                     101         131             50        150
       the tax package, and the ultimate cost scoring by the
                                                                   Pension/insurance         211         203             25        200
       CBO, which we have attempted to estimate.
                                                                   Fed                       301          35            315        816
       Gross coupon Treasury issuance will probably be             Other private              -49         10              0          0
       around $2.1 trillion, assuming stable nominal Treasury
       auction sizes and a small increase in TIPS supply.          Total                    1532         840            670       2616
                                                                   Source: Deutsche Bank
       Maturing coupon Treasury notes and bonds total
       $790 billion in 2011.                                       The major classes of investors are likely to continue
       The balance of the funding requirements will be             increasing their Treasury buying. Foreign investors,
       minimal and likely come from net bill issuance.             particularly central banks, will continue to accumulate
                                                                   Treasuries given the status of a reserve asset. This buying
Treasury issuance assuming unchanged coupon sizes                  could increase in size if the dollar declines and foreign
and increased TIPS issuance                                        central banks are obliged to intervene in the currency
                                                                   markets to support the dollar exchange rate. Households
                                      Projected 2011               are expected to continue buying Treasuries given the high
                                                                   savings rate and the volatility of risky assets. Banks will
                                       issuance $bn
                                                                   seek to buy Treasuries as a liquidity reserve; in the past
           2Y                                    408
                                                                   quarter, the growth in Treasury holdings by banks was
           3Y                                    384
                                                                   particularly large, at $67.4 bn, or 0.5% of assets, resulting
           5Y                                    420
                                                                   in 2.0% of bank assets in Treasuries. Pension plans were
           7Y                                    348               also substantial buyers of Treasuries, at $55 bn, or 0.6%
           10Y                                   264               of assets, resulting in a Treasury allocation of 7.7%. In
           30Y                                   168               2011, we don’t see this pattern of Treasury demand
           TIPS                                  134               changing significantly.
           Gross issuance                       2126
           Less: Maturing                        790               Finally, the Federal Reserve is likely to keep buying
           Net coupon issuance                  1336               Treasuries at a pace of just over $100 bn per month. We
           Plus: Bills                            84               have included an extension of the Fed’s purchases for the
           Total net issuance                   1420               rest of the year in the “Max” scenario below.
Source: Deutsche Bank

                                                                   Future supply/demand estimates for Treasuries
Assuming the tax proposals are adopted, there is little
                                                                                                       2011 full year
need for the Treasury to change its issuance patterns or
                                                                                                    Baseline            Max
issue sizes for the coming year. Thus there are not likely
                                                                   Foreign                              900             1250
to be significant technical issues for the Treasury market,
                                                                    BOJ                                 100             300
as the Fed buys off-the-runs and new supply pours in
through the Treasury auctions.                                      Other official                      700             800
                                                                    Other foreign                       100             150

Demand/supply dynamic remains positive                             Households                           550             700
Despite the anticipated increased supply caused by the             Banks                                150             200
Administration’s tax package, we don’t see a significant           Pension/insurance                    200             250
shift in the supply/demand dynamic in Treasuries. The
theme of overwhelming demand for Treasuries across the             Fed                                  816             1266
spectrum of investors remains. In the tables below, we
update out supply/demand projections with the latest               Total demand                        2616             3666
Federal Reserve Flow of Funds data for Q3.
                                                                   Projected supply                    1400             1400
                                                                   Source: Deutsche Bank

Deutsche Bank AG/London                                                                                                        Page 21
10 December 2010                Fixed Income Outlook 2011

Tightening swap spreads                                                Over the longer term, the main driver of the 10 year
We are closing our long swap spread trade in the                       swaps in 2011 will continue to be the oversupply of
portfolio. This trade had benefited from the pain trade and            government debt relative to private debt. The tax deal in
convexity paying through early December. While 10yr                    the Congress and the potential for additional fiscal policy
spreads have already tightened about 8bp over the past                 will lead to tighter spreads in the 10Ysector. However,
week, prospective corporate issuance in early 2011 as                  we think that the demand for Treasuries will be robust
well as the surprise fiscal stimulus bodes well for some               during the year from the central banks and domestic real
further narrowing.                                                     money managers. This will limit the tightening of spreads,
                                                                       perhaps by about 10 bps.
In general, corporate issuance tends to accelerate
following the New Year, after a weak issuance period in                On the 10 year sector, we think that the effect on
December. On average since 1999, the January issuance                  convexity hedging will add some directionality to the
has been about $48 billion, nearly 45% more than in                    spreads. If the market sells off to a level above 3.5%, the
December. Higher corporate issuance tends to tighten                   convexity payers will drive spreads wider. If the market
swap spreads. 10yr swap spreads have exhibited an                      sells off further, and say MBS 4.5s become par, convexity
average tightening of about 8bp in January over the past               will disappear from the market. Treasury supply will be
six years. We acknowledge that swap spread tightening                  the only driver and we will experience massive tightening.
trades looked better a week ago, but may still have some               It will not surprise us if we see a negative 10 year swap
room to go.                                                            spreads in the scenario.

Monthly average corporate bond issuance                                The 2 year spreads will be heavily driven by the Libor-OIS
                                                                       outlook. The financial crisis is Europe is likely to continue
 60                                              Avg 1999-2010         with Portugal next in line. The effect of the Irish crisis was
                                                                       fairly muted on the LIBOR-OIS spread relative to the past.
                                                                       Thus we don’t expect a large move in the 2Y spread
 50                                                                    unless something momentous happens such as a crisis in
                                                                       Spain. So we are quite neutral on the 2 year spreads.
                                                                       Front end TIPS out to the 5yr offer value
 40                                                                    TIPS offer value in the front end out to five years. This is
                                                                       as much due to the fact that breakevens are very low and
                                                                       near term technical factors that can elevate CPI, at least
 30                                                                    temporarily.
         Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: IFR and Deutsche Bank                                          We believe that 2012 TIPS are not pricing in enough
                                                                       inflation for year 2011, and therefore, offer value. Despite
                                                                       this week’s widening, the TIPS Jan-2012 breakeven
                                                                       implying only 1% of inflation between Oct/Nov 2010 and
Seasonality in 10yr swap spreads                                       Oct/Nov 2011, about 100bp below our CPI forecast. The
                                                                       same is true for other 2012 TIPS. Inflation expectations
  30                                                                   priced in for year 2011 remain very low historically and
                                                                       particularly low against our 2% CPI forecast.

  10                                                                   The front end TIPS have tended to underestimate the
                                                                       actual year-over-year inflation one year ahead, at least in
                                                                       four out of the past five years. For example, in December
                                                                       2006, the 1/15/2008 TIPS had an average breakeven
 -20                                                                   around 2.25%. At the end of 2007, the year-over-year
                                                                       headline CPI was north of 4%. The trade did not work
                        2010             2005-2009
                        2009             2008                          during the financial market crisis in late 2008, when the
 -40                    2007             2006                          actual inflation was less than what was implied by front
 -50                                                                   end TIPS in late 2007. One of the reasons why 1/2012
       Jan   Feb Mar       Apr May Jun   Jul   Aug Sep Oct   Nov Dec   TIPS look cheap is probably because they are due to be
Source: Deutsche Bank
                                                                       excluded from the index in January 2011. We think this
                                                                       presents an opportunity for non-index based investors.

Page 22                                                                                                    Deutsche Bank AG/London
10 December 2010            Fixed Income Outlook 2011

Front end TIPS have tended to underestimate the                 5yr TIPS breakevens are likely to rise at a faster pace
year-over-year inflation one year ahead                         in a scenario of further market sell-off
                                                Headline CPI
              Period         TIPS Dec Avg BE       1yr Later
              Dec-05    1/15/2007        1.92           2.54
              Dec-06    1/15/2008        2.25           4.08
              Dec-07    1/15/2009        2.15           0.09
              Dec-08    1/15/2010       -5.67           2.72
              Dec-09    1/15/2011        0.71           1.20
Source: Deutsche Bank

Bearish investors should consider being long 5yr TIPS
BEs. 5yr BEs have traded in a 1.40% to 1.60% range most
of the time since early October, despite of the market sell-
off. In a scenario of further backup in rates, 5yr BEs are
likely to widen at a faster pace. The relationship between
BEs and Treasury yields at the 5yr maturity appears like a
                                                                Source: Deutsche Bank
“hockey stick,” where BEs tend to have little correlation
with Treasury yields in a rally, but widen quickly in further                             Dominic Konstam (1) 212 250-9753
sell-off with a high correlation. The former probably is                                Mustafa Chowdhury (1) 212 250-7540
related to the deflation put option embedded in the                                            Marcus Huie (1) 212 250-8356
recently auctioned 5yr issue. We estimate that option is                                            Alex Li (1) 212 250-5483
worth about 17bp on the 4/2015 5yr, and almost
worthless in the seasoned 1/2015 issue.

Deutsche Bank AG/London                                                                                              Page 23
10 December 2010     Fixed Income Outlook 2011


    The Treasury market has re-assessed its outlook            Bush tax cuts had been assumed to be extended. The
    for 2011 after the recent massive sell-off. High           new “big ticket” items in the news this week were the
    rates may not be sustainable if the economy                2% reduction in Social Security taxes and the extended
    doesn’t get enough momentum from the fiscal                federal unemployment benefits, which are estimated to
    stimulus and QE2. Supply will be more. While               cost around $180 billion, and had not been priced in by
    more cost details on the deals are still needed, we        markets.
    believe net Treasury issuance will probably be
    around $1.42 trillion in calendar year 2011, a             Net coupon Treasury issuance will probably be
    couple of hundred billion dollars more than what           around $1.42 trillion in 2011
    had been priced in.
    The sell-off has cheapened the belly of the curve                                        U.S. Treasury
                                                                    $1,600                   Notes and Bonds:
    significantly. The 5s/10s/30s spread, for instance,
                                                                    $1,400                   Net Issuance
    has moved from being about 2.5 standard                                                  (Bil.$)
    deviations rich in early November to fair valued.
    10s are back to a valuation level on the curve
    similar to pre-QE. We believe the belly will likely
    remain directional into early 2011.
    Fed custody holdings of Treasuries dropped again
    in this week’s data release, a second time decline
    in the last few weeks. The data points to
    weakness in foreign demand for Treasuries,
    consistent with the consecutive tails in recent
                                                                                  98         00        02        04     06    08    10
    Treasury note auctions (2s and 5s in late
                                                               Source: Bureau of Public Debt and Deutsche Bank
    November, and 3s and 10s this week).
    While spreads tightened about 8bp in the 10yr              While more cost details on the deals are still needed, we
    this week, prospective corporate issuance in early         believe net Treasury issuance will probably be around
    2011 as well as the fiscal stimulus supports some          $1.42 trillion in calendar year 2011. Prior to the news this
    further narrowing.                                         week, we had expected some modest cuts in Treasury
    We highlight opportunities in long STRIPS. We              issuance in 2011, especially in the short to intermediate
    like 5/2040 principal STRIPS, currently trade at           coupon Treasury notes. We now believe the front end
    about +34bp over the 4.375s of 5/2040 whole                issuance will probably remain relatively stable, due to the
    bond, and have about a 3.0 three-month t-stat on           additional borrowing requirements to fund the tax cuts
    our spline model. The Treasury reported hefty net          and a still uncertain economic outlook.
    stripping in November. The 5/2040 bond alone
                                                               The tax deals also means that the expected deficit
    saw $4 billion net stripped.
                                                               reductions beyond 2011 were optimistic. For example, we
    In TIPS, we like front end breakevens out to the           had expected a $1 trillion budget deficit in fiscal year
    five-year maturity. We believe that 2012 TIPS are          2012. The figure now looks more likely to be above $1.1
    not pricing in enough inflation for year 2011, and         trillion.
    therefore, offer value. 5yr TIPS BEs also have
    room to widen, especially in a sell-off scenario. In       Here are some details of our Treasury supply outlook for
    the long end, 30yr TIPS breakevens are a better            next year based on the currently available information.
    value than 20yr breakevens.                                       Net Treasury supply will probably be around $1.42
                                                                      trillion in 2011.
Supply Outlook for 2011
                                                                      Gross coupon Treasury issuance will probably be
Investors have re-assessed the Treasury supply outlook
                                                                      around $2.1 trillion, assuming stable nominal Treasury
for the next couple of years based on the latest tax deals
                                                                      auction sizes and a small increase in TIPS supply. The
from Washington. The price tags have ranged between
                                                                      tax cut extensions are likely to keep front end
$700 billion and $900 billion in the media. In our view, the
                                                                      issuance elevated, in our view.
market expectations of additional Treasury supply only go
up by a fraction of those figures, because some forms of

Page 24                                                                                                               Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

       Maturing coupon Treasury notes and bonds total             Fed custody holdings of Treasuries and agencies,
       $790 billion in 2011.                                      four-week change
       The balance of the funding requirements will likely                        120,000

       come from net bill issuance. Treasury bills
       outstanding as a percentage of total marketable debt
       are low by historical standards. That said, we are
       currently about $500 billion below the $14.294 trillion

       debt limit. Treasury debt will probably get close to the
       limit by April or May 2011, which may affect bill
       issuance. Unfortunately, the recent proposed tax                                                                  Total: $3,338.9B
       legislation hasn’t included a provision for raising the                                                           Treasuries: $2,607.9B
       debt limit, so the likelihood of changes in financing to                   -80,000
                                                                                                                         Agencies: $731.0B

       avoid the debt limit is becoming more likely.                                    Jul-08      Jan-09      Jul-09        Jan-10        Jul-10

                                                                  Source: Federal Reserve and Deutsche Bank
Treasury bills outstanding as a percentage of total
marketable debt are low by historical standards                   Tightening swap spreads
 36%                                                              Swap spreads tightened over the past week. While
                         Bills as % of Total Marketable Debt      spreads tightened about 8bp in the 10yr, prospective
                                                                  corporate issuance in early 2011 as well as the surprise
 32%                                                              fiscal stimulus supports some further narrowing.
 30%                                                              10yr swap spreads have exhibited an average
 28%                                                              tightening of about 8bp in January over the past six
 24%                                                                   30

 22%                                                                   20

   Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08
Source: US Treasury and Deutsche Bank                                 -20

                                                                      -30              2005-2009         2010                2009
Fed custody data points to recent weakness in foreign                 -40              2008              2007                2006
demand for Treasuries                                                                  2005
Fed custody holdings of Treasuries dropped again in this                    Jan    Feb Mar       Apr May Jun      Jul     Aug Sep Oct         Nov Dec
week’s data release, a second time decline in the last few        Source: Deutsche Bank

weeks. Treasury holdings dropped 2.9 billion, while
agency and MBS holdings were 2.8 billion lower. The               In general, corporate issuance tends to accelerate
back-to-back drop in foreign central banks’ Treasury              following the New Year, after a weak issuance period in
holdings has not occurred often since June 2010.                  December. On average since 1999, the January issuance
                                                                  has been about $48 billion, nearly 45% more than in
The four-week change in the custody holdings of                   December. Higher corporate issuance tends to tighten
Treasuries peaked in August/September to nearly +$100             swap spreads. 10yr swap spreads have exhibited an
billion, but has dropped to almost zero now. The recent           average tightening of about 8bp in January over the past
weakness in the custody data has coincided with the               six years. We acknowledge that swap spread tightening
consecutive tails in recent Treasury note auctions (2s and        trades looked better a week ago, but may still have some
5s in late November, and 3s and 10s this week).                   room to go.

                                                                  Hefty net stripping again in November; 5/2040 Ps look
                                                                  We like 5/2040 principal STRIPS in the long end. They
                                                                  currently trade at about +34bp over the 4.375s of 5/2040
                                                                  whole bond, and have about a 3.0 three-month t-stat on
                                                                  our spline model. The Treasury reported hefty net

Deutsche Bank AG/London                                                                                                                              Page 25
10 December 2010                                     Fixed Income Outlook 2011

stripping in November. The 5/2040 bond alone saw $4                                                                                    likely to widen at a faster pace. The relationship between
billion net stripped. A total close to $8 billion bonds were                                                                           BEs and Treasury yields at the 5yr maturity appears like a
net stripped from the 11/2039 to 11/2040 maturity, likely                                                                              “hockey stick,” where BEs tend to have little correlation
due to high insurance company demand on a relatively                                                                                   with Treasury yields in a rally, but widen quickly in further
steep 10s/30s curve as well as the backup in rates.                                                                                    sell-off with a high correlation. The former probably is
                                                                                                                                       related to the deflation put option embedded in the
Net stripping in November 2010, in $ millions
                                                                                                                                       recently auctioned 5yr issue. We estimate that option is
       $5,000                                                                                                                          worth about 17bp on the 4/2015 5yr, and almost
       $4,000                                                                                                                          worthless in the seasoned 1/2015 issue.

       $3,000                                                                                                                          30yr TIPS breakevens are a better value than 20yr
                                                      Nov-10                                                                           breakevens
                                                                                                                                       While 20-year TIPS BEs have cheapened recently from
                                                                                                                                       rich levels, we believe investors can find better relative
            $0                                                                                                                         value in 30yr BEs in the long end. The 20s-30s breakeven
                                                                                                                                       curve has flattened from a peak of around +20bp in mid
                                                                                                                                       October to the latest level of about +7bp. The flattening of
      -$2,000                                                                                                                          the BE curve has been consistent with the flattening of













                                                                                                                                       the nominal 10s-30s Treasury curve. Although we cannot
                                                                                                                                       rule out further flattening of the 10s-30s Treasury curve,
Source: US Treasury and Deutsche Bank
                                                                                                                                       and subsequent flattening of the 20s-30s breakeven
                                                                                                                                       curve, 30yr TIPS do present better relative value than 20s.
Front end TIPS out to the 5yr offer value
TIPS offer value in the front end out to five years. We                                                                                20yr to 30yr TIPS breakeven curve has flattened
believe that 2012 TIPS are not pricing in enough inflation
                                                                                                                                            0.25                          20s-30s BE
for year 2011, and therefore, offer value. Despite this
week’s widening, the TIPS Jan-2012 breakeven implying
only 1% of inflation between Oct/Nov 2010 and Oct/Nov                                                                                       0.20
2011, about 100bp below our CPI forecast. The same is
true for other 2012 TIPS. Inflation expectations priced in
for year 2011 remain very low historically and particularly                                                                                 0.15
low against our 2% CPI forecast.

The front end TIPS have tended to underestimate the
actual year-over-year inflation one year ahead, at least in
four out of the past five years. The trade did not work
during the financial market crisis in late 2008, when the
actual inflation was less than what was implied by front                                                                                       Mar-10          May-10   Jul-10   Sep-10   Nov-10
end TIPS in late 2007. One of the reasons why 1/2012                                                                                   Source: Deutsche Bank
TIPS look cheap is probably because they are due to be
excluded from the index in January 2011. We think this
presents an opportunity for non-index based investors.
                                                                                                                                       The Fed will announce the next round of QE operations
Front end TIPS have tended to underestimate the
                                                                                                                                       Friday, December 10 at 2PM. Based on the prepayments
year-over-year inflation one year ahead
                                                                                                                                       in November, we estimate that the next QE operations
                                                                                                     Headline CPI
                                                                                                                                       will total about $106 billion. Higher rates have reduced our
              Period                       TIPS Dec Avg BE                                              1yr Later
              Dec-05                  1/15/2007        1.92                                                  2.54                      prepayment projections in the months ahead, resulting
              Dec-06                  1/15/2008        2.25                                                  4.08                      smaller reinvestment requirements.
              Dec-07                  1/15/2009        2.15                                                  0.09
              Dec-08                  1/15/2010       -5.67                                                  2.72
              Dec-09                  1/15/2011        0.71                                                  1.20
Source: Deutsche Bank

Bearish investors should consider being long 5yr TIPS
BEs. 5yr BEs have traded in a 1.40% to 1.60% range most
of the time since early October, despite of the market sell-
off. In a scenario of further backup in rates, 5yr BEs are

Page 26                                                                                                                                                                          Deutsche Bank AG/London
10 December 2010           Fixed Income Outlook 2011

Monthly QE2 projections                                        5s/10s/30s butterfly, PCA weighted (52% and 48% risk
                         Reinvestments                         weights on the wings)
                          MBS Agency        QE2        Total
                Aug-10    14.6       2.9                 17
                Sep-10    24.6       2.4                 27
                Oct-10    27.5       4.4                 32
                Nov-10    28.4       1.5      75        105
                Dec-10    30.5       0.7      75        106
                Jan-11    31.3       2.8      75        109
                Feb-11    25.1       1.4      75        102
                Mar-11    25.5     10.8       75        111
                Apr-11    26.4       7.4      75        109
                May-11    28.2       6.0      75        109
                Jun-11    30.8       2.4      75        108
Source: Deutsche Bank

                                                               Source: Deutsche Bank

The sell-off has cheapened the belly of the curve
significantly. The 5s/10s/30s spread, for instance, has        CFTC commitment of traders report shows non-
moved from being about 2.5 standard deviations rich in         commercial investors are now net short TY
early November to fair valued. 10s are back to a valuation            500,000                               2s: -31,094
level on the curve similar to pre-QE. We believe the belly                                                  5s: 52,275
                                                                      400,000                               10s: -67,655
will likely remain directional into early 2011. CFTC
                                                                                                            Bonds: -12,071
commitment of traders report shows non-commercial                     300,000
                                                                                                            Ultra Long: -10,329
investors are now net short TY, a sharp decline from being            200,000
net long two weeks ago.




                                                                             1/1/08     7/1/08   1/1/09     7/1/09    1/1/10      7/1/10
                                                               Source: CFTC and Deutsche Bank

                                                                                                              Alex Li (1) 212 250-5483
                                                                                                          Marcus Huie (1) 212 250 8356

Deutsche Bank AG/London                                                                                                                    Page 27
10 December 2010      Fixed Income Outlook 2011


    Although range bound rates and, especially, their           policy including its effectiveness and its long-term side
    return to the lower bound would generically be              effects. In addition, we have the unknowns regarding the
    bearish for vol, we think that there are some               output gap and the Fed reaction function, disagreements
    specifics of the current market environment that            about the interpretation of growth numbers and recovery
    are likely to be vol supportive.                            signals, future dynamics of growth and unemployment.

    In the first quarter of 2011, lack of consensus and
                                                                Although range bound rates and, especially, their return to
    continued repricing should keep realized vol high.
                                                                the lower end would generically be bearish for vol, we
    A possible increase of activity in convexity
                                                                think that there are some specifics of the current market
    hedging would further reinforce a bid for gamma.
                                                                environment that are likely to be vol supportive.
    Vol should continue to trade directionally with
    initial inversion of the surface followed by a              In the first quarter, lack of consensus and continued
    gradual decline in gamma in a rally.                        repricing should keep realized high. A possible increase of
                                                                activity in convexity hedging would further reinforce a bid
    The presence of the Fed as a buyer of duration at
                                                                for gamma. Servicers and GSE have been extremely
    the lower boundary would generally reduce
                                                                inactive in the last year and further decline in there activity
    volatility, while the side-effects of such actions
                                                                is unlikely. In that context, any changes in their reaction
    would raise risks of higher rates in the future.
                                                                function can create an upside for vol. Furthermore, with
    Long dated payers would catch a bid and forward             continued issuance of mortgages and their migration back
    vol should stay elevated. Very long dated should            to the private sector could only be supportive for vol.
    underperform, while gamma could outperform
    intermediates.                                              As a consequence of heterogeneity of views each
                                                                economic outlook will be represented through first order
    With the expectations of possible decline in vol
                                                                risk, while adverse scenarios are likely to be hedged
    and rates settling lower in the second half of
                                                                through OTM options. A buildup of such hedges at the
    2011, we would look to establish a carry trade in
                                                                ends of the range could transform into thresholds of
    the 2Y2Y-3Y2Y sector of the curve through a long
                                                                negative convexity which could amplify the trend near the
    position in low strike receivers. Hybrid version
                                                                boundaries, while the multi-sided positioning could cause
    with KO at equity levels stuck at 85% S&P trade
                                                                higher vol as investors cover their position within the
    about 40-50% cheaper relative to vanilla.
    We would look for attractive levels to get long
    high strikes in 2Y2Y sector either outright or in an        Vol should continue to trade directionally with initial
    RV context.                                                 inversion followed by a gradual decline in gamma in a
                                                                rally. The presence of Fed as a buyer of duration at the
    Given the distribution of economic risks and
                                                                lower boundary would generally reduce volatility, while
    coordinated response across different market
                                                                the side-effects of such actions would raise risks of higher
    sectors, hybrid structures offer high degree of
                                                                rates in the future. As a consequence, the long dated
    flexibility in articulating the response to such an
                                                                payers would catch a bid and forward vol should stay
    environment through trades with attractive
                                                                elevated. Very long dated should underperform, while
    payout ratios.
                                                                gamma could outperform intermediates.
2011: Continued lack of consensus and
                                                                A brief summary of 2010: from split to multiple
heterogeneity of positioning                                    personality of the vol surface
The last weeks of 2010 are likely to set a template for         Going into the year we expected to see a sustained
behavior of the markets in the first quarter of the next year   surface normalization trend across the board on the back
when we expect to see continued bifurcation of views            of rebound in supply and partial normalization of the
away from consensus with considerable amount of                 markets together with repaired liquidity. This was front-
money put behind each view. There are several obstacles         run but the decline in gamma in the second half of 2009,
which are likely to prevent formation of consensus in the       but the real shift in vega did not take place until the last
forthcoming months. On the fundamental level we are             weeks of that year.
facing the uncertainties regarding the effects of monetary

Page 28                                                                                              Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

2010 could be characterized as the year of searching for       Comparing different expiries in 10Y tenors:
an equilibrium in an attempt to start building the             fragmentation in the second half of the year
consensus about the economy. During that process we
                                                                 180                                         1Y10Y (left)       105
acquired considerable clarity about the potential risks in
                                                                 160                                         10Y10Y             100
the market with the underlying dynamics revolving around
                                                                 140                                                            95
a gradual buildup of coordination across different assets
                                                                 120                                                            90
as the effects of the monetary policy propagated through
                                                                 100                                                            85
different market sectors.
                                                                  80                                                            80
                                                                    Jan-10             Apr-10   Jul-10     Oct-10
To put things in perspective, we summarize the main
developments of the vol surface as follows:
                                                                 150                                         1Y10Y (left)       140
                                                                 140                                         3M10Y              130
                                                                 130                                                            120
    Repricing of intermediate vol on the back of                 120                                                            110
    restoration of supply, lack of rebound in mortgage           110                                                            100

    related buying and decline in payer skew demand              100                                                            90
                                                                  90                                                            80
                                                                    Jan-10             Apr-10   Jul-10      Oct-10
    Fragmentation of the surface as a reflection of log-
                                                               Source: Deutsche Bank
    normality at the short end due to proximity of the
    zero-rate boundary
                                                               In terms of skew there has been even more volatility as
                                                               we this market recorded a full roundtrip from near record
    Return of the bid for low-strike protection
                                                               highs to brief visit to the pre-crisis levels. The figure below
                                                               shows the recent history of volatility skew for 5Y10Y
    Sustained bid for the very long end due to legislative
                                                               payers and receivers 100b OTM on both sides.
    changes in the treatment of the trust preferred and
    the disappearance of supply in that sector
                                                               Extreme volatility in skew: 5Y10Y +/- 100bp OTM
    Collapse of the upper left corner                             15                                                Payers
    Transmission of volatility from rates to FX due to QE2        10

    A strong bid for vol in the last weeks of the year             5

    Extreme volatility in skew
We have seen some extreme repricing across different
sectors of the surface. Although at some point we saw an          -5
almost complete convergence of the surface to what
resembled a pre-crisis equilibrium shape, the touchdown          -10
was brief as different economic and structural changes             Jan-09              Jul-09   Jan-10     Jul-10
started kicking in leading to various distortions across       Source: Deutsche Bank
different sectors. The figure below illustrates the timeline
associated with these distortions. Very short and very         Although the levels are less extreme than in 2009, the
long expiries are compared with intermediates which            volatility has been high on both sides as rates went
underwent the most radical changes. While for the most         between the boundaries of the range.
part, the repricing carried on in a coordinated way,
structural and fundamental changes resulted in                 2010 stats
accelerated rebound in the wings.                              How much has vol moved relative to where we started
                                                               the year in January. The figure below shows the quartile
                                                               plot for the term structure of 10Y vol in units of January

Deutsche Bank AG/London                                                                                                  Page 29
10 December 2010              Fixed Income Outlook 2011

2010 stats: 10Y tenors (in units of Jan-4 levels)                      only the first two quarters and, when annualized, is of the
                                                                       similar magnitude as 2009.
    1.1       10Y Tenors

                                                                       Buying of interest rates derivatives by insurance
    0.9                                                                             Cap
                                                                         40         Corridor
                                                                         35         Payer Swaption
                                                                         30         Floor
                                                                Last     25         Receiver Swaption
                                                                Mean     20
            1m          3m   6m   1y   2y    5y    7y     10y            10

Source: Deutsche Bank                                                     5
The wings, 1M10Y and 10Y10Y, are where we started the                     -5
year, while intermediates are roughly 10% lower. On the                           2005         2006     2007   2008   2009     2010
average gamma and vega (with the exception of the very                 Source: Deutsche Bank

longs) have been trading 20% lower with the downward
correction reaching as much as 35% in the third quarter.               We expect the insurance companies to continue to be
30Y tenors show more or less the same pattern with                     buyers of rates vol of similar size or higher with attention
some exception in the extremes.                                        on regulatory, macro and business risks.

For the short tenors, the entire term structure is lower for           While money managers activity should remain unchanged,
the year: Vol never exceeded Jan levels with the                       growth of the RV universe, which is near the pre-crisis
maximum downward correction in the ULC in excess of                    level, is likely to put some pressure on vol once we see
60% while longer expiries held in. On the average the                  the first signs of consensus.
ULC traded 30-40% relative to Jan.
                                                                       Although the Berm should persist, it is not likely to be of
The year ended with a rebound of vol across all sectors on             the same magnitude as we saw at the end of 2009.
the back of repricing in the rates market. The rally in vol            Similarly, callable supply should persist at similar pace as
was driven predominantly by high realized and a                        in 2010, while the effects of trust prefereds withdrawal
commensurate response in gamma, amplified by                           are going to be gradually priced out with further softening
convexity trade and stop-outs on steepener positions.                  of the lower right corner as the dealers seem to have
                                                                       adjusted their positions in anticipation of the possible
What to expect in 2011                                                 unwinds of the hedges.

Although their presence and level of involvement in the                With the new regulatory changes in Europe, their
vol market is not clear, servicers and GSE can not get                 insurance companies are likely to emerge as the buyers of
much smaller (in terms of their hedging activity). If we see           vol due stricter capital requirements and change in risk
a rebound of convexity hedging, they can emerge as                     limits. It is likely to see insurance companies as more
buyers of gamma. This is likely to solidify the risk                   active liability hedgers and structural buyers of vol in
premium and push short dated vol beyond the levels we                  Europe. We anticipate the market to front run this trend
saw in the last year. The effect could especially be visible           which should result in a bid for Euro vol. in the absence of
if high realized volatility persists.                                  structural buyers in the US, the spread between US and
                                                                       EU vega is likely to tighten.
Insurance companies could emerge as new buyers of
volatility, based on the growth of their business and the
                                                                       Economic paths & Tail risk
need to hedge and meet regulatory requirements. In the
last two years their participation in the options market has           Our projection for the rates is the 2.50-3.50% range.
grown considerably. The figure below shows their                       Under the assumptions of a mild recovery and a rebound
purchases of interest rates options in units of $bn                    in economic growth we expect the USD to remain well
notionals across different instruments. The 2010 reflect               supported with possible firming up by up to 5% on TWI
                                                                       basis. This would be based on higher US rates and

Page 30                                                                                                        Deutsche Bank AG/London
10 December 2010                       Fixed Income Outlook 2011

possible flat European rates and weaker Euro due to                                            3)   A sign of very strong growth should be supportive for
persistence of problems in European peripherals, which                                              risky assets, but could lead the Fed to tighten
could push Euro as far as 1.20. Stocks could see a 20%                                              aggressively which could go against the stocks, while
increase under this scenario.                                                                       the USD should firm up.
                                                                                               4)   In a normal recovery, both rates and equities are likely
                                                                                                    to trend higher while the currency trades sideways
Further rally in rates would be consistent with flat USD if
rates stabilize near 3%, while further rally in the 2.5-3%
range would be bearish for currency with USD down by
                                                                                               While the US sovereign risk appears remote, stagflation
up to 5%.
                                                                                               seems to be much more realistic outcome than the
                                                                                               market is pricing in. In most developed economies the
Deflation would be neutral on currency although a
                                                                                               structural decline in economic growth could be
possible flight to quality, that would take place in the early
                                                                                               interpreted as an irreversible correction in the
stages, could be short-term bullish for USD. Equities could
                                                                                               misallocation of capital which was allowed to build up
decline down to 900. We see more radical decline (a la
                                                                                               before the crisis – the potential was high due to excess
what happened with NIKKEI in the 90’s) as unlikely due to
                                                                                               leverage and is now lower as a consequence of the forced
stronger correlation between the US and emerging
                                                                                               deleveraging. In addition, the bigger role of the
markets economies.
                                                                                               government can be perceived as a source of inefficiency,
                                                                                               while the cost of regulation is introducing economic
Stagflation risk could push rates beyond 4% with possible
                                                                                               rigidities, both of which translate into lower production. In
weakening of the USD as much as 10-12%. This would be
                                                                                               such an environment, even slow growth can create an
a bearish path for equities which could decline by more
                                                                                               excessive demand, relative to the potential supply of the
than 20%.
                                                                                               new economy, which could push prices of consumer
                                                                                               goods up and give rise to higher core inflation and the
The figure below shows what we consider as the four
most likely economic paths for the near term. They are
represented in the rates-equity plain with lines of constant
currency.                                                                                      Trades
                                                                                               In the first quarter of the next year we expect elevated
Rates-equity interaction across different econ paths                                           levels of realized volatility with continued repricing of the
        1600                                                          $ down 10%               forwards. With intermediates close to their fair value and
        1500                                                                                   declining enthusiasm for the very long end, after six
        1400                                                                                   months of sustained bid, we expect further inversion of
        1300                                                              4         $ flat     the surface with the middle as a pivoting point. Our core
                            1b                                                                 position in the near term would be long gamma, neutral
        1200                               1a

                                                                                               vega and short 10Y10Y sector. With repricing of the
                                                                                               forwards and revisions of the outlook on monetary policy,
        1000                                                                  3
                                                                                               we should see considerable volatility in the short tenor
        900                                                                                    intermediates as well as high risk premium in the 2Y2Y
                                                                                  $ up 10%
        800             2                                                                      forward sector. On the other hand, given the aggressive
        700                                                                                    run ULC had, we would be less reluctant to short 2Y
            -100                     -50               0             50                  100   gamma, especially given our view of slow growth and
                                            Shift in 10Y rate (bp)                             continued Fed on hold.
Source: Deutsche Bank

                                                                                               With the expectations of possible decline in vol and rates
1)      High liquidity is supportive for both stocks and bonds;                                settling lower in the remainder of 2011, we would look to
        the price is paid by weaker currency. Rates and                                        establish a carry trade in the 2Y2Y-3Y2Y sector of the
        equities appear to have negative correlations without
                                                                                               curve through a long position in low strike receivers. This
        violating their historical relationships.
                                                                                               sector remains still attractive for such a trade as the curve
             a. Transmission of liquidity through lower rates
             and lower stocks while the currency remains                                       offers the most aggressive carry while the vol roll down
             unchanged                                                                         remains benign. We would consider either vanilla
             b. Currency devaluation and out performance of                                    receivers or hybrids with KO at very low equity levels as
             risky assets as a consequence                                                     we expect the Fed to remain constructive on the risky
2)      Despite abundant liquidity, the growth remains                                         assets and adjust the monetary policy in such a way to
        anemic while currency firms up and investors                                           prevent a substantial decline in stocks. The barrier stuck at
        abandon US equities.

Deutsche Bank AG/London                                                                                                                             Page 31
10 December 2010      Fixed Income Outlook 2011

85% S&P cheapens hybrid receivers by about 40-50%                Stagflation Hedges
relative to vanilla.                                             The inability of the Fed to raise rates due to slow growth
                                                                 and a buildup of inflation in such a scenario would be
It is likely that high strike payers will remain well bid due    bearish for both currency and risky assets. While the front
to continued attraction to carry and possible adverse            end of the curve remains anchored at low levels, the back
effects bear flatteners could have on the market. We             end would sell off as the market reprices higher inflation
would look for attractive levels to get long high strikes in     expectations. To some extent the gold market is already
this sector either outright or in an RV context which would      pricing in the risk of such an economic path.
reduce the impact of negative carry.
                                                                 While the gold market is pricing higher uncertainties in
Hybrids                                                          the future corresponding to the shift caused by the
The general logic behind positioning in the market with          introduction of QE and government purchasing
multiple economic paths is to buy (generally far) OTM            programme, the rates seem to be in tune with the pre-
options for each adverse path either as an outright              crisis regime with no additional premium attached to
position or as an overlay to the existing positing in terms      the risk of massive bear steepening of the curve.
of first order risk. In selecting the structures we would
look for those with high payout ratio so that one of them        As a hedge against this risk we consider two variants of
pays for all if when it kicks in.                                hybrid trades

For the base case scenario of continued QE2 and support              Equity puts which knock in at high rates with KI
for risky assets in the near term we would be buyers of              barrier set for 10Y CMS at 4.50% (current spot is at
equity upside with low rates KI as equities are likely to            3.29%). For 3y S&P 100% (or 90%) puts subject to KI
rally on the back of more stimulus. As a hedge against               at maturity the price is reduced by 60% relative to
deflation we would consider longer dated equity puts                 vanilla.
struck ATM with KI at lower rates. This would typically be           Equity puts with knock in at weak USD: 1Y S&P
the the hedge for the first trade if the monetary policy fails       93% put with European knock in with USDCHF below
and the risky assets decline after initial rally.                    0.87. The premium is 70% relative to vanilla

Protection against further decline of stocks in a rally due                            Aleksandar Kocic (1) 212 250 0376
to continued high unemployment and continued decline in
growth, i.e. an outright failure of QE to support risky
assets, is articulated through

    Equity puts with rates knock in: Buy 3M S&P puts
    struck at 97% subject to knock in on 5Y CMS below
    1.45% at expiry. The price is about 60% lower
    relative to vanilla.

    A possible flight to quality mode on the back of
    further spread of the European crisis would be
    manifested by a bid for USD. If the currency remains
    strong, support for US risky assets should weaken
    increasing the probability of deflationary scenario. As
    a hedge against such a scenario we would position
    in terms of

    Equity puts with FX knock in with strong USD: 3M
    S&P puts struck at 93% with European knock in with
    EURUSD below 1.20. The price is about 50% lower
    relative to vanilla

Page 32                                                                                            Deutsche Bank AG/London
10 December 2010     Fixed Income Outlook 2011


Funding the GSEs                                               Figure 1: Issuance by FNMA, FHLMC through Oct. ‘10
                                                               Short Term Debt                              2008       2009   2010 YTD
    Regulatory momentum and higher long rates may
                                                               Gross                                        2371       1965        833
    squeeze the agency debt market of fresh issuance
                                                               Net                                              209    -216        -21
    in 2011. Any unexpected decline in the supply of
                                                               Long Term Debt                               2008       2009   2010 YTD
    bonds by Fannie and Freddie could decrease the
    relative liquidity of agency bonds and delink              Gross                                            518    668         677

    spreads.                                                   Net                                               -45    65         -18
                                                               Total Debt                                   2008       2009   2010 YTD
    Issuance of GSE bonds may fall short of
                                                               Gross                                        2889       2632       1510
    redemptions and maturities by $100 billion in
    2011. The decay of mortgage portfolios and the             Net                                              164    -151        -39

    extension effect of the recent rates sell-off on           Long-Term Type                               2008       2009   2010 YTD
    callables may diminish funding needs.                      Callable                                         61%    58%        66%
                                                               Non-Callable                                     39%    42%        34%
    We outline a scenario in which gross issuance              Source: Deutsche Bank; Fannie Mae; Freddie Mac
    reaches $1.1 trillion, comprised of approximately
    $410 billion in short-term debt, $385 billion in           As the table in Figure 1 shows, Fannie and Freddie pared
    longer-term bullets, and $300 billion in callable          their reliance on short-term debt in 2010. In early 2008 the
    bonds. Variables include the pace of mortgage              two GSEs were together raising $200 billion a month in
    portfolio runoff, investor term preference, long-          short-term debt. This fell to a monthly rate of around $150
    term funding conditions, callable redemptions,             billion last summer, and to $75 billion or so by the end of
    and any unexpected new funding requirements.               this year. One role of short-term funding is to insure
The start of 2011 marks a critical juncture for housing        against a liquidity crunch, and we presume that the GSEs
finance. While the trajectory of GSE funding requirements      believe the need for this insurance is reduced given the
points south, near-term factors cloud the prospects for        the explicit financial support of the federal government.
the composition of debt and the gross supply of issuance.      With agency bonds trading off a spread to Treasuries, the
In an environment of slower mortgage portfolio runoff,         GSEs may also have taken advantage of the yield
lower long rates, and increased callable redemptions, the      environment on Treasury notes to lock in less expensive
gross supply of debt could remain on par with 2010. In         longer-term funding.
contrast, regulatory momentum and higher long-term
rates could place 2011 on path to be a paltry year for new     One can spot a relationship between the supply of short-
bond issues from Fannie Mae and Freddie Mac. In the            and long-term debt and 10-year Treasury yields in Figures
backdrop lie the effects of unanticipated regulatory           2 and 3 below. The first figure plots short-term issuance
changes, the term preference of agency investors, and          against 10-year yields, while the latter shows long-term
the sanctity of the federal backstop. Issuer-specific credit   issuance against the reciprocal of yields. A sustained
factors will play a smaller factor in the near term, but       increase in long rates would shift the balance back toward
could be expected to resurface in the mid-to-long term.        shorter-term funding, though we do not expect the share
                                                               of short-term funding to return to 2008 levels.
A shift toward longer-term and callable debt in 2010
In the year through October 2010, Fannie Mae and
Freddie Mac issued approximately $830 billion in short-
term debt and $680 billion in long-term debt, based on
figures provided by the companies. Of long-term debt,
around two-thirds of the amount was of the callable
variety, a higher share than in recent years. (See Figure 1)
Slim yields in comparable fixed-income products, and a
perception of a low and steady rates environment, made
the pickup of agency callables to bullets more desirable to
credit-averse investors in 2010. On a net basis, issuance
declined by $39 billion, the consequence of a shrinking
asset base.

Deutsche Bank AG/London                                                                                                       Page 33
10 December 2010                   Fixed Income Outlook 2011

Figure 2: Short-term debt issuance has fallen with                     10% annual pace, about $150 billion would be freed up
declining long-term rates                                              next year, but they could also afford a slower runoff of
                                                                       5%, freeing up $75 billion. Should political or regulatory
  250                                                            4.5
                                      Issued      UST 10 yield         considerations, on the other hand, prompt a quicker
                                                                 4     winding down of the GSEs, a portfolio runoff of $200
  200                                                                  billion or more is also possible.

                                                                       Figure 4: The glide path of GSE portfolios
                                                                 2.5              2,000                                            GSE portf
                                                                                  1,800                                            GSE portf (10% runoff)
  100                                                                             1,600                                            FHFA Combined Limit
                                                                 1.5              1,400

                                                                        $ (bil)
                                                                 0.5               800
     0                                                           0
         1/08                      1/09            1/10

Source: Deutsche Bank                                                                0

Figure 3: Long-term issuance tracked against
reciprocal of 10Y UST shows sensitivity to rates                       Source: Deutsche Bank; Fannie Mae; Freddie Mac; FHFA

  120                   Callable                                 0.5
                        Noncallable                                    All else equal, these scenarios suggest a decrease in net
                        UST10 yld (1/x)                                issuance in 2011 of between $75 billion and $200 billion.
  100                                                                  A more rapid winding down of Fannie Mae and Freddie
                                                                       Mac would require the political and regulatory will to
   80                                                                  develop an alternative arrangement for housing finance. In
                                                                 0.3   its absence, we would assign a higher probability to a
                                                                       portfolio decline in 2011 in the range of $100 billion to
                                                                       $125 billion.
                                                                       Gross issuance and the callable variable
                                                                       We turn now to gross issuance, taking a first pass without
   20                                                                  the consideration of callables. Public data shows that
                                                                       approximately $660 billion in debt comes due next year at
     0                                                           0.0   Fannie and Freddie, refundable with any combination of
         1/08                      1/09            1/10                short- and long-term debt. In our scenario above, the
                                                                       GSEs could fund $110 billion of this need outside of the
Source: Deutsche Bank                                                  capital markets, through portfolio reduction. For the
                                                                       remainder, at a historical average of about 70% of long-
The elephant in the room                                               term funding, the GSEs would issue around $385 billion in
Any discussion of GSE debt supply cannot stray far from                longer-term debt. A short-term funding hole of $265
their primary use of funds: a (shrinking) portfolio of                 billion, funded with bills with a maturity profile of about 5
mortgages. We expect Fannie Mae and Freddie Mac to                     months, would require about $410 billion in newly issued
end 2010 with a combined portfolio of approximately $1.5               shorter-term debt. This figure is well below recent
trillion, comfortably below the combined limit imposed by              issuance levels. One factor that may drive up higher short-
the Federal Housing Finance Agency (see Figure 4).                     term issuance is a shorter maturity profile. One seasonal
Because the combined limit contracts at a pace of 10                   factor here is the timing of maturities, which for bullets
percent a year, we take as a starting point a contraction of           are generally skewed toward the first half of 2011, as the
10 percent in the GSE portfolio in 2011. As a decrease in              figure below shows.
assets is a source of funds, the GSEs can count on the
portfolio reduction to free up funds otherwise needed via
the capital markets. The GSEs have plenty of regulatory
headroom in their portfolio and could slow the runoff. At a

Page 34                                                                                                                       Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

Figure 5: Maturities of fixed-rate agency bonds, 2011                                    over the past two years, or yearly run rates of $240 billion
                                                                                         to $600 billion. Given the generally lower portfolio and the
                                                                                         overhang of higher rates, we would expect an amount

                                                      FHLB         FNMA        FHLMC
    40                                                                                   toward the lower end of this range, in the area of $300
                                                                                         billion. All in, the scenario outlined above would lead to
                                                                                         gross issuance of approximately $410 billion in short-term
    30                                                                                   debt, $385 billion in longer-term bullets, and $300 billion in
                                                                                         callable bonds, for total gross issuance of $1.1 trillion.

    20                                                                                   Figure 7: Maturities through 2012, FNMA and FHLMC
    15                                                                                         40

                                                                                                                                           Callable       Floating         Fixed

             12    1    2      3       4      5   6     7      8     9    10   11   12
Source: Deutsche Bank

Callable issuance adds a wrinkle to the funding outlook,                                       15
since they are not classified as short-term debt but can be
called, and refunded, within a year or less of issue.
Callable debt issuance by Fannie and Freddie grew from                                          5
$300 billion in 2008 to $448 billion. The GSEs haved
generally issued new callables in about the same                                                0
proportion as the amount of debt called, as the figure                                              12      2      4      6      8    10    12    2   4       6       8    10      12
shows. A sustained increase in Treasury yields would be                                  Source: Bloomberg Financial; Deutsche Bank

expected to extend the average maturity of GSE debt and
reduce refunding needs overall.                                                          Figure 8: Potential fixed rate callable redemptions,
Figure 6: Monthly callable bond issuance by FNMA,

FHLMC, netted against amounts called ($b)                                                                                                                                 FFCB
   80                                                                                          70                                                                         FHLB
                            Callable                  Called               Net
                                                                                               60                                                                         FHLMC
                                                                                               50                                                                         FNMA


   20                                                                                          30


  -40                                                                                                 12    01     02     03     04   05    06   07   08     09      10   11     12
                                                                                         Source: Bloomberg Financial; Deutsche Bank

                                                                                         Agency spreads holding steady, but watch liquidity
  -80                                                                                    Agency bonds have traded relatively steady against
          1/08                         1/09                        1/10                  benchmark Treasury securities, as the following two
Source: Deutsche Bank                                                                    charts demonstrate. Spreads have withstood the early
                                                                                         December rates sell-off, suggesting some resilience to a
While less than $15 billion in Fannie and Freddie callables                              rebasing of government yields. However, our supply
maturing in 2011, more than $300 billion in bonds reach                                  outlook should suggest some growing concern over
their next call date sometime that year. This creates an                                 liquidity factors in the agency bond market. An
interest-rate sensitive variable for issuance. Callable                                  unexpected decline in supply could decrease the relative
supply has averaged between $20 and $50 billion a month                                  liquidity of agency bonds versus possible alternative

Deutsche Bank AG/London                                                                                                                                                   Page 35
10 December 2010                    Fixed Income Outlook 2011

investments, including Treasuries and corporate bonds.                     Figure 10: Fannie Mae 5Y spread to Treasuries
Moreover, proposals to rapidly move the GSEs into an
alternative to conservatorship may create legal uncertainty                                                  spread           UST 5Y       FNM 5Y

for bondholders that could add a risk premium.

Figure 9: Fannie Mae 2Y spread to Treasuries
    0.80                      spread           FNM 2Y           UST 2Y


    0.50                                                                          0.50

                                                                                         Sep                     Oct             Nov          Dec
    0.20                                                                   Source: Deutsche Bank; Bloomberg Financial


           Sep                       Oct            Nov              Dec                                                Daniel Sorid (1) 212 250-1407
Source: Deutsche Bank; Bloomberg Financial


                                                                           Beyond supply and demand, the bloom has come off of
Competing for relative value
                                                                           QE2 for MBS investors. A muddling sales job for the
Originally published on 8 December 2010.                                   program by the Fed, a little politics, some positive
For the first time in years, MBS performance looks likely                  economic data and lately the debt tremors out of Europe
to depend almost entirely on relative value. Not on buying                 have all turned the tables on expectations. Rates, volatility
by big asset-liability managers. Not on the balm of low                    and spreads have gone up instead of down. And without
yields and declining volatility. MBS increasingly has to                   QE2 to calm rates and help MBS performance, supply and
compete with other assets for relative value dollars. And                  demand has taken the wheel. That’s a prescription for
the spread on MBS that brings those dollars in is very                     wider spreads.
likely 10 bp to 20 bp wider than today’s levels.
                                                                           Impact of the Fed’s absence
For most of the last 15 years, well capitalized asset-                     The likely widening in MBS spreads is probably best
liability managers have driven MBS spreads. The GSEs                       anticipated by work done to estimate the impact of Fed
defined levels in the late 90s, the banks into and out of the              buying on MBS. Johannes Stroebel and John Taylor,
recession of ’01, foreign portfolios through the middle                    economists at Stanford, estimated that the Fed program
‘00s, and the Fed until last spring. Not today. Instead,                   ultimately tightened MBS spreads by 30 bp. Passive Fed
most big asset-liability managers have become passive                      selling should consequently widen spreads, although the
sellers of MBS. Since the August FOMC, the Fed has let                     market today may have more potential MBS buyers than
$25 billion to $30 billion a month in MBS principal roll out               when the Fed first intervened in late 2008. If 30 bp of
of its portfolio and into Treasury debt. The GSEs, too, have               widening represents a complete unwinding of the Fed’s
let their MBS portfolios slide by an average of $12 billion a              impact, then today’s healthier market makes a widening
month since mid-summer. And foreign portfolios for                         of 10 bp to 20 bp seems reasonable
months have shown about as much interest as
schoolboys at the middle school dance. Only banks have                     A historic spread of MBS to corporate debt
added MBS since June at a pace of around $10 billion to
                                                                           One place where MBS may be well positioned to draw a
$25 billion a month—healthy but not enough to offset the
                                                                           backstop bid is from the $4.3 trillion invested in non-
steady tide of secondary supply.
                                                                           financial corporate debt. That capital does not cross the

Page 36                                                                                                                       Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

border into MBS easily—balance sheet and prepayment                          Figure 2: MBS reaches multi-year wides to investment
analysis often sit uneasily in the same room—but spreads                     grade corporate debt
in MBS have reached levels where some corporate
investors have started to notice.
Since August, the spread between par MBS and the
5-year point on the swap curve—the single point with the                                      50
most similar duration—has widened from 177 bp to
206 bp. The premium for 5-year investment grade CDS                                                        0

meanwhile has tightened from 105 bp to 91 bp (Figure 1).
While investment grade CDS may not be a perfect proxy                                  -50
for corporate bond spreads, it is undoubtedly a
transparent, liquid and diversified one. Mortgage spreads
largely show the impact of the change in Fed portfolio
policy. Corporate spreads reflect cash-rich corporate
                                                                                                        Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
balance sheets and a solid investor appetite for yield.
                                                                             Source: Deutsche Bank

Figure 1: Diverging spreads in MBS and investment                            Finding fair value between MBS, corporates
grade corporate debt                                                         The current nominal spread alone might look wide enough
                                                                             for some investors to allocate from corporates into MBS.
                                                                             The MBS yield advantage does give a big lift to current
         300          Curr Cpn sprd to 5y swap
                                                                             income, but not one big enough yet to push projected
                      IG corp 5yr sprd
         250                                                                 returns on MBS above returns on the average investment
                                                                             grade corporate (Figure 3). The MBS wins on cash flow,
                                                                             returning slightly more than 1% a year in extra coupon.
         150                                                                 But MBS loses on repricing since the corporate bond rolls

                                                                             down a steep yield curve. But portfolios that value current
         100                                                                 income or expect a flatter yield curve—one that would
                                                                             mute the repricing advantage of the corporate bond—
                                                                             might still prefer the MBS.
          Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10                          Figure 3: Projected 1-year net returns on MBS – IG

•          Note: Spreads in MBS represented by the difference between                                           2.00
par MBS yields and the 5-year Treasury note, and spreads in corporate debt
                                                                                  Proj. 1Y Return: MBS - Corp

represented by the on-the-run CDX IG 5-year CDS.                                                                1.00
Source: Deutsche Bank, Bloomberg Finance LP
The latest divergence between MBS and corporate
spreads has put the yield gap between the two sectors at
116 bp—the widest level since the launch of the                                                                 -2.00
investment grade CDS index in 2005 (Figure 2). The                                                                                           Total
                                                                                                                -3.00                        Price
average gap between par MBS and CDS over that span
has been 37 bp.                                                                                                 -4.00
                                                                                                                        -100   -50   -25 Base +25        +50   +100
                                                                                                                                     Yield Curve Shift

                                                                             •            Note: Data show projected 1-year returns on a mix of 30-year
                                                                             3.5% and 4.0% pass-throughs with duration equal to a 5-year bullet
                                                                             corporate bond. The corporate coupon equals the 5-year swap yield plus
                                                                             the 5-year IG premium. Projected returns assume rates constant, a linear
                                                                             shift in the yield curve over one year, and repricing at a constant OAS. All
                                                                             market levels as of 2 Dec 2010.
                                                                             Source: Deutsche Bank

                                                                             Beyond nominal relative value, the risk-adjusted value of
                                                                             MBS relative to corporates is obviously much harder to
                                                                             measure. But at a simple level, the spread volatility of the

Deutsche Bank AG/London                                                                                                                                        Page 37
10 December 2010                                         Fixed Income Outlook 2011

two asset classes says something about relative risk. The                                                                                 MBS to corporate debt has opened the door to asset
MBS spreads reflect changing views of prepayments,                                                                                        reallocation, although the magnitude and timing is an
supply and demand, liquidity, financing and other value                                                                                   educated guess. But in the business of educated
drivers. The corporate spreads signal shifts in downgrade                                                                                 guessing, 10 bp to 20 bp and the first half of 2011 sound
and default risk as well as the other usual suspects. By                                                                                  like pretty good answers.
that metric, MBS offers much more incremental yield per
unit of risk, with volatility in MBS spreads running well                                                                                                            ***
below volatility in the 5-year IG (Figure 4).
                                                                                                                                          The view in rates and volatility
Figure 4: Lower 60-day spread volatility in MBS                                                                                           The rates market looks and acts like QE2 has come and
                    120                            IG Spread Vol                                                                          gone. It is uncanny how similar the reaction is to the one
                                                   MBS CC Spread Vol                                                                      the market had in the spring of 2009, just after the Fed
                                                                                                                                          announced its decision to include Treasury debt in the
                    80                                                                                                                    Large-Scale Asset Purchase program. The market in 2009
    Annl vol (BP)

                                                                                                                                          priced in the Fed demand and pushed yields down, and
                                                                                                                                          then immediately started repricing yields higher. This time
                    40                                                                                                                    through, the market priced in the Fed demand and then
                                                                                                                                          started back-pedaling once QE2 political backlash raised
                                                                                                                                          doubts about the Fed’s ability to follow through. At this
                     0                                                                                                                    point, we have a failed QE2 on our hands, a Fed with










                                                                                                                                          some new political bumps and bruises, and a market
                                                                                                                                          where rates, volatility and spreads are likely to go higher.

•          Note: Data show the running 60-day volatility of the MBS-to-5-                                                                 The view in spread markets
year-swap spread and the IG CDS premium.
Source: Deutsche Bank                                                                                                                     A difficult rates market and the steady rise in secondary
                                                                                                                                          supply of MBS should keep MBS spreads moving wider
By disaggregating MBS and corporate spreads into
                                                                                                                                          until relative value buyers set a backstop. Portfolios can
compensation for different risks and then comparing
                                                                                                                                          shed spread duration by moving up in coupon.
assets, the analysis gets sharper but more difficult. Art
                                                                                                                                          Prepayments in those pass-throughs should remain muted
swamps science here. For MBS, option-adjusted spread
                                                                                                                                          under the drag of high LTVs, high agency delivery fees
analysis tries to distill the price of prepayment risk, and
                                                                                                                                          and originators worried about reps-and-warrants risk.
that analysis on par 30-year pass-throughs suggests that a
116 bp spread to 5-year swap rates becomes a 10 bp
option-adjusted spread to the whole swap curve. For                                                                                       The view in mortgage credit
corporate debt, a rough analysis of the spread                                                                                            Spreads in non-agency MBS could feel some pressure if
compensation for downgrade and default risk, detailed at                                                                                  yields in safer assets keep rising. Some investors in non-
the end of this note, suggests that the 91 bp spread in IG                                                                                agency MBS are there simply because nothing else offers
CDS becomes a credit-adjusted 49 bp. Some of the                                                                                          enough yield. If safer assets eventually allow those buyers
difference between OAS and the credit-adjusted IG                                                                                         to hit yield bogeys, then watch out.
premium surely narrows after considering the broader
liquidity in MBS. But this approach implies that MBS still                                                                                                      Steven Abrahams (1) 212 250-3125
has to widen to corporate debt to win on risk-adjusted
relative value.
On from here
The steady pressure of secondary supply looks likely to
continue pushing MBS spreads wider, but relative value
eventually should set the backstop. The wide spread of

Page 38                                                                                                                                                                      Deutsche Bank AG/London
10 December 2010       Fixed Income Outlook 2011

                               Calculating a credit-adjusted spread on a corporate index
 Corporate debt spreads compensate investors not just for default risk but for downgrade risk, too, and resulting wider
 spreads. To estimate the embedded compensation for default and downgrade, we turned first to Moody’s 1970-2005
 corporate rating transition data. Since the average rating on the 5-year IG CDS is Baa, we looked at the historic probability
 that an issuer would migrate over five years from that rating to any other rating between Aaa and defaulted. With those
 probabilities in hand, we then looked at the current yield spread between 5-year Baa industrial debt and industrial debt in all
 other rating categories. The probability-weighted spread was 43 bp, suggesting that the investor gets that much spread as
 compensation for potential downgrade and default (Figure 5). This approach assumes that the issuer can migrate with a
 certain probability immediately to any other rating category. An alternative approach would be to look at migration
 probabilities over shorter intervals and the resulting 5-year terminal values for the bond, and then solve for the spread that,
 on average, reprices the bond to par. Stay tuned.

  Figure 5: A rough estimate of spread compensation for 5-year Baa downgrade and default risk

                                              Aaa      Aa     A     Baa    Ba      B          Caa      Ca  Default Total
  Transition prob from Baa (5-year period)   0.32%   1.55% 18.18% 61.44% 11.78% 3.80%        0.67%   0.11% 2.15% 100.00%
  Spread difference from Baa (bp)             -120    -110   -92     0     138   279          915     1216  1275    43
  Prob weighted spread compensation (bp)        0       -2   -17     0      16    11            6       1    27     43

Deutsche Bank AG/London                                                                                                  Page 39
10 December 2010    Fixed Income Outlook 2011

Euroland Strategy

    The dynamics of Euro Area in 2010 has been a                   breakevens and long gamma positions in the 5Y
    reflection of a 16 country monetary union but a                sector
    16-country fiscal dis-union. Political differences, a          A number of risks exist to our central scenario
    reactive rather than a pro-active policy response              including contagion fears, potential sovereign
    function and a missed opportunity in terms of                  restructuring, haircuts for senior bond holders or
    bank stress tests have compounded peripheral                   Spain needing to tap the EFSF facility. As a hedge
    woes and reduced the effectiveness of various                  to our core views, we recommend adding a short
    rescue measures announced so far                               Euro position, basis widener trades and a long
    Our outlook for 2011 is characterized by a muddle              30Y gamma position to our portfolio
    through approach but with contained systemic
    risks. A convincing solution to Euro Area
                                                            The year of sovereign concerns
    problems is unlikely in 2011: Political and legal       The dynamics of Euro area in 2010 has been a reflection
    risks make a full fiscal union or Euro-bonds            of a 16 country monetary union but a 16-country fiscal dis-
    practically unviable, restructuring of either the       union. Sovereign spreads for countries vulnerable from a
    sovereign or senior bond holders is fraught with        fiscal and current account deficit perspective widened to
    contagion risks and there is little incentive for       unprecedented and in some cases unsustainable levels.
    either a strong or a weaker country to leave the        The European Union (and the IMF) responded to the crisis
    Euro Area                                               through a number of measures including the Greek bail
    In the near term, event risks remain on the             out package of EUR 110bn and the EFSF fund of EUR
    horizon with Irish elections, a high probability of     440bn which combined with the EFSM and IMF’s
    Portugal tapping the EFSF facility and refinancing      commitment provides a EUR 750bn support facility. The
    concerns from Spain adding to risk aversion over        ECB’s SMP program (EUR 69bn of peripheral bonds have
    a 3M period                                             been bought so far) and further extension of the
    The key differentiator between a near term              extraordinary liquidity policies have in addition been
    uncertain outlook and a medium term ‘systemic           necessary to calm the markets.
    risks contained’ view is Spain. Given the low debt      Political differences, a reactive rather than a pro-active
    to GDP levels, the Spanish debt trajectory of           policy response function and a missed opportunity in
    Spain remains sustainable even after accounting         terms of bank stress tests have compounded peripheral
    for capital injections in the banking sector            woes and reduced the effectiveness of various rescue
    Over next year, we expect an underperformance           measures announced so far. Peripheral spreads touched
    of twin deficit countries, higher volatility, further   new highs last week before ECB buying into the year-end
    divergence     between     core    and      non-core    illiquid market led to some normalization.
    economies, flatter 2Y10Y curve and bearish              2010: A year of sovereign concerns
    pressure on core rates driven by an improving
    economy and increased contingent liabilities                                            0Y
                                                                                  A verage 1 spread o f
    The ECB’s reaction function is likely to reflect the                         peripherals vs. Germany
    growing divergence between core and non core
    economies. While liquidity measures are required            400

    for the weaker peripherals, rates appear too low
    for core countries. We expect the ECB to start
    hiking rates by end Q2 2011, while maintaining              200
    the safety net of unlimited 1W tenders
    Our top trade recommendations going into 2011
    include: EUR 2Y10Y swap flattener, bearish front               0
    end Euribors, short France vs. Germany and on                   Jan-      A pr-     Jul-      Oct-      Jan-   A pr-   Jul-   Oct-
                                                                     09        09        09        09        10     10      10     10
    ASW, short Portugal vs. Ireland and Spain, long
                                                            Source: Deutsche Bank, Bloomberg Finance L.P.

Page 40                                                                                                            Deutsche Bank AG/London
10 December 2010                     Fixed Income Outlook 2011

Near term uncertainty to remain                                                          Portugal’s application for aid could lead to short term
                                                                                         volatility, as the market is likely to focus on whether Spain
In previous years, our annual outlook has focused on                                     could be next in line and political backlash around the
developing a medium term strategic investment theme.                                     EFSF mechanism might increase in the core countries.
We entered 2009 with the theme of riding the wave of                                     However, we would argue that despite the near term
government intervention while in 2010 the focus was on                                   volatility, if a line can be drawn at Portugal it should prove
the vulnerability of twin deficit countries. However, for                                to be positive for market sentiment and peripheral
2011, the uncertainty surrounding peripheral Europe and                                  spreads over the medium term.
the US economy makes us focus on two distinct themes
– risk aversion and volatility in the near term but contained                            Irish elections, due in January/February also have the
systemic risks and a step towards normalization over the                                 potential to unnerve the market. Fine Gael, the largest
medium term.                                                                             opposition party has indicated that it could review the
                                                                                         EU/IMF package. In addition, the Labour Party and Sinn
Over a three month horizon, the market is likely to test the
                                                                                         Fein, the two junior opposition parties have demanded
political will of the policy makers to continue supporting
                                                                                         that senior bank bond holders should bear some of the
the weaker peripherals and financial institutions. A
                                                                                         restructuring costs. Recent opinion polls indicate that if an
number of events could reshape market pricing over Q1
                                                                                         election were to be held in January/February the
                                                                                         opposition is likely to form the new government which
In January/February, it is likely that Portugal applies to the                           could result in volatility surrounding the bailout package
EFSF for aid. We have maintained the view that from the                                  and contagion risks from a hair-cut to the senior bond
sovereign standpoint, Portugal is structurally weaker than                               holders.
Ireland and is lagging behind in both fiscal consolidation
and correction of current account deficits. The aid                                      The key determinant of our near term uncertain outlook
package that Portugal might potentially require should be                                and our medium term view that systemic risks will be
similar to that of Ireland of around EUR 90bn. The tables                                contained is Spain. Concerns over Spain are driven by the
below shows the financing needs for Ireland and Portugal                                 banking sector rather than sovereign woes. In this
over a three year horizon                                                                respect, the situation is different from Greece (or Portugal)
                                                                                         where liquidity and solvency of the sovereign are the main
Financing requirement of Irish sovereign and Irish
bank redemptions 2011-133
                                  Bond     Deficit Sovereign      Bank
                             Redemption financing Financing redemptions
                                                                                         The EU bank stress tests conducted in July was a lost
                                                                                         opportunity for restoring confidence in the banking sector
2011                             4,539             18,400           22,939      15,720
2012                             5,613             16,200           21,813      18,389
                                                                                         by credibly underpinning the recapitalisation needs of the
2013                             6,134             13,100           19,234      17,221   system. Acknowledging the need to address market
Total                           16,286             47,700           63,986      51,330   concerns, EU commissioner Oli Rehn has stated that a
Outstanding bills                                                       6,000            new round of co-ordinated stress tests which include
Total refinancing                                                   69,986      51,330   liquidity assessment and greater transparency would
Source: Deutsche Bank, Bloomberg Finance L.P., Irish finance ministry
                                                                                         begin in February. Ireland has also announced a second
                                                                                         round of bank stress tests, to be completed by Mar 2011
Financing requirement of Portuguese sovereign and                                        as part of the EU/IMF programme.
Portuguese bank redemptions 2011-13
                                                                                         To quantify the potential capital requirement for Spanish
                                  Bond     Deficit Sovereign      Bank
                             Redemption financing Financing redemptions                  banks, we recalibrate the stress tests, using the July
2011                             9,633              8,097           17,730      13,633   stress tests as the starting point. To improve credibility,
2012                             8,518              7,476           15,994      14,816   (1) we use a 12.5% Tier I ratio as the target which should
2013                             8,738              6,713           15,451      8,563    be consistent with the 10.5% core Tier I ratio target for
Total                           26,888             22,286           49,174      37,012   Irish banks under the EU/IMF programme and, (2) we
Outstanding bills                                                   17,513               recognize only half the operating profit and capital gains
Total refinancing                                                                        estimated at the time for 2010 and 2011 (effectively
requirement                                                         66,687      37,012
Source: Deutsche Bank, Bloomberg Finance L.P. Portuguese Finance Ministry                ignoring future income).

                                                                                         The two internationally active banks, namely BBVA and
                                                                                         Santander are excluded from this exercise, as their
                                                                                         exposures to domestic Spanish developments are lower
  For bank redemptions data please refer “Deutsche Bank Global Credit
Outlook, 2011: Think the Unthinkable…?”

Deutsche Bank AG/London                                                                                                                        Page 41
10 December 2010                  Fixed Income Outlook 2011

and they have better access to funding from capital                            have demonstrated a strong will to support the European
markets.                                                                       Union and the euro currency. We believe that, if need be,
                                                                               a credible plan to prevent systemic risks from spreading
The capitalization requirements for the Cajas and domestic                     to Spain would be put in place by Q1 2010
listed banks apart from BBVA and Santander are EUR 58
bn and EUR 17bn respectively. The total capitalization                         Redemption hump would force a credible resolution
requirement for Spanish banks would then be EUR 75bn,                          in Q1 2010
within the FROB limit and would account for 7.1% of
2010 GDP which is reasonable compared to Ireland’s                                          EUR mn        So vreing bo nd & bill redemptio ns & co upo n payments
recapitalisation requirements and sustainable for Spanish                        25,000
                                                                                                          B ank redemptio ns
public finances.
Recapitalisation requirements for Ireland and Spain
put into context                                                                  15,000

                                            Ireland            Spain
Additional recapitalisation                   27                    75
requirements since stress
tests (EUR bn)                                                                    5,000

2010 Nominal GDP (EUR bn)                    157                   1053
Domestic banking system size                 517                   3408
                                                                                            Jan Feb M ar A pr M ay Jun          Jul   A ug Sep Oct No v Dec
(EUR bn)
                                                                               Source: Deutsche Bank, Bloomberg
 -Recap requirements as % of
2010 GDP                                    17.3%                  7.1%
- Recap requirements as % of
domestic banking assets                     5.2%                   4.4%
Source: Deutsche Bank

Even after accounting for the additional capital injections
                                                                               The table below outlines the key events to watch in Q1
that the Spanish banks may require, the debt to GDP ratio
of Spain would stand at around 72%, one of the lowest
among the European countries
                                                                               Key event risks on the horizon

Spanish debt one of the lowest in Europe                                       End Dec-10 Criteria for second round of stress tests
                                                                                          finalised in Ireland. These could become
               201 Debt/GDP ratio
                                                                                          benchmark for other European countries
  140%                                                                         Jan-11              EFSF starts issuing bonds
  120%                                                                         Jan/Feb-11 Likelihood of Portugal tapping the EFSF
                                                                               Jan/Feb-11 Irish parliamentary elections
                                                                               Feb-11              Recapitalisation of Irish banks (AIB, BoI and
   40%                                                                         Mar-11              Redemptions of EUR 21bn from Spanish
   20%                                                                                             banks

                                                                               Mar-11              Irish bank stress tests using a core tier 1 ratio
              FI     ES      NL   AT   DE    PT     FR   IE   BE     IT   GR                       of 10.5%
Source: Deutsche Bank, Eurostat                                                Mar-11              Review of Irish fiscal performance and next
                                                                                                   tranche of funds provided to Ireland
From a liquidity perspective, Spain faces nearly EUR 21bn                      Apr-11              Redemptions of EUR 17bn of Spanish
of redemptions from the banking sector in March and EUR                                            sovereign debt and 54bn of bank debt
17bn sovereign and EUR 15bn from the banking sector in                         Source: Deutsche Bank

April. Given the hump in redemption profile in March-April
2011, it is likely that market concerns over Spanish
funding requirement materialize in the first quarter of
2011. The policy response function has been reactive
rather than pro-active till now, nonetheless the authorities

Page 42                                                                                                                          Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

Muddling through but with contained                             focuses back on fundamentals, the high twin deficit
                                                                countries would remain vulnerable relative to the fiscally
systemic risks in the medium term                               responsible countries. We plot below our ranking on the
Beyond the near term uncertainty, our central scenario is       various European countries based on their twin deficits -
one of muddling through but with contained systemic             fiscal and current account as well as credibility. We define
risks. A convincing solution to Euro area problems              fiscal metric as the cumulative fiscal consolidation
remains a low probability event in 2011 for a number of         recommended by the ECB over a five year horizon while
reasons                                                         the current account deficit is the EC forecast for 2011.
                                                                Credibility is measured based on the adherence to the 3%
    A full fiscal union or a Euro bond issuance involves a      deficit to GDP criteria – the cumulative deviation from the
    major change to the Lisbon treaty. Political and            3% deficit target from 1997-2007 period is used as the
    implementation risks around these measures makes            credibility metric
    it practically unviable (see Euroland Sovereign
                                                                The twin deficit metric
    Outlook for discussion)
                                                                Country             Fiscal       Current         Fiscal        Final            10Y          10Y
    A restructuring of either the sovereign or senior bond                           msr.        account         cred.         metric          ASW          ASW
                                                                                                                                               level      rich/che
    holders is fraught with contagion risks given the                                                                                                     ap (-)/(+)
    cross-border exposure of security holdings. In an           Germany               1.5           -4.6           2.8           -0.1           -34            -41
    environment of fragile market sentiment, this route is      France                4.0            3.4           2.2            3.2             2           -157
    unlikely to be preferred by the EU                          Italy                 1.5            2.7           2.7            2.3           109             -9
                                                                Spain                 6.0            3.8           1.1            3.6           183             3
    Little incentives exist for a stronger or a weaker
                                                                Netherlands           2.3           -6.8           0.1           -1.5            -8            49
    country to leave the EMU. The weaker countries
                                                                Belgium               3.0           -2.0           0.0            0.3            65            38
    would need to default on their sovereign obligations,
                                                                Austria               2.3           -3.5           1.4            0.1            12             -2
    potentially face capital flight and have little or no
                                                                Portugal              5.0            8.0           5.7            6.2           255            -45
    recourse to the EU support facility in the event of exit.
                                                                Ireland               12.6          -1.5           4.2            5.1           395           147
    For stronger countries, both the level of domestic real
                                                                Finland               0.0           -1.6           0.0           -0.5            -5             8
    rates and the domestic currency would become
                                                                Greece                14.0           8.0          18.8           13.6           648             7
    overly restrictive if they leave the EMU (see Fixed         Source: Deutsche Bank, EC
    Income Outlook 2009)                                        Notes: Positive current account balance is a negative number as it improves the twin deficit metric

This effectively leaves two principal options: the EFSF (or
its successors) and the ECB. Until an adjustment to the         Not surprisingly Germany, Finland and Netherlands rate
size/structure/mandate of the EFSF is agreed, the ECB is        very highly on our metric while Greece rates the worst.
likely to be forced to provide enough liquidity and/or          However, the relative ranking between the countries is of
continue its SMP to control systemic risk. This is the basis    interest – France, despite being a AAA rated country
on which we expect the muddle through scenario to               scores worst than Italy on our metric and is just better
prevail for now.                                                than Spain. Among the high beta countries, Portugal
                                                                appears in a worse shape relative to Ireland
However, the sustainable debt trajectory for Spain even
after accounting for bank losses provides confidence in         Thus, over the medium term, where fundamentals rather
our view of differentiating between a short term and a          than sentiment move to the driving seat, we recommend
medium term outlook. While risks exists that things could       underweighting the twin deficit vulnerable countries: short
probably get worse first but our central scenario remains       France versus Germany and short Portugal versus Ireland
one of contained systemic risks over the medium term.           and Spain. For investors seeking the normalization of
                                                                peripheral concerns, the short end of Italy offers the best
This environment is likely to be characterized by an            risk reward profile.
underperformance of twin deficit countries, higher
volatility, further divergence between core and non-core
economies, bearish pressure on core rates driven by an
                                                                Divergence between core and non core
improving economy and increased contingent liabilities, a       economies
flatter curve and an ECB that is likely to separate its         The divergence between core and non-core economies is
liquidity and rate setting policy.                              the price for co-existence of a 16 nation monetary union
Peripheral economies would continue to command a risk           and a 16 nation fiscal dis-union. The PMIs between the
premium as a convincing resolution mechanism for                two blocs are showing clear signs of divergence
Europe as a whole is unlikely to materialize. As the market

Deutsche Bank AG/London                                                                                                                                     Page 43
10 December 2010                   Fixed Income Outlook 2011

Core and Non-core PMIs are diverging                                                        But restrictive for Spain
                                                                                               1.5                                       Spanish sho rt real rate (lhs)            5
   60                               Non-core                                                                                             Spanish unemplo yment                     7
                                    Core (Germany & France)                                    1.0
   55                                                                                                                                                                              9


   45                                                                                          0.0

   40                                                                                         -0.5
                                                                                              -1.0                                                                                 21
         2007              2008                 2009              2010                           Jan-08        A ug-08         M ar-09       Sep-09       A pr-10         Oct-10
                                                                                            Source: Deutsche Bank, Bloomberg
Source: Deutsche Bank, Bloomberg

For core countries, the real short rates are negative and                                   ECB: Separation of liquidity and rate
the level of the currency is undervalued relative to                                        target policy
fundamentals. This supports a relatively positive outlook
for core economies as they continue to benefit from an                                      The above divergence between the core and non core
accommodative policy stance                                                                 economies needs to be acknowledged by the ECB to
                                                                                            maintain its credibility as an inflation fighting institution.
                                                                                            Currently the ECB employs two sets of policy tools –
Policy stance appears accommodative for Germany
                                                                                            liquidity and rate target. While ample liquidity is necessary
   3.0                                       German sho rt real rate (lhs)            7.4
                                                                                            to support the weaker peripherals and their financial
                                             German Unemplo yment                     7.5   institutions, the level of rates appear too low for the core
                                                                                      7.6   economies.
   1.5                                                                                7.8   As the divergence between core and non-core economies
   1.0                                                                                7.9   grow, the ECB is likely to draw a sharp distinction
                                                                                            between the two policies. In its December meeting, the
                                                                                            ECB extended unlimited 1W, 1M and 3M tenders till at
   0.0                                                                                      least Q1 2011. In our view the ECB would maintain, at the
                                                                                            minimum, the safety net of 1W tenders into 2011.
                                                                                            However to balance the ample liquidity provision and to
  -1.0                                                                                8.4
                                                                                            maintain its inflation fighting credentials, the ECB could
     Jan-08        A ug-08         M ar-09       Sep-09       A pr-10        Oct-10
                                                                                            adopt a hawkish tone and eventually raise rates by the
Source: Deutsche Bank, Bloomberg
                                                                                            end of Q2 2011. Our economists expect the first rate hike
                                                                                            by end Q2 2011, with the base rate reaching 1.75% by
The peripheral economies however face a restrictive
                                                                                            end 2011. This should be supportive of bear flattener
policy stance. Short real rates are restrictive and the level
                                                                                            trades in the 2Y-10Y sector.
of euro is overvalued relative to domestic fundamentals.
The restrictive policy stance along with the fiscal
                                                                                            The contraction of ECB’s balance sheet has been
consolidation that has been necessitated by the sovereign
                                                                                            supportive of ECB’s bias to seek to normalize the
spread dynamics implies that the non-core economies
                                                                                            accommodative policy stance. However, the aggregate
would continue to drag in 2011
                                                                                            reduction in ECB’s balance sheet hides the tiering of
                                                                                            financial institutions in Europe. While stronger financial
                                                                                            institutions (from stronger sovereigns) may not need
                                                                                            ECB’s support, continued non-standard measures are a
                                                                                            lifeline for weaker institutions. As the chart below shows,
                                                                                            over 65% of usage of ECB’s balance sheet stems from
                                                                                            Greece, Portugal, Spain and Ireland

Page 44                                                                                                                                           Deutsche Bank AG/London
10 December 2010                  Fixed Income Outlook 2011

ECB balance sheet has shrunk…but peripheral                                          caution and do more rather than less to support the ailing
countries remain under stress                                                        economy. The abundant liquidity environment, along with
                                                                                     accommodative policy bias creates a favourable
   1000                 ECB mo n po licy o ps ( EUR bln)                       70%
                                                                                     environment for risky assets. The main risk, however, for
                        % Usage Ireland P o rtugal Greece Spain rhs
    900                                                                        60%   risky assets is higher rates which in itself should limit the
                                                                                     sell-off in the fixed income market.
    800                                                                        50%

    700                                                                        40%
                                                                                     Should help solvency ratio of ALM
    600                                                                        30%   players
    500                                                                        20%
                                                                                     A favourable outlook for risky assets should be supportive
    400                                                                        10%   of the solvency ratios for ALM players. The long end of
                                                                                     the EUR curve is driven more by the supply demand
    300                                                                        0%
       Jun-07     Jan-08     Jul-08    Feb-09    A ug-09   M ar-10    Sep-10
                                                                                     dynamics and ALM hedging and less by fundamentals.
                                                                                     ALM hedging decisions are contingent on the solvency
Source: Deutsche Bank, ECB
                                                                                     ratio of the ALM players and hence influenced by the
The possibility of a policy error by the ECB either in the                           performance in risky assets. Currently around 65% of
form of tightening monetary policy too early or an overly                            pension assets for the Dutch pension funds are linked to
aggressive withdrawal of liquidity support cannot be                                 risky assets
ignored. Possibility of such policy error from the ECB
supports implementing the flattening trade via swaps                                 Outlook for risky assets key for pension funds
rather than bonds.
                                                                                     solvency ratio
Bearish pressure on rates globally…and                                                                            Equity + alternative assets (as a % o f to tal assets)
favourable outlook for risky assets                                                    65%

For core European countries, continued supportive policy
stance, both in terms of level of rates as well as the                                 55%

currency along with increased contingent liabilities should                            50%
exert a bearish pressure on core rates. In the US, the
recent announcement of fiscal expansion should lower the
probability of QE v3, increase deficit levels and be positive                          40%
for 2011 growth – all factors bearish for 10Y rates. In the                            35%
UK, the inflation profile remains sticky and could lead to
the BoE embarking on rate hikes by end H1 2011. The
                                                                                              M ar-08        Sep-08     M ar-09       Sep-09       M ar-10       Sep-10
above factors should be bearish for rates, particularly
                                                                                     Source: Deutsche Bank, DNB
given the still low bond risk premium

                                                                                     The chart below outlines our estimates of the solvency
Bond risk premium still low by historical standards
                                                                                     ratios for aggregate Dutch pension funds – the solvency
   2.0                        B o nd risk premium                                    picture has improved markedly since the lows in August
    1.5                                                                              of this year. An improvement in the solvency ratios for the
                                                                                     pension funds should reduce the receiving pressure at the
                                                                                     long end of the curve and be supportive to 10Y30Y
   0.5                                                                               steepeners as well as a short position in long dated
   0.0                                                                               forwards.



     Jan-99              Jan-02              Jan-05          Jan-08

Source: Deutsche Bank, Consensus Economics

The macro environment should also be supportive of risky
assets. Policy makers have a bias to err on the side of

Deutsche Bank AG/London                                                                                                                                        Page 45
10 December 2010                    Fixed Income Outlook 2011

Dutch pension fund solvency ratio has improved since                                           dispersion and hence higher volatility in the market. Our
the August lows                                                                                favourite trades going into 2011 include

  1.3                            Dutch P ensio n Funds avg so lvency ratio
                                 (lhs)                                                         EUR 2Y – 10Y flattener
                                 EUR 1 5Y rate                                                 As discussed above, the ECB would differentiate between
  1.2                                                                                    5     rate hikes and liquidity policies. While liquidity is required
                                                                                               for the weaker peripherals, short rates appear too low for
   1.1                                                                                         the core economies. We expect the ECB to acknowledge
                                                                                         4     the strength in the core economies by moving to a
     1                                                                                   3.5
                                                                                               hawkish tone while maintaining the safety net of 1W
                                                                                               unlimited tenders. The ECB is expected to move to a rate
                                                                                               hiking mode by end H1 2011 with the base rates reaching
                                                                                         2.5   1.75% by year end, which should lead to a bear flattening
                                                                                               of the EUR 2Y10Y curve
  0.8                                                                                    2
    Jun-08              Dec-08           Jul-09          Jan-10            A ug-10
                                                                                               Risks of policy error by the ECB of normalising monetary
Source: Deutsche Bank, DNB
                                                                                               policy too aggressively exist. We thus favour
                                                                                               implementing the 2Y10Y flattener in swaps space
Given the indexation on inflation, the proportion of
liabilities that are real in nature and hence need to be
                                                                                               Bearish EUR front end
hedged depends on the solvency ratio. At current levels,
                                                                                               The short position is based on the expectations of the
the solvency ratio is still far from levels where pension
                                                                                               ECB moving to a rate hike cycle by end H1 2011 as well
funds would need to actively hedge inflation risks.
                                                                                               the risks of a policy error from the ECB. The Dec-12
However, inflation hedging may become a main driver for
                                                                                               Euribor is pricing in a little over four hikes over a two year
long end breakevens if solvency ratio improves further.
                                                                                               horizon which appear at odds with our view. We
We thus favour implementing the short long dated
                                                                                               recommend a short position in Dec-12 Euribor contracts
forwards and 10Y30Y steepeners in nominal rather than
real space
                                                                                               Risks to the above view is contagion risk in Europe
                                                                                               leading to a more accommodative monetary policy from
As the solvency ratio improves, pressure could build                                           the ECB
up on long dated breakevens
  100%                                                                                         EUR 10Y30Y steepener
   90%                                                                                         An improvement in solvency ratio of the ALM players
   80%                                                                                         should reduce the need for hedging and hence lower the
   70%                                                                                         receiving pressure at the long end. The second half of
   60%                                                                                         2010 has seen the EUR swap curve in a flattening trend in
   50%                                                                                         contrast to the historically steep long end curve in the
   40%           Current estimate
                                                                                               USD and GBP markets
   30%                                                  P ro po rtio n o f liabilities
                                                        that behave real in nature             Our analysis of excess flatness of the curve, using the
                                                                                               level of 10Y rates, and the 5Y-10Y slope as the explanatory
                                                                                               variables also suggests that the EUR 10Y30Y curve
                                                                                               appears too flat. We recommend a EUR 10Y30Y
         0.6       0.8       1.0        1.2      1.4        1.6      1.8       2.0       2.2
                                        S o lv e nc y ra t io                                  steepener. Combining with our EUR 2Y10Y flattener, the
Source: Deutsche Bank                                                                          trade can also be implemented as a EUR 2Y10Y30Y fly.

Top ten trades for 2011                                                                        The risks to the above trades is pension fund receiving if
                                                                                               their solvency ratio falls due to a sell-off in risky assets
Given the uncertain macro environment, the macro theme
for 2011, appears less structured than it was going into                                       Short the long end in Europe vs. UK
2010. Investment themes that are likely to perform are                                         As discussed above, the 10Y30Y slope in EUR appears
continued pressure on weaker twin deficit countries but                                        too flat vs. the GBP curve. The relative differential is
with contained systemic risks, a separation between                                            driven chiefly by the 30Y sector that appears too rich vs.
liquidity and rate hike policies at the ECB and a wider                                        the UK 30Y. We recommend shorting the 30Y sector in
                                                                                               Germany/France vs. UK Gilts. Increase in contingent

Page 46                                                                                                                            Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

liabilities for the core European countries should also          1.5% versus DB forecast of 1.8% inflation over the next
support the underperformance vs. UK Gilts                        five years. Admittedly, inflationary pressures are likely to
                                                                 be muted in the peripheral economies but the Euro area
Risk to the trade is inflationary risks in the UK leading to a   aggregated inflation, which is more influenced by the core
further cheapening of the UK long end                            economies, should continue to remain supported

Short France vs. Germany and on ASW                              Given attractive valuations and inflationary pressure from
France scores poorly on our twin deficit measure of fiscal       core economies, we recommend long EUR breakevens
and current account deficits. As market focuses back on          particularly in the 5Y sector. Please see the European
fundamentals, countries vulnerable on a twin deficit             Inflation section for details and risk statements
measure are likely to underperform. In addition, tapping of      Long gamma positions in the 5Y sector
the EFSF facility increases the contingent liability of the      The near term environment of heightened uncertainty
core countries and should be bearish for core rates on an        favours long gamma positions. As mentioned above,
ASW basis                                                        significant event risk exists over the next 3M horizon
                                                                 which could result in high realised volatility. The increased
We recommend short France versus Germany as well on              dispersion of views regarding both the macro outlook and
an ASW basis.                                                    the market direction favour a long vol position. In
                                                                 particular we favour long gamma in the 5Y sector. Please
Long front end of Italy                                          see the EUR derivatives section below for details and risk
Over the medium term horizon, as fears of systemic risks         statements
ease, we expect spreads for the stronger peripheral
countries to normalise. For investors seeking a                  Risks to our scenario
normalisation in peripheral spreads, the short end of Italy
offers attractive risk reward profile with favourable carry      Our central scenario of Europe muddling through, but with
and roll down. The search for yields in an environment           contained systemic risks is subject to a number of risks
where risk aversion remains for higher beta peripherals          including a) Restructuring of sovereign debt b) contagion
should favour Italian spreads. We favour long positions in       fears as senior bond holders are forced to take a haircut c)
2Y Italian spreads as well as a 2Y10Y spread steepener in        Spain needing to tap the EFSF facility d) stresses in the
Italy                                                            financial system.

                                                                 The dispersion around our central scenario is aggravated
Risks to the above trades is fears of contagion risks
                                                                 by the fact that political rather than economic
leading to an underperformance of Italy front end
                                                                 considerations may drive any potential rescue packages.
                                                                 As a hedge, we recommend adding a short euro position
Short Portugal vs. Ireland and Spain
                                                                 to our portfolio as systemic risks are likely to occur with
We maintain the view that Portugal remains structurally
                                                                 increasing concerns over the stability of the euro area. We
weaker than Ireland. Portuguese spreads have benefited
                                                                 would also implement wideners on the EUR/USD cross-
over the last few weeks from ECB buying in a relatively
                                                                 currency basis and on the Euribor/Eonias basis in order to
illiquid environment. But this is a more stop gap measure
                                                                 capture a flight to quality towards the US dollar and
and does not alter our fundamental outlook on Portugal.
                                                                 growing tensions in the European banking system. In
                                                                 addition, we favour adding a long gamma position in 30Y
If Portugal taps the EFSF facility, spread between Ireland
                                                                 tails as a hedge against market stress moving to the
and Portugal is likely to converge. Adding Spain to the
                                                                 pension fund industry. Currently gamma on long dated
long basket provides protection in a scenario of risk
                                                                 tails appears cheap versus realised volatility and should
aversion over peripherals which should see an
                                                                 cushion against aggressive receiving pressure driven by a
underperformance of Portugal. Risk to the above trade is
                                                                 fall in solvency ratio of pension funds.
aggressive ECB buying of Portuguese paper.
                                                                                         Mohit Kumar (44) 20 7545 27776
Long EUR breakevens                                                                 Abhishek Singhania (44) 20 7547 4458
EUR breakevens appear too low relative to our forecasts                                Soniya Sadeesh (44) 20 7547 3091
of inflation – the 5Y sector breakevens are trading around

Deutsche Bank AG/London                                                                                               Page 47
10 December 2010     Fixed Income Outlook 2011

Sovereign Outlook

    We discuss the likely development of sovereign             viewpoint is unjustified in our eyes for two reasons. First,
    solvency and of support mechanisms                         it can lead to absurd consequences, such as Germany
                                                               partly underwriting a support package for Ireland that will
    We believe that there is a large difference
                                                               partly be used for supporting senior Irish bank debt in the
    between liquidity concerns and solvency
                                                               same week as the German upper house (Bundestag)
    problems, and that the market cannot force
                                                               signed off on a law that could force losses on holders of
    liquidity shortfalls to lead to solvency problems in
                                                               German senior bank debt. Second, sovereign support
    the near term
                                                               appears to run counter to the plain language of the EU
    The correct context for future stability regimes is        treaties. In what follows, we, therefore, consider post-
    the status quo before the Greek support package,           EFSM/EFSF mechanisms from first principles rather than
    not the current EFSM mechanism                             relative to the current system.

    To date, all measures that were adopted to
                                                               The first important question is whether a permanent
    address solvency concerns (Greece, Ireland)
                                                               bailout mechanism is even necessary. For this to be the
    merely postpone the resolution of the problems
                                                               case, the threat of market funding being cut off must be
    In our eyes, much of the current market                    so large as to create solvency problems.
    discussion is unnecessarily side-tracked by the
    existence of the monetary union. We discuss the            We agree that liquidity problems (i.e. lack of easy market
    particular issue of German constitutional                  access) can eventually turn into solvency problems (i.e.
    constraints in detail                                      structurally negative cashflow balances). To judge
                                                               whether this is possible we need to consider the impact
    Fundamentally, the exit routes for excessive debt
                                                               on public finances if yields were to remain at current
    levels inside EMU are the same as for countries
                                                               levels or increase further for euro-area sovereigns.
    outside a monetary union

    We believe that political obstacles will prevent           The current average yield level is higher than the weighted
    the adoption of decisive but costly measures. This         average coupon of outstanding marketable debt for only
    will keep solvency issues at a sub-critical level for      Greece, Ireland and Portugal. Therefore, it is only for these
    the next year                                              countries that borrowing at current costs will increase the
                                                               average interest cost on debt. For Spain, the current yield
A key issue for the sovereign spread development in 2011
                                                               is close to the average coupon while Italy has a cushion of
will be the finalising of a crisis resolution mechanism
                                                               about 75bp and Belgium has a cushion of about 145bp.
(European stability mechanism, ESM) for Eurozone
sovereigns. In the current discussion about this topic,
there is a plethora of biased comments from various            Current yield vs. coupon rate on existing debt
interested parties. The resulting confusion has been one         12
                                                                               Current co upo n
of the factors that prevented the actions taken (joint           10            Current yield
support for Greece and Ireland, ECB bond purchases)
from achieving their potential effects. In this article, we       8

attempt to delineate the areas that we believe are subject        6
to legal constraints from those that depend on political
The last weeks of 2010 are characterised by an
environment where individual sovereigns find that market
access for new debt is only possible at high interest rates.
This then leads to market speculation that external help is
necessary to stabilise solvency.
                                                               Source: Deutsche Bank, Bloomberg Finance L.P.

An unfortunate consequence of the Greek support
package and the establishment of the EFSM/EFSM is that         The above analysis however does not consider whether
some form of sovereign support mechanism is now seen           the current yield levels are appropriate for the current
as a given, and any reduction of such support is viewed as     economic outlook for these countries. We analyse the
weakening the credit of Eurozone sovereigns. This              impact of higher interest rate on the debt dynamics by

Page 48                                                                                                        Deutsche Bank AG/London
10 December 2010                  Fixed Income Outlook 2011

breaking down the increase in debt into its various                           the exception of Germany, Finland and Belgium 5 . Using
components 4 which shows that the increase in the                             the 2011-12 differential between nominal GDP growth and
debt/GDP ratio is due to the differential between the                         implied interest rates on government debt from the
interest rate paid on debt and nominal GDP growth rate                        European Commission forecasts, assuming primary
rather than the absolute level of rates themselves.                           budget is balanced and the average maturity of existing
                                                                              debt is maintained we show below the impact of a 100bp
Dt = Dt −1 (1 + i ) + PDt + SFt                                               and 200bp rise in interest rate on debt/GDP ratios and
                                                                              interest expenditures as a share of GDP.
    Dt Dt −1 1 + it PDt SFt
       =              +    +                                                  The base case and the incremental increase in the
    Yt   Yt −1 1 + yt   Yt   Yt                                               debt/GDP ratio arising due to an increase in interest rates
    Dt Dt −1 Dt −1 it − yt PDt SFt                                            of 100bp and 200bp over the next five years for euro-area
      −     =             +    +                                              sovereigns is shown in the table below. The base case
    Yt Yt −1 Yt −1 1 + yt   Yt   Yt
                                                                              impact for Greece and Portugal on the debt/GDP ratio and
                                                                              interest expenditure as a proportion of the GDP given the
where Dt = general government gross debt, it = implicit                       current level of interest rates and growth outlook is
interest rate, PDt = primary deficit, SFt = Stockflow                         already quite elevated.
adjustment which includes accumulation of financial
assets, changes in valuation of foreign currency debt and                     Effect on debt/GDP ratio of differential between
other statistical adjustments, Yt = GDP at current market                     interest rate on debt and nominal GDP growth
prices, yt = nominal GDP growth rate                                                                     Base case        Incremental    Incremental
                                                                                                                              rise in        rise in
                                                                                                                        debt/GDP ratio debt/GDP ratio
The increase in debt/GDP ratio due to the differential                                                                      for 100bp      for 200bp
                                                                                                                           increase in    increase in
between interest rate paid on debt and nominal GDP
                                                                                                                         interest rates interest rates
growth rate is a function of                                                  Germany                      -0.4%              1.1%             2.2%
                                                                              France                       0.4%               1.0%             2.0%
       The spread between interest rate and nominal GDP                       Netherlands                  1.6%               2.4%             5.0%
       growth                                                                 Finland                      -4.5%              0.7%             1.5%
                                                                              Austria                      2.4%               0.8%             1.7%
       The initial level of debt/GDP ratio                                    Belgium                      -0.9%              1.3%             2.7%
                                                                              Italy                        7.7%               1.5%             2.9%
Nominal GDP growth rate and implicit interest rate on                         Spain                        5.5%               0.9%             1.8%
government debt                                                               Portugal                     15.8%              1.3%             2.6%
                                                                              Ireland                      9.4%               1.4%             2.7%
      6.0                        1 2
                              201 -1 no minal GDP gro wth                     Greece                       36.2%              2.0%             4.1%
                                 1 2
                              201 -1 implicit interest rate o n go vt. debt   Source: Deutsche Bank

      4.0                                                                     Average interest rate expenditure as % of GDP over
                                                                                                        2006-10      Base case      100bp       200bp
      2.0                                                                                               average                  increase in increase in
                                                                                                                                   interest    interest
      1.0                                                                                                                            rates       rates
                                                                              Germany                     2.7%         2.5%          2.7%        3.0%
                                                                              France                      2.6%         2.8%          3.0%        3.3%
                                                                              Netherlands                 2.2%         2.4%          2.6%        2.8%
                                                                              Finland                     1.3%         1.4%          1.6%        1.7%
                                                                              Austria                     2.7%         2.9%          3.1%        3.3%
Source: Deutsche Bank, European Commission Autumn Forecasts                   Belgium                     3.7%         3.6%          3.9%        4.2%
                                                                              Italy                       4.8%         5.1%          5.4%        5.7%
                                                                              Spain                       1.7%         2.7%          2.9%        3.0%
From the above chart it is quite evident that purely from a
                                                                              Portugal                    2.8%         4.1%          4.4%        4.6%
debt sustainability point of view the current level of
                                                                              Ireland                     1.7%         3.9%          4.2%        4.5%
interest rates are high for most euro-area countries with                     Greece                      5.0%         7.2%          7.6%        8.0%
                                                                              Source: Deutsche Bank

                                                                                The implicit interest rate on government debt is different from the current
                                                                              coupon on existing debt as the implicit interest rates is calculated as total
  European Commission General Government Data:                                interest expenses divided by General government debt. General
http://ec.europa.eu/economy_finance/db_indicators/gen_gov_data/time_ser       government debt is a broader definition than marketable debt as it includes
ies/index_en.htm                                                              central, state, local government debt as well as social security funds

Deutsche Bank AG/London                                                                                                                          Page 49
10 December 2010      Fixed Income Outlook 2011

Amongst the countries where pressure might emerge in             Assuming the correlation of defaults of Eurozone
2011 - i.e. Spain, Italy and Belgium - Italy appears to be       governments is not 100%, such instruments have a higher
potentially most at risk as it suffers from both a high          probability of default than the probability of default of any
debt/GDP ratio and significant differential between              individual government’s debt. This higher probability of
interest rate and nominal GDP growth rates. Italy is,            default will be offset by a lower loss ratio because only a
however, addressing this risk by running a primary surplus       part of the bond notional would be affected by a
on a cyclically adjusted basis (1.3% and 1.6% in 2011 and        sovereign default. Still, severally guaranteed instruments
2012 respectively). The risk in Spain which is still running a   might be seen as having a lower credit quality than the
primary deficit on a cyclically adjusted basis (-2.5% and -      weakest of the participating sovereigns and could,
2.0% in 2011 and 2012 respectively) is, however, slippage        therefore, increase the funding cost of all sovereigns. This
on the fiscal front rather than an increase in interest rates    is a negative selection effect that is likely to make these
as the interest cost would only increase to around 3%            bonds unattractive. The German LANDER issues are a
from a rise in interest rates alone.                             successful funding vehicle because the fiscal strengths of
                                                                 the participating Lander are comparable, and the gain in
Thus, it would take a substantial amount of time for high        liquidity premium outweighs the credit spreads.
funding rates to meaningfully affect the ability of Euroland
sovereigns to service their debts provided that market           Joint debt instruments with a joint and several guarantee
access remains in place.                                         are, in our view, explicitly ruled out by article 125 of the
                                                                 Treaty on the Functioning of the European Union 6 . This
Joint bonds (Euro-bonds)                                         article rules out any form of guarantee by one member
The discussion about joint debt instruments has                  state for the liabilities of another except in the context of
reappeared from various sources but we see it as purely          specific joint projects. As we will outline further below,
political positioning without economic substance at this         we envisage problems with at least the German
point. We do not believe that equalising funding costs for       constitutional court if Eurozone sovereigns were to
euro-area sovereigns, should that be the primary purpose         attempt to sidestep this limitation. We would also argue
of joint European bonds, would solve the problem at hand.        that because a joint and several guarantee requires a lot of
Almost identical funding costs prevailed in the euro-area in     trust in the other joint creditors, the fact that final deficit
the years leading up to the crisis and the low level of          numbers for Greece for 2009 were obtained only recently
funding costs for the weaker sovereigns is arguably one          shows there is simply no history of having a factual basis
of the reasons for the current sovereign crisis, and it is       on which to decide whether or not to extend such
therefore not clear why lower funding costs would                guarantees to another sovereign. The Japanese JTMUNI
become a cure to the crisis in the future. Notwithstanding       structure is possible largely because there is a uniform
the above criticism, we discuss the other operational and        fiscal transparency regime enforced by a higher authority
legal problems that such a program is likely to run into         (the central government of Japan), and because the
                                                                 strongest Japanese prefecture (Tokyo Metropolis) funds
There are two fundamental versions of joint debt                 only about 1.5bp tighter through its own bonds than
instruments, namely bonds with several guarantees and            through the JTMUNI bonds it participates in.
bonds with joint and several guarantees. Both types of
joint funding structures exist today in the municipal bond       The German constitutional constraints
market; the German LANDER issues are severally                   In 2003, the Land of Berlin asked the constitutional court
guaranteed while Japanese JTMUNI are joint and                   of Germany (Bundesverfassungsgericht) for a ruling that
severally guaranteed.                                            would entitle Berlin to higher transfer payments from the
                                                                 German federation. The court declined the request on 19
If bonds are severally, but not jointly and severally            October 20067 for two reasons. First, it ruled that Berlin’s
guaranteed, it is unlikely that they would obtain very high      financial situation was not as bad as the Land had
credit ratings. A very instructive recent example is the         suggested, and second, it clarified that a financial crisis
ratings result for the EFSF (severally guaranteed by the         was not, by itself, a reason to expect federal help. We
EMU sovereigns except Greece) where the rating                   view this second part of the ruling as very useful to
agencies did effectively not give any diversification benefit
to the overall structure and EFSF is instead relying on
large cash buffers (in the order of 30% of total funding) to
achieve a triple-A rating. It is unlikely that such an             http://eur-
inefficient structure would be designed purely as a              PDF
permanent funding tool for a large share of total Eurozone       7

government funding.                                              http://www.bundesverfassungsgericht.de/entscheidungen/fs20061019_2b

Page 50                                                                                                   Deutsche Bank AG/London
10 December 2010            Fixed Income Outlook 2011

examine the German legal position vis-à-vis support for                       We expect the constitutional court to maintain its stance
struggling Euroland sovereigns.                                               with respect to the first point when looking at a sovereign
                                                                              rescue in the eurozone. More than a German
Without doubt, there are substantial differences between                      constitutional issue, this thinking reflects a particular
a sovereign rescue in the Eurozone and mutual support of                      understanding of democracy under the subsidiarity
German states. Inside Germany, there is a fiscal transfer                     principle.    The     population       exercises,    through
mechanism and mutual financial support has the rank of a                      democratically elected governments, sovereign rights,
constitutional item (Article 107(2)3). In contrast, while the                 which in the current state of the EU includes fiscal policy.
EU has structural cohesion funds, fiscal assistance is all                    The freedom to exercise these rights cannot be separated
but ruled out explicitly (Articles 125 and 123 on the Treaty                  from the responsibility to do so in a careful way. If the
on the functioning of the European Union). At the same                        population of a given eurozone country has chosen to
time, both the German constitution and the EU treaties                        elect governments that run persistent fiscal deficits, it is
recognise the role of the state as provider of essential                      first incumbent on that population to endure the hardships
services. This right of citizens to expect a certain                          that come with a fiscal tightening or restructuring. The
minimum level of public services creates the need for                         current statements from German politicians appear to also
fiscal resources. Furthermore, Germany’s participation in                     imply an unrelated wider responsibility: Private creditors
the Greek rescue package and the EFSF has not been                            who choose to lend money in open market transactions
struck down by the constitutional court as yet.                               do so at their own risk. This is of course nothing new.

In the 2006 ruling, the court made the following point (our                   The German constitution makes it clear that citizens can
translation): ‘Additional federal grants do […] in principle                  expect the government to provide basic services while
not serve to mitigate the financial weaknesses that are a                     the constitution outlines technical means by which a
direct and foreseeable consequence of political decisions                     necessary aid transfer can be effected. It is less certain
that a Land itself has made in the course of executing its                    that the German court will view this point in the same way
duties. Independence and political autonomy imply that                        in the case of a sovereign rescue given that article 125
Lander have to take responsibility for the fiscal results of                  appears to rule out transfers. We therefore see the
such decisions’8.                                                             attitude displayed in the 2006 ruling only as the furthest
                                                                              limit of what the court would countenance on a
The court goes on to note: ‘Because, and as far as,                           permanent basis.
situations arise in which the constitutionally mandated
freedom of action of a Land cannot be maintained in any                       That said, Germany is signatory to the EU Treaty which
other way, federal assistance through restructuring funds                     contain article 2(2): ‘The Union shall offer its citizens an
is allowed as an ultima ratio, and then also federally                        area of freedom, security and justice without internal
mandated.’9                                                                   frontiers, in which the free movement of persons is
                                                                              ensured in conjunction with appropriate measures with
These points can be summarised as follows: (1) The                            respect to external border controls, asylum, immigration
freedom of a democratically elected Land government to                        and the prevention and combating of crime.’ This would
make fiscal decisions (subsidiarity principle) necessarily                    seem to imply that a police force and judiciary, for
entails the risk to make wrong choices, and the burden to                     instance, must be maintained. It would, therefore, be
deal with the consequences of these choices rests with                        difficult to deny aid to a country that otherwise would not
that government. (2) However, where a Land government                         be able to provide such services. However, the EU
is unable to fulfil its constitutional duties, its citizens can               treaties are comparatively silent, for example, on the need
expect federal help.                                                          for sovereign creditors to be made whole in all

                                                                              We therefore view the German government as very tightly
8                                                                             constrained in any sort of rescue that it can agree upon,
  Dagegen dienen Bundesergänzungszuweisungen, wie der Senat bereits
in seiner Entscheidung im Jahr 1986 hervorgehoben hat, grundsätzlich          and mere insolvency (inability to pay) of a sovereign is not
nicht dazu, finanziellen Schwächen abzuhelfen, die eine unmittelbare und      one of the reasons that could trigger such a rescue. To us,
voraussehbare Folge von politischen Entscheidungen sind, die von einem
                                                                              the interesting question is, therefore, not why the German
Land in Wahrnehmung seiner Aufgaben selbst getroffen werden.
Eigenständigkeit und politische Autonomie bringen es mit sich, dass die       government is talking about private investor participation
Länder für die haushaltspolitischen Folgen solcher Entscheidungen selbst      in any future rescue operation, but why Germany
einzustehen haben
9                                                                             participated in the Greek rescue and EFSF in the first
  Weil und soweit Situationen eintreten, in denen die verfassungsrechtlich
gebotene Handlungsfähigkeit eines Landes anders nicht aufrecht zu             place.
erhalten ist, ist bundesstaatliche Hilfeleistung durch Mittel zur Sanierung
als ultima ratio erlaubt und dann auch bundesstaatlich geboten.

Deutsche Bank AG/London                                                                                                           Page 51
10 December 2010       Fixed Income Outlook 2011

The answer, to us, is that as a result of the sub-prime           Whatever treaty changes the van Rompuy commission
crisis, bank equity buffers were insufficient to absorb a         will propose in December, current indications are that the
sovereign default. Not to agree to a rescue at this stage         language will be very brief and unspecific. We think it is
would have endangered the eurozone banking system and             very unlikely that investors will find a clause that provides
hence Germany as well. After all, persistent trade                explicit haircut calculations in the event of a restructuring.
surpluses for Germany mean that German investors now              Anything less specific than such a clause would fail to
hold a lot of foreign debt. However, if banking system            remove uncertainty from the market relative to what was
stability is the raison d’etre for a rescue, it is clear that a   known before the insertion of the new language into the
more stable banking system would reduce the incentive             EU treaties.
and room for manoeuvre for the German government to
put German tax payer money at risk.                               It has been suggested by some politicians that debt
                                                                  issued before 2013 should be exempt from the new debt
European stability mechanism (ESM)                                restructuring mechanism. This is likely to be unworkable
The current political pronouncements about a permanent            for a number of reasons. First, we note that it is
replacement for the temporary EFSM/EFSF must be seen              uncommon for sovereigns to issue domestic debt under
in the context of what the German government can agree            explicit sovereign debt laws. An example of government
to in the light of its constitutional constraints. We believe     debt issued under special law is in Japan where the
that any permanent mechanism that provides for a bailout          sovereign can, by an act of parliament, restructure debt
of insolvent sovereigns as a matter of principle would be         explicitly. In most other cases, while the right of the
unacceptable to Germany on constitutional grounds, aside          respective ministry of finance or treasury to issue debt is
from the obvious conflict with article 125 of the EU treaty       governed by a budget law, the debt itself, once issued, is
which should also mobilise other governments against              a common law obligation of the government.
such plans. Any permanent mechanism would, therefore,             Inapplicability of standard insolvency procedures to such
have to include a restructuring event under some                  debt does not by itself remove it from the range of
conditions even if political manoeuvring means that these         common law obligations. Of course, a sovereign could, in
conditions will not be met in practice.                           extremis, change the common law legal framework
                                                                  although it may be possible that the European Court of
Practically speaking, it appears unlikely to us that it will be   Justice may restrict that freedom somewhat. For debt
possible to separate sovereign stability and financial            that is issued after 2013 to be different from existing debt,
stability in the Eurozone for some time. The structural           the countries that do not have specific laws governing
trade imbalances in the euro area mean that there is a            their liabilities would first have to establish such laws.
need to fund trade deficits and invest trade surpluses on a       Unless the EU can, very quickly, produce a standard for
long-term basis. Given that the European financial markets        such issuance laws, there is likely to be competition to
are largely bank-based, this means that banks structurally        push for the most generous terms for creditors because
build assets in current account deficit countries and fund        sovereigns in the eurozone have to compete for investors.
them with liabilities to customers in current account             Providing more ‘security’ in the terms of new debt is cost-
surplus countries. An insolvency of a deficit country will        free for the relevant sovereign because such extra terms
therefore almost always lead to potential bank crises. In         would only be relevant when the sovereign has lost all
the current episode, governments preferred to support             fiscal flexibility anyway.
sovereigns to protect banks, but future support may take
different forms.                                                  The second problem is that if new debt were to be issued
                                                                  under substantially different terms, investors would
Debt issued before and after June 2013                            require a spread between outstanding and existing issues.
More doubtful is the idea of a different treatment for debt       This spread would be the wider the more ‘discretionary’
issued under the ‘old’ and ‘post-2013’ crisis resolution          the market judges the trigger for orderly restructuring to
regime, whatever that will turn out to be. A first starting       be. Of course, a higher hurdle for restructuring means a
point to any analysis is that the introduction of a debt          less favourable cashflow position at the time of
restructuring mechanism will not by itself create the risk        restructuring, which means that the chances of the
of such an event occurring. Given that the present legal          restructuring being orderly are reduced.
framework explicitly rules out fiscal rescues, investors are
already in the last resort faced with potential defaults by       The third problem is simple logistics: June 2013 is the cut-
Euroland sovereigns. Since 1 January 1999, the only risk-         off date for new aid from EFSF, but that does not
free assets in the eurozone have been deposits with the           necessarily mean that there is no risk of default on any
ECB.                                                              outstanding debt after that point. In such a case, while the
                                                                  debt issued after the cut-off would be dealt with by the

Page 52                                                                                               Deutsche Bank AG/London
10 December 2010             Fixed Income Outlook 2011

new restructuring mechanism, the old debt would not be                    Theoretical CDS levels for post- and pre-2013 debt for
supported through EFSF. Hence, it would either be                         Germany and Italy
restructured in what would be a less orderly default
                                                                                                  Germany Post 2013           Germany Pre 2013
procedure, or it would be senior to the post-2013 debt.
                                                                                                  Italy Post 2013             Italy Pre 2013
The latter scenario would lead to extremely wide spreads                     5.0%
on debt issued early under the new terms because the
holders of the initially small amounts of those new
securities would be subordinated to the much larger
amount of outstanding old debt. This would make capital
markets access prohibitive for countries that would be
thought to be at risk in 2013. Issuers could solve this
problem through exchange programmes, but this would
entail substantial transaction costs.
We can estimate the impact of such subordination if we
                                                                                          6M      1Y      2Y        3Y   4Y    5Y       7Y       10Y
assume that the current CDS market is rationally priced
                                                                          Source: Deutsche Bank
and will remain the same until 2013. We also assume that
existing debt is replaced over a 10Y horizon and that the
                                                                          The calculations show that the difference between fair
overall haircut (cash amount of debt forgiveness)
                                                                          value CDS on existing bonds and new bonds will be
necessary to restructure a given sovereign is independent
                                                                          widest at the point where the new bonds will absorb all
of the debt structure. We use the historical average 54%
                                                                          the expected losses upon default. If the market were to
recovery value established by Moody’s between 1983 and
                                                                          charge bond spread in line with these CDS spreads,
200710. We then find the following CDS curves for Ireland,
                                                                          sovereign interest costs would rise dramatically under the
Italy, Portugal, and Spain for the existing and new
                                                                          new regime. This assumes that the new bonds are
structure debt.
                                                                          subordinated to the existing debt.

Theoretical CDS levels for post- and pre-2013 debt for                    Another critical obstacle is likely to be the existence of
Ireland, Portugal and Spain                                               eurobonds (in the sense of bonds issued under non-
                         Ireland Post 2013         Ireland Pre 2013       domestic law or in the non-domestic market) of Eurozone
                         Portugal Post 2013        Portugal Pre 2013      governments. The documentation of these bonds usually
     14%                 Spain Post 2013           Spain Pre 2013         contains negative pledge language which makes it difficult
     12%                                                                  to subordinate them relative to debts raised in support
                                                                          operations. This increases the amount of subordination
                                                                          suffered by bond holders not protected by similar clauses.

      6%                                                                  In summary, the transition to a co-existence of debt
                                                                          entitled to a bailout and debt subject to an ‘orderly’ default
                                                                          is extremely difficult to envisage. Instead, it is likely that
                                                                          by the end of the EFSF, the market will have realised that
      0%                                                                  any Euroland sovereign debt is subject to default risk and
                6M      1Y     2Y      3Y     4Y   5Y      7Y       10Y   that the financial institutions are judged to be able to
Source: Deutsche Bank                                                     withstand such a shock without leading to a domino
                                                                          effect of failing financial intermediaries, negating the need
                                                                          for assistance. This, of course, is exactly the way the
                                                                          world looked before the 2008 crisis.

                                                                          Collective Action Clauses
                                                                          We believe that collective action clauses themselves do
                                                                          not change the ex-ante probability of a sovereign
                                                                          restructuring event. What they do, however, is to provide
                                                                          a concrete mechanism to implement the no-bailout rule of
                                                                          the EU treaties. We view the exact trigger mechanism for
                                                                          a restructuring as not particularly decisive given the
http://www.moodys.com/cust/content/content.ashx?source=StaticContent      experience of the current crisis. External observers may
0000482445.pdf                                                            generally decide earlier than the affected sovereign that a

Deutsche Bank AG/London                                                                                                                        Page 53
10 December 2010      Fixed Income Outlook 2011

restructuring is inevitable, but in practical terms the         for Eurozone governments’ ability to service their debt.
market can withdraw liquidity so quickly that the timing        Generally, an overly indebted country has a number of
will be almost the same in either case.                         options:

The collective action clause idea is not a new idea in                   Explicit default or restructuring
sovereign bonds but has until now been associated
                                                                         Debasement of the currency
mostly with emerging market debt. The simple purpose of
introducing such clauses is to make sure that an                         Increased taxation and spending cuts
economically sensible restructuring cannot be blocked by
                                                                         Higher growth
a small minority of investors who are looking for better
separate settlements. For instance, there have been                      Transfer payments from other governments
instances in the past where investors sought to seize off-
                                                                All these options are still present in the Eurozone although
shore assets from governments in default by appealing to
                                                                the scope the second option is much reduced by common
overseas courts. In the EU, the European Court of Justice
                                                                monetary policy. However, the current focus on the last
leads to a situation where sovereignty may no longer be
                                                                option should not preclude a thorough analysis of the
absolute even on the territory of a member state. This
                                                                other four. At the current stage, the ECB’s monetary
creates a small risk that investors could influence even
                                                                policy (as opposed to liquidity policy) is likely to be
domestic decisions by a restructuring sovereign although
                                                                unaffected by fiscal worries because 80% of Eurozone
it seems unlikely that the court would pass a ruling that
                                                                GDP are in countries that are seen as relatively stable by
favours one creditor over others.
                                                                the market. Investors should take into account, however,
                                                                that quantitative easing would be a possible policy option
In the presence of collective action clauses, a
                                                                for the ECB if a sovereign crisis were to threaten deflation
restructuring and settlement of final terms can be
                                                                in the Eurozone; a scenario that we view as unlikely.
conducted relatively quickly. Academic studies suggest
that the economic cost of a restructuring with collective
                                                                The Greek support appears to have been priced with the
action clauses is lower than without such clauses because
                                                                third option, higher taxation, in mind, because scope was
equilibrium solutions with stand-offs are avoided. To us,
                                                                seen for improved tax collection. The idea that higher
this consideration is even more important for EMU
                                                                growth can pay for higher funding costs in those countries
countries than for emerging markets. At least while a debt
                                                                where higher taxation is less of an option is more tenuous.
restructuring process is ongoing, a sovereign will find
                                                                If we assume that Eurozone interest rates roughly reflect
itself unable to borrow at sustainable interest rates. Still,
                                                                economic fundamentals, the observation that the
the business of government has to continue, as will
                                                                Eurozone sovereign index trades at an average asset
government expenditure on healthcare, policing, schools,
                                                                swap level of E+48bp means that a sovereign borrowing
welfare, etc. The share of government expenditure in GDP
                                                                at E+300bp from EFSM/EFSF would have to achieve
is much higher in developed countries than in transition
                                                                about 250bp higher nominal growth to break even on the
and developing economies. This means that a disruption
of cash flow through the government could affect the
economy more, and we think it is, therefore, more
                                                                To us, the non-default exit strategy from high debt for
beneficial to cut the period of uncertainty to a minimum.
                                                                Eurozone sovereigns, and indeed for high-welfare
This would not least benefit creditors because the less
                                                                countries generally, is to reduce government expenditure
disruptive the process is, the more the stricken
                                                                relative to tax income. This ‘original accumulation of
government can afford to pay out to creditors.
                                                                capital’ strategy takes a significant amount of time and
                                                                therefore needs to be flanked by accommodative
To us, the advantages of a collective action clause
                                                                monetary policy. Inside the Eurozone, such monetary
outweigh the perceived disadvantage of lowering the cost
                                                                accommodation can be achieved if high-growth countries,
of default, and thereby increasing moral hazard. The
                                                                where inflationary pressures may pose a danger, tighten
problem is rather that introducing collective action clauses
                                                                fiscal policy disproportionately to create sufficient fiscal
would require the creation of a specific legal framework
                                                                drag on their economies to suppress domestic demand
for sovereign debt in each country. We view it as
                                                                and keep inflationary pressures in check.
unrealistic that this can be completed in the course of
2011 as mooted in press reports, or indeed until 2013.

Back to basics
To us, the focus on cross-government support is
obscuring a rational discussion about the actual prospects

Page 54                                                                                             Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

Sovereign Strategy                                             Twin deficit and fiscal credibility shows Portugal and
                                                               France remain rich, more so in bonds than in CDS
    On the basis of our twin deficit metric we
                                                                 700           0Y
                                                                              1 A SW
    recommend (1) short Portugal vs. Ireland and
                                                                                                                          y = 46.24x + 11.50
    Spain and (2) short France on ASW                            600
                                                                                                                               R 2 = 0.88

    The CDS-bond basis in Portugal is at historical              500                                                                                  GR

    wide levels as ECB buying has caused bonds to                400                                                 IE
    richen relative to CDS. We recommend a CDS –
                                                                 300                                                                PT
    bond basis tightener in Portugal
    An accommodative ECB remains supportive of the                                                        IT

    front-end of Italy and Belgium compared to Spain              100                                BE
    which is running significant primary deficits and                             NL        FI
                                                                    0                                AT
    its banks remain under pressure. We recommend                                                          FR
                                                                 -100                       DE              Twin deficit and fiscal credibility metric
    steepeners in Italy and Belgium and flatteners in
                                                                         -5                      0                        5                    10            15
    Spain vs. Germany
                                                                 1000         5Y CDS
    Carry and roll down makes the 4Y-5Y sector in
    core countries attractive                                     900                                                     y = 61.46x + 84.68
                                                                                                                               R2 = 0.91
The key theme in our 2010 Outlook was the repricing of                                                                                                GR
sovereign risk in the euro-area and our framework of
                                                                  600                                                     IE
analysis was correct in highlighting countries where these
risks were mis-priced. Our framework led us to focus on           500                                                               PT

countries with twin deficits, i.e. countries with high            400

required fiscal adjustments and large current account             300                                                  ES
deficits.                                                         200                                          IT
                                                                  100                                AT             FR
Twin deficit and fiscal credibility metric: Portugal and             0                      DE       NL
                                                                                                                    Twin deficit and fiscal credibility metric
France remain rich                                                       -5                      0                      5                 10                  15
On our twin deficit and fiscal credibility metric, France      Source: Deutsche Bank
continues to trade rich while Portugal appears rich relative
to Ireland and Spain. This discrepancy is greater in bonds     The impact of the ECB buying on Portuguese bonds can
where Portugal has been supported by ECB buying and            be seen via (1) the widening of the Portugal CDS – bond
France benefits from being a large AAA rated issuer and        basis and (2) the richening of Portuguese bonds relative to
hence benefiting from benchmark investors who would            Spain and Ireland. We would recommend putting on CDS
find it hard to be short France amidst the uncertainty         – Bond basis tighteners in Portugal or being short
surrounding the peripheral issuers.                            Portuguese sovereign risk relative to Spain and Ireland
                                                               either via bonds or CDS.

Deutsche Bank AG/London                                                                                                                               Page 55
10 December 2010                Fixed Income Outlook 2011

Portugal benefiting from ECB actions: CDS – bond                                   2Y-10Y steepener in Belgium and Italy, flattener in
basis at historical wide and Portugal trades rich vs.                              Spain
                                                                                   The conclusion of the analysis in the previous section
Spain and Ireland
                                                                                   suggests that a move towards a fiscal union either via
  250                                                                              European bonds or a practical realisation of the ESM
                          P o rtugal CDS - bo nd basis                             framework as it stands at present remains uncertain. At
                                                                                   the same time while the banking sector in the euro-area is
                                                                                   strengthened sufficiently to absorb the losses resulting
                                                                                   from an eventual restructuring of the debt of
                                                                                   fundamentally insolvent euro-area countries, the ECB will
                                                                                   have to continue to provide support via its liquidity
                                                                                   operations and/or via the Securities Market Program.

                                                                                   Contributions to change in debt/GDP ratio over 2011-
     Sep-09 No v-09 Jan-1 M ar-1 M ay-1
                                0      0            Jul-10    Sep-1 No v-1
                                                                   0      0          20.0                                            Sto ckflo w effects
                                                                                               % o f GDP
                                                                                                                                     Interest rate - No minal
   500                                                                               15.0                                            GDP gro wth differential
                    P o rtugal Oct-1 vs.
                                    4                                                                                                P rimary deficits
   400                            4
                    Ireland Jan-1 &                                                  10.0
                    Spain Jul-1 4




  -200                                                                             Source: Deutsche Bank, European Commission
     M ay-09      A ug-09    No v-09       Feb-10   M ay-10    A ug-10   No v-10
Source: Deutsche Bank                                                              In such an environment, for countries with high debt/GDP
                                                                                   ratios namely Belgium and Italy, ECB’s actions of
Similarly, the richening of French bonds is illustrated by                         maintaining low policy rates and accommodative liquidity
the wide level of the CDS – bond basis in France. We                               policy should be supportive in the short-run. However, the
hence maintain our short France on ASW basis as a way                              risk premium at the longer-end of the curve should
to position for this trade.                                                        increase as these countries need to either maintain GDP
                                                                                   growth rate above the interest rate paid on debt or run
French bonds continue to trade rich as reflected in the                            primary surpluses leaving little room to absorb further
widening of the CDS bond basis                                                     shocks. In contrast, Spain’s public finances are expected
                                                                                   to worsen due to continuing primary deficits and concerns
  140                                                                              about its banking sector persist. In such a scenario, the
                        France CDS - bo nd basis
                                                                                   shorter term risks are unlikely to be resolved by the ECB’s
                                                                                   actions alone and as we have highlighted all of the
  100                                                                              schemes and proposals to address the crisis remain open
                                                                                   to debate.

   60                                                                              However, the 2Y-10Y slopes for these three sovereigns
                                                                                   are roughly at similar levels. We would recommend
                                                                                   steepeners in Italy and Belgium and flatteners in Spain vs.
   20                                                                              Germany.
                        0      0
    Sep-09 No v-09 Jan-1 M ar-1 M ay-10             Jul-10         0
                                                              Sep-1 No v-10

Source: Deutsche Bank

Page 56                                                                                                                         Deutsche Bank AG/London
10 December 2010               Fixed Income Outlook 2011

2Y-10Y slopes in Belgium, Italy and Spain are at                           and we would recommend being overweight these
roughly similar levels                                                     sectors on the AAA rated sovereigns

                    B elgium                                               6M carry and roll down most attractive in 4Y-5Y
                    Italy                                                  sector for AAA rated countries
  250               Spain
  200                                                                                  bp
                                                                             30                                Germany        Netherlands

   150                                                                       25                                Finland        A ustria

   100                                                                       20

      Jan-     M ay-    Sep-   Jan-   M ay-   Sep-   Jan-   M ay-   Sep-
       08       08       08     09     09      09     10     10      10       -5

Source: Deutsche Bank                                                        -10
                                                                                                                              M aturity (yr)
Long 4Y-5Y sector in AAA rated countries for carry                                 0          5    10     15     20      25          30        35
and roll down                                                              Source: Deutsche Bank

The environment should also be conducive for carry
trades on the curves of the highly rated sovereigns such                                            Alexander Duering (44) 20 7545 5568
as Germany, Netherlands and Austria. Carry and roll down                                           Abhishek Singhania (44) 20 7547 4458
on the AAA rated curves peaks around the 4Y-5Y sector

Supply Outlook 2011

         Gross issuance in 2011 is estimated to be                                 around the lowest levels since the inception of
         approximately EUR 877bn, a decline from the EUR                           the EMU
         923bn seen in 2010. Net issuance is seen at EUR
         356bn, compared to EUR413 bn in 2010, and                         Issuance needs remain substantial
         representing a rise of around 7% in the equivalent
                                                                           With the peripheral crisis far from over, issuance will
         bond universe. These do not include bill funding,
                                                                           continue to be a focus for the market in 2011. This is
         and we assume that neither Ireland nor Greece
                                                                           particularly true for peripheral countries, and it seems
         return to coupon funding next year
                                                                           likely that pressure points will be concentrated around key
         When comparing across the same universe of                        redemption months.
         countries, gross issuance declines marginally
         from EUR 890 bn to EUR 877bn. Net issuance,                       Gross issuance for EU 11 in 2011 is seen at around EUR
         meanwhile, declines 10% to EUR 356bn                              877bn, a decline from the EUR 923bn seen in 2010. Net
                                                                           issuance is approximately EUR 356bn, compared to EUR
         The largest decline in issuance in absolute terms
                                                                           413bn in 2010, and representing a rise of around 7% in
         is seen in Italy and France, while the remainder
                                                                           the equivalent bond universe. These do not include bill
         sees marginal declines in reliance on the market
                                                                           funding, and we assume that neither Ireland nor Greece
         Funding conditions for peripherals came under                     return to coupon funding next year.
         the spotlight this year, and this is likely to
         continue into 2011. The peripheral crisis is likely               It could be argued that the EU-11 aggregates do not
         to be ongoing, and the policy response                            compare like for like across 2010 and 2011 as two
         characterized more by a piece-meal approach,                      countries have dropped out. When comparing across the
         which could lead to bouts of risk aversion                        same universe of countries, gross issuance declines
                                                                           marginally from EUR 890bn to EUR 877bn. Net issuance,
         This year saw a shift away from short dated
                                                                           meanwhile, declines 10% to EUR 356bn.
         paper, and the terming out of issuance, which is
         expected to continue. This is particularly so in
         core countries, where long dated yields are

Deutsche Bank AG/London                                                                                                                   Page 57
10 December 2010                   Fixed Income Outlook 2011

Gross and net coupon supply for 2011 expected to fall                                    While funding conditions are challenging
                                      Gross Issuance                  Net Issuance
                                                                                         Over the course of 2010, it became clear funding
          (EUR bn)             2010E 2011E             %    2010E 2011E   %
                                                     Change             Change           conditions were increasingly diverging between those
          Germany                204          239     17%        70        92     30%    who could and those who couldn’t. This is likely to
          France                 208          195     -6%        124       100    -19%   continue into 2011, with weaker sovereigns arguably
            Italy                238          224     -6%        63        69     9%
                                                                                         supported more by domestic banking systems, and by
                                                                                         extension, ECB access.
           Spain                  93          85      -9%        59        39     -33%
      Netherlands                 52          51      -1%        29        24     -19%
                                                                                         Last year we noted that extreme levels of issuance might
          Belgium                 40          38      -6%        14        10     -29%
                                                                                         prompt countries to diversify their funding instruments
          Austria                 20          19      -5%        11        11     -2%
                                                                                         and investor base. The peripheral crisis rendered this
          Portugal                21          18      -15%       15        9      -44%
                                                                                         somewhat futile as investors focused simply on the
          Finland                 14          9       -36%       9         3      -65%   sovereign creditworthiness, rather than spread pick up or
           Total                 890          877     -1%        395       356    -10%   other relative value measures. This is likely to remain the
          Ireland                 20          0                  19        0             case next year, with opportunistic issuance via EMTN
          Greece                  13          0                  0         0             programmes in core countries where possible.
       Total EU-11               923          877     -5%        413       356    -14%
Source: Deutsche Bank,                                                                   This year, issuance was concentrated in the 10Y sector,
                                                                                         while on aggregate the proportion of 2Y and 5Y issuance
Despite the fiscal consolidation plans that have been                                    declined slightly. We would expect the shift away from
passed over the course of the year, redemptions in most                                  short date paper, and the terming out of issuance to
countries rise in 2011 relative to that seen this year. This                             continue. This is particularly so in core countries, where
will in part counter the positive supply impact seen from                                long dated yields are around the lowest levels since the
declining deficits. Redemptions amount to slightly over                                  inception of the EMU.
half of gross issuance in 2011, with the remainder due to
deficit financing.
                                                                                         Issuance has shifted away from short dated paper
Redemptions remain a distinct proportion of gross
issuance                                                                                   25%
   1 0%
    1                                                            Deficit
                                                                 Rdemptio ns               20%
                                                                                            15%                                                                        2009
   80%                                                                                                                                                                 2010

   70%                                                                                      10%


   40%                                                                                       0%
                                                                                                      2Y-3Y          5Y          10Y         15Y      30Y     IL   FRN/ Ot her
                                                                                         Source: Deutsche Bank, Various National Debt Agencies

            DEM          FRA    ITL     ESP         NET   B EL    A US     P OR   FIN    The stock of outstanding bills has remained roughly at
Source: Deutsche Bank, Bloomberg Finance LP                                              similar levels over the year, and is relatively sizable in
                                                                                         some countries. While this would have lowered funding
All countries bar Germany see a reduction in gross                                       costs over the crisis, it would also seem reasonably that
issuance, and we note this is simply because we expect                                   some bill issuance is transferred to bond markets going
some reduction in bill funding towards coupon funding.                                   forward. This would both reduce some of the short term
The largest decline in issuance in absolute terms is seen                                rollover risk, and reduce exposure to potential rate hikes
in Italy and France, while the remainder see marginal                                    from the ECB.
declines in reliance on the market. Refinancing risk is
expected to remain in focus next year, particularly for the

Page 58                                                                                                                                            Deutsche Bank AG/London
10 December 2010                    Fixed Income Outlook 2011

Bill stocks have barely changed over the past year                                      Euro sovereign debt investors may now be (very) familiar
                                                                                        with Article 125, which explicitly rules out guarantees by
                                                              Current (rhs)             one member over liabilities of another except in the case
                                                                                        of specified joint projects. Even if Eurozone leadership
                                                                                        decide to side step the issue, the challenges such a
                                                                                        construct would face from constitutional courts would be
   150                                                                                  considerable – we discuss this further in the Euroland
                                                                                        Sovereign Outlook article.
                                                                                        From a cost perspective, relative to current funding levels,
      50                                                                                both constructs would currently offer no advantages to
                                                                                        several of the guarantors. It is difficult to see countries
                                                                                        voluntarily giving up low funding costs, unless
            DEM      FRA         ITL    A US        NET    P OR    ESP     B EL   FIN
                                                                                        circumstances materially change. In the near term at least,
                                                                                        it seems unlikely that the Eurozone moves fully to a fiscal
Source: Deutsche Bank, Bloomberg Finance LP
                                                                                        union in which such a construct would be viable.
Funding costs have diverged wildly this year, with core
countries benefiting from the spread widening seen in                                   Detailed Country Overview
peripherals. With absolute level of gross issuance still
remaining around high levels, and added competition from                                Germany
                                                                                         EUR       2Y-3Y        5Y   10Y   15Y   30Y   IL    Total
high quality supra names, the cost of funding will remain
an important issue going into next year. This will be
                                                                                         2011        72         72   72     0    12    12     239
particularly true for sovereigns approaching yield levels
                                                                                         2010        74         52   60     0    10    8      204
which start impacting debt sustainability.
                                                                                        Source: Deutsche Bank

The cost of refinancing remains a key issue                                             German bond issuance is seen rising relative to 2010
  9         %                  Current iB o xx YTM                                      levels, despite an improvement in the deficit. This is in
                               YTM 1 A go                                               part because redemptions are higher, but also because
                                                                                        there have been suggestions that the proportion of bill
                                                                                        issuance, which had risen significantly over the last few
  6                                                                                     years, will decline. Here we tentatively assume a third
  5                                                                                     decline in outstanding bill stocks, which adds EUR 28bn to
  4                                                                                     coupon funding. Continued support for the linker
                                                                                        programme.is expected, with potential for a new bond.

   1                                                                                     EUR       2Y-3Y        5Y   10Y   15Y   30Y   IL    Total
           A US   B EL     FIN      FRA       GER    IRE     ITL     NET   P OR   ESP    2011        29         59   49    20    20    20     195
Source: Deutsche Bank, iBoxx                                                             2010        32         55   52    25    16    24     204
                                                                                        Source: Deutsche Bank

Eurobonds: interesting in theory, difficult in practice
The concept of Eurobonds has been reemerged recently,                                   French issuance is seen at EUR 195bn, down slightly from
with several high profile officials voicing support for the                             2010. The proportion of short end (2Y & 5Y) issuance last
idea. In theory, this can be done in two forms, the first                               year declined slightly from 2009 levels, and was made up
being a joint and several guarantee, and the other being                                for in linker issuance. The proportion of long end issuance
simply a several guarantee.                                                             remained roughly similar to 2009.

The latter format of guarantee can be seen via the EFSF.                                Next year new benchmarks in the 3Y, 5Y and 10Y sector
Notably, the rating agencies required significant cash                                  are expected, with potentially a long dated issue as well.
buffers to attain a triple A rating, and the instrument did                             In the linker market, a new 15Y+ bond is also a possibility.
not benefit much from the guarantees of the stronger
countries. In itself, this would be an inefficient form of
financing for all but the most stressed.

Deutsche Bank AG/London                                                                                                                     Page 59
10 December 2010             Fixed Income Outlook 2011

Italy                                                                          Belgium achieved its funding target early this year, and
 EUR       2Y-3Y        5Y   10Y    15Y       30Y         IL   Other   Total   continued issuing to achieve around EUR 5 bn of
  bn                                                                           prefunding for 2011. This has helped keep gross 2011
 2011        34         45   34     27        13         16     56      224    issuance at similar levels. As with the Dutch, long end
 2010        38         45   41     25        12         19     60      239    issuance in Belgium rose as a proportion to around 17%
Source: Deutsche Bank                                                          of gross issuance last year, from around 5% in 2009. The
We expect Italy to reduce gross issuance by around 6% in                       reduced reliance on short end paper is expected to
2011. In 2010, the proportion of issuance across sectors                       continue, with the bulk taken up by the belly of the curve.
was relatively steady, however linker issuance was short                       New benchmarks are likely in the 10Y and 5Y sector, with
of the 10% seen in 2008 and 2007. In 2011, we expect                           opportunistic use of the EMTN programme.
BTPS will again make up the bulk of issuance, while zero-
coupon and floating rate instruments accounting for                            Austria
around a quarter.                                                               EUR       2Y-3Y        5Y   10Y   15Y      30Y     IL    Total
Spain                                                                           2011         0         5     9     3        2      0      19
 EUR       2Y-3Y        5Y    10Y     15Y           30Y        IL      Total    2010         0         5    11     2        2      0      20
  bn                                                                           Source: Deutsche Bank

 2011        17         21    25         13          8         0        85
 2010        20         21    29         16          7         0        93     2011 gross issuance in Austria is expected to come in at
Source: Deutsche Bank                                                          around similar levels as 2010. This year, around half of
Spain is likely to be the key tipping point in the peripheral                  gross supply was targeted at the 10Y sector, with the
crisis, and there will likely to be an ongoing focus on                        remainder split between the 5Y and long end. Long end
refinancing and redemption dates.                                              supply is still below pre crisis proportions, at 21%
                                                                               compared to 40%, and this should slowly move back. A
In 2011, gross issuance has declined, in part due to                           new 10Y benchmark is likely, as per the regular schedule.
expectations from the government for funding via asset
sales. In 2010, there was some terming out of issuance,                        Portugal
with front end issuance declining to 44% from 55% seen                          EUR       2Y-3Y        5Y   10Y   15Y      30Y     IL    Total
in 2008, and long end issuance making up a quarter of                            bn
overall gross supply. A similar profile could be seen this                      2011         1         6     8     2        1      0      18
year, with potentially further duration extension, subject to                   2010         2         7    11     2        0      0      21
market conditions. New benchmarks are likely in the 10Y                        Source: Deutsche Bank

and 5Y sectors.
                                                                               Portugal could also come under pressure next year, as we
Netherlands                                                                    discuss in the Euroland Strategy article. Gross issuance is
 EUR       2Y-3Y        5Y    10Y     15Y           30Y        IL      Total
                                                                               expected to remain around similar levels, with the regular
                                                                               syndication likely for the first quarter. Issuance was
 2011        14         13    17          0          8         0        51
                                                                               concentrated in the 10Y sector with taps across the
 2010        16         13    13          0          7         0        49
                                                                               remainder of the curve which is likely to continue.
Source: Deutsche Bank

Dutch capital market issuance is set to remain at similar                      Finland
levels to 2010, assuming no change in the proportion of                         EUR       2Y-3Y        5Y   10Y   15Y      30Y     IL    Total
bill funding.                                                                    bn
                                                                                2011         0         3     3     2        0      0      9
Sector wise, a noticeable trend this year was a return to
long end funding, which made up 14% of gross issuance,                          2010         0         5     7     3        0      0      14
                                                                               Source: Deutsche Bank
up from 3% in 2009. This is still short of the 21% see in
2007, however, and this trend could continue into 2011.
                                                                               Finland held several tap auctions this year, to adjust to the
This was accompanied by a slight reduction in short dated
                                                                               larger than usual gross issuance requirement. This was
funding, but more so in 10Y.
                                                                               spread out across the 5Y, 10Y and 15Y sector, which is
Belgium                                                                        likely to remain the key sectors tapped in 2011.
 EUR       2Y-3Y        5Y    10Y     15Y           30Y        IL      Total
  bn                                                                                                        Soniya Sadeesh (44) 20 7547 3091
 2011         4         13    13          2          6         0        38
 2010         2         15    15          2          5         0        38
Source: Deutsche Bank

Page 60                                                                                                                 Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011


    The volatility experienced by the rates market this          left. The driving force for carving such a landscape is the
    year is no less than a roller-coaster ride. With             record low interests at the curve front end and the strong
    front end yields rallying to new lows before QE              demand for EUR vega over the year. To understand the
    and the long end being released,, the front end              evolution of the vol surface reshaping, we review how the
    vol has collapsed and long end vol soared. EUR               market has gone through.
    vega rose sharply towards 08Q4 levels, led by
    10Y2Y and 10Y10Y sectors.                                    EUR vol surface relative richness/cheapness
    We believe 2011 will be the beginning of the next
    tightening cycle, and policy makers will remain
    the dominant driver for the vol surface reshaping
    in 2011. Our core view is that the ECB will start

    hiking rates in the second half of 2011, and at the
    same time the ECB will maintain liquidity support
    for the sake of peripheral country funding needs.
    Peripheral debt shocks will remain a problem, but
    systemic risk is less likely.

    The financial markets are exposed to substantial
    risks if the ECB starts to hike rates, due to the
    widely-held expectation that monetary policies of
    the     major    central    banks    will   remain
    accommodative. Such risk is not only limited to
    the front end sell-off, it could also spill over to
    other asset classes and then feed back to the long           Source: Deutsche Bank

    end of the yield curve.
                                                                 Financial markets started optimistically at the beginning of
    With sovereign risks and the uncertainties to
                                                                 2010, and back then “exit strategy” was at the center of
    global growth, volatility for the belly and long end
                                                                 the stage. The theme saw a sharp U-turn in the middle of
    of the curve will be well supported for the coming
                                                                 the year as the European sovereign debt crisis and the
    year. 5Y gamma is likely to outperform as the
                                                                 weaker US data shifted the market’s focus to a double-dip.
    consensus takes time to build regarding the
                                                                 With the fear of deflation dominating financial markets,
    growth outlook. We recommend being long 5Y
                                                                 the adverse scenario was perceived as a Japanese style
    gamma using straddles or strangles to position
                                                                 deflation with low rates and decline in equities. The Fed
    for both rosy scenarios and double dips.
                                                                 has been committed to avoid such a deflationary path
    Long-term supply and demand dynamics is still                with more QE. The point of QE is precisely to push
    very supportive to EUR vega. Persistent sovereign            government bonds above their fundamental values and
    debt shocks and regulation reforms require                   crowd out the private investors towards risky assets. In
    portfolio managers to hedge tail-risks and are               the three months prior to QE2 both stocks and bonds
    likely to create more demand for long-dated vega.            rallied in line with the Fed’s objective. Excess liquidity,
    We are more bullish 20Y-tail and 30Y-tail vega               which is supportive for both stocks and bonds, has been
    which are still at relatively attractive levels. Shall       keeping rates low and equities performing well before the
    the EUR vega decline after the new year, we view             QE announcement. However, the backlash against QE
    it as a better buying opportunity.                           also gained strength right after the QE announcement.
                                                                 The re-pricing of central bank expectations and the long-
Red hot volatility                                               end disappointment triggered massive sell-offs on the
                                                                 curve belly and outwards. In Europe, the ECB is facing a
The       heatmap      below       shows      the     relative
                                                                 conflict between the strong Germany growth and the
richness/cheapness for the EUR implied vol surface
                                                                 crisis for peripheral sovereign debts. Although real interest
(generated by applying PCA analysis to the data of the
                                                                 rates are too low for the core Eurozone and the ECB has
past year). The red hot 10Y2Y sector (high volatility), rising
                                                                 been biased towards normalization throughout the year,
from an elevated plateau (orange) on the vega surface,
                                                                 the dire situation of peripheral markets forced the ECB to
forms a sharp contrast to the dark blue 1Y1Y sector (low
                                                                 extend its liquidity support.
volatility) which is confined into a tiny corner at the upper

Deutsche Bank AG/London                                                                                              Page 61
10 December 2010                      Fixed Income Outlook 2011

The volatility experienced by the rates market this year is                             2)        Demand for hedging the exotic books (mainly 2Y/10Y
no less than a roller-coaster ride. With front end yields                                         CMS spread options) supported vega on 2Y and 10Y
rallying to new lows before QE and the long end being                                             tail, particularly around 7Y to 10Y expiry where the
released, the front end vol got crushed and long end vol                                          forward curve slope is close to flat.
soared, as shown in the chart below. This is the driving
force for the low levels of 1Y1Y implied vol compared to                                3)        Increasing CMS issuance required more vega for
1Y10Y or long-expiry vega.                                                                        hedging purpose, concentrating around OTM strikes
                                                                                                  for 10Y and 30Y tail.
Roller-coaster ride with EUR realized volatility
     9                                   2y            5y          10y         30y      2011: tightening begins
     8                                                                                  With the loose monetary policies keeping rates low vs
                                                                                        fundamentals, we believe 2011 will mark the beginning
                                                                                        for the next tightening cycle. Policy makers will remain the
     6                                                                                  dominant driver for the vol surface reshaping in 2011. Our
     5                                                                                  core view is that the ECB will start hiking rates in the
                                                                                        second half of 2011, and at the same time the ECB will
                                                                                        maintain liquidity support for the sake of peripheral
     3                                                                                  country funding needs. By doing so, the ECB will confirm
                                                                                        that the liquidity supporting measure and monetary policy
                                                                                        are two different issues.
  Dec-09                Mar-10                Jun-10             Sep-10        Dec-10
                                                                                        The ECB surely has a strong reason to start tightening, as
Source: Deutsche Bank
                                                                                        shown by the chart below. Growth in core Europe has
                                                                                        been extremely robust, with Germany running at close to
With the sovereign risk and regulation reform weighing on                               3% GDP growth annualized. While growth should
the financial markets, the decline of vega at the beginning                             decelerate somewhat, it is likely to remain strong and
of the year was only a prelude to a trending upward move,                               above potential given that (1) Neither the public nor the
particularly towards the year end of 2010. Without any                                  private sectors are over-levered, (2) the economy remains
meaningful supply, the continued buying has pushed vega                                 competitive at current exchange rate, (3) unemployment
to successive new highs. EUR 10Y10Y vega is at similar                                  rate is back to pre-crisis levels, (4) assets (housing) is not
levels of 08Q4 crisis, as shown in the chart below.                                     overvalued, (5) real rates are too low.

EUR vega is getting close to 08Q4 crisis levels                                         ECB’s monetary policy is too loose for Germany
  90                                                                                      115                                                                  5.5
                                                                                                                     Germany IFO
  85                                                                                                                                                           5.0
                             EUR 10Y10Y vol                                               110                        ECB (6 months trailing)
  80                                                                                                                                                           4.5
  75                                                                                      105                                                                  4.0
  70                                                                                                                                                           3.5
  65                                                                                                                                                           3.0
  60                                                                                         95
  55                                                                                                                                                           2.0
  50                                                                                                                                                           1.5
  45                                                                                         85
  40                                                                                         80                                                                0.5
         01    02       03       04      05      06         07    08      09   10                 01   02       03     04     05    06     07   08   09   10
Source: Deutsche Bank                                                                   Source: Deutsche Bank

The following flows have been driving up vega,                                          Euro peripheral debt market will remain under pressure,
                                                                                        but it will not stop the ECB from hiking. In fact, by being
1)       Demand for Euribor caps from corporates for funding                            forced to extend the liquidity support to the peripheries, it
         protection and from banks for capped mortgage                                  could on the margin make the ECB more compelled and
         lending lifted vega around the 5Y2Y and 10Y2Y sector.                          more comfortable to address the problem of the core.

Page 62                                                                                                                                    Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

A systemic meltdown is less likely as it is the scenario the     Equity-rates correlation at different rates levels
policy makers will take whatever measures to avoid. The
                                                                                             1.0                                      stock-rates correlation
persistent pressure on the peripheral debt market will
                                                                                             0.8                                      June 2010 -Present
prevent the core debt market from any significant sell off.                                                                           Oct 93 - Aug 94

                                                                   stock-rates correlation
With the hawkish ECB and the chronicle tension of the
sovereign debt crisis, bear flattening is our core view for
the EUR yield curve.
The timing and the pace of the ECB hikes are likely to
create tensions in the front end. Given the status quo of
the peripheral crisis, we think the ECB is likely to be
cautious on how to deliver the rate hikes and is more
likely to take an incremental approach. Our central
                                                                                                   0   2             4          6              8             10
scenario is that the ECB will start to hike in Q3 and hike by                                                       UST 10Y yields
25bp per quarter into 2013. If we are correct, 1Y rates will     Source: Deutsche Bank
be close to 2.15% at year end of 2011, 40bp higher than
the current 1Y forwards. There is a chance that the ECB          However, the correlation between rates and equity could
may hike more aggressively at the first few hikes if the         turn around. Europe has experienced one classical
inflation concerns become elevated. In a scenario that the       episode of negative correlation between stocks and rates
ECB delivers 50bp hikes for each of 11Q3 and 11Q4 and            on the back of the unexpected rate hike. In June 2008,
then 25bp hike per quarter in 2012, 1Y rates will be close       while the subprime crisis in the US was developing into a
to 3.0% at year end of 2011.                                     global financial crisis, the ECB sent out a tightening signal.
                                                                 With market participants rushing to cover one-sided long
Financial markets are exposed to substantial risks as the        positions, the EUR front end sold off heavily and the yield
ECB starts to hike rates, due to the widely-held                 curve inverted. The shock in the rates markets spilled over
expectation that monetary policies of the major central          to equities and caused heavy selling. By middle July, two
banks will remain accommodative. Such risk is not only           weeks after the ECB actually delivered the rate hike, Euro
limited to the front end sell-off, it could also spill over to   stoxx had dropped by almost 20% and underperformed
other asset classes and then feed back into the long end         the S&P by 5%, as shown in the chart below.
of the yield curve.
                                                                 Euro Stoxx was a victim of 2008 ECB hiking surprise
When the fear of peripheral debt crisis and deflation
                                                                   4.40                                                                                      105
dominated financial markets, the adverse scenario was                                                  3M Eonia          S&P 500            Euro Stoxx
perceived as a Japanese style deflation with low rates and         4.35
a decline in equities. The overwhelming number of trades                                                                                                     100
which reflected the hedging of this risk was long
correlations between yields and equities. This is                  4.25                                                                                      95
coincidently consistent with the usually positive                  4.20
correlation between equities and yields over the past                                                                                                        90
decade, which has developed on the back of seeking
general protection against a traditional flight to quality         4.10
mode and demand shock to the economy. The positive                 4.05
correlation between stock and rates peaked during the
                                                                   4.00                                                                                      80
summer when the weak US data elevated the deflation
                                                                                        May-08             Jun-08            Jul-08                 Aug-08
concerns, as shown in the chart below.
                                                                 Source: Deutsche Bank

                                                                 Shall such shock occur again, the collateral damage to
                                                                 equities due to rates hikes may feed back into the EUR
                                                                 curve long-end, triggering a sharp flattening similar to the
                                                                 episode of June 2008.

Deutsche Bank AG/London                                                                                                                                 Page 63
10 December 2010              Fixed Income Outlook 2011

Long gamma                                                      1Y1Y vol is still pricing in substantial risk premium
With periodical sovereign debt shocks and the                                           1Y1Y implied
uncertainties to global growth, the volatility for the belly      8
                                                                                        Ex-post delivered term volatility for
and long end of the curve will be well supported for the                                1Y1Y option
coming year. Taking into consideration both the volatility        7                     estimated term vol for the past 3
likely to be delivered and the extent being priced into           6
implied, we are bullish on 5Y gamma. 5Y sector of the
curve has become increasingly volatile over the past few          5

months as the growth and monetary policy outlook being            4
repriced since the QE2. Due to uncertainties regarding the
fate of QE2, sovereign risk, and fiscal consolidation for the     3
US, a consensus for the outlook will take time to build.
This will lend more support to the volatility in the belly of         00    01      02       03     04     05     06     07     08   09   10
the curve.
                                                                Source: Deutsche Bank

Although 10Y and 30Y have been delivering higher
volatility than 5Y in 2010, the implied for these two           Long vega selectively
sectors has settled at higher levels accordingly, as shown      Vega surface has been elevated to very high levels. As we
in the chart below. We think 5Y gamma has the potential         recall, EUR vega also spiked up at the end of 2009 but
to move closer to the volatility levels of 10Y sector and       saw a significant decline after the new year. Will we see a
buying 5Y gamma will deliver more attractive returns than       similar move in Q1 2011? Surely the recent sharp spike,
long end gamma. We recommend being long 5Y gamma                for example on EUR 10Y10Y vega, shows some sign of
using straddles or strangles to position for both rosy and      seasonal effects at the year end, and it is likely part of the
double-dip scenarios.                                           recent gain on EUR vega to be corrected if sellers come
                                                                into the market in the new year. However, long-term
5Y gamma (implied/realized) is the most attractive              supply and demand dynamics is still very supportive to
  9.0                                                           EUR vega.
            Realized Vol on
                                                                Peripheral sovereign risk will likely to be a chronicle
  7.0          03-Jun-10
                                                                problem for EUR financial market, which will support the
  6.0          10-Sep-10
                                                                long-term volatility. The anticipation of ECB hikes may
  5.0                                                           trigger more interest for buying long-dated Euribor caps
  4.0                                                           before rates gap higher. Vega demand for the CMS
                                                                hedging and exotic hedging purpose is likely to remain
                                                                strong until long-dated forward rates become significantly
                                                                higher. Periodical sovereign debt shocks and regulation
  1.0                                                           reforms require portfolio managers to hedge tail-risks and
  0.0                                                           are likely to create more demand for long-dated vega. On
                 2y             5y           10y          30y   the other side of the equation, EUR Bermudan option
Source: Deutsche Bank                                           market remains inactive and looks unlikely to provide the
                                                                vol supply as the USD market does. Although the
Although we are bearish front end rates, we still think it is   Eurozone callable bond issuance is recovering in terms of
still too early to buy vol outright at the front end.           notional amount, the issuance has not led to much
Assuming the ECB will hike rates in 2nd half of the year,       meaningful supply in terms of Bermudan options.
we believe the front end rates will remain anchored for
the near term and we are bearish gamma on the very
front end of the curve. The implied vol at the front end are
pricing in a substantial amount of risk premium for the
higher volatility for the coming years. Given the steep roll
down for volatility, outright long vol position at the front
end adds more pain to the negative carry in terms of
curve roll down. Instead, we would pay 1Y1Y using
forward swaps outright.

Page 64                                                                                                                Deutsche Bank AG/London
10 December 2010                       Fixed Income Outlook 2011

EUR callable issuance has been rising for 2010                                  Trade Recommendations
  30                                                    EUR callable issuance
                                                                                Long 6M5Y straddle vs 6M2Y straddle
  25                                                                            Expressing the view of a more volatile 5Y sector than the
                                                                                front end in the intermediate term before the market
  20                                                                            reaches a consensus on growth outlook.

                                                                                EUR 1Y2Y/1Y30Y conditional bear flattener
  10                                                                            Buying EUR 1Y2Y ATMF strike payer and selling EUR
                                                                                1Y30Y ATMF or OTM payer to express the view of ECB
   5                                                                            hikes and curve bear flattening.. There is unlimited
                                                                                downside risk on 30Y rates sell-off, although we think
                                                                                such risk is mitigated by the support to the EUR long end
     Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
      99 00 01 02 03 04 05 06 07 08 09 10
                                                                                from ALM accounts.
Source: Deutsche Bank, Dealogic
                                                                                Long 1Y2Y ATMF payer vs 2Y1Y high strike payer
In the longer term, we think EUR vega is likely to move                         This trade can benefit from forward curve flattening and
closer to the levels seen in the US, as shown in the chart                      1Y2Y/2Y1Y vol spread widening on aggressive ECB hikes.
below. Given the elevated levels on the left half of the                        Risk to the trade is the ECB stays on hold in 2011, and the
EUR vega surface, we are more bullish the 20Y-tail to 30Y-                      trade is exposed to unlimited downside if rates stay low
tail vega sectors which are still at relatively attractive                      for 2011 but sell off after that.
levels. Shall the EUR vega decline after the new year, we
view it as a better buying opportunity.                                         Long 10Y20Y payer spreads
                                                                                Buying 10Y20Y ATMF/+150bp payer spreads to express
                                                                                long 10Y20Y vega view and steepening view for the long-
Vega for USD vs EUR
                                                                                end. Risk is limited to the loss of premium.

                                                                                                              Lei Chen (44) 20 7545 3860




        00     01       02        03    04   05   06   07   08     09   10
Source: Deutsche Bank

Deutsche Bank AG/London                                                                                                            Page 65
10 December 2010   Fixed Income Outlook 2011

EUR Liquid Credit

    With EUR 279 bn (equivalent) of publicly issued      EUR benchmark covered bonds will likely again
    covered bonds, 2010 was close to the record of       be dominated by French covered bonds and
    EUR 285 bn in 2006. In the Eurozone, however,        “other” covered bond countries. Dutch and also
    EUR 185 bn of publicly placed covered bonds in       UK covered bonds may benefit in this
    2010 is far from the EUR 253 bn set in 2003. Given   environment. While covered bond redemptions
    the ongoing decline in Pfandbrief issuance for       are low, with senior bank bond redemptions of
    structural reasons and limited demand for most       over EUR 40 bn in 2011, Italian banks are likely to
    peripheral covered bonds, this may again be true     shift further issuance into covered bonds.
    in 2011 despite higher refunding frequencies due
                                                         Cédulas redemptions of EUR 40 bn in 2011 in
    to shorter maturities since 2008.
                                                         relation to total Spanish bank assets of around
    EUR 203 bn of Eurozone covered bonds mature in       EUR 3472 bn suggests that redemptions would
    2011. Compared to a historical record issuance of    probably be less of a concern in a more unified
    EUR 253 bn, redemptions would probably be            Eurozone market. However, refinancing from EUR
    easily manageable in a more homogenous               benchmark covered bond investors, typical
    Eurozone market. However, this is unlikely to        sensitive to credit risk, will likely be challenging.
    happen in 2011. Spreads are likely to be
                                                         As we expect the ECB to provide liquidity support
    dominated by sovereign trends.
                                                         as long as needed, we do not expect peripheral
    With overall EUR 94 bn (equivalent) of publicly      issuers to capitulate and issue at extremely high
    issued covered bonds by non-Eurozone countries,      spreads just to attract sufficient investor demand.
    covered bond issuance was at clear record levels     This would lead to a further erosion of their net
    in 2010, significantly higher than the previous      interest margin which faces a brutal compression
    record of EUR 59 bn in 2007. Given our               already.
    expectations regarding issuing plans of non-
                                                         Overall, we expect issuers willing to issue at least
    Eurozone issuers (e.g. UK, Norway, Canada,
                                                         EUR 200 bn of EUR benchmark covered bonds in
    Sweden, Switzerland, New Zealand, Denmark),
                                                         2011. Even without any issuance from peripheral
    covered bond issuance by non-Eurozone countries
                                                         countries (although this would suggest a
    is likely to remain high. Due to diversification
                                                         challenging financial market environment in
    needs of Eurozone investors and increasing
                                                         general), net supply of EUR benchmark covered
    importance of non-Euro new covered bond
                                                         bonds is unlikely to decline in 2011 compared to
    markets, demand is likely to remain sufficiently
                                                         the EUR 30 bn in 2010. Given that there is no ECB
                                                         buying scheme available in 2011 and the macro
    Given high supply intentions and lack of             environment seems extremely fragile, there is risk
    secondary market liquidity, primary markets are      to the downside.
    likely to provide the best opportunities to access
                                                         Without a broader change in the Eurozone macro
    core covered bonds. High issuance will also likely
                                                         sentiment, covered bond spreads are unlikely to
    prevent strong tightening of secondary market
                                                         converge and numerous peripheral covered bonds
    spreads (absent of significant sovereign spread
                                                         seem still vulnerable. However, from a pure
                                                         stand-alone fundamental point of view, we see
    With USD 30 bn in 2010 (mainly from non-             Irish covered bonds as the best Irish bank bond
    Eurozone issuers), USD covered bond issuance         instrument regarding downside risk in relation to
    was almost 10fold compared to USD 3.2 bn in          current spreads.
    2009 and significantly higher than the previous
                                                         European agencies and supras will continue to
    record of USD 23.5 bn in 2007. Due to Fed
                                                         show high positive net supply in 2011. With KfW,
    quantitative easing driving low yields of non-
                                                         EIB and CADES alone expected to issue around
    sovereign triple A bonds in USD, we again expect
                                                         EUR 200 bn, gross issuance of main agency/supra
    high issuance of USD covered bonds in 2011.
                                                         issuers may hit new historical record levels. The
    With low issuance of German Pfandbriefe and          same holds true regarding net supply (with
    peripheral covered bond issuance dependent on        around EUR 100 bn of net supply by these three
    general peripheral country risk, 2011 issuance of    issuers alone). While spreads seem obviously

Page 66                                                                               Deutsche Bank AG/London
10 December 2010                    Fixed Income Outlook 2011

         vulnerable, ongoing peripheral concerns may be a                             Total covered bonds publicly placed – 2010 very close
         supporting factor for core agency/supra issuers.                             to record levels in 2008
         While government guaranteed bond issuance                                       Bn EUR
         declined significantly in 2010, also due to high
         spreads in case of numerous countries and high
         issuance fees, overall redemptions of government
         guaranteed bonds in Europe of over EUR 250 bn                                  200
         (equivalent) in 2011, on top of the high net supply
         of European supras and agencies, suggests that                                 150

         ongoing public intervention will dominate the
         financial system. We expect a further extension of
         state guarantees beyond June 2011 and                                           50
         consequently further interventions in the financial
         system.                                                                           0










                                                                                      Source: Dealogic, Deutsche Bank
Covered bonds – growth driven by non-
Eurozone countries                                                                    Covered bond issuance by Eurozone countries – 2010
                                                                                      higher than 2009 but still far away from record levels
Covered bond issuance close to new historical record                                  With EUR 185 bn of publicly placed covered bonds out of
level                                                                                 Eurozone countries in 2010 (based on Dealogic data),
With EUR 305 bn (equivalent) of new covered bonds                                     covered bond issuance by Eurozone countries is far from
registered in Dealogic 2010 was the second strongest                                  its record volumes of EUR 253 bn in 2003, EUR 240 bn in
covered bond year after 2008 with EUR 373 bn, but still                               2005 and EUR 239.5 bn in 2006. Hence, while some
significantly higher than 2009 with EUR 262 bn.                                       Eurozone countries (e.g. particularly France) had high
                                                                                      positive net supply of covered bonds in recent years,
Total covered bonds issuance – close to record levels                                 covered bond market growth is mainly driven by non-
from 2008 (which was driven by retained issues)                                       Eurozone countries.

   Bn EUR
  400                                                                                 Publicly placed covered bond issuance by Eurozone
  350                                                                                 countries is far from record volume (2003: EUR 253 bn)
  300                                                                                   Bn EUR
  250                                                                                   300

  100                                                                                   200












Source: Dealogic, Deutsche Bank

We note that 2008 was a year of high volumes of retained                                   0
covered bonds. Hence, taking into account only publicly










issued covered bonds of EUR 279 bn in 2010 was closer
                                                                                      Source: Dealogic, Deutsche Bank
to the historical record volume of publicly issued covered
bonds of EUR 285 bn in 2006.                                                          Redemptions suggest Eurozone covered bond
                                                                                      refinancing may be challenging in 2011
                                                                                      EUR 203 bn of Eurozone covered bonds mature in 2011
                                                                                      (based on Dealogic data). From a historical perspective,
                                                                                      with a record of publicly placed covered bond issuance by
                                                                                      Eurozone countries of EUR 253 bn in 2003, redemptions
                                                                                      of EUR 203 bn in 2011 seem easily manageable. However,
                                                                                      record covered bond issuance of 253 bn in 2003 was

Deutsche Bank AG/London                                                                                                                                        Page 67
10 December 2010                         Fixed Income Outlook 2011

primarily driven by German Pfandbriefe (EUR 185 bn).                                                     Record issuance of covered bonds issued by non-
Spanish Cédulas accounted for EUR 33 bn of the 2003                                                      Eurozone countries
supply and French covered bonds a further EUR 26 bn.
                                                                                                           Bn EUR
While Pfandbrief issuance is declining for structural                                                      100
reasons and due to the ongoing restructuring of numerous                                                    90
Pfandbrief issuers, Cédulas issuance is likely to remain                                                    80
low mainly due to investors being cautious on Spanish risk                                                  70
in general.                                                                                                 60
2011 redemptions of Eurozone covered bonds of EUR                                                           40
203 bn higher than issuance of publicly placed covered                                                      30
bonds by Eurozone countries of EUR 185 bn in 2010                                                           20
  Bn EUR
  250                                                                                                         0











                                                                                                         Source: Dealogic, Deutsche Bank

  150                                                                                                    Taking into account retained issues, covered bonds by
                                                                                                         non-Eurozone countries were at record levels in 2008 with
  100                                                                                                    an overall volume of EUR 154 bn equivalent. This was due
                                                                                                         to EUR 116 bn (equivalent) of UK covered bonds, mainly
   50                                                                                                    for the Bank of England (BoE) SLS.

     0                                                                                                   EUR 55 bn redemptions of covered bonds by non-













                                                                                                         Eurozone countries in 2011 suggest that covered bonds
Source: Dealogic, Deutsche Bank
                                                                                                         issued by non-Eurozone covered bonds will remain a
                                                                                                         growing market.
Also in 2011 covered bond issuance by Eurozone
countries is likely to remain far from historical high levels.                                           Redemptions by non-Eurozone countries significantly
Given overall EUR 203 bn of Eurozone covered bonds                                                       below 2010 issuance, suggesting further growth
becoming due in 2011 compared to a historical record
                                                                                                           Bn EUR
issuance of EUR 253 bn, redemptions would be easily                                                        70
manageable if the Eurozone covered bond market was
more homogenous. However, at this stage, we are not
even close to a homogenous Eurozone covered bond                                                           50

Covered bond issuance by non-Eurozone countries                                                            30
suggests strong market growth
Interestingly, with overall EUR 94 bn (equivalent) of
covered bonds, publicly issued covered bonds by non-                                                       10
Eurozone countries was at clear record levels 2010 (based                                                   0
on Dealogic data), significantly higher than the previous












record of EUR 59 bn (equivalent) in 2007.
                                                                                                         Source: Dealogic, Deutsche Bank

Given our expectations regarding issuing plans of non-
                                                                                                         USD covered bond market at record levels – issuance
Eurozone issuers for 2011 (e.g. UK, Norway, Canada,
                                                                                                         likely to remain high
Sweden, Switzerland, New Zealand, Denmark), covered
                                                                                                         With USD 30 bn in 2010 (mainly from non-Eurozone
bond issuance by non-Eurozone countries is likely to
                                                                                                         issuers), USD covered bond issuance was almost 10fold
remain high. Due to diversification needs of Eurozone
                                                                                                         compared to USD 3.2 bn in 2009 and significantly higher
investors and increasing importance of non-Euro new
                                                                                                         than the previous record of USD 23.5 bn in 2007.
covered bond markets, demand is likely to remain
                                                                                                         Quantitative easing by the Fed has caused low yields of
sufficiently strong to absorb that supply.
                                                                                                         non-sovereign triple A bonds in USD. With basis swap
                                                                                                         also at favourable levels, we expect high issuance of USD

Page 68                                                                                                                                                                                 Deutsche Bank AG/London
10 December 2010                            Fixed Income Outlook 2011

covered bonds again 2011. In 2010, around 80% of                                                                                 Hence, with EUR 150 bn of EUR benchmark covered bond
issuance was done in 144a format. We expect the share                                                                            redemptions in 2010, the market grew by around EUR 30
of 144a issuance to remain high.                                                                                                 bn (which coincidently is in line with the volume of ECB
                                                                                                                                 buying in H1 2010).
USD covered bond issuance at new record levels
  Bn USD
                                                                                                                                 Outstanding volume of EUR benchmark covered bonds
                                                                                                                                 increased by around EUR 30 bn in 2010
  30                                                                                                                                Bn EUR            GE                 FR            SP
                                                                                                                                                      NL                 AT            FI
  25                                                                                                                                900
                                                                                                                                                      SW                 NZ            IT
                                                                                                                                    800               UK                 DK            NO
                                                                                                                                    700               PT                 LX            IR
  15                                                                                                                                600               GR                 CA            HU
                                                                                                                                    500               US                 CH
   5                                                                                                                                300






















Source: Dealogic, Deutsche Bank

Around EUR 180 bn of EUR benchmark covered bonds                                                                                 Source: Deutsche Bank
in 2010 - close to the record of EUR 186 bn in 2007
Given the lack of any meaningful market making                                                                                   We highlight that the growth of EUR benchmark covered
agreements, “Jumbo” covered bonds in the old sense of                                                                            bonds in 2010 was strongly driven by “new” covered
the word do no longer exist. Defining benchmark covered                                                                          bond countries.
bonds, which is mainly an expression of issuance volume,
is also difficult these days. Due to increased issuance of                                                                       “Other” countries, i.e. not Germany, France, Spain,
covered bonds with a volume of EUR 500 m and above
                                                                                                                                 Portugal and Ireland issued historical high volumes of
(around EUR 35 bn in 2010) and the changed market
                                                                                                                                 EUR benchmark covered bonds in 2010
environment, we include covered bonds with EUR 500 m
and above in our statistics for benchmark covered bonds                                                                             Bn EUR
in 2010. In this respect, total issuance of EUR benchmark
                                                                                                                                   180                          GE                             FR
covered bonds amounted to EUR 180 bn in 2010
compared to around EUR 120 bn in 2009, showing a                                                                                                                SP                             IR
significant increase in new issuance.                                                                                                                           PT                             Others
EUR benchmark covered bond issuance 2010* close to
record levels seen in 2006                                                                                                          60
   Bn EUR                                                                                                                           40
  200     GE                     FR             SP            CH             NZ
  180            AT              FI             SW            IT             UK
  160            DK              NL             NO            PT             LX

  140            IR              GR             CA            HU             US
                                                                                                                                 Source: Deutsche Bank
                                                                                                                                 German Pfandbriefe continue to show negative net supply
                                                                                                                                 (due to abolition of state guarantees for Landesbanks and
                                                                                                                                 savings banks in 2005 and the ongoing restructuring of
                                                                                                                                 numerous Pfandbrief issuers). With issuance of German
                                                                                                                                 Pfandbriefe to remain low and peripheral covered bond
                                                                                                                                 issuance dependent on general peripheral country risk,

                                                                                                                                 2011 issuance of EUR benchmark covered bonds will
*including issues with EUR 500 and above; Source: Deutsche Bank                                                                  likely be dominated again by French covered bonds and
                                                                                                                                 non-traditional covered bond countries. Dutch and also UK
                                                                                                                                 covered bonds may benefit in this environment. While

Deutsche Bank AG/London                                                                                                                                                                                                                                        Page 69
10 December 2010                         Fixed Income Outlook 2011

covered bond redemptions are low, with senior bank bond                                                                      With issuance of around EUR 50 bn, France may again be
redemptions of over EUR 40 bn in 2011, Italian banks are                                                                     the biggest issuer of EUR benchmark covered bonds. This
likely to shift further issuance into covered bonds.                                                                         is also suggested by taking a look at 2010 total covered
                                                                                                                             bond issuance and 2011 redemptions per country based
German EUR benchmark Pfandbriefe showed high                                                                                 on Bloomberg data.
negative net supply in 2010
                                                                                                                             Covered bonds in total – issuance 2010 and
   Bn EUR
  160                     GE                        FR
                                                                                                                             redemptions 2011 (including retained issues) based on
  140                                                                                                                        Bloomberg data
  120                     SP                        IR
                                                                                                                               Bn EUR
  100                     PT                        Others                                                                     70
   60                                                                                                                          60
     0                                                                                                                         40                                                                        Redemption 2011
  -20                                                                                                                                                                                                    Issuance 2010
  -40                                                                                                                          30

Source: Deutsche Bank

Issuance in 2010 was mainly dominated by the medium                                                                                             FR          SP         IR            UK          PT          NO            IT
term sector, where the 5-7 year maturity bracket saw the                                                                     Source: Bloomberg Finance LP, Deutsche Bank
largest amount of around EUR 55 bn. Peripheral covered
bond issuance was focused on the short dated maturities,                                                                     Despite an ongoing decline, we expect German issuers to
mainly due to investors being cautious. This has led to                                                                      issue still around EUR 22 bn of EUR benchmark covered
increasing asset-liability mismatches in most of these                                                                       bonds (compared to EUR 26 bn in 2010). With around
covered bonds. Given higher funding cost but mainly long                                                                     EUR 45 bn of redemptions in 2011, redemptions are
dated residential mortgages with a fixed spreads,                                                                            significantly lower than the EUR 71 bn in 2010. However,
peripheral covered bonds run into increased margin                                                                           net supply is consequently very likely to remain negative.
pressure. Hence, high issue spreads are also a burden for                                                                    Five German issuers among the top 10 issuers in terms of
the credit quality of the existing cover pools.                                                                              highest total (not only benchmarks) covered bond
                                                                                                                             redemptions in 2010 confirm the structural change in the
2010 issuance of EUR benchmark covered bonds                                                                                 German Pfandbrief market, particularly regarding public
focussed on the 5-7 maturity bracket                                                                                         Pfandbriefe.
  Bn EUR
  60                                                                                                                         10 issuers with highest covered bond redemptions*
                2007           2008
                                                                                                                             2011 (according to Bloomberg data)
                2009           2010                                                                                             Bn EUR
  40                                                                                                                           30

  30                                                                                                                           25

          1-3 Years              3-5 Years                  5-7 Years             7-10 Years            Above 10                5
Source: Deutsche Bank







EUR benchmark covered bonds – investor demand
remains crucial                                                                                                              *excluding Danish issuers; Source: Bloomberg Finance LP, Deutsche Bank
Overall, we expect issuers to be willing to issue at least
EUR 200 bn of EUR benchmark covered bonds in 2011.

Page 70                                                                                                                                                                                   Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

While issuance of covered bond from peripheral countries       market environment in general, net supply of EUR
remains highly dependent on sovereign bond spreads,            benchmark covered bonds is unlikely to decline in 2011
issuance of non-peripheral covered bonds is likely to be       compared to the EUR 30 bn in 2010. Given that there is
very large again. We expect issuance plans of non-             no ECB buying scheme available and the macro
peripheral covered bonds to amount to around EUR 150           environment seems extremely fragile, there is risk to the
bn (France: EUR 50 bn, Germany EUR 22 bn, UK EUR 20-           downside.
25 bn, Netherlands EUR 10-15 bn, Sweden EUR 10 bn,
others EUR 30 bn) and benefitting from relatively strong       EUR benchmark covered bond redemptions – 2011
investor demand. On the other hand, as we expect the           significantly less than 2010
ECB to provide liquidity support as long as needed, we do
not expect peripheral issuers to capitulate and issue at         EUR bn                                              FI        FR        AT    IR     GE
extremely high spreads simply to attract sufficient                                                                  NL        IT        SP    CH     UK
                                                                  140                                                GR        DK        SW    NO     FI
investor demand because that would lead to a further
                                                                  120                                                PT        LX
erosion of their net interest margin which faces a brutal
compression already.                                              100

UK benchmark covered bond issuance could increase
UK EUR benchmark covered bond issuance was EUR 17.5
bn in 2010. The record so far was EUR 20 bn in 2006.                20
Issuance in 2009 was only EUR 3.75 bn. We highlight that             0
the total outstanding volume of UK covered bonds







amounts to around EUR 200 bn (equivalent) and total                   06








redemptions in 2011 amount to EUR 30 bn (based on              Source: Deutsche Bank

Dealogic data). However, with an outstanding volume of
EUR 67 bn, the EUR benchmark covered bond market is            EUR benchmark covered bonds - monthly redemptions
only part of the UK covered bond market. In our view,          2011
most of the difference is likely to be on the BoE balance        EUR bn
sheet. Hence, issuance potential is significant and                20                                  FI       FR        AT        IR        GE      NL
issuance is likely determined by investor demand at                  18                                IT       SP        CH        UK        GR      DK
respective spreads. We expect that UK covered bonds                  16                                SW       NO        FI        PT        LX
might benefit from not being part of the Eurozone in this            14
respect. Numerous typical covered bond investors (who                12
are typically unwilling to take too much credit risk) remain         10
cautious regarding peripheral covered bonds. However,                 8
covered bonds of core-Eurozone countries trade with                   6
relative tight spreads. Hence, UK covered bonds are likely            4
to be perceived as some kind of sweet spot. The fact that
UK RMBS trade at similar levels as UK covered bonds
suggest that spreads are at least not obviously too tight                  Jan Feb Mar Apr May Jun                   Jul Aug Sep Oct Nov Dec
even though the spread difference to Cédulas is at
                                                               Source: Deutsche Bank
historical highs.
                                                               Cédulas redemptions are a cause of concern for 2011
Net supply of EUR benchmark covered bonds likely to
                                                               Dealogic and Bloomberg data suggest around EUR 40 bn
remain positive
                                                               of Cédulas redemptions in 2011. Redemptions of public
With EUR 120 bn of redemptions of publicly outstanding
                                                               EUR benchmark Cédulas amount to around EUR 27 bn in
EUR benchmark covered bonds in 2011, redemptions are
                                                               2011. The difference is due to retained issues and private
markedly lower than in 2010 (around EUR 150 bn).
                                                               placements. Moody’s suggests that Spanish Cédulas
Historically, redemptions are still extremely high. In our
                                                               issuers rated by Moody’s have Cédulas redemptions of
view, this is a doubled edged sword. While it suggests
                                                               EUR 70 bn in 2010 and 2011.
lower refinancing pressure for covered bond issuers, it
also suggests high net positive supply in 2011.

Overall, even if there was no issuance from peripheral
countries, which would suggest a challenging financial

Deutsche Bank AG/London                                                                                                                            Page 71
10 December 2010                                 Fixed Income Outlook 2011

Annual redemptions of Cédulas (based on Dealogic                                                                                                       unlikely to converge. However, from a pure stand-alone
data)                                                                                                                                                  fundamental point of view, we see Irish covered bonds as
                                                                                                                                                       probably the best Irish bond instrument regarding
  EUR bn                                                                                                                                               downside risk in relation to current spread.
                                                                                                                                                       2010 – spreads of covered bonds more or less followed
     35                                                                                                                                                sovereign spread trends and hence strongly diverged
     25                                                                                                                                                   420                                                     France Covered
     20                                                                                                                                                   380                                                     German Mortgage Pfandbriefe
     15                                                                                                                                                   340                                                     German Public Pfandbriefe
     10                                                                                                                                                   300                                                     Spanish Covered
      5                                                                                                                                                   260                                                     Other Covered
                                                                                                                                                          220                                                     Ireland Covered
                                                                                                                                                          180                                                     UK Covered
Source: Dealogic, Deutsche Bank                                                                                                                           100
Cédulas redemptions of EUR 40 bn in 2011 in relation to                                                                                                    20
total Spanish bank assets of around EUR 3472 bn mean











that redemptions would probably be less of a concern in a
more unified Eurozone market, However, refinancing via
                                                                                                                                                       Source: Iboxx ,Deutsche Bank
EUR benchmark covered bond investors, who typically are
sensitive to credit risk, will likely be challenging.
                                                                                                                                                       Basel III probably not the main driver for covered
                                                                                                                                                       bonds (yet)
Further new countries likely to tap the market
                                                                                                                                                       Given that Basel III implementation will not fully start
While the legislative processes typically take much longer
                                                                                                                                                       before end of 2012 and the current fragile capital market
than expected at the beginning, with countries like Canada,
                                                                                                                                                       environment, other topics may dominate investment
Cyprus, South Korea, US and Japan working on covered
                                                                                                                                                       behavior, at least at the beginning of 2011. However,
bond legislations (or banks lobbying for it), further new
                                                                                                                                                       issuers and investors may already prepare themselves for
countries are likely to tap the market for specific legal
                                                                                                                                                       upcoming regulatory changes.
framework based EUR benchmark covered bonds in 2011.
These issuers could benefit from continuing caution of
                                                                                                                                                       The Liquidity Coverage Ratio (LCR) in the proposals seeks
typical covered bond investors regarding most peripheral
                                                                                                                                                       to create a 30 day liquidity buffer comprising high quality
covered bonds. We would be surprised to see significant
                                                                                                                                                       securities. Covered bonds are likely to be included and the
issuance by US issuers, however, because the US legal
                                                                                                                                                       Deutsche Bundesbank for instance already confirmed this
framework for covered bonds may take a while longer to
                                                                                                                                                       a few times publicly in the German press. The trouble is
be finalised. Of course, investor demand remains crucial.
                                                                                                                                                       that covered bonds are being hit with a 15% haircut and
Hence, in case of Cyprus, at this stage, retained issuance
                                                                                                                                                       an overall holding limit of 40% on covered and corporate
is most likely.
                                                                                                                                                       bonds. As haircuts go, in our view, this is still a grade 1
                                                                                                                                                       military “buzz cut” but is probably the result of the lack of
Spread differentiation unlikely to disappear
                                                                                                                                                       liquidity that numerous covered bonds faced in 2008 (or
Differences in refinancing volumes and issuance intention
                                                                                                                                                       still face). In our view, country risk will still remain crucial,
suggest than any convergence in European covered bond
                                                                                                                                                       i.e., core-country banks are unlikely to use peripheral
spreads is highly dependent on the macro development.
                                                                                                                                                       covered bonds as assets in their liquidity buffers and
Moreover, rating agencies methodologies work extremely
                                                                                                                                                       haircuts may not be crucial in this respect. This also
procyclically, confirmed by the downgrade of a Cédulas
                                                                                                                                                       suggests the conflict in regulation. While international and
Hipotecarias of a “BBB- “rated Spanish savings bank to
                                                                                                                                                       European regulation tries to implement a level playing
“A-“ from “AA” by Fitch and recent announcements
                                                                                                                                                       field, national specific and patriotic tendencies still seem
regarding refinancing margins by Fitch. An “A-“ Cédulas
                                                                                                                                                       to drive investment behavior, i.e. local regulators may
rating seems like a capitulation, i.e. the rating agency,
                                                                                                                                                       push (even though potentially only with “moral suasion”
whatever methodological explanation it comes up with,
                                                                                                                                                       policies or questionnaires regarding certain exposures)
does not really believe in a preferential claim on the whole
                                                                                                                                                       their banks in line with national interest and national risk
mortgage book. Overall, without a broader change in the
Eurozone macro sentiment, covered bond spreads are

Page 72                                                                                                                                                                                                                        Deutsche Bank AG/London
10 December 2010       Fixed Income Outlook 2011

The Net Stable Funding Requirement (NSFR) is basically              Pfandbrief issuance by foreign banks
an inverted loan-to-deposit ratio making funding of loan-to-        In our understanding, numerous foreign banks consider
deposit ratios above 100% very challenging. The NSFR is             issuing Pfandbriefe via a German subsidiary. If a foreign
to mitigate a Northern Rock style funding crunch. Hence,            bank has a German subsidiary with a banking license, the
banks are going to need to find more and more long dated            German subsidiary can apply for a Pfandbrief license.
funding. Hence, issuers having access to long-dated                 However, in our view, as will be elaborated in our
covered bond issuance at reasonable levels may increase             upcoming annual “Overview of Covered Bonds” (to be
issuance at some point in time.                                     published beginning of 2011), foreign banks face
                                                                    numerous obstacles. Hence, while Pfandbrief issuance by
In our view, most Basel III changes are positive for                German subsidiaries of foreign banks is possible, due to
covered bonds. For instance, in the NSFR calculation,               requirements of the German Pfandbrief Act, it is likely
covered bonds and corporate bonds with a maturity above             challenging and generally costly. In our view, Pfandbrief
one year rated at least double A get a favourable                   issuance by foreign banks is unlikely in the short-term and
treatment of 20% compared to 100% of lower rated                    even more unlikely to change the trend of declining
covered bonds and corporate bonds and 5% of highly                  outstanding volume of German Pfandbriefe.
rated sovereigns. Given that covered bonds are on
average still higher rated than corporates (even though             German insurers are big covered bond investors
this may be the result of support assumptions) and senior           While credit investors may tap the peripheral covered
bank bonds, this is a clear advantage for covered bonds.            bond market and generally may tap in case of significantly
                                                                    increasing spreads, the typical covered bond investor
One negative point for covered bonds regarding the Basel            base allowing issuers to issue at tight spreads has in our
III NFSR calculation seems that weighting of residential            view grown less than issuers’ total willingness to issue
mortgage loans in cover pools is higher (probably 100%)             covered bonds. Hence, in this respect, covered bond
than residential mortgage loans on the bank balance sheet           spreads, will continue to face a technical demand and
outside the cover pool (probably 65%). This suggests an             (intended) supply imbalance.
advantage regarding senior bank bond issuance versus
covered bond issuance. Generally, banks also need                   German insurance companies may increase buying of
unencumbered funding and the increasing use of covered              non-German covered bonds
bonds by banks has to stop at same point in time (i.e.              According to BaFin, German insurers hold around EUR
caps regarding covered bond issuance as suggested by                300 bn of covered bonds. With around 25% of their total
some regulators, e.g. the UK FSA, may be needed).                   investments of around EUR 1200 bn, German insurers are
                                                                    significant covered bond investors. The outstanding
Covered bonds are not “bail-in-able”                                volume of registered Pfandbriefe amounted to EUR 265
One key advantage of covered bonds in our view is that              bn as of Q2 2010. German insurers are the typical buyers
covered bonds are not directly impacted from potential              of registered Pfandbriefe. Hence, it seems likely that
bail-ins of senior banks bonds and this is legally confirmed        German insurers also held around EUR 35 bn of non-
in case of German Pfandbriefe by the Bank Restructuring             German covered bonds. Given that the total EUR
Act. In this respect, covered bonds seem not “bail-in-              denominated covered bond market amounts to around
able”. In our view, the whole concept of bail-in is highly          EUR 1700 bn, German insurers hold around 18% of the
political and the risk of bail-ins is likely to drive some credit   total EUR covered bond market. Given that the total
investors to covered bonds, particularly in cases where             outstanding Pfandbrief volume is likely to decline further,
senior bank and covered bond spreads are too close to               this is probably also (at least partly) true for registered
each other. It seems the reason for no bail-ins of senior           Pfandbriefe. Hence, while Solvency II puts covered bonds
bank bonds in case of Irish banks so far was the argument           at a disadvantage versus sovereign bonds (via introducing
of preventing contagion. Taking a look at the covered               a capital charge for covered bonds but not for sovereign
bond market and the lack of market access for most                  bonds), but privileges covered bonds versus corporate
peripheral issuers, we wonder what kind of contagion                bonds and senior bank bonds (via a 2/3 capital charge
politicians want to prevent. In our view, denying bail-ins of       compared to equally rated corporate bonds), German
failed banks is feeding contagion. As we assume that this           insurers are likely to remain key investors in covered
insight may find its way to the European Commission, we             bonds and may increase non-German covered bond
see this as a benefit of covered bonds. This is not                 exposure.
necessarily saying that covered bonds are attractive
versus senior bonds in every scenario, but at least they            BoE announcing strict transparency requirements
provide more fundamental downside protection on a                   The new ambitious transparency requirements by the BoE
stand-alone basis.                                                  regarding covered bonds suggests that the BoE wants to

Deutsche Bank AG/London                                                                                                Page 73
10 December 2010                   Fixed Income Outlook 2011

limit its own risks as one the main risk taker of UK                                             supra issuance posts a new record, particularly when
covered bonds currently. However, it suggests that                                               taking into account that 2009 gross issuance included
increasing transparency is an ongoing topic in the covered                                       French SFEF (which does no longer issue). Even when
bond market and while the process may be slow, the                                               excluding EFSF and including it in the sovereign area,
direction seems clear. With BoE making this                                                      expected issuance of EUR 325 bn remains extremely high.
announcement, the ECB may come under pressure to
publish something similar, very likely less strict but at                                        Despite historical high redemptions, redemptions remain
least something to show that it also pushes for                                                  significantly below expected issuance confirming the
transparency. Generally, it seems justified that investors                                       ongoing positive net supply and hence importance of
get the same level of transparency as rating agencies.                                           supra and agency issuer for European economies.

                                                                                                 Agencies and supra redemptions in 2011* suggest
Agencies and supra supply – again at                                                             ongoing high positive net supply
record levels                                                                                        Bn EUR
European agencies and supras will continue to show high
positive net supply in 2011. With KfW, EIB and CADES                                                60
alone issuing around EUR 200 bn, gross issuance of main                                             50
agency/supra issuers is expected to hit record levels.

Expected issuance of European supras and agencies
   Bn EUR
  80                                                                                                10
  70                                                                                                 0








                                                                                                 *FMSWER redemptions are all retained former Soffin bonds of HRE; Source: Bloomberg Finance LP,
  30                                                                                             Deutsche Bank

  10                                                                                             Taking into account expected issuance and upcoming
   0                                                                                             redemptions KfW and EIB alone account for around EUR
                                                                                                 50 bn of expected net supply in 2011. Taking into account






                                                           NRW Bank

                                                                                                 also the expected 2011 gross issuance of CADES of EUR
                                                                                                 65 bn (and around EUR 10 bn of redemptions), this would
Source: Bloomberg Finance LP, Deutsche Bank                                                      account for around EUR 100 bn of positive net supply by
                                                                                                 the three biggest issuers alone.
Expected issuance of core European agency and
supra issuers                                                                                    Overall, prime agency and supra issuers mentioned above
                  KFW                                      EUR 75 bn                             (excluding EEC and EFSF) may account for around EUR
                  EIB                                     EUR 65-70 bn
                                                                                                 130 bn of net supply already. FMS Wertmanagement
                                                                                                 (EUR 25 bn) and EEA (EUR 5 bn) are likely to account for
                 CADES                                     EUR 65 bn
                                                                                                 another around EUR 30 bn of net supply (redemptions of
                  BNG                                      EUR 16 bn
                                                                                                 FMS Wertmanagement shown in the table above are so
                  ICO                                      EUR 15 bn
                                                                                                 far former Soffin-bonds of HRE). Moreover, Spanish FADE
                NRW Bank                                  EUR 10-12 bn
                                                                                                 (Fondo de Amortizazion del Deficit Electrico), created to
                NEDWBK                                    EUR 10-12 bn
                                                                                                 allow electricity companies to sell tariff deficit receivables
                 L-Bank                                   EUR 8-10 bn                            (and having a explicit guarantee from the Kingdom of
                FMSWER                                     EUR 25 bn                             Spain), is about to tap the market, adding to further net
                ERSTAA                                     EUR 5 bn                              supply of agency/supra bonds.
                  EEC                                      EUR 20 bn
                  EFSF                                     EUR 30 bn
Source: Deutsche Bank

Taking into account expected issuance from the issuers
above, around EUR 350 bn of expected gross agency and

Page 74                                                                                                                                                    Deutsche Bank AG/London
10 December 2010                       Fixed Income Outlook 2011

Overall gross issuance of European agencies and                                                                            Government guaranteed bonds – 2010
supras in recent years (based on Dealogic)                                                                                 with significantly less issuance than
   Bn EUR
                                                                                                                           Issuance of government guaranteed bonds declined
                                                                                                                           significantly in 2010. This was due to the improved market
  300                                                                                                                      environment but also due to increased overall costs for
  250                                                                                                                      using government guarantees.
                                                                                                                           The data below includes retained issues. For instance,
  150                                                                                                                      German government guaranteed bonds by Hypo Real
  100                                                                                                                      Estate in 2010 were all retained. This is also confirmed by
                                                                                                                           redemptions of government guaranteed bonds in 2011,
                                                                                                                           which with EUR 128 bn is dominated by German
                                                                                                                           government guaranteed bonds (mainly repainted issues).














Source: Dealogic, Deutsche Bank                                                                                            The European Commission approved a six-month
                                                                                                                           extension of government-guaranteed debt scheme of
Overall redemptions of European agencies and surpass                                                                       countries applying for it until 30 June 2011. This is e.g. the
at historical high volumes in 2011 (based on Dealogic)                                                                     case regarding Spanish and Irish government guaranteed
                                                                                                                           bonds, for instance. While issuing costs and fees are high,
   Bn EUR
                                                                                                                           this measure provides an additional safety net for Spanish
                                                                                                                           banks. As of 2 Dec, Spanish financial institutions have
  200                                                                                                                      issued EUR 55.6 bn of government guaranteed debt. In
                                                                                                                           June, the European Commission raised government-
  150                                                                                                                      guaranteed debt issuance fees to bring the funding costs
                                                                                                                           of beneficiary banks closer to market rates. In particular, a
  100                                                                                                                      20 bn increase was added to existing costs for entities
                                                                                                                           rated A1 and A2, a 30 bp increase for those rated A3, and
   50                                                                                                                      a 40 bp increase for entities rated below A3. Hence, given
                                                                                                                           also high new issue spreads, using state guarantees was
                                                                                                                           very costly for Spanish banks.










                                                                                                                           The use of government guaranteed bonds went down
Source: Dealogic, Deutsche Bank
                                                                                                                           significantly in 2010
Overall, even if actual redemptions may be somewhat                                                                          Bn EUR
                                                                                                                             500                                                GE   UK     FR   SP
higher than suggested by Bloomberg or Dealogic, overall
                                                                                                                             450                                                IR   NE     DE   AS
expected net issuance would still be very high. It seems
worth mentioning that the years 2008 and 2009, easily                                                                        400                                                SW   GR     PO   BE
digested overall around EUR 70 bn of positive net supply                                                                     350
from French SFEF. Moreover, while potential pressure on                                                                      300
spreads of agencies and supras seems obvious, ongoing                                                                        250
peripheral concern is likely to support demand for core                                                                      200
agencies and supra issuers in 2011.                                                                                          150
High share of USD issuance of European supra and                                                                              50
agencies may continue to support spreads                                                                                        0
Like in 2010, high USD issuance by European agencies                                                                                           2008                      2009             2010
and supras may also support market absorption capacity                                                                     Source: Bloomberg Finance LP, Deutsche Bank
in EUR and hence spreads in EUR agency and supra
bonds in 2011. We highlight that agency and supra bonds
are based on explicit or very strong implicit sovereign
guarantee mechanisms.

Deutsche Bank AG/London                                                                                                                                                                      Page 75
10 December 2010                    Fixed Income Outlook 2011

Redemptions of government guaranteed bonds in                                                 Government guaranteed bond issuance dominated by
2011 are dominated by Germany and UK                                                          Germany in 2010
   Bn EUR                                                                                       Bn EUR
                                                                                                80                                                     UK         FR     SW

                                                                                                                                                       GE         AS     SP
    80                                                                                                                                                 GR         DE     IR
     0                                                                                           0









           GE     UK    FR    SW AS           NE   SP     BE    IR    PO    LX    DE   NO
Source: Bloomberg Finance LP, Deutsche Bank
                                                                                              Source: Bloomberg Finance LP, Deutsche Bank

2010 issuance of government guaranteed bond by                                                The use of government guaranteed bonds in 2009 was
peripheral countries was low – also due to high                                               much more heterogeneous
spreads and high issuance fees
   Bn EUR
                                                                                                 Bn EUR                                                  UK        FR          SW
                                                                                                                                                         NE        PO          GE
                                                           2010                                                                                          AS        SP          LX
                                                           2009                                 50                                                       GR        BE          DE
  200                                                      2008
                                                                                                40                                                       IR

  100                                                                                           20

   50                                                                                           10

     0                                                                                           0
          GE     UK     FR     SP     IR      NE   DE     AS SW GR           PO   BE     LX







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

Overall redemptions of government guaranteed bonds                                            Overall use of government guaranteed bonds 2008 to
in Europe are extremely high in 2011                                                          2010 by country
   Bn EUR
                                                                                                 Bn EUR
  300                                                          GE       UK         FR
                                                               SP       NE         IR
                                                               DE       AS         SW
  250                                                                                            300
                                                               GR       PO         BE
                                                               LX       NO
  200                                                                                            250


               2011             2012               2013              2014         2015
                                                                                                            GE    UK    FR    SP     IR     NE    DE     AS SW GR PO                 BE   LX
Source: Bloomberg Finance LP, Deutsche Bank
                                                                                              Source: Bloomberg Finance LP, Deutsche Bank

Page 76                                                                                                                                                Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

German federal states with record bond                                                NRW remains the biggest bond issuer
issuance in 2010                                                                        EUR bn
German federal states issued new record volumes of                                        20
bond in 2010. Given high redemptions and budget deficits                                  18
in 2010 (despite recent significant budget improvements),                                 16
this is likely to continue in 2011. Due to strong German
investor bid and at little foreign investor involvement at                                10
this stage, which would likely be easily accessible in case                                8
of need, we expect spreads to continue to trade stable                                     6
versus swaps despite high issuance. This is also                                           4
suggested by the fact that, due to strong domestic
investor bid for private placements, the need for public










benchmark issuance was not particularly high in 2010.
Rating news may also support ongoing tight spreads.
                                                                                      Source: Bloomberg Finance LP, Deutsche Bank

Due to a new rating approach for sub-sovereigns in
general, S&P has Baden-Württemberg (AA+), Hamburg                                     Redemptions of German federal state bonds and
(AA-), Saxony (AA+) and Saxony-Anhalt (AA-) on review for                             ongoing budget deficits suggest high issuance in 2011
upgrade. With an upgrade of Baden-Württemberg and
                                                                                           EUR bn                                                               BADWUR                            BAYERN                           BERGER
Saxony, three German federal states would be rated AAA.
                                                                                             60                                                                 BRABUR                            BREMEN                           HAMBRG
So far, only Bayern is rated AAA by S&P. Fitch rates all                                                                                                        HESSEN                            LANDER                           MECVOR
German federal states AAA. Moody’s, like S&P,                                                   50                                                              NIESA                             NRW                              RHIPAL
                                                                                                                                                                SAARLD                            SACHAN                           SAXONY
differentiates between the different German federal                                                                                                             SCHHOL                            THRGN
states. In our view, like in case of S&P, this is due to a
lack of understanding of the German constitution. In our                                        30
view, due to German constitutional principles of federal
loyalty and revenue equalization, all German federal states
have a credit quality in line with the German sovereign,                                        10
hence at this stage triple A.









Bond issuance of German federal states at new record
                                                                                      Source: Bloomberg Finance LP, Deutsche Bank
                   BADWUR          BAYERN        BERGER      BRABUR
                   BREMEN          HAMBRG        HESSEN      LANDER
   EUR bn                                                                             Outstanding volume of bonds of German federal states
     70            MECVOR          NIESA         NRW         RHIPAL
     65            SAARLD          SACHAN        SAXONY      SCHHOL                         EUR bn
     60            THRGN
     55                                                                                       80
     50                                                                                         70
     40                                                                                         60
     30                                                                                         50
     20                                                                                         40
     15                                                                                         30
      5                                                                                         20
              2002     2003      2004     2005   2006     2007   2008   2009   2010

Source: Bloomberg Finance LP, Deutsche Bank











                                                                                      Source: Bloomberg Finance LP, Deutsche Bank

                                                                                                                                                                  Bernd Volk, (41) 44-227 3710

Deutsche Bank AG/London                                                                                                                                                                                                                     Page 77
10 December 2010    Fixed Income Outlook 2011

UK Outlook 2011
    In 2011, the UK fixed income landscape is likely to     Cautiously optimistic outlook
    be shaped by how the domestic economy reacts
    to the fiscal tightening measures, developments         UK growth has surprised to the upside this year as the UK
    in peripheral Europe and US economy and the             economy as a whole has rebounded strongly, particularly
    outlook for the currency                                in recent quarters. However there are questions over
                                                            whether this is sustainable, with the growth trajectory
    Our macro outlook is one of gradual
                                                            likely to be volatile. The fiscal consolidation plans being
    normalization as the UK avoids a double dip
                                                            implemented are expected to weigh on growth, and
    scenario and deflation risks are priced out. This
                                                            particularly consumer related activity.
    scenario should be characterised by an unwind of
    the risk premium built into the curve with the
                                                            However, the magnitude (and even sign) of fiscal
    long end outperforming, be supportive for higher
                                                            multipliers in a recovery scenario is at best debatable as
    breakevens and result in higher short dated
                                                            cyclical factors associated with a recovery counterbalance
    volatility. The fiscal consolidation measures
                                                            the drag from fiscal consolidation. The credit impulse in
    enacted in the UK should also result in the
                                                            the UK has rebounded, and along with a weaker currency,
    outperformance of UK fixed income versus both
                                                            is supportive of positive growth in future. The strength
    the US and core European countries
                                                            seen in the manufacturing sector too is supportive of our
    In particular, we recommend being long UKT 30Y          base case scenario that the UK avoids a double dip.
    on ASW, or on a cross market basis versus Bunds
    or OATs.                                                The credit impulse has been supportive of growth
    The curve, currently at extreme steep levels, is           6                                                                       4

    expected to flatten, as higher risk premia is priced                                                                               2
    into the front end. We favour 5Y-10Y flatteners in
    swaps                                                                                                                              0
    The linker market has yet to reflect fully the risks                                                                               -2
    on entrenched elevated inflation levels, and as            0
    such we like being long short end breakevens
    Low strike receivers offer a hedge against a
    double dip scenario driven either by stringent            -4                                                                       -8
                                                                                Real GDP gro wth yo y (lhs)
    fiscal consolidation or global economic risks
                                                              -6                Change in net lending as a % o f GDP (yo y)            -10
Overview                                                      M ar-88             A ug-93            Feb-99      A ug-04      Jan-10
                                                            Source: Deutsche Bank, Haver Analytics
At the start of the year, the concerns surrounding the UK
rates market was level of debt and deficits, and the        However the risks of additional QE at this point cannot be
potential path to normalization in a post crisis world.     ruled out, and we currently see it being dictated, in
                                                            addition to economic developments, largely by the level of
An aggressive fiscal consolidation path has since been      the currency. With consumer spending likely to remain
implemented, alleviating concerns that the UK would         dampened as deleveraging and fiscal consolidation both
experience its own Greek tragedy. Looking forward, the      take their toll, growth will have to be rebalanced towards
key issues will be how the domestic economy reacts to       exports. Indeed, this has been a key message repeatedly
the tightening, and whether global growth remains           put forth by the Governor. In this respect, we think the
supportive next year.                                       focus will be on whether trade weighted sterling remains
Our base scenario is one in which the UK avoids a double
dip, with the Bank of England on hold for the time being    The main risks here stem from the Eurozone, where the
while assessing the incoming data and external growth       single market project has come under question, as the
environment. We outline the reasons for this below, and     region is a key export destination for the UK. Additionally,
in turn, consider the trades which should perform in such   as USD and JPY are being supported by loose central
a scenario.                                                 bank policy, and EUR under pressure due to the crisis,

Page 78                                                                                                       Deutsche Bank AG/London
10 December 2010                    Fixed Income Outlook 2011

strengthening pressure may fall on GBP by default. This is                            for monetary policy as dictated by the pull of CPI versus
particularly true with Asian economies also tightening                                the currency. For the time being, uncertainty prevails, and
liquidity and monetary policies. Thus, it may be the case                             the MPC are likely to monitor the data and external
next year that a round of competitive devaluation in the                              environment at least into the first quarter, while
UK is required to even the playing field.                                             maintaining the monetary policy on hold

Currency depreciation supported the export sector                                     The first quarter of 2011 remains critical in terms of
                                                                                      events, with Portugal likely to have to tap the EFSF, and
                                                                                      Spain facing redemptions later in the quarter. There
                                                                                      remains also substantial uncertainty over the format of the
                                                                                      final resolution of the crisis, which could result in further
                                                                                      turmoil over the next year.
                                                                                      Over the medium term, our base scenario is for the UK to
                                                                                      ultimately move back to a sustainable growth scenario,
                              Trade Weighted GB P                                     and for the path of policy normalization to continue.
                                                                                      Deflation risks are likely to be priced out further as
                                                                                      inflation proves sticky. We expect the risk premium priced
  60                                                                                  into the UK curve to unwind and the long end to
       Jan-   Jan-     Jan-    Jan-       Jan-   Jan-     Jan-   Jan-   Jan-   Jan-
        01     02       03      04         05     06       07     08     09     10
                                                                                      outperform, both versus rest of the curve as well as
                                                                                      relative to European markets
Source: Deutsche Bank, Bloomberg Financial LP

On the flip side, the stickiness of inflation cannot be                               Better solvency ratios support long end
ignored. CPI has remained above target for all of 2010,
                                                                                      The long end of the UK is largely driven by supply demand
and 9 letters to the Chancellor have been written since
                                                                                      dynamics and hedging from pension funds and insurance
2007. This is clearly a concern, and central bank rhetoric
                                                                                      companies rather than fundamentals.
has become slightly stronger when addressing the
inflation targeting credibility of the Bank. In part this is
                                                                                      Pension funds solvency ratios have subsequently
likely due to the upward revision of Inflation Report
                                                                                      improved from the post Q408 lows, with the latest Purple
forecasts to show above target inflation over the next
                                                                                      Book suggesting funds under their coverage universe are
year. While inflation is expected to fall back to target over
                                                                                      now in surplus on aggregate, with the aggregate funding
the medium term, there are questions over the true
                                                                                      ratio seen at 104% at the end of Q110.
output gap in the UK, and whether the inflation prints will
lead to an unanchoring of inflation expectations.
                                                                                      Funding ratios have improved back to pre crisis levels
Inflation is expected to remain sticky in the near term                                 120%
                                                                                                                                     Funding Ratio
   6                          CP I yo y
                                                                                         1 0%
                              B o E No vember
   5                          Inflatio n Repo rt
                              Target                                                    100%




                                                                                                       M ar-07               M ar-08           M ar-09   M ar-10
                                                                                      Source: Purple Book, Pension Protection Fund
  Sep-02                 M ay-05                 Feb-08             No v-10
Source: Deutsche Bank, BoE , Bloomberg Financial LP
                                                                                      Pension funds are a substantial investor in the Gilt market,
                                                                                      and this is likely to be concentrated in the long end, given
The uncertainties surrounding the outlook are obvious,
                                                                                      the ALM mismatches faced.
with even MPC members disagreeing as to which
direction policy should take. We currently see the balance

Deutsche Bank AG/London                                                                                                                                     Page 79
10 December 2010                   Fixed Income Outlook 2011

Gilts remain a key asset class for pension funds                           (post haircuts) that was in place at the time the scheme
                                                                           closed. The Bank also noted at the time that collateral
                                                        2006               primarily consisted of RMBS or covered bonds.
  60                                                    2007
                                                                           There is little information over the exact redemption
  50                                                    2009
                                                                           profile, nor how much, if any, already been pre-funded,
  40                                                                       which makes assessing the associated risks difficult.
                                                                           However, it is notable that the Bank of England has been
                                                                           quite vocal in its desire firstly, not to extend the SLS, and
                                                                           secondly, for banks to address refinancing needs in a
                                                                           timely manner. Banks are likely to face pressure from the
   10                                                                      regulators to refinance when and however possible.
                        Equities                  Gilts & Fixed Interest   UK banks have been able to access the market
Source: Deutsche Bank                                                        25       EUR mn
                                                                                                                                       UK B anks Issuance

 Another important development for the industry is the                       20
proposal to switch pension fund indexation from RPI to
CPI. This would on average improve the solvency ratios,                       15
as RPI inflation has exceeded CPI inflation by
approximately 85bps since 1997. The government has                            10
recently released a consultation paper in which it notes it
does not plan to override private sector pension deeds,
nor propose legislation that would allow modification of
                                                                                   Jan-      Jul-     Jan-      Jul-      Jan-       Jul-     Jan-    Jul-
This has cleared up some uncertainty in the Gilt linker                             07        07       08        08        09         09       10      10
market, as it suggests there will continue to be a sizeable                Source: Deutsche Bank

amount of RPI linked liabilities, necessitating the
continuation of RPI linked Gilts. As we discuss in the                     UK banks have not had difficulty accessing the market this
global linker section, it also suggests that in the new                    year, and this is likely to remain the case next year. That
financial year, new CPI-linked Gilts are likely to be                      said, UK banks do face a heavy redemption calendar over
introduced. In any case, the clarity offered should prove                  the next year.
supportive for the linker market
                                                                           Bank face a heavy redemption calendar in 2011
There is significant latent demand for hedging by ALM                        90
accounts in the UK, and the improvement in solvency                                        USD bn
ratios should trigger de-risking trades and be supportive
for the long end of the Gilt market.                                         70
                                                                                                                                                 Co vered
                                                                                                                                                 State Guaranteed
SLS & the banking sector                                                     50                                                                  Senio r

Next year, one of the major bank rescue schemes will                         40

start to unwind. As a reminder, the Special Liquidity                        30
Scheme, was announced on April 2008 as a way for banks                       20
to swap illiquid assets for a three-year period. The scheme
closed in Jan 2009, and over the next year, these asset
swaps will be unwound and alternative means of                                0
                                                                                    Q111     Q311   Q112     Q312      Q113   Q313     Q114   Q314   Q115    Q315
financing them will need to be found. As the Eurozone
                                                                           Source: Deutsche Bank, Dealogic
crisis has illustrated, there is a critical interplay between
banks and the sovereign, which makes a smooth
                                                                           If conditions do deteriorate banks have access to
unwinding of this facility important.
                                                                           emergency funding facilities, albeit at punitive funding
                                                                           levels. Alternatively, the BoE can always offer temporary
In a speech given in September, Fisher noted that there
                                                                           OMOs to tide banks over if necessary. Our central
was GBP 128 bn outstanding, down from the GBP185bn

Page 80                                                                                                                              Deutsche Bank AG/London
10 December 2010     Fixed Income Outlook 2011

scenario remains one where the expiry of the SLS should       EU crisis has lead to some diversification into Gilts
not be a disruptive force in the UK financial markets but
given the fragile market sentiment, volatility around
refinancing concerns cannot be ruled out.                                                                           Central bank
                                                                50000                                               ho ldings o f Gilts
                                                                                                                    (GB P mn)

Trades                                                          40000

Our macro outlook is one of gradual normalization as the        30000
UK avoids a double dip scenario and deflation risks are
priced out. This scenario should be characterised by an         20000
unwind of the risk premium built into the curve with the
long end outperforming, be supportive for higher                 10000

breakevens and result in higher short dated volatility. The
fiscal consolidation measures enacted in the UK should
                                                                      Dec-66 Dec-72 Dec-78 Dec-84 Dec-90 Dec-96 Dec-02 Dec-08
also result in the outperformance of UK fixed income
                                                              Source: Deutsche Bank, Haver Analytics
versus both the US and core European countries. Going
into 2011, our favorite trades include:
                                                              In particular, given our view on the long end, we
                                                              recommend being long UKT 30Y vs DBR or OATs.
Long 30Y Gilts on ASW and vs the 5Y sector
We find the long end offers most value on the curve, and
prefer being long UKT 30Y on ASW. Long dated Gilts
                                                              We favour curve flatteners, as the curve is currently at
trade cheaper to swaps given the constrained balance
                                                              extreme steep levels. The front end remains extremely
sheet of ALM players The improvement in pension fund
                                                              rich, and underprices somewhat the risks of monetary
solvency ratios should result in some de-risking prompting
                                                              policy tightening, To alleviate some of the negative carry,
a switch into long dated Gilts. The trade could also be
                                                              we prefer implementing it via 5Y-10Y swap flatteners.
implemented against short 5Y ASW, as the sector appears
                                                              Long Breakevens
                                                              UK inflation, contrary to other G3 countries, has
And against Europe
                                                              persistently surprised to the upside over the last year.
In addition, we like being long Gilts versus Bunds. The
                                                              While this can be in part due to one-off factors, such as
peripheral crisis response has been one where the EMU
                                                              the VAT hike and depreciation in sterling, it cannot be
moves further towards some semblance of fiscal union.
                                                              discounted that this could filter through in inflation
While it is not full transfer union at this point, Germany
                                                              expectations. These risks are yet to be reflected in the
has had to accept some contingent liabilities, which
                                                              inflation market, and we find being long breakevens
should be reflected in Bunds. Additionally, it has
                                                              attractive particularly in the 5Y sector. See Global Linkers
prompted investors to reconsider their EUR allocation,
                                                              for a further discussion.
which has in part benefited GBP assets. This dynamics
should continue, as the peripheral crisis is far from
                                                              Long 5Y gamma vs 2Y and 30Y gamma
resolved, with Q1 expected to remain eventful.
                                                              The belly of the curve is likely to be more volatile, as the
                                                              market clarifies the medium term outlook on rates. The
                                                              theoretical maximum loss to the trade is unlimited.

                                                              Hedge against deflation scenario
                                                              While our main view is that the UK avoids a double dip,
                                                              low strike receivers offer good protection against a
                                                              scenario in which the fiscal consolidation impacts the UK
                                                              economy more adversely than expected. In particular, we
                                                              recommend being long 2y2y OTM receivers.

                                                                                                         Mohit Kumar, (44) 20 7545 2776
                                                                                                       Soniya Sadeesh, (44) 20 7547 3091

Deutsche Bank AG/London                                                                                                               Page 81
10 December 2010     Fixed Income Outlook 2011

Overview                                                       Figure 1: 10yr JGB yield vs. USD/JPY
                                                                                         USD/JPY, LHS               10yr JGB yield, RHS   %
                                                                130                                                                       2.0
    We anticipate a ceiling for the 10yr JGB yield of
    around 1.4% in 2011 (the same as in 2010) despite           125

    some concerns that US and European official                                                                                           1.8
    interest rates may start rising in the second half of       115
    the year. Domestic capital spending looks likely to                                                                                   1.6
    enter another slump, leaving banks with ample
    surplus funds to invest in the yen bond market.             105                                                                       1.4

    The Bank of Japan appears virtually certain to              100
    maintain its ultra-low interest rate policy for as            95

    long as the CPI inflation rate remains in negative
    territory, and upward pressure on the yen should                                                                                      1.0
    also help to keep JGB yields in check even if
    overseas interest rates do indeed begin to head               80                                                                      0.8
                                                                    2007                 2008                2009           2010
                                                               Source: Bloomberg Finance LP, Deutsche Securities
    At this point in time we expect JGB market
    issuance for FY2011 to be increased by just JPY 3          We expect the aforementioned domestic drivers to
    trillion from FY2010 as the Kan administration             remain largely unchanged in 2011, but overseas interest
    attempts to maintain a path of fiscal discipline.          rates could start to move higher in the second half of the
    Market participants will be watching closely to            year on concerns of possible policy rate hikes by the Fed
    see whether the government is capable of: (1)              and ECB. We expect the global economy to regain
    keeping its commitment to limit FY2011 issuance            momentum in 2H 2011 as the US and Chinese
    of new financial resource bonds to the FY2010              governments step up their efforts to provide fiscal
    level of JPY 44.3 trillion; and (2) stepping up its        stimulus, but with domestic economic conditions unlikely
    efforts to secure a stable tax revenue base,               to improve to the point where the BOJ can realistically
    include preparations for a consumption tax hike.           contemplate an interest rate hike, we do not expect the
Overseas rate hikes may start to appear more likely in         on-the-run 10yr JGB yield to break through its 2010 ceiling
2011, but upside risk to JGB yields still appears              of 1.4%. We are also anticipating a floor of 0.8%, which
limited                                                        would see it maintain its 2010 range of 0.8%–1.4%. In
The on-the-run 10yr JGB yield has ranged between 0.8%          addition to benign monetary conditions and strong
and 1.4% in 2010, down from a 1.1%–1.6% range in 2009.         demand from banks, we expect persistent upward
The key domestic drivers have been: (a) an expectation         pressure on the yen to provide support for the JGB
that    monetary     conditions    will   remain     highly    market as a whole.
accommodative as the Bank of Japan attempts to combat
persistent deflationary pressures with further easing; and     Domestic corporate capex appears likely to remain in a
(b) strong demand for yen bonds from a banking sector          slump, leaving banks with ample cash to invest in yen
that remains awash with surplus cash. JGB-positive             bonds. Past experience suggests that capital spending
factors from overseas have included: (i) a flight to quality   does not usually increase sufficiently to boost production
from early spring onwards triggered by concerns over the       capacity until the capacity utilization index has risen
eurozone sovereign debt crisis; (ii) the Fed's launch of a     beyond 80%. Capacity utilization currently remains below
second round of quantitative easing measures ("QE2")           70%, however, and appears likely to drop even lower
amid fears of an economic slowdown; and (3) a                  (albeit perhaps only temporarily) from 4Q 2010 onwards in
strengthening of the yen towards the USD/JPY=80 level.         line with a slowdown in export growth. We therefore see
                                                               little prospect of capacity utilization breaking through the
                                                               80% threshold before the end of 2011, which suggests
                                                               that the Japanese economy—faced with weak corporate
                                                               capex—may be headed for a period of stagnation before
                                                               export demand starts to pick up in the second half of next

Page 82                                                                                                             Deutsche Bank AG/London
10 December 2010                     Fixed Income Outlook 2011

Figure 2: Manufacturing capacity utilization and the                                            Figure 3: Deutsche Securities forecasts for the core-
production capacity index                                                                       core CPI
             %                                                                                    YoY, %
                                                                              2005=100            0.5                                                                         DB Forecast
   95                                                                                     115

   85                                                                                             0.0

   80                                                                                     105

   75                                                                              69.4           -0.5
   65                                                                                             -1.0
   60                                             Operation ratio, LHS
   55                                             Output index, RHS                               -1.5

   45                                                                                     80      -2.0
        80          85            90            95           00          05         10
                                                                                                         07               08                  09             10                11

                                                                                                Source:Bank of Japan, Deutsche Securities
Source: Ministry of Economy, Trade and Industry, Deutsche Securities

Yen bonds should also receive a certain amount of
support from Japan's ongoing deflationary predicament.
We expect the year-on-year core-core CPI inflation rate (–                                      Figure 4: Impact of 2006 CPI rebasing (from 2000 to
0.8% as of October 2010) to rise only slightly (to around –                                     2005)
0.3%) by this time next year, with more significant price                                        YoY, %
                                                                                                                                   2000 base                      2005 base

increases likely to be prevented by a still-wide output gap
(the amount by which actual GDP falls short of potential)                                         0.6

and this year's strengthening of the yen. The median                                              0.4
forecast of BOJ policy board members for the FY2011
core CPI inflation rate is +0.1%, but their forecasts range
between –0.2% and +0.4%. In a December 1 speech to                                                0.0

business leaders, BOJ policy board member Miyako Suda                                            -0.2
indicated that she sees little possibility of the core CPI
inflation rate moving into positive territory in FY2011. It
should also be noted that our current CPI forecasts—like                                         -0.6
those of the BOJ—do not make allowance for the                                                          1/2005   4/2005     7/2005        10/2005   1/2006   4/2006    7/2006       10/2006

potential impact of next year's CPI rebasing (from 2005 to                                      Source: Datastream, Deutsche Securities

2010). As can be seen from Figure 4, the 2006 rebasing
lowered the average inflation rate for January–July by                                          Sluggish growth in domestic corporate capex should see
around 0.5%pt. If this were to be repeated, then the                                            the banking sector as a whole remain awash with surplus
BOJ's current forecast range for FY2011 would actually                                          funds. According to the BOJ's latest Principal Figures of
translate into a (2010-base) core CPI inflation rate of                                         Financial Institutions, deposits were up 2.7% from a year
somewhere between –0.7% and –0.1%. Nor does a                                                   earlier in November, while outstanding loans and
return to positive territory in 2012 appear likely unless                                       discounts were down 1.8% year-on-year after adjustment
economic growth for 2011 is significantly above potential.                                      for special items, thereby continuing the recent
We are forecasting economic growth of just +0.2% for                                            downtrend. We see no obvious reason to expect a
FY2011, which would probably make it very difficult for                                         resurgence of lending activity in 2011, while firms and
the BOJ to contemplate a policy rate hike before the end                                        households will probably continue to channel significant
of FY2012. With the BOJ's ultra-low interest rate policy                                        portions of their funds into bank deposits. With a BOJ rate
therefore looking likely to be maintained for at least the                                      hike appearing highly unlikely, this widening gap between
next two years, we expect yields for the short- to                                              deposit inflows and lending outflows will almost certainly
medium-term sector to remain sufficiently stable to                                             leave private-sector financial institutions with a strong
prevent a dramatic rise in longer-term yields.                                                  incentive to invest in yen bonds.

Deutsche Bank AG/London                                                                                                                                                               Page 83
10 December 2010                    Fixed Income Outlook 2011

Figure 5: Bank lending vs. growth in deposits & CDs                                  suggesting that an official announcement is not likely until
  YoY, %                  Bank lendings (after adjustment for special items)         around December 20. We are currently forecasting that
   5                      Deposits and CDs                                           calendar-base market issuance (JGBs issued at scheduled
  4                                                                                  auctions from April through March) will be increased by
  3                                                                                  just JPY 3.0 trillion from FY2010 to JPY 147.3 trillion,
                                                                                     which should be too small an increase to trigger a
                                                                                     significant deterioration in the overall supply/demand

  -1                                                                                 On the expenditure side, the government's Fiscal
  -2                                                                                 Management Strategy (passed by Cabinet in June of this
                                                                                     year) calls for FY2011–FY2013 general account
                                                                                     expenditures (excluding debt servicing costs) to be
    2005           2006          2007           2008   2009        2010
                                                                                     capped at JPY 71 trillion. We have therefore assumed that
Source: Bank of Japan, Deutsche Bank
                                                                                     local allocation tax grants and general expenditures for
                                                                                     FY2011 will total JPY 71 trillion. The government's budget
Yen strengthening still a very real risk
                                                                                     request guidelines for FY2011 pointed to JPY 24.1 trillion
We expect that US and European rate hikes will start to
                                                                                     in debt-servicing costs, but given that this forecast was
look more likely in the second half of 2011. Some might
                                                                                     (as usual) based on very conservative interest rate
expect this to be conducive to a weakening of the yen
                                                                                     assumptions whereas the 10yr JGB yield still stands at
versus the US dollar and euro, but we are skeptical as to
                                                                                     around 1.2%, we expect that the actual figure will be
whether rate hike concerns will in themselves be
                                                                                     around JPY 21.0 trillion. This would translate into total
sufficient to reverse the yen's longer-term trend. History
                                                                                     expenditures of JPY 92.0 trillion, down from JPY 96.7
tells us that the USD/JPY exchange rate and the US-Japan
                                                                                     trillion at the initial budget request stage.
policy rate gap seldom move in the same direction, with
the yen only tending to weaken once the Fed's policy rate
                                                                                     We are anticipating tax revenues of JPY 41.0 trillion and
is around 2–3% higher than the BOJ's. In other words, a
                                                                                     non-tax revenues of JPY 6.7 trillion. The government
gap of this magnitude may be necessary in order for the
                                                                                     upgraded its FY2010 tax revenue forecast to JPY 39.6
yen to take over as the carry trade currency of choice. We
                                                                                     trillion when formulating its supplementary budget, which
therefore expect the yen to remain under upward
                                                                                     suggests that revenues of JPY 41.0 trillion should be
pressure in 2H 2011 even if overseas rate hikes do indeed
                                                                                     achievable in FY2011 provided that nominal economic
begin to appear more likely, which should also help to
                                                                                     growth remains positive. Transfers from the BOJ are
limit the potential for significant rises in JGB yields.
                                                                                     typically the main source of non-tax revenues, but we
                                                                                     expect the government to make significant transfers from
Figure 6: US-Japan policy rate gap vs. USD/JPY
                                                                                     special accounts for a third year running. The FY2010
  %                             US-Japan policy rate gap, LHS                        budget included JPY 4.7 trillion from the Special Account
  8                             USD/JPY, RHS                                   170
                                                                                     for Fiscal Investment and Loan Program and JPY 2.8
  7                                                                            160   trillion from the Special Account for Foreign Exchange
  6                                                                            150   Funds, but transfers of this magnitude are likely to prove
                                                                                     somewhat difficult in FY2011. That said, with the
  4                                                                                  government having previously committed to a JPY 44.3
  3                                                                                  trillion cap on issuance of new financial resource bonds,
                                                                               120   we expect that it will once again tap special account
                                                                               110   reserves—with a particular reliance on surplus in the
                                                                                     Special Account for Foreign Exchange Funds—by way of
  0                                                                            100
                                                                                     an "emergency" measure. Highlighting this resolve,
  -1                                                                           90
                                                                                     Finance Minister Yoshihiko Noda indicated on December
  -2                                                                           80    5 that the government has every intention of limiting
       87 89 91           93 95 97          99 01 03    05 07 09       11            FY2011 issuance of new financial resource bonds to no
Source: Bloomberg Finance LP, Deutsche Securities                                    more than JPY 44 trillion.

Can the DPJ-led government gain sufficient support to
enable meaningful fiscal reforms?
The Ministry of Finance has yet to finalize its JGB
issuance plan for FY2011, with past experience

Page 84                                                                                                                Deutsche Bank AG/London
10 December 2010                      Fixed Income Outlook 2011

Figure 7: General account revenue/expenditure                                                        base market issuance would need to total around JPY
forecasts                                                                                            156.4 trillion. However, by depleting around JPY 4.6 trillion
                                                   FY2008     FY2009     FY2010     FY2011           of its roughly JPY 10 trillion in front-loaded issuance
                                                    Initial    Initial    Initial Forecast           (whereas there was no such depletion in FY2010), it
Total expenditure                                    83.1       88.5       92.3         92.0
                                                                                                     should be possible for the MOF to limit the year-on-year
                                                                                                     increase in market issuance to around JPY 3 trillion. It is of
                                       JGB           20.2       20.2       20.6         21.0
                                                                                                     course possible that the government will find itself unable
                        Local allocation             15.6       16.6       17.5
                              tax grants                                                             to limit issuance of new financial resource bonds to JPY
                                General              47.3       51.7       54.2                      44.3 trillion, but we would expect it to match any increase
                             expenditure                                                             beyond that figure with an additional depletion of front-
Revenues                                             57.8       55.3       48.0         47.7         loaded issuance, thereby avoiding the need to increase
                            Tax revenues             53.6       46.1       37.4         41.0         calendar-base market issuance by more than JPY 3 trillion.
                      Non-tax revenues                 4.2        9.2      10.6          6.7
New financial resource bonds                         25.3       33.3       44.3         44.3         In summary, we do not expect increased JGB supply to
Source: Ministry of Finance, Deutsche Securities                                                     have a major impact on yen interest rates in 2011. The
                                                                                                     government's ability to limit new issuance to no more
Assuming JPY 44.3 trillion in new financial resource bonds,                                          than JPY 44.3 trillion is likely to be viewed as an important
JPY 112 trillion in refunding bonds, and JPY 15.5 trillion in                                        litmus test of its fiscal management credentials, but JGB
market issuance of FILP bonds, JGB issuance for FY2011                                               market participants will also be watching to see whether
appears set to total JPY 171.8 trillion. We have assumed                                             the ruling Democratic Party of Japan can form the
that refunding bond issuance is to be reduced by around                                              alliances that will be needed in order to pave the way for
JPY 3 trillion (from what would otherwise be a total of JPY                                          further fiscal rebuilding (including a consumption tax hike).
115 trillion) by using a portion of reserves from the                                                Concerns over sovereign risk are unlikely to come to the
National Debt Consolidation Fund Special Account to pay                                              fore in 2011 given that domestic investors should have
down outstanding JGBs. Assuming that issuance to retail                                              little difficulty absorbing virtually all JGB issuance, and we
investors will decline from FY2010 and that issuance to                                              would actually view any meaningful progress towards
the BOJ will increase to around JPY 13.1 trillion, calendar-                                         fiscal reforms as a positive surprise for yen bonds.

Figure 8: JGB issuance forecasts for FY2011
By issuance, trn yen                                                       FY2008              FY2009            FY2010                         FY2011
                                                                           revised             revised         initial          YoY        Forecast            YoY
Total JGB issuance                                                           138.0              158.4           162.4            4.0          171.8            9.4
                New financial resource bonds                                   33.2               53.5           44.3           -9.2           44.3            0.0
                Refunding bonds                                                94.1               90.8          102.6           11.8          112.0            9.4
                Market issuance of FILP bonds                                  10.7               14.1           15.5            1.4           15.5            0.0

By undertaker, trn yen                                                     FY2008              FY2009         FY2010         FY2011
                                                                           revised             revised         initial          YoY        Forecast            YoY
Total JGB issuance                                                           138.0              158.4           162.4            4.0          171.8            9.4
                JGB for retail investors                                          2.4              1.3            2.0            0.7            1.5            -0.5
                Postal Bank OTC (other OTC)                                       1.8              0.8            0.8            0.0            0.8            0.0
                Issuance to BOJ                                                   9.6             10.7           11.3            0.6           13.1            1.8
                Market issuance (calendar base)                              124.2              145.6           148.3            2.7          156.4            8.1
Non-price competitive auction second                                              4.3              5.3            4.0           -1.3            4.5            0.5
Front-loaded issuance                                                          13.6                2.8            0.0           -2.8            4.6            4.6
Market issuance (calendar base)                                              106.3              137.5           144.3            6.8          147.3            3.0
Source: Ministry of Finance, Deutsche Securities

                                                                                                                          Makoto Yamashita, (81) 3 5156 6622

Deutsche Bank AG/London                                                                                                                                   Page 85
10 December 2010      Fixed Income Outlook 2011

Japan Relative Value

    We use a new statistical technique (multi-regime              MRPA has a number of gratifying epistemological
    probabilistic analysis, MRPA) to gain insight into            properties. We can interpret the PCA components in each
    risk in Japanese bank portfolios and the swaption             regime as before in terms of characteristic curve
    volatility skew                                               movements, such as bear-steepening, butterflies, etc. At
                                                                  the same time, while PCA itself remains constrained to
    MRPA decomposes the historical data into
                                                                  normality of the distribution, MRPA can explain fat tails as
    multiple joint normal distributions with different
                                                                  switches to more volatile (high standard deviation), but
    means and standard deviations which are mixed
                                                                  still normal regimes. Non-Gaussian behaviour, in other
    with time-varying mixing coefficients
                                                                  words, is induced by regime switches, not the underlying
    We find that the JGB portfolio adjustments of                 distributions. From a risk management perspective,
    megabanks in recent years have made them, on                  finding one or more characteristic stress modes from data
    the surface at least, less sensitive to a 2003-type           analysis is also less subjective than identifying stress
    crisis                                                        scenarios by hand, and provides an estimate of the
                                                                  probability of the stress events.
    The volatility skew on swaptions appears to
    underestimate the risk of front-end sell-offs
                                                                  Japanese large bank JGB investments
    relative to the long end
                                                                  We have a rough idea of the cash investment in JGB of
The last Financial Stability Reports of the Bank of Japan         the large banks from their financial reports (figure 1).
have highlighted increasing interest rate risk (measured as       These numbers are consistent with the latest BoJ
capital sensitivity to parallel shifts in the yield curve) at     Financial Stability Report which also showed a decline in
Japanese banks, especially in the regional bank sector. At        the average maturity of bond holdings. However,
the same time, rolling value-at-risk (VaR) measures in the        exposure numbers do not translate directly into rates risk
same report show declining rates risk due to reduced              because the banks do of course use derivatives for
rates volatility. The Bank notes that bank risk management        hedging and our own flows suggest that at least some
has become more sophisticated and stress tests include            part of duration risk is now taken via swaps rather than in
scenarios such as the 2003 sell-off.                              cash bonds.

We propose to use a novel approach to expressing                  Figure 1: Breakdown of megabank JGB portfolio
interest rate risk that in our eyes provides deeper insight       holdings
into the structure of portfolio risk. This approach is multi-
regime probabilistic analysis (MRPA) as proposed by
Bollier, Hedges, and Schwartz. The basis of MRPA is
principal component analysis (PCA) which models                       75%
historical stochastic data as joint normal distributions. By
providing a rotation matrix from the original data to a new           50%
set of coordinates (the eigenvectors of the covariance
matrix), PCA allows the optimal reduction of the
dimensionality of the original data. Optimality here means
that the reduced set of factors explains the maximum
variance possible with a given number of factors under                 0%
the assumption of normality of the original data. MRPA                      03/3      04/3   05/3   06/3     07/3    08/3   09/3     09/9   10/3
extends the PCA concept by modelling the original data as                                 10y-       5-10y           1-5y          -1y
a time-variant mix of multiple joint normal distributions
                                                                  Source: Deutsche Bank
with different but constant means and variances. Each
normal distribution is described by a PCA and Bayesian
                                                                  With this caveat in mind, we can at least establish an idea
estimation is used to find the PCA components and
                                                                  of the change in duration risk that would result from a
mixing ratios. MRPA interprets each normal distribution as
                                                                  regime switch in the JGB market.
a ‘regime’ and the mixing ratios as the probabilities of
being in a given regime at any time. We can label the
                                                                  We conduct an MRPA with three regimes and three PCA
regimes ‘quiet’, ‘high volatility’, ‘crisis’, etc depending on
                                                                  factors on JGB yield data since January 2000, using the 1Y,
their overall volatility but that interpretation of the regimes
                                                                  2Y, 3Y, 4Y, 5Y, 6Y, 7Y, 10Y, 15Y, 20Y, and 30Y points on
does not add to the overall analysis.

Page 86                                                                                                             Deutsche Bank AG/London
10 December 2010                    Fixed Income Outlook 2011

the curve. The original data distribution and the individual                             eigenvalues of the PCA in the different regimes that the
probability distributions are shown in figure 2.                                         crisis regime is more of a two factor model than the usual
                                                                                         JGB curve (figure 5).
Figure 2: MRPA decomposition of JGB curve
movements                                                                                Figure 5: PCA eigenvalues (re-normalised)
                                                                                                                      Quiet     High Vol 1        Crisis
                                                                                         Factor 1                     1.000         1.000          1.000
                                                                                         Factor 2                     0.096         0.096          0.172
                                                                                         Factor 3                     0.015         0.018          0.056
                                                                                         Source: Deutsche Bank

                                                                                         The increase in volatility across the maturity buckets is
                                                                                         shown in figure 6. We note that although the average
                                                                                         annual volatility across all rates increases by a factor of 3.4
                                                                                         from a switch to the crisis regime (figure 3), the 2Y-5Y
                                                                                         area volatility increases more than 5-fold.

                                                                                         Figure 6: Annualised volatility
Source: Deutsche Bank TradeFinder                                                                                     Quiet     High Vol1         Crisis
                                                                                         1Y                            0.06           0.06          0.24
The ‘Crisis’ scenario is extremely rare and corresponds to
                                                                                         2Y                            0.09           0.13          0.63
rapid rises (5.08% annualised) in JGB yields. Such events
                                                                                         3Y                             0.2           0.56          1.69
occurred for instance in 2003 as well as in March and
                                                                                         4Y                            0.26           0.67          1.90
September 2008. As the summary in figure 3 shows, the
drift is statistically significant for the crisis scenario only.                         5Y                            0.30           0.74          2.22
                                                                                         6Y                            0.35           0.86          1.41

Figure 3: Summary of MRPA results                                                        7Y                            0.39           0.94          1.49

                                          Quiet        High Vol1                Crisis   10Y                           0.34           0.83          1.02

Average Probability (%)                   85.27             14.27                0.46    15Y                           0.35           0.84          0.93

Annual Drift                              -0.12              0.38                5.08    20Y                           0.33           0.81          0.94

Total Annual Volatility                    0.24              0.61                0.81    30Y                           0.33           0.79          0.64
Source: Deutsche Bank TradeFinder                                                        Source: Deutsche Bank

Of more interest for portfolio risk is the structure of the                              Relatively speaking, the risk in the front end of the curve is
curve moves especially in the crisis scenario.                                           higher than in the tenors beyond 5Y simply because the
                                                                                         front end is normally so well behaved. We would
Figure 4: First PCA factor in the three MRPA regimes                                     therefore argue that the risk reduction suggested by the
                                                                                         data in figure 1 is actually not as dramatic. The data in
    0.5             Quiet                                                                figure 6 suggests that the average rate volatility on the
                    High Vol1                                                            current average portfolio of the megabanks would
    0.4                                                                                  increase by a factor of 4.12 in a crisis scenario while at the
                                                                                         time of the maximum long end exposure (end FY07), it
    0.3                                                                                  would have increased only by a factor of 3.71. That said,
                                                                                         the average duration of the portfolio has fallen by about
    0.2                                                                                  1/3 since then so that total rates risk has declined by
                                                                                         about 18% over this period in our analysis. Still, this
                                                                                         decline is just over half of what would be suggested by a
                                                                                         parallel curve shift analysis.
              1Y        2Y   3Y      4Y   5Y      6Y   7Y   10Y     15Y   20Y    30Y
Source: Deutsche Bank

The analysis shows, unsurprisingly, that the futures sector
leads curve movements. We also note from the

Deutsche Bank AG/London                                                                                                                         Page 87
10 December 2010        Fixed Income Outlook 2011

Swaption skew                                                     Figure 8: Volatility estimates in different regimes
Another interesting insight from a multi-regime analysis is                                            Quiet       High Vol1      High Vol2           Crisis
that the volatility skew should reflect the behaviour of the      Average Probability (%)                  30.3           33.57         28.65          7.48
curve in the stress scenarios. One of the more popular
                                                                  Annual Drift                         -0.04              -0.16         -0.23          1.15
macro-trades of 2009 in Japan and other currencies were
                                                                  Volatility from Principal                0.16            0.33          0.39          0.80
high-strike payer swaptions or CMS caps that were                 Components
viewed as highly leveraged exposures to an inflationary           Volatility from PC                         0               0             0           0.01
exit from the financial crisis. These structures have turned      Residuals
in a mixed performance which was largely dependent on             Total Annual                             0.16            0.33          0.39          0.80
shifts in the volatility skew (ie, the price investors have       Volatility
                                                                  Source: Deutsche Bank TradeFinder
been willing to pay for high-rate protection) rather than
shifts in the rates themselves (figure 7).
                                                                  In other words, the market appears to spend around 7.5%
                                                                  of the time in a ‘crisis’ regime where volatility is about five
Figure 7: Total and pure rates delta performance of a             times higher than normal. During these episodes, yields
6% 5Yx10Y CMS cap entered in April 2009                           rise at an average annualised speed of 1.15%. The drifts
                                                                  in the other scenarios are smaller than the volatilities and
                                                                  therefore statistically less significant.

                                                                  We can now consider the increase of volatility of each
                                                                  curve point during a change from a non-crisis to the crisis
                                                                  regime and compare this to the skew. For a fair
                                                                  representation of the skew, we use the difference in
                                                                  implied volatility between the ATMF strike and the strike
                                                                  that is two annualised implied volatilities above the ATMF
                                                                  strike. We use 5Y expiry swaptions since that appears to
                                                                  have been the most popular point for the bearish trades in
                                                                  2009. For instance, for the 5Yx10Y swaption, the ATMF
                                                                  strike is 2.492% and the annualised implied volatility
Source: Deutsche Bank
                                                                  70.7bp, so the OTM strike we use for the skew is 3.905%.
                                                                  Figure 9 shows the ratio of high-strike to ATM strike
In a multi-regime setting, we can interpret the skew as an        normal volatility, and crisis to non-crisis volatility,
expression of the change in volatility when the market            respectively.
switches from a low-volatility regime to a high-volatility
regime. Especially for high-strike swaptions, even                Figure 9: Swaption implied skew OTM/ATM ratio and
reaching the strike requires higher market volatility so that     historical crisis/non-crisis volatility ratio
when rates are near the strike, the curve dynamics should             3.5                                         Implied skew
be in line with the high-volatility market regime. By
                                                                                                                  MRPA volatility change
comparing the volatilities of rates in the ‘quiet’ and ‘crisis’
regimes, we can obtain an estimate of how much the                    3.0
volatility skew should be reflective of higher volatility at
higher strikes.

We use four regimes and three PCA factors for the
analysis, resulting in the breakdown given in figure 8. The
input were the time series for the 1Y, 2Y, 3Y, 4Y, 5Y, 6Y,
7Y, 10Y, 15Y, 20Y, and 30Y swap rates since January 2000.
                                                                                1Y        2Y   3Y     4Y     5Y      6Y      7Y   10Y    15Y    20Y    30Y
                                                                  Source: Deutsche Bank

                                                                  What we see is that the skew is lower than the MRPA
                                                                  measure but that is simple a scaling issue: Our choice of
                                                                  OTM strike at ATMF plus twice the ATMF implied volatility
                                                                  was arbitrary and mainly motivated by the 5Y expiry

Page 88                                                                                                                   Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

( 5 ≈ 2.24 ). More interesting is that MRPA indicates            Figure 10: Normalised first PCA factor
that the increase in volatility in a crisis is more pronounced
in the short and long end, while around the 5-7Y part of                             Quiet
the curve there is less extra volatility. This is probably                           High Vol 1
connected to the experience that the 5-7Y sector is an
                                                                                     High Vol 2
important hedge area for bank carry portfolios and
                                                                     0.30            Crisis
therefore relatively volatile even outside crisis regime.
This is borne out by the first PCA factors in each regime.           0.25

Figure 10 shows that the main movement in the crisis                 0.20
scenario is a bear steepening that is not too dissimilar             0.15
from the quiet regime (the higher volatility does not show           0.10
up in the normalised factors). Meanwhile, the first high             0.05
volatility scenario, which is more than four times more              0.00
likely than the crisis scenario, shows a strong movement                        1Y      2Y     3Y      4Y   5Y   6Y   7Y   10Y   15Y   20Y   30Y
of the belly of the curve relative to the wings.
                                                                 Source: Deutsche Bank TradeFinder

                                                                 The downwards slope of the implied skew, however,
                                                                 indicates that value in high strikes is present mostly in
                                                                 long tail options, although short tails also offer value
                                                                 relative to 5-7Y expiries.

                                                                                                     Alexander Düring, (44) 20 754-55568

Deutsche Bank AG/London                                                                                                                 Page 89
10 December 2010    Fixed Income Outlook 2011

EM Rates

Outlook for Rates
    This year local EM curves priced extreme                Lessons from 2010
    scenarios due to dramatic shifts in data, market
    focus and sentiment. While global drivers have          The year was marked by dramatic shifts in data, market
    played a crucial role, idiosyncratic drivers have       focus and sentiment. Local curves priced extreme
    also been important.                                    scenarios ranging from fears of “exit” in 1Q10 to a
                                                            double-dip recession in 2Q10/3Q10, before tentatively
    In 2011, we expect increased differentiation
                                                            settling in between amid the accommodation of QE2 and
    across markets and identify four main themes to
                                                            renewed concerns about a debt crisis in Europe. We
    guide our strategy recommendations.
                                                            believe that the same themes will feature prominently in
    Central banks face a delicate policy rebalancing        2011, although in different order and magnitude.
    act as output gaps are closing amid a mix of
    depressed core inflation in advanced economies,         The strong fiscal and inventory stimulus of the previous
    and rising headline inflation risks originated in       year, and thus the sharp (elastic) rebound in growth we
    commodity prices. Central banks also face a             had factored in for 1Q10, have given way to a more
    difficult trade-off between increasing interest         gradual recovery. Fears of “exit” have subsided and
    differentials and attracting speculative capital        become more backloaded. We expect QE2 will anchor
    inflows.                                                rates lower during 1Q11 as the tail-end of housing
                                                            deflation and inventory adjustment delay faster growth to
    Inflation pressures could mount on some EM
                                                            2H11 or 2012. Moreover, we expect the risk of a double-
    countries due to the combination of rising food
                                                            dip to be less pronounced in 2011, as mending consumer
    prices, relatively loose fiscal stance, gradualism in
                                                            balance sheets, persistent monetary stimulus, and the
    monetary tightening, and a scarce room for FX
                                                            tentative signs of recovery in labor markets and activity
    appreciation due to overvaluation, capital controls
                                                            point towards above potential US growth and thus sound
    and market interventions.
                                                            enough activity to avert deflation. Still, credit markets will
    Technicals should continue to be an important           likely remain tense in the year ahead as authorities have
    driver of performance. Foreign buying has been a        yet to confine sovereign risks to the EU periphery. Should
    key contributor to total demand in some markets,        EU authorities eventually succeed – as we believe – and
    making them more vulnerable to shifts in global         dollar weakness resume amid QE2, we expect inflation to
    sentiment. Supply pressure is also an important         resurface as an important theme to reckon with in 2011.
    risk to consider, particularly in countries that lack
    a deep pension system and where local banks             The reduced importance of global drivers
    absorb an important part of government debt.               Share of commovement (1st PCA); 2010

    Exposure to core rates and EU credit pose a risk            80%
    to local curves since many of them tend to                                                        EU crisis
                                                                                    Exit                            high-yielders
    overreact to volatility on core interest rates. We          70%

    suggest payer spreads to protect against this risk
    in selected curves.                                         60%
                                                                                                                   QE2 / EU
    Based on the analysis of these themes, we find              50%
    attractive to receive nominal rates in Colombia,
    Mexico, Singapore and South Africa and real rates           40%
    in Brazil. Additionally, we favor long breakevens
    in Chile and Poland, and outright payers in China           30%

    and Hungary.
                                                                                    Jan-Apr      May-Jul          Sep-Dec
                                                            Source: Deutsche Bank

Page 90                                                                                                 Deutsche Bank AG/London
10 December 2010            Fixed Income Outlook 2011

Differentiation across markets is likely to increase during                    The conditions central banks face vary substantially across
2011. It is clear that global drivers have played an                           emerging markets. The chart below shows output gap
important role in EM rates during this year, but domestic                      estimates 12 and unemployment rates (relative to recent
(idiosyncratic) drivers have also at times been dominant –                     historical averages) for some EM countries. Brazil and
especially in the latter part of the year when QE2 tamed                       Argentina stand out as tightest in terms of output and
risks of deflation and a double-dip11. In the recent months,                   labor markets, while Hungary is on the other extreme. The
idiosyncratic drivers have account for 1/2–1/3 of the                          bulk of the countries are in between, a situation where
recent variation in local rates. Looking ahead, we expect                      monetary authorities need to reign in inflation and inflation
UST 10Y to rally back to 2.5% in 1Q10 as the US economy                        expectations but have some leeway to tighten the grip so
gradually builds momentum amid lingering EU risks, which                       as not to attract “excessive” speculative inflows.
should continue to benefit local rates.
                                                                               A wide spectrum of narrowing output gaps
Where to receive? The opportunities are becoming                                 Output Gap (% lo g dif.)
scarcer, but – after the recent overshooting in some                                             ARS
curves – we still see value in Colombia, Mexico,                                                  BRL                   PEN

Singapore, and South Africa. Although we see limits to
inflation propagation while core inflation in the world is
                                                                                                                 PLN ILS
around 1%, EM is most sensitive to headline pressures                                                             COP
                                                                                                                        CLP       ZAR                               MXN
                                                                                    -2                                          TRY
stemming from commodities we foresee for the next year
and thus favor more defensive positioning via linkers in                            -4

Brazil, Chile, and Poland.                                                                                              RUB

Where to pay? Tight output gaps and domestic drivers                                     0.50               0.75                1.00              1 .25              1.50
                                                                                                              Unemplo yment (ratio o ver 1 average)
are dominant in Brazil and China. We favor short-end
                                                                               Source: Deutsche Bank. Note: output gap is computed as actual GDP –potential GDP
payers in China and – although we believe the
government will try to delay hikes to at least March –
                                                                               Barring a strong positive surprise in US growth and a fast
more overshooting seems likely. We expect increasing
                                                                               resolution of the EU debt problems – two unlikely events
risks of selling pressure as 2H11 approaches and possibly
                                                                               under present circumstances – we believe that the short-
tighter monetary conditions in Europe and in the UST
                                                                               end of EMEA and LatAm curves offer enough premium to
could weigh more heavily on Chile, Czech Republic, and
                                                                               cover the risks. The following chart shows our policy calls
Israel, and also in the long end of Hungary where pent-up
                                                                               under our baseline scenario and two alternative (bullish
supply may become an issue.
                                                                               and bearish) growth scenarios. In most cases – especially
                                                                               in Mexico, Brazil, Turkey, and Hungary the market pricing
In the following sections we discuss the themes we
                                                                               is already in line with our most bullish scenario. While
expect to be dominant in 2011 and that provide the basis
                                                                               Brazil does face a tight output gap and Hungary’s
for these strategies.
                                                                               premium is also influenced by EU risks, this pricing seems
                                                                               at odds with the wide output and employment gaps faced
Theme 1: Delicate Policy Rebalancing                                           by Mexico, which is one of our favored receivers.
Output gaps have closed in only a few countries, but they
are nearly closed for a handful of them. Core inflation
remains subdued, but headline inflation is becoming a
more pressing issue in Asia and in several other emerging
economies. In addition, fiscal tightening is likely to take
place only where imposed by market pressure, increasing
the onus on monetary policy. Moreover, given the
prospect of building capital inflows, central banks will
likely continue to favor gradualism over frontloading.

   The chart shows the principal component analysis (PCA) of 10Y yields in
the most relevant EMEA and LatAm markets. The results for 2Y yields are
similar. The co-movement in rates has been largely driven by UST yields;          We filter the series using a modified band-pass filter as presented in
excluding surges in risk aversion, UST yields and idiosyncratic drivers have   Christiano, Lawrence J. and Terry J. Fitzgerald. "The Band Pass Filter,"
had similar contributions to EM yield variation.                               International Economic Review, 2003, v44(2,May), 435-465.

Deutsche Bank AG/London                                                                                                                                           Page 91
10 December 2010                     Fixed Income Outlook 2011

Market prices different “exit” speeds                                                               pass-through to consumer prices tends to be very fast in
 12m forecast vs. market and bearish and bullish scenarios (%)                                      Asia, while the lag has been 2-4 months in EMEA, and
                                                                                                    could take longer than six months in LatAm. Altogether,
                                                                                                    we may still have months of food inflation pressure
                      Baseline          M arket

  8.0                                                                                               We believe there are at least three reasons to expect food
                                                                                                    inflation will remain an important risk to EM 13 : 1) Food
                                                                                                    prices are most sensitive to EM growth, which we expect
                                                                                                    to remain upbeat; 2) Food prices account for a substantial
                                                                                                    share of EM CPI baskets (see chart below); and 3) A 1
  2.0                                                                                               percentage increase in food prices could have a 0.1-0.6
          M XN         CLP        PLN        HUF         ZAR         TRY        RUB      BRL        percentage impact on non-food prices, according to an
Source: Deutsche Bank. Bullish: Back to pre-crises growth; bearish: US growth at 1.5%
                                                                                                    IMF study on the BRICs.

                                                                                                    EM CPIs are very sensitive to food inflation
Theme 2: The Resurgence of Inflation
The core economies are still fighting against deflation risks
and it may take years until pricing power is restored to
pre-crises levels. Nevertheless, we believe that headline
inflation pressures may mount on some EM countries on
the combination of rising food prices, relatively loose
fiscal stance, and gradualism in monetary tightening. It is
true FX appreciation could help to counteract these
effects, but as we discuss in our FX Outlook, the room for
appreciation for many EM currencies is now more limited.

Food leads headline price pressures
   Commodities Inflation                                             Agricultural goods inflation
   70%                                                                                       50%
                                                                                                    Source: Deutsche Bank, Haver
                         Agric                                                               40%
                                                                                                    Which countries and regions are most exposed?
                                                                                             20%    Regionally, the latest surge in commodity prices of 2007-
   10%                                                                                       10%    2008 suggests that EMEA and LatAm sensitivities are
                                                                                             0%     similar, while Asia’s is about half as high. Countries such
                                                                                                    as Argentina, Brazil, Peru, and Poland, where capacity
  -30%                                                                                              utilization and employment are relatively high seem more
                                                                                                    exposed to a supply shock. In contrast, Hungary and
  -50%                                                                                       -30%
                                                                                                    Mexico have more domestic slack to accommodate a
        Dec-05             Feb-07             Apr-08             Jun-09             Aug-10
                                                                                                    possible rise in food prices. The following chart shows the
Source: Deutsche Bank, Bloomberg Finance LP                                                         output gap (as a proxy for risk of propagation of inflation
                                                                                                    shocks) against our assessment of potential inflation
How strong are the supply price shocks? In contrast with                                            surprises vs. what is already priced in for the markets that
2007-2008, food (or, more generally agricultural goods)                                             trade inflation linkers 14 . Brazil currently stands out,
prices have led the reflation in commodities seen since                                             although Poland and Chile will likely approach Brazil in
the 2Q09 trough. While gasoline prices are hovering                                                 2011 as their output gap closes.
around the average of the past five years, most
agricultural prices other than wheat and soybeans are
already near or above the 2008 peak – despite temporary
dollar strength (see chart above). Moreover, our
commodity strategists see tight inventory conditions in                                             13
                                                                                                       Looking beyond food, metals have lagged but have room to catch up,
corn and soy and upside risks for wheat as well. How                                                according to our strategists. Given their high correlation with producer
                                                                                                    prices, this may become an additional source of inflation risk for EM.
important and persistent this shock could be? Recent                                                14
                                                                                                       We excluded Argentina because of the distortions in inflation reporting,
history suggests that under our baseline scenario we may                                            but it would obviously stand out for its combination of high capacity
still be less than half-way through this latest cycle. The                                          utilization and inflation.

Page 92                                                                                                                                          Deutsche Bank AG/London
10 December 2010                               Fixed Income Outlook 2011

Inflation risks vs. slack in the economy                                                             are naturally exposed to steepening should inflows into
 Potential inflation upside surprise vs. market                                                      EM local markets turn around.

  100%                                CLP
                                                                                                     The importance of the foreign bid
                                                                                                       YTD increase in foreign holdings of domestic government debt
   80%                                                                                                                                                                                           data
                                                                                                       USD bn (and as % of market)
                                                                                   BRL                                      0           5           10         15          20          25        as of
                                                                                                              Indonesia                              13.9%                                       31Oct
   40%                               ZAR
                  MXN                                                                                          Malaysia                              12.2%                                       30Sep

                                                                                                           South Africa                             11.0%                                        30Nov
                        TRY                                                                            Czech Republic                       10.6%                                                31Oct
       0%                                                                                                        Mexico                                                                 10.6% 31Oct
                          COP                                                                                    Poland                                          7.9%                            30Sep
        -2.5       -2         -1.5         -1     -0.5     0    0.5     1    1.5         2     2.5
                                                                                                           South Korea                                                    6.4%                   31Oct
                                                   Output Gap                                                     Turkey                                    5.5%                                 31Oct
                                                                                                                   Brazil                                        1.9%                            31Oct
Source: Deutsche Bank
                                                                                                                  Russia         1.4%                                                            30Jun
                                                                                                                Thailand         0.7%                                                            31Oct
Where inflation will finally settle depends on the reaction                                                                     0.2%                                                             1Dec
of monetary authorities. In the case of Argentina, we do
                                                                                                     Source: Country sources, Deutsche Bank. For more details, see “Perspectives on the Capital Flows to
not expect much resistance despite its 25% estimated                                                 EM” on this publication.

inflation. We expect the central banks of Peru, and
particularly, Brazil, to react more forcefully, followed by                                          Modeling inflows into EM is fraught with difficulty if
Poland. Putting together the sensitivity to inflation,                                               anything because of limited investor coverage and history,
domestic conditions, and our estimated central bank                                                  but – as the following chart shows – inflows into local
reaction functions, the following chart compares our                                                 markets vs. external debt is sensitive to risk (proxied by
inflation forecasts to inflation breakeven prices under our                                          the VIX) and to interest rate differentials. Inflows into local
baseline and alternative bullish and bearish growth                                                  markets have lagged on the recent rise in risk aversion,
scenarios. The inflation premium seems particularly low in                                           but – barring an escalation in the EU crisis – our baseline
Chile and Poland, favoring long breakeven positions. In                                              scenario of reflation amid QE2 bodes well for search for
Brazil, the premium is also relatively low, but we would                                             yields. As external debt returns are more sensitive to US
still favor linkers given the risks of policy mismanagement                                          yields (which are artificially depressed vs. long-term fair
by the new government.                                                                               value) and yield differentials should continue to favor local
                                                                                                     markets, we expect external demand for EM local fixed
Where inflation breakevens are still low                                                             income to remain favorable. However, if quantitative
 Inflation Outlook: bearish, bullish, base scenarrios and 1Y breakeven (%)                           easing is phased out and liquidity conditions start to
 8.0                                                                                                 tighten (or EU risks surge), those curves that have
                                                                                                     received substantial foreign inflows are the obvious
                  Baseline           M arket                                                         candidates for steeping.

                                                                                                     Domestic supply is also an important risk to consider.
                                                                                                     Naturally, higher issuance (government dissaving) may be
 4.0                                                                                                 more than offset by increased private savings and indeed
                                                                                                     this has taken place across most markets, particularly
                                                                                                     those with sound private pension systems. Local banks
                                                                                                     have also been important buyers in many cases, most
            PLN           CLP               COP          M XN     ZAR       BRL          TRY         notably in Russia but also in Hungary, Mexico, and
                                                                                                     Colombia. Should banks increase lending or should credit
Source: Deutsche Bank
                                                                                                     risk rise, banks may reduce their portfolio of government
                                                                                                     bonds or require higher net margins, thus causing the
Theme 3: Inflows, supply, and demand                                                                 curves to steepen.
Technicals have been an important component of
performance in 2010 and we expect this to extend into
2011. Foreign buying has been a very important
contributor to total demand especially in Indonesia,
Malaysia, South Africa and Mexico (see chart below).
Since foreigners favor longer-dated bonds, these curves

Deutsche Bank AG/London                                                                                                                                                                       Page 93
10 December 2010                     Fixed Income Outlook 2011

Local flows dictated by risk and rate differential                                     partially, it could trigger a sizable credit event that would
         % for yield diff; USDbn for flow diff
                                                                                 0     likely have an important contagion effect on EM spreads
                                                                    %; VIX
  2.0                                                                            10    and local curves. These could delay curve flattening.
                                                                                       Overreaction to EU credit spread shocks
  0.5                                                                                   z-scores of 2s10s vs. 2s (steepener carry to vol in brackets)                                 Steep
                                                                                 50                                                    HKD ( 0.0 )
                                                                                            2.5                                                                            ZAR ( 0.39 )
 -1.0                                                                                                                                 MXN ( 0.2 )
                                                                 Yield Diff                                                                                    SAR ( 0.05 )
 -1.5                                                                            70           2                                  ILS ( 0.31 )                                 CZK ( 0.36 )
                                                                                                                                 AED ( -0.07 )                      SGD ( 0.0 )
 -2.0                                                            VIX             80
                                                                                                                          HUF ( 0.28 )                      PLN ( 0.56 )
 -2.5                                                                            90                       INR ( 0.0 )                               TRY ( 0.35 )
  Dec-2007                     Dec-2008           Dec-2009                  Dec-2010
                                                                                                    CLP ( 0.47 )
Source: Deutsche Bank; EPFR

In EMEA, we believe this could be an important risk in                                        0                 RUB ( 0.54 )
Hungary because of the recent quasi nationalization of the
pension system and the expected heavy issuance of HUF                                      -0.5
                                                                                                 -0.5            0.0           0.5              1.0           1.5           2.0            2.5
denominated debt during 2011. In Poland, while net
                                                                                          Flat                                  z-score 2s10s vs sovex              Period: Jul10 Nov10
issuance is expected to decrease, potential changes to
                                                                                       Source: Deutsche Bank; EPFR
the pension system adds some uncertainty to the demand
side. In LatAm, we think there is less supply risks as
                                                                                       Evidently, another source of external risk is given by US
issuance is not expected to be particularly large.
                                                                                       rates. As seen during the last few months, after the hint
Argentina, where the pension system was recently
                                                                                       of further quantitative easing by Fed officials, most local
nationalized, is not expected to tap the markets even if
                                                                                       curves have been affected, albeit to a different degree, by
expenditures are growing at an accelerated pace. Mexico
                                                                                       the increased volatility in UST. Moreover, most of them
could even announce lower issuance for 1Q11 than
                                                                                       also seem to have overshot the final move in the UST (see
previously expected and counts with ample liquidity in the
                                                                                       following chart). For instance, the ZAR curve seems
pension system. Chile has also announced manageable
                                                                                       particularly steep when compared to the level of 2Y rates
                                                                                       in South Africa and the level of UST 10Y. The BRL curve is
                                                                                       on the other extreme, although its shape now hinges on
Theme 4: Exposure to core rates and EU                                                 the pace and size of the expected tightening cycle. In the
                                                                                       middle of these extremes, the CLP curve, while
In our assessment, the impact of EU and UST risks on EM
                                                                                       particularly sensitive to UST movements, still has room to
curves depend on the magnitude and length of the
potential dislocations. There are three main channels of
contagion: First and most immediately, the can generate
technical dislocations; second, they can lead to a repricing                           Overreaction to UST moves
                                                                                        z-scores of 2s10s vs. 2s (steepener carry to vol in brackets)                                 Steep
of growth and monetary policy actions across EM, and;
third, these risks could trigger a generalized credit                                                                                      CZK ( 0.36 )
                                                                                                                                                          HKD ( 0.0 )
                                                                                            2.5                                                                      ZAR ( 0.39 )
contagion, with high betas suffering the most.                                                                            ILS ( 0.31 )
                                                                                                                                          MXN ( 0.2 )      SGD ( 0.0 )
                                                                                                                                                             SAR ( 0.05 )
                                                                                                                                         PLN ( 0.56 )          AED ( -0.07 )
So far the latest round of selling has been limited to                                                                  INR ( 0.0 )                         TRY ( 0.35 )
                                                                                                                                                      HUF ( 0.28 )
technical dislocations as investors protected their gains                                                                                CLP ( 0.47 )
into year-end. As the charts below show, most curves
look steep when measured vs. credit spreads and UST
                                                                                           -0.5                                  RUB ( 0.54 )
yields. Although the first chart indicates that there is room
for these curves to flatten if the crisis in EU is contained, it
is more likely that the situation in the EU will remain in flux                            -1.5

for longer. Moreover, if the situation persists and/or
                                                                                                        BRL ( 0.18 )
deteriorates, it could begin to have some real effects in                                  -2.5
                                                                                                 -3.1           -2.1           -1.1          -0.1            0.9           1.9            2.9
the global economy, and as a consequence it could trigger
                                                                                          Flat                                 z-score 2s10s vs UST10               Period: Jul10 Nov10
a repricing of monetary policy in some EM countries,
                                                                                       Source: Deutsche Bank; EPFR
leading to additional steepening. Finally, if some of the
risks associated with the EU periphery materialize, even if

Page 94                                                                                                                                                 Deutsche Bank AG/London
10 December 2010      Fixed Income Outlook 2011

In search of protection                                          Protection via payer spreads
                                                                  3M 10Y payer spread moneyness rat io (at mf +25/ 50)
Although we expect US rates to rally in 1Q11 as QE2
gains traction, liquidity conditions could start to tighten in     0.45

the latter part of the year, or even before, should US              0.4                                                                                            CZK

growth surprises to the upside. In addition, we cannot rule        0.35
out further worsening in EU before authorities face the
                                                                                                                                                     PLN           ZAR
problems more forcefully. Finding protection for this risk
requires some analysis. Since several curves may have              0.25

already overshot UST and EU-related moves, outright                 0.2

payers may already be stretched in terms of valuation. An          0.15                                                    HUF                 TRY

alternative is to use payer spreads instead. We try to find         0.1

those that offer the highest payout (defined as the
difference between upside and downside) scaled by the

breakeven – spot. The chart below shows this payout                  0
                                                                          0        0.1         0.2         0.3              0.4        0.5       0.6         0.7     0.8     0.9

index vs. the betas to the UST. Ideally we want the                                                                             0
                                                                                                                 B et a t o UST1 ( Last 4mo)

                                                                 Source: Deutsche Bank;
combination of high betas and payout indices – thus the
northeast quadrant of the chart. Israel, Czech Republic,
South Africa and Mexico are the curves that stand out.
Note that in the case of Mexico and South Africa, a
                                                                 On the following page, please find a summary of our rates
correction in US yields could be amplified by a turnaround
                                                                 strategy views by country.
in foreign demand, as discussed before.

                                                                                Drausio Giacomelli, New York, (1) 212 250-7355
                                                                                Guilherme Marone, New York, (1) 212 250-8640
                                                                                      Mauro Roca, New York, (1) 212 250-8609


    Local market returns in Asia this year were in                        regulatory controls and administrative (as against
    large part driven by the dynamics of global capital                   monetary policy) measures.
    flows – reflecting as much the ultra-low interest
                                                                          The backdrop of narrowing economic slack,
    rates in G3 (the ‘push’ factor) as a re-rating of the
                                                                          inflation tail risks, and low real yields should
    credit fundamentals of Asia and a structural
                                                                          increasingly favor equities and FX over fixed
    reduction in the under allocation of global capital
                                                                          income. Indeed, we expect currency returns to
    to EM as an asset class across (the ‘pull’ factor).
                                                                          exceed gains from duration in holding local fixed
    We don’t see these dynamics changing in a                             income investments in 2011.
    significant manner in the next 3-6 months, with
                                                                          It will also likely be a year of greater
    Asia needing to feature prominently in the
                                                                          differentiation. We foresee a greater focus on
    adjustment in G2 exchange rates in the wake of
                                                                          relative   value   curve   plays   and    tactical
    the crisis. Diversification needs of DM pension
                                                                          opportunities in rates space, versus structural or
    funds, growing pools of asset under management
                                                                          thematic long duration positions.
    for sovereign wealth funds, and the increasing
    trend of intra-regional investments will add to the                   We think monetary policy is in general too lax
    pool of capital looking for return in local market                    across most of the region. But with policymakers
    assets.                                                               likely to remain constrained in tightening policy
                                                                          as they struggle to deal with the domestic
    But as policy makers become increasingly less
                                                                          monetary implications of capital inflows, market
    welcoming to such capital for fear that the
                                                                          interest rate curves will steepen to express the
    absorptive capacity of their economies fall short,
                                                                          tail risk on inflation.
    gains in local markets could get more punctuated
    by volatility around the shape and form of

Deutsche Bank AG/London                                                                                                                                                  Page 95
10 December 2010                   Fixed Income Outlook 2011

       Supply dynamics are likely to get more                                     Strong inflows into EM local debt as an asset class
       challenging in parts of Asia in 2011, as the delta                          13-week MA fund flows (% AUM)
       from fiscal consolidation falls (and even reverses
       in some cases).
       In the event that increasingly punitive measures
       to restrict capital inflows were to slow down the                            1.00

       flow of foreign purchases of bonds, it would likely                          0.00
       expose – in markets like Indonesia and Malaysia –
       a particularly large bid-ask spread between the                             -1.00
                                                                                                                                                            All EM debt funds
       current level of yields and where local investors                           -2.00                                                                    Local ccy funds
       might again get interested.                                                                                                                          Hard ccy funds
Asian Rates in 2011                                                                    Nov-07        May-08         Nov-08       May-09         Nov-09       May-10         Nov-10

                                                                                  Source: Deutsche Bank, EPFR
Local market returns in Asia this year were in large
part driven by the dynamics of global capital flows –
                                                                                  Offshore purchases of Asian fixed income*…
reflecting as much the ultra-low interest rates in G3                                50
(the ‘push’ factor) as a re-rating of the credit                                               USD bn
                                                                                                                    full year 2009          2010 ytd

fundamentals of Asia and a structural reduction in the                                                                                               USD67bn
under allocation of global capital to EM as an asset
class across (the ‘pull’ factor). Offshore investors have
bought a total of USD67bn in Asian local currency fixed                              30

income assets year to date, more than twice the amount
in 200915. And these purchases sponsored between 30%                                 20
of net issuance of government bonds in Thailand to as
much as 160% in Malaysia, in the process driving yields
sharply lower, and much below (in some cases) the hurdle
rates for domestic asset managers. While flows into EM
outpaced developed markets across the capital structure,
                                                                                                India      Indonesia         Korea        Malaysia       Thailand         Total
local currency debt was the clear outperformer, with
assets under management of mutual funds, for example,                             Source: Deutsche Bank, CEIC *includes corporate bonds in India, SBIs in Indonesia, MSBs in Korea,
                                                                                  BNM paper in Malaysia, and BOT bonds in Thailand
dedicated to investing in EM local currency debt almost
doubling over the course of the year.                                             …sponsored most of the local currency government
                                                                                  bond issuance for the year
Local market returns year to date                                                    200%

    35%                                                                                                                           net purchases/net
                                     currency        duration*                       150%
                                                                                                                                issuance (12M rolling)
    30%                                                                              100%
    10%                                                                                                           indonesia
      5%                                                                                                          korea
                                                                                    -150%                         malaysia
      0%                                                                                                          thailand
                                                                                               Feb-08      Jul-08      Dec-08      May-09        Oct-09      Mar-10       Aug-10
               CNY HKD         IDR     INR     KRW MYR          PHP SGD THB TWD
                                                                                  Source: Deutsche Bank, CEIC, Bank Indonesia, FSS, Thai BMA
Source: Deutsche Bank *calculated using 10Y government bond yields

                                                                                  While central banks in much of the region initiated their
                                                                                  exit from the ultra loose policy settings in place since the
                                                                                  financial crisis of 2008-09, they were mostly constrained
                                                                                  in their pace of tightening by the weak backdrop of G2
   This refers to flows into India, Indonesia, Malaysia, Korea and Thailand,
                                                                                  growth, and the fear of exacerbating inflow of capital
which make available this data.                                                   threatening to overwhelm the absorptive capacity of the

Page 96                                                                                                                                       Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

domestic economies. The fixed income markets were also                                 Within local markets, the backdrop of narrowing
helped by a largely benign supply backdrop, with several                               economic slack, inflation tail risks, and low real yields
governments in the region proactively consolidating their                              should increasingly favor equities and FX over fixed
fiscal positions. Prudent debt management strategy, such                               income. Indeed, we expect currency returns to exceed
as the diversifying of sources of demand to retail or other                            gains from duration in holding local fixed income
sectors (Indonesia, Philippines), also helped keep supply                              investments in 2011.
pressures under check.
                                                                                       Unattractive real yields
Fiscal consolidation efforts kept supply in check                                          9                               10Y nominal yield
Year-on-year increase in gross LC bond issuance in 2010*                                   8
                                                                                                                           average 2011 inflation (DB)

     40%                                                                                   7

     30%                                                                                   6

     20%                                                                                   5

     10%                                                                                   4

                                                                                                    IDR        INR   KRW   MYR      PHP        SGD       THB
    -40%                                                                               Source: Deutsche Bank

                MYR KRW CNY              SGD      INR     PHP      THB TWD HKD   IDR
Source: Deutsche Bank   *2010-11 for HK and India, and 2009-10 for Thailand
                                                                                       It should also likely be a year of greater differentiation. We
                                                                                       foresee a greater focus on relative value curve plays
We don’t see the macro dynamics of ‘push’ and ‘pull’                                   and tactical opportunities in rates space, versus
of global capital changing in a significant manner in                                  structural or thematic long duration positions.
the next 3-6 months (the visibility is admittedly much
poorer beyond that). Market and political forces should                                Monetary policy is in general too lax across most of the
and do encourage Asia to feature prominently in the                                    region. And while our economists are looking for between
adjustment needed in G2 exchange rates in the wake of                                  50-100bp of rate hikes in pretty much every country in
the crisis in those regions. But as policy makers become                               Asia next year, policymakers are likely to remain
increasingly less welcoming to such capital for fear that                              constrained in their pacing of interest rate tightening as
the absorptive capacity of their economies fall short, gains                           they struggle to deal with the domestic monetary
in local markets could get more punctuated by volatility                               implications of capital inflows. Market interest rate
around the shape and form of regulatory controls and                                   curves will steepen in such an environment to express
administrative (as against monetary policy) measures.                                  the tail risk on inflation.

Local market returns expected in the next 12 months                                    Supply dynamics are also likely to get more
                                    currency         duration*
                                                                                       challenging in parts of Asia in 2011, as the delta from
                                                                                       fiscal consolidation falls (and even reverses in some
     12%                                                                               cases). The headwind will not necessarily be from the
                                                                                       availability of liquidity (as central banks struggle to fully
                                                                                       sterilize their intervention), but in terms of appetite for
                                                                                       duration. The skewed liability profiles of government debt
      6%                                                                               in at least some of the markets might preclude cutting
                                                                                       back on the DV01 of issuance to mitigate any adverse turn
                                                                                       in sentiment.


                CNY HKD IDR             INR KRW MYR PHP SGD THB TWD
Source: Deutsche Bank *calculated using 10Y government bond yields

Deutsche Bank AG/London                                                                                                                                  Page 97
10 December 2010                    Fixed Income Outlook 2011

Supply outlook is more mixed for 2011                                                               China
Year-on-year increase in gross LC bond issuance in 2011*
                                                                                                    China local rates should underperform in 2011 as
                                                                                                    inflation outlook and policy response remains
                                                                                                    uncertain while the PBoC shifts its stance from ‘loose’
                                                                                                    to ‘prudent’. Fixed income market performance will hinge
    30%                                                                                             crucially on the pace of this transition, as well as the
                                                                                                    choice of policy instruments by the CB.
                                                                                                        In H1, we foresee greater chance for bond yields and
    10%                                                                                                 rates to break higher and overshoot on the back of
                                                                                                        rising CPI and heightened risk of policy tightening
                                                                                                        through interest rate hikes (DB is calling for 75bp in
                                                                                                        tightening till June 2011).
              INR       TWD THB         CNY KRW           HKD SGD              PHP    IDR     MYR       We could see a turning point on bond yields early in
Source: Deutsche Bank    *2011-12 for HK and India, and 2010-11 for Thailand                            H2 as inflation and real GDP growth decelerate,
                                                                                                        causing the policy bias to likely stay more neutral until
In the event that increasingly punitive measures to                                                     end of the year.
restrict capital inflows were to slow down the flow of
                                                                                                        We expect 10Y CGB yield to drift towards 4.2% in H1
foreign purchases of bonds, it would likely expose – in
                                                                                                        and stay around that level through end of the year. 1Y
markets like Indonesia and Malaysia – a particularly
                                                                                                        PBoC bill yields in the primary auctions should follow
large bid-ask spread between the current level of
                                                                                                        1Y deposit rate to rise towards 3.3%-3.5%.
yields and where local investors might again get
interested. This could cause significant bear steepening                                                Liquidity conditions should get progressively tighter
in curves. In others, which are only now beginning to                                                   as money supply/loan growth decelerates. Money
open up to foreign capital (like India or the Philippines), or                                          market rates should continue to climb as PBoC
have strong domestic bids from investors with long term                                                 delivers further interest rates and RRR hikes. Our
liability profiles (like in Korea), the technicals should prove                                         base case view is for the 3MMA of 7D repo rate to
more supportive.                                                                                        settle between 3-3.2%, and 3M Shibor at above 4%.

                                                                                                        Shibor swap curve is likely to underperform the repo
The curves might need to re-price significantly in                                                      swap curve on interest rate hikes, hence widening
markets like Malaysia to make them attractive to local                                                  risk in Shibor Repo IRS basis.
investors again
                                                                                                        CGB supply risk is low but market’s appetite for
   5.0                     domestic purchases (3m rolling sum, right)                          25
                                                                                                        bonds is likely to be lukewarm in H1 considering the
                           5y av yield (left)
                           10y av yield (left)
                                                                                               20       uncertainty of policy response. We estimate net
   4.5                                                                                                  financing requirements for the central government at
                                                                                 MYR bn        15
                                                                                                        CNY920bn, 70bn more than in 2010. Gross CGB
   4.0                                                                                         10       issuance will reach CNY1498bn next year, 3.5% more
                                                                                              5         than in 2010. Total net issuance by the central and
   3.5                                                                                                  local government is approximately 6.7% higher than
                                                                                                        in 2010. Commercial banks will absorb roughly half of
                                                                                              -5        the net supply, and the rest will be split between
                                                                                              -10       insurance companies, funds and other investors.
   2.5                                                                                        -15       Outlook on CNH bond market: (a) We expect CNH
         Feb-08     Jul-08      Dec-08      May-09       Oct-09       Mar-10         Aug-10             deposits to more than double from November this
Source: Deutsche Bank, BNM                                                                              year to about 500bn by the end of next year. (b) More
                                                                                                        issuers are likely to tap the CNH bond market for
Finally, carry will likely outweigh on a 12-month horizon                                               attractive cost of financing; we forecast gross
the negative delta from higher rates in markets like India                                              issuance at CNY150bn in 2011 (130bn net), 90bn
(and even China), as local dynamics, including significant                                              more than in 2010. (c) While a majority of the supply
pools of domestic captive investor base would help cap                                                  will come from high grade names, we expect
bond yields.                                                                                            growing number of other corporates to seek funding
                                                                                                        in this market.

Page 98                                                                                                                                Deutsche Bank AG/London
10 December 2010                  Fixed Income Outlook 2011

Strategy: (a) Stay defensive in the 2-3Y tenors on the CGB                    Risk: A re-pricing of Fed rate expectations, and/or slow
and policy bank bond curve, extend duration on dips. (b)                      down in the pace of CNY appreciation.
Pay 5Y Shibor-Repo basis swaps to position for policy rate
hikes at flat carry. (c) Buy short dated CNH bonds.                           Front-end Hi/Li basis is highly directional with CNY
Risk: Downside surprises on CPI or a less hawkish PBoC                        appreciation expectation
could change the outlook on rates. The key risk to the                                                12M USDCNY NDF       2Y Hi/Li basis
CNH market would be from regulatory changes, or if there
                                                                                     7.6                                                     30
arises a significant dislocation between CNH and CNY
                                                                                     7.4                                                     20
spot pricing.                                                                        7.2                                                     10
Policy rate, CPI and CGB yield                                                       6.8
                        10Y CGB         1Y Depo       CPI YoY (rhs)                                                                          -20
  5.0                                                                    10                                                                  -30
  4.5                                                                    8             6                                                     -40

                                                                         6           5.8                                                     -50
                                                                                     5.6                                                     -60
  3.5                                                                                   Dec-07            Dec-08       Dec-09           Dec-10
                                                                              Source: Deutsche Bank

  2.5                                                                    -2
  2.0                                                                    -4
                                                                              Liquidity and inflation dynamics will be key drivers of
     Jun-06              Jul-07       Aug-08      Sep-09        Oct-10
                                                                              the rates market as policy normalization enters into
Source: Deutsche Bank
                                                                              its final lap; carry should be more important than
                                                                              duration risk on the cash bond curve. The key theme in
Hong Kong                                                                     fixed income markets in 2010 was the big swing in
The key drivers for HK rates would be US rates, CNY                           liquidity, beginning with but not limited to the much higher
appreciation and equity market performance. With Fed                          than expected take up in the 3G/BWA auctions, which
likely on hold, HKD liquidity should remain flush over the                    resulted in what has turned out to a significant mismatch
next three to six months although a couple of large IPO                       between receipts and spending of the government. While
funding activities could cause short-dated Hibor to                           this episode probably just brought forward what was an
underperform US rates temporarily. We take a tactical                         inevitable squeeze, it did provide an opportunity for the
bullish view on the front-end of HKD rates where                              CB to effectively tighten monetary settings by as much as
significant tightening by the Fed has been priced in –                        150-bp (then the width of the LAF corridor), and underline
140bp in 1 year vs. our forecast of 25bp. We see                              its blessings for the switch to repo (from reverse repo) as
widening risk at the front end of the Hibor-Libor basis                       the effective policy rate. Except for a brief period, the
curve since we expect faster CNY appreciation in 2011                         banking system has since been a net borrower from RBI.
(5% against the USD)) and a possible widening in the                          The cash squeeze has got uncomfortably worse recently,
USDCNY trading band to push USD-HKD forwards lower.                           with borrowings on the LAF window averaging INR1tn in
The long-end of the basis curve is more likely to narrow                      the month of November. The CB still considers the same
from current levels on corporate liability hedging flows.                     as frictional shortage, though we fear that it might also
We estimate net HKD government bond issuance at HKD                           reflect upward stickiness in the currency-deposit ratio,
20bn in 2011 with key tenors in 2Y, 5Y and 10Y, and gross                     because of greater transactional demand for cash in line
EF notes issuance at HKD16.4bn, to fully roll over                            with high food price inflation. We think for all its inflation
maturing paper.                                                               concerns, RBI will not sacrifice its growth bias, and will
                                                                              strive to provide sufficient reserve money growth to
Strategy: (a) Receive (tactically) 6m forward 2Y HKD IRS                      ensure credit is not hampered. Of course, with little or no
fixed at 1.03% (this position carries 4bp of roll down per                    addition as yet to NFA on its balance sheet, it would do so
month). (b) Receive 2Y/5Y/10Y butterfly spread at 1.2bp                       mainly via lending to the banking system through LAF, and
carry per month. (c) Receive 2Y Hi/Libor basis at -20bp,                      that more or less pegs the front end of the curve to the
with a target of -35bp and a stop loss at -10. Pay Hi/Li                      repo rate. We see the front end as fairly pricing in rate
basis at the long-end (5Y or 10Y).                                            hike expectations at this stage, given in particular the delta
                                                                              of a more significant positive swing in liquidity after the

Deutsche Bank AG/London                                                                                                                     Page 99
10 December 2010                     Fixed Income Outlook 2011

turn of the quarter (as government spending surges into                                 domestic asset managers, causing domestic appetite
end of the fiscal year, and because of RBI’s efforts to                                 to dry up early on in the year.
ease the cash situation). The possibility of such swings
                                                                                        Capital flows are straining domestic monetary
will give tactical opportunities to trade the slope of the
                                                                                        management for the CB, and have pushed overnight
curve, like at the moment. We see the back end as more
                                                                                        rates to almost 85bp below policy rates. It will have
likely to re-price higher (in yields) if the inflation trajectory
                                                                                        to fight back to retain greater autonomy on its
remains sticky. As for the cash bond curve, fiscal
                                                                                        monetary conditions in 2011, and that would likely
consolidation, the SLR bid from banks (the importance of
                                                                                        have to include more punitive tax or quantitative
which is even more obvious now as it remains the only
                                                                                        measures to restrict capital inflows. We expect the
source of borrowing liquidity), and the expansion in
                                                                                        same to focus more on restricting foreign inflows into
foreign access to local markets; should mean carry will
                                                                                        short term instruments, but is likely to increase the
exceed any negative delta from duration.
                                                                                        regulatory risk premium across markets and curves.
Strategy: Tactical 2Y/5Y steepeners on the OIS curve; buy                               If the same were to then slow down offshore
local currency HG corporate debt for carry.                                             purchases of bonds, it might require a significant re-
                                                                                        pricing of the bond curve to make it attractive for
Risk: Persistent liquidity shortage beyond quarter end.                                 domestic investors to step in to buy duration. The
                                                                                        supply to be absorbed in 2011 will be up a substantial
Liquidity should ease in the Jan-Mar quarter as                                         49% (local currency, net) year-on- year, though like
government spending picks up                                                            with this year, the biggest positive risk to these
   2.0                                                                                  numbers could be from the government carrying over
                                            addition to liquidity   govt non-
                                                                    int exp             surplus financing over the budget year as a result of
                                   INR tn
                                                                    int                 under spending (realization on budget disbursements
   1.0                                                                                  was a poor 56% up until November 22).
                                                                    corp tax
                                                                                 Strategy: Underweight duration, with a more tactical buy-
                                                                    receipts     on-dips strategy if 10Y yields backs up above 8%.
                                                                    issuance     Risk: The global flow of funds seeking EM exposure
                                                                    issuance     continues to overwhelm fundamentals.
                                                                    of SDLs
                                                                    maturities   It might need a significant re-pricing of the yield curve
                                                                    chg          to make it attractive for local investors again
                                      withdrawal of liquidity       currency                                       domestic purchases (3m rolling sum, right)
  -2.0                                                                                18.0                                                                      40
                                                                    total                                          5y yield (left)
          Jun-10      Aug-10        Oct-10       Dec-10   Feb-11
                                                                                      16.0                         10y yield (left)                             30
Source: Deutsche Bank, CEIC, RBI

                                                                                      14.0                                                                      20

Indonesia                                                                             12.0                                                                      10

The risk reward on owning duration is poor as the                                     10.0                                                                      0
curve is too expensive relative to history and to
market liquidity. While Indonesia has been one of the                                  8.0                                                                      -10

key beneficiaries of the re-allocation of global capital                               6.0                                                            IDR tn    -20
towards EM assets, we worry about the following;
                                                                                       4.0                                                                      -30

         The CB is at risk of falling behind the curve, as the                               Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10
         output gap closes and supply side constraints                           Source: Deutsche Bank, Ministry of Finance

         manifest themselves more acutely in 2011.

         It is likely to have a limited tolerance for further                    Korea
         appreciation in the currency, as is already obvious in                  Korean rates curve is likely the best expression of
         the pickup in its pace of intervention.                                 inflation tail risks in the region, with regulatory
         This the flattest the yield curve has ever been ahead                   uncertainty and North Korean tensions adding to the
         of a rate tightening cycle, with offshore flows having                  case for steepening. The macroeconomy should
         driven rates significantly below hurdle rates for                       normalize to more trend growth, but there remains a
                                                                                 wider band of uncertainty around the inflation profile for

Page 100                                                                                                                              Deutsche Bank AG/London
10 December 2010              Fixed Income Outlook 2011

next year. The inflation momentum is on the rise, and                       Malaysia
while weather related supply shocks can be blamed for
part of the same (and one can hope that would normalize),                   Reversal of fiscal consolidation is likely to cause
but narrowing economic slack and exposure to                                Malaysian fixed income to underperform inspite of a
commodity prices pose upside risk. Our economists’                          benign policy/inflation mix in the near term. The cross
projections put the CPI trajectory yet again threatening the                currents we expect should eventually cause the curve to
top end of the BOK target band of 2-4% by late 1Q/early                     bear steepen. Among the more supportive factors for the
2Q. That said, the central bank is unlikely to step up the                  rates outlook include, 1) the demand side price pressures
pace of normalizing its policy. DB expects three evenly                     should be modest as growth slows down to 4%E versus
spread out rate hikes through 2011, which seem mostly                       potential of 4.5%E; 2) having been ahead of the curve this
priced in by the curve. Appreciation in the currency (which                 year, Negara should be able to avoid raising rates till likely
remains cheap on valuations, and supported by current                       H2 when real rates threaten to become negative; 3) the
account flows) should do some of the leg work in                            currency is still one of the cheapest in the region on our
tightening monetary conditions for the CB; but equally a                    REER valuation metric; and 4) BNM is more likely to deal
highly leveraged household sector, and fears of furthering                  with the monetary implications from capital inflows via
capital inflows would constrain any more rapid pace of                      hiking reserve requirements or possibly administrative
monetary tightening. The burden of a higher growth-                         measures to deal with price pressures in specific sectors
inflation mix would then be borne we think by a higher                      (for example, mortgage rules), as against capital controls.
curve premium. The bond market technicals are more                          But as growth considerations for the government seem to
mixed. The latest indications from the MOF suggest only                     again be more important than fiscal consolidation, the
an 8% increase in net issuance of KTBs. But we expect                       market will see probably the biggest swing in supply
them to increase the proportion of long end supply, with                    dynamics for any country in Asia, with gross issuance up
10Y sector likely between 25-40% of issuance. Interest                      50% on the year (net +26%). Our economists point out
from foreign investors (who sponsored 53% of net                            that for all the promises of a smaller role for the public
issuance this year) will be more subject to stonewalling by                 sector in the new Economic Transformation Program
the authorities. The withholding tax is almost a done deal                  (ETP), the 2011 Budget shows that large fiscal deficits are
(and arguably in the price), but more is likely in store in the             here to show. Indeed, Malaysia is an outlier among EM in
form of capital control measures.                                           this respect, and in that the debt trajectory (if not the
                                                                            quantum of debt) is more akin to DM economies. With
Strategy: Pay 1Y/5Y steepeners (target 100bp) with a                        64% of the outstanding MGS maturing in the next 5 years,
carry and roll of 3bp/month; scale into short 3Y KTB                        the ability of the government to soften the duration impact
futures versus IRS into end of the year.                                    of such an increase in supply would be limited. While
                                                                            there is potentially ample liquidity in the domestic markets
Risk: A more hawkish than expected stance by the CB                         to fund the borrowing plans of the government, there is
could force a re-pricing in the front end of the curve.                     not necessarily the appetite. Foreign investors have
                                                                            bought equivalent of 1.6x the net issuance of MGS this
Will offshore appetite be dampened by capital control                       year, in the process driving yields significantly below
measures next year?                                                         hurdle rate for domestic asset managers. While currency
                                                                            return expectations (and possibly the fact that the markets
Net purchases of KTBs by foreigners
                                                                            here are more likely to remain open for business than
                                                                            others) could further this case, the lack of domestic
                                       net purchases/net                    appetite is likely to bite in the face of heavy supply. With
                                     issuance (12m rolling)                 both banks and EPF being net sellers of risk for all of this
                                                                            year, and EPF having recently got the go-ahead for an
                                                                            increase in offshore investment limits from current 7% to
                                                                            20%; we doubt if current valuations will interest them.
                                                                            They, like offshore investors, could find it more appealing
                                                                            to go down the credit curve (and PDS issuance could
                                                                            increase on the back of the government’s ETP proposals).
                                                                            Strategy: Reduce duration on the cash curve; pay 2Y/5Y
                                                                            IRS steepeners on dips towards 50bp.
            D-07    A-08   A-08   D-08   A-09   A-09   D-09   A-10   A-10

Source: Deutsche Bank
                                                                            Risk: (1) Reallocation of EM money as other peer group
                                                                            raise barriers to capital inflows; (2) renewed effort

Deutsche Bank AG/London                                                                                                          Page 101
10 December 2010                Fixed Income Outlook 2011

towards selling government stakes could lessen the need                      particularly given the costs of currency appreciation to the
to fund the budget via the bond markets; and (3) a strong                    competitiveness of its export industry, and the balance
verdict for BN if the PM decides to call early elections                     sheet cost for the CB in sterilizing intervention liquidity via
could raise hopes of expediting fiscally prudent strategies                  SDAs. But the risks of capital controls we still think are
like implementation of GST.                                                  relatively limited in this market, with the CB relying more
                                                                             on other market based measures, like forcing down FX
Reversal of fiscal consolidation                                             implied yields by lettings its forward swap contracts
                               deficit      net domestic financing
                                                                             mature, thereby making it unattractive to hold peso longs
            MYR bn
                                                                             at these levels. Technicals of the market are strong, with
  50                                     60%                -35% 26%         flush liquidity onshore, and growing interest in accessing
                                                                             local rates by global investors after the launch of the GPN
                                                                             deal. A key factor to watch would be if the desire to avoid
                                                                             further dollar inflows causes the Treasury to lean more
               45%                                                           heavily on domestic issuance, already pegged at 73% of
                                                                             gross offerings for next year (vs. 67% average in the last 5
                                                                             years). Note also that the liability restructuring exercise
                                                                             being undertaken by the Treasury is likely to cause a
                                                                             heavier supply of duration to the markets (e.g., it will be
                                                                             auctioning a 25Y paper every quarter in 2011).
             2006       2007         2008        2009      2010E     2011F
                                                                             Strategy: Market weight; add to duration on any backup
Source: Deutsche Bank
                                                                             in yields north of 6.5% (10Y).

Philippines                                                                  Risk: The honeymoon period for President Aquino comes
                                                                             to an end without significant yield from his government’s
Valuations have richened significantly, but benign
                                                                             fiscal efforts.
macro fundamentals remain supportive of local fixed
income. The two big game changers for peso markets in
2010 were, 1) the election of a popular (albeit, relatively                  Surplus liquidity parked with BSP
inexperienced) President boosting both investor                                1400                               special deposit accounts
sentiment, and credit ratings; and 2) launch of the first                                                         reverse repo
                                                                               1200        P billion
global peso bond by the government, which opened up a
new investor base hitherto unable to access local rates in                     1000
the Philippines because of the cost and logistics of
onshore payment and settlement of withholding tax, and
which has meant inclusion of the sovereign in EM local                           600
currency indices like GBI. The good intentions and
technocratic profile of the new set of economic managers                         400

has translated into some early successes, including (for                         200
bond investors in particular) a relatively smooth passage
thus far for the Budget, and plans in motion for debt                               0
consolidation. The key question for 2011 is if the Aquino                               S-06     A-07      N-07      J-08     J-09     A-09   M-10   O-10
premium can translate into a more sustained fiscal                           Source: Deutsche Bank, CEIC

consolidation effort, and a new investment boom (for
which the success of the new public-private partnership                      Singapore
initiatives of the government will be essential). Outside of
that, the macro backdrop is enviably benign with a) an                       Singapore rates should outperform the US as the
unthreatening inflation trajectory which puts BSP as                         global growth backdrop improves, with its safe haven
among few central banks in Asia not under pressure to                        and financial centre status attracting more capital
tighten monetary conditions (outside of what is being                        inflows. The key dynamic in Singapore fixed income this
achieved via FX appreciation); and b) strong balance of                      year has been the record issuance of corporate debt (SGD
payments with a cleaner profile, underwritten by steadily                    25bn, Vs SGD11.5bn in 2009), which has provided an
growing remittance (DB expects 7% increase in 2011) and                      attractive investment opportunity for banks and asset
BPO dollars, versus short term portfolio capital. That is                    managers. This has cheapened the SGS curve, particularly
not to say Philippines does not have to deal with                            around the 10Y part. As the structural reallocation of
managing the monetary implications of capital inflows –                      capital out of G3 into EM continues in 2011, one can

Page 102                                                                                                                         Deutsche Bank AG/London
10 December 2010                     Fixed Income Outlook 2011

expect strong capital inflows (both portfolio and FDI) into                         Taiwan
Singapore. Additionally, as other Asian economies
consider capital controls to prevent financial instability,                         We retain our core bearish view on Taiwan rates,
Singapore, with its transparent and deep financial markets                          which we expect would normalize albeit slowly in
is likely to be used as a proxy to play the Asian FX                                2011. DB expects four policy rate hikes over the course of
appreciation theme. MAS intervention in the FX market to                            the year, to bring the policy rate (discount rate) to 2% by
prevent the NEER from breaching the top end of the band,                            the end of 2011. We forecast 10Y TGB yield to rise
is likely to inject liquidity (assuming <100% sterilization)                        towards 1.60% over the next 12 months. The front end of
thus increasing the deposit base of banks. This should be                           the NDIRS curve is currently pricing in close to 35bp in
supportive of bank demand for SGS, which is mostly in                               hikes over the next 12 months, which is less aggressive
the front end and belly of the curve. Liquidity ratio in                            than our forecasts. We believe the risk-reward still favours
banks has fallen to multi year lows with banks seeking this                         positioning from the short side in this market - paying on
year to improve profitability by going lower in the credit                          dips or putting on curve steepeners. The 2Y/5Y slope has
spectrum (corporate bonds do not qualify for SLA). As                               been directional to the level of interest rates – bull
growth in Singapore normalizes into 2011, and the pace of                           flattening and bear steepening, and we expect such
corporate issuances slows down, this should leave banks                             directionality to hold. Steepeners currently cost nothing in
with more investible deposits to put into SGS. Bonds                                carry and roll down. Technicals for the cash bond market
should therefore be able to outperform swaps in a bearish                           on the other hand should be fairly supportive for 2011. We
rates environment. Historical data also suggests that                               estimate the gross government bond supply (TGB) to
swap spreads are directional. Singapore rates should                                decline by 18% from TWD 610bn to about 580bn in 2011,
outperform the US, and this is an inexpensive way to                                equivalent to about 22% reduction in net issuance. We
position for backup in global yields. With a historical beta                        forecast net demand for bonds to be at least TWD 350bn,
of 0.48, upside in Singapore rates should be limited in a                           of which, 62% should come from lifers, 25% from the
bear fixed income scenario.                                                         Post and the rest from monetary institutions and other
                                                                                    investors. Demand from foreign investors will likely be
Strategy: (1) Pay 5Y swap spreads below +50bp, with a                               low as it is restricted by the new limit on foreign holding
target of +90bp (stop +35). Since the repo is 25bp below                            of TGB bonds.
the SOR fixing, this position can be taken at flat carry and
                                                                                    Strategy: Pay DV01 neutral TWD 2x5 steepeners at 53bp
roll down. (2) Receive Singapore rates versus the US.
                                                                                    with a target of 73bp and a stop loss of 40bp.

Risk: Weaker than expected data in the US could again                               Risk: Aggressive liquidity withdrawal or faster monetary
cause the market to price out any exit from easy money                              tightening by CBC poses bear-flattening risk to the curve.
policy by the Fed.
                                                                                    Directional risk in TWD NDIRS 2Y/5Y curve slope
Bank liquidity ratio is at multi year lows, which
                                                                                    (data since July 2009)
should be technically bullish for SGS demand
    80                                statutory liquid assets (SGDbn, left)   21%
                                                                                                                 y = 159.25x - 93.401
                                      liquidity ratio (right)                                      90
                                                                                                                      R² = 0.5206
                                                                              20%                  80

    70                                                                                             70
                                                                                     2/ 5 Sl ope

                                                                              18%                  50
    55                                                                                             30

    50                                                                        16%                  20

         J-07     J-07        J-08    J-08     J-09      J-09   J-10   J-10                              0.80   0.85    0.90     0.95      1.00   1.05   1.10   1.15
                                                                                                                                    2Y r at e
Source: Deutsche Bank, CEIC                                                         Source: Deutsche Bank

Deutsche Bank AG/London                                                                                                                                     Page 103
10 December 2010      Fixed Income Outlook 2011

Thailand                                                         Risk: A pickup in forward dollar sales by exporters could
                                                                 again widen the negative spread between the policy rate
We recommend cutting back duration going into 2011               and 6M THB swap fixing, pulling down the front end of
and look to actively trade curve exposure to generate            the curve.
returns. Technicals of the bond market should remain
supported by growing demand from local asset managers            DV01 supply is likely to be 26% higher in FY2011*
and offshore EM debt funds, but we are concerned about               4                 FY 10         FY 11
the following;
                                                                                          USD mn
    DB expects 100bp of rate hikes by BOT in 2011, as                3

    domestic demand led growth intensifies inflationary
    pressures in the economy. The CB has maintained
    that monetary policy needs to be pre emptive in
    preventing core inflation in 2011 from breaching the
    top end of the inflation band (0.5%-3%).                         1

    Post the imposition of WHT, bond inflows have
    slowed down sharply as foreign investors, (who                   0
    sponsored one third of net issuance in FY10) remain                             Q1                     Q2                     Q3                    Q4
    wary of increase in regulatory risk. The baht has            Source: Deutsche Bank, BOT, * The DV01 supply is based on the current level and shape of the yield
    already appreciated by over 10% YTD despite active           curve

    FX intervention by the BOT, and the authorities are
    unlikely to be tolerant of another sharp move higher.                                    Sameer Goel, Singapore, (65) 6423 6973
    A pick up in capital inflows again in 2011 would likely                                   Linan Liu, Hong Kong, (852) 2203 8709
    be met with further restrictive measures. Greater                                        Arjun Shetty, Singapore, (65) 6423 5925
    control over capital inflows would in turn allow the
    central bank more traction on normalizing its
    domestic interest rate policy.

    The curve is very flat with backend yields below the
    hurdle rate for local insurers and pension funds
    (estimated at between 4.5-5%). With falling birth
    rates and policies to limit the size of the civil service,
    for example, there is a need for major fixed income
    investors like GPF (Government Pension Fund) to
    increase investment returns to fund future liabilities.
    This will mean diversifying out of low yielding local
    fixed income into equities, commodities and credit.

    Even though nominal issuance in FY11 is similar to
    FY10, the supply of DV01 is likely to be much higher,
    because PDMO has decided to issue a higher
    proportion of bonds in >10Y bucket in order to extend
    the maturity profile of its liabilities. Statements from
    PDMO suggest Q2 will most likely see the peak in
    supply of duration to the markets.

The recent back up in 6M swap fixing (after the BOT rate
hike) has made expressing an outright bearish view on the
curve relatively cheaper. Support from the growing AUMs
of mutual funds should also help bonds trade better than
swaps up to the belly of the curve.

Strategy: (1) Reduce duration by switching into the belly
of the curve (5-10Y). (2) Pay 2Y forward 1Y swaps, with a
target of 3.6% (we initiated this position on Oct 1, at a
level of 2.93%). This trade has a negative slide of
2bp/month. (3) Pay 5Y swap spreads at or below par.

Page 104                                                                                                                     Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

Dollar Bloc Strategy
Last week we considered the AUD fixed income market in                         We would usually turn to the shift in front-end
some depth. This week it’s the turn of Canada and NZ.                          expectations to explain the relative performance of the
                                                                               10Y CAN. While the following chart suggests that the
        The CAN and NZD front-ends have repriced in the
                                                                               relative move in expectations for the CAN front-end can
        second half of 2010 by scaling back on the extent
                                                                               very broadly explain the performance of the 10Y CAN if
        of rate hikes. More recently this has combined
                                                                               we just compare now, or perhaps more correctly a week
        with the sharp sell-off in the US long-end to
                                                                               ago, to the start of the year, there was a period of sharp
        steepen both the CAD and NZD curves.
                                                                               divergence in the two spreads in March and April. This
        This curve steepening has attracted attention and                      divergence saw the 10Y CAN outperform its UST
        if our forecasts for the BoC and RBNZ in 2011 are                      counterpart despite the CAN front-end significantly
        correct then we are likely to see material curve                       repricing the outlook for the BoC. There has also been
        flattening at some point. But with both central                        divergence in the past week as the sharp sell-off in the
        banks on hold in the near-term, implementing                           10Y UST has pushed the CAN/UST spread down to flat
        curve flatteners is akin to going long the 10Y UST                     despite little move in the short-end gap.
        – but in a negative carry fashion. For this reason
        we are avoiding flatteners until the case for front-
                                                                               10Y CAN/UST spread vs expected short-end gap
        end weakness is stronger.             Instead we
                                                                                                       1 CA N/UST spread (LHS)
        recommend receiving the 5Y5Y NZD rate at its                               0.4                                                                            1.40
                                                                                                       4th B A X/ED spread (RHS)
        current level of around 6.5%.                                              0.3                                                                            1.20
        Another trade we hare our eye on is shorting the                           0.2
        10Y CAN against the 10Y UST. This is very
        directional with the US market, however.                                                                                                                  0.80
10Y CAN yield looks set to end the year lower, but                                                                                                                0.60
underperforms 10Y UST; curve flattening the                                        -0.1

dominant trend until recently                                                     -0.2

Our starting point for this review is to look back briefly at                                                                                                     0.20
what happened in 2010, at least up to 8 December. The
first thing we’d note is that the 10Y CAN yield has fallen                        -0.4                                                                            0.00
                                                                                     Jan-10       M ar-10      M ay-10          Jul-10    Sep-10    No v-10
over the year as a whole, though as we write it is up
                                                                               Source: DB Global Markets Research, Bloomberg Finance LP
some 50bp from its low of around 2.7% in early October.
The low point for the year occurred at the same time as
                                                                               This highlights that the relative performance of the 10Y
that for the 10Y UST, though over the year as a whole the
                                                                               CAN over at least the past year has been very dependent
10Y CAN has underperformed the 10Y UST.
                                                                               on the direction of the 10Y UST (see below).

10Y CAN and 10Y UST in 2010
                                                                               10Y CAN/UST spread vs 10Y UST – the directional link
                                                                   1 CA N
                                                                               has been very strong
  3.8                                                                             0.5                                                                              2.2
                                                                                                   1 CA N/UST spread (LHS)
                                                                   1 UST
  3.6                                                                             0.4                                                                              2.4
                                                                                                   1 UST - inverted (RHS)
  3.4                                                                             0.3                                                                              2.6

  3.2                                                                                                                                                              2.8
  3.0                                                                              0.1
  2.8                                                                             0.0
  2.6                                                                             -0.1
  2.4                                                                             -0.2                                                                             3.8
  2.2                                                                             -0.3                                                                             4.0
    Jan-10        M ar-10        M ay-10         Jul-10   Sep-10     No v-10
                                                                                  -0.4                                                                             4.2
Source: DB Global Markets Research, Datastream
                                                                                    Jan-10        M ar-10       M ay-10          Jul-10    Sep-10     No v-10

                                                                               Source: DB Global Markets Research, Datastream

Deutsche Bank AG/London                                                                                                                                       Page 105
10 December 2010                   Fixed Income Outlook 2011

The outperformance by the 10Y CAN in March/April                                          Marketing pricing for the BoC in 2011 only has modest
reflected the upward spike in the 10Y UST yield. The                                      rate hikes
reversal of the UST sell-off then saw the 10Y CAN/UST
spread ‘catch-up’ with the widening short-end differential.                                                          B o C o vernight rate
The recent spike in the 10Y UST above 3% has seen the                                        1.5
                                                                                                                     Overnight rate priced by
10Y CAN/UST spread drop sharply and by more than                                             1.4                     the market
implied by the move in the short-end spread.

The link between the front-end and the curve over the                                        1.2
past 12 months has also been somewhat shaky, though in
general terms of the lift in expectations about the cash
rate has been associated with a flattening in the curve.                                     1.0
Indeed, the flattening of the 2Y/10Y slope from mid-                                        0.9
February to the end of September was one of the
strongest trends in the Canadian market over the course
                                                                                                        0      0     1
                                                                                                   Sep-1 No v-1 Jan-1 M ar-1 M ay-1 Jul-1 Sep-1 No v-1
                                                                                                                            1      1     1     1      1
of 2010.
                                                                                          Source: DB Global Markets Research, Bloomberg Finance LP

2Y/10Y CAN slope
                                                                                          Still, it is our expectation that the BoC will shift the cash
  2.6                                                          0Y
                                                           2Y/1 CA D swap           0.4   rate upwards by considerably more than is currently
                                                                                          priced. This has us looking for the yield curve to flatten
  2.4                                                                               0.6
                                                           3M rate implied by             materially as a whole over 2011 and for the 10Y CAN/UST
                                                           B A 2, inverted
  2.2                                                      (RHS)                    0.8   spread to widen – unless we get a further major sell-off in
                                                                                          the 10Y UST. If we do get a large sell-off in the 10Y UST,
  2.0                                                                               1.0   to 4% say, then the experience in 2010 suggests that as
  1.8                                                                               1.2
                                                                                          far as relative performance is concerned this will dominate
                                                                                          any movement in the relative short-end gap and the 10Y
  1.6                                                                               1.4   CAN will outperform, with the spread moving into
                                                                                          negative territory, i.e. the 10Y CAN yield dropping below
  1.4                                                                               1.6
                                                                                          that of the 10Y UST.
  1.2                                                                               1.8
    Jan-10        M ar-10       M ay-10         Jul-10         Sep-10     No v-10         Though pricing has lifted from the recent low
Source: DB Global Markets Research, Bloomberg Finance LP
                                                                                            3.0                                        1
                                                                                                               3M rate implied by Dec-1 B A future co ntract

There has been a partial reversal of this trend since the                                   2.8

end of September. This has in part reflected a modest                                       2.6
rally in the front-end as the market has pushed out rate                                    2.4
hikes, but also the sell-off in the US long-end since early

CAN front-end not adequately priced for the eventual                                         1.8
resumption of rate hikes by the BoC                                                          1.6
Our starting point for thinking about relative market
performance and the CAN yield curve in 2011 is market
pricing for the cash rate in 2011. As we write the market
                                                                                              Jun-10        Jul-10      A ug-10       Sep-10         Oct-10   No v-10   Dec-10
has around 50bp of hikes priced for next year. When we
                                                                                          Source: DB Global Markets Research, Bloomberg Finance LP
consider the still very low level for the overnight rate this
level of pricing doesn’t look to be all that much. It is,
                                                                                          Given our outlook for UST yields and the BoC cash rate for
however, a reasonable amount more than was priced for
                                                                                          2011, our base case has 10Y CAN yields modestly higher
2011 at the recent low in expectations in mid-October. At
                                                                                          by the end of 2011 than currently – but with lots of
that point the market was barely pricing one rate hike into
                                                                                          volatility over the year and the opportunity to trade from
2011. This means we can’t take for granted that market
                                                                                          both the short and the long-side. We have the 10Y
expectations for the cash rate can only shift higher from
                                                                                          CAN/UST spread reaching a peak of perhaps +75bp at
this point.
                                                                                          some point, though this forecast does require the 10Y
                                                                                          UST yield to drop back under 2.5% while at the same time

Page 106                                                                                                                                             Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

the market anticipates a numbers of BoC rate hikes. Such                           We think the front-end rally has been a factor in pushing
a combination will produce a very sharp flattening of the                          the NZD yield curve back to its steepest point for the year.
yield curve and we think the curve flattener will be one of                        But the following chart makes it quite clear that the move
the key trades in 2011 at some point.                                              in the NZ front-end has only been one factor in
                                                                                   determining curve shape. There have been long periods
The phrase “at some point” is an important caveat. As                              in 2010 when the move in the curve has diverged
we write the US sell-off is causing the yield curve to                             substantially from the move in the short-end. And the
steepen and the 10Y CAN/UST spread to fall. This                                   very sharp steepening in the yield curve since early
pressure will continue if the US long-end sells-off further,                       November has in large part reflected the dramatic sell-off
since we don’t have any near-term expectation of BoC                               in the 10Y UST – from around 2.5% in early November to
rate hikes to act as an offset to the impact of the UST                            more than 3.2% as we write.
direction. This means we are not yet recommending the
CAN curve flattener or the 10Y CAN/UST spread widening                             With this pullback having implications for the yield
trades.                                                                            curve
                                                                                     1.8                     0Y
                                                                                                         2Y/1 NZD swap curve (LHS)                                     3.4
NZ growth lost momentum in 2010 and with it the                                                          3M rate implied by ZB 4, inverted (RHS)
                                                                                     1.7                                                                               3.6
push for a higher cash rate and flatter yield curve
The RBNZ has just delivered its final formal commentary                              1.6                                                                               3.8

for 2010 with the publication of the December Monetary                               1.5                                                                               4.0

Policy Statement (MPS). The opening comment from the                                 1.4                                                                               4.2
Bank is that “the pace of economic growth appears to
                                                                                     1.3                                                                               4.4
have moderated, reflecting weak domestic demand and
                                                                                     1.2                                                                               4.6
the constraining effects of the high New Zealand dollar.”
We think this loss of momentum has been dominating                                    1.1                                                                              4.8

market thinking for some time, with the front-end rallying                           1.0                                                                               5.0

and the yield curve steepening as a consequence. The                                 0.9                                                                               5.2
recent sell-off in the US long-end has contributed to the                              Jan-10       M ar-10        M ay-10          Jul-10    Sep-10    No v-10

pressure on the curve to steepen.                                                  Source: DB Global Markets Research, Bloomberg Finance LP

Expectations about the pace of RBNZ rate hikes have                                As far as the absolute movement in the NZ long-end is
                                                                                   concerned, the following chart shows that on the morning
fallen sharply since the start of 2010
                                                                                   of 9 December the 10Y NZGB yield was still about 30bp
                                                              3M rate implied by   below its starting point for the year of a little above 6%.
  5.0                                                         4th futures          But there has been a pullback of some 80bp since the
                                                              co ntract
                                                                                   yield low for the year in early October.

                                                                                   Path of 10Y NZGB heavily influenced by direction of
                                                                                   the 10Y UST
                                                                                     6.2                                                                                4.2
                                                                                     6.0                                                         0Y
                                                                                                                                                1 NZGB (LHS)
  3.6                                                                                                                                            0Y
                                                                                                                                                1 UST (RHS)             3.6
  3.4                                                                                                                                                                   3.4
    Jan-10         M ar-10       M ay-10         Jul-10    Sep-10    No v-10         5.4                                                                                3.2
Source: DB Global Markets Research, Bloomberg Finance LP                                                                                                                3.0
Expectations about the pace of tightening by the RBNZ                                5.0
have actually been falling since the start of the year,                              4.8
though the really steep decline started in late July when
                                                                                     4.6                                                                                2.2
the RBNZ shifted the OCR to 3% but noted that “the pace                                Jan-10       Mar-10         May-10           Jul-10     Sep-10     Nov-10
and extent of further OCR increases is likely to be more                           Source: DB Global Markets Research, Datastream

moderate than was projected in the June Statement.”
From that point the 12 month ahead expectations have                               The sell-off since early October effectively matches the
dropped to the point the market is now only pricing                                move in the 10Y UST. The above chart shows that
around 50bp of hikes during 2011.

Deutsche Bank AG/London                                                                                                                                           Page 107
10 December 2010                  Fixed Income Outlook 2011

regardless of domestic influences the 10Y UST has                             But if we are going to base some trades around the
continued to play a critical role in the direction of the 10Y                 possible direction of the US long-end, we’d rather do so
NZGB. This is an important consideration for our view of                      with positive than negative carry. The trade that springs
the curve for 2011 – at least while the market thinks the                     to mind is to receive the 5Y5Y rate.
RBNZ is on hold.
                                                                              NZD 5Y5Y has backed up materially from its low
In 2011 the curve will be driven by the direction of the
US long-end until the NZ front-end starts to price a                                                                                       NZD 5Y5Y rate
more aggressive outlook for the RBNZ                                            6.8

We think there will be a lot of focus on the NZ curve in                        6.6
2011, with the eventual resumption of RBNZ tightening                           6.4
likely to cause a material flattening in the curve at some
point. But as we saw from an earlier chart, the curve is
driven by more than just the direction of the NZ front-end.
As the chart below makes clear, the US long-end also                            5.8

plays a key role. And there are times when the directions                       5.6
of the front-end and the 10Y UST combine to produce                             5.4
very sharp moves in the NZ curve – as has been the case
since early November when the rally in the NZ front-end                           Jan-10        M ar-10       M ay-10        Jul-10      Sep-10    No v-10
has interacted with the 10Y UST sell-off to push the NZ
                                                                              Source: Deutsche Bank, Bloomberg Finance LP
yield curve back to its high for the year.
                                                                              Interestingly, it hasn’t moved higher in the past few days
The NZ swap curve and the 10Y UST                                             despite the sharp sell-off in the US long-end over this
   1.8                                     2Y/1 NZD swap slo pe (LHS)
                                               0Y                       4.2   period and the steepening of the 2Y/10Y slope. We think
   1.7                                                                  4.0   this a good sign that the 5Y5Y rate has reached a level
                                           1 UST(RHS)
   1.6                                                                  3.8
                                                                              where it is starting to attract flows. We’d receive the NZD
                                                                              5Y5Y at its current level of 6.5%, with a target of sub-6%
   1.5                                                                  3.6
                                                                              and a stop around 6.75%. The key risk to the trade is a
   1.4                                                                  3.4
                                                                              sharply steeper NZ yield curve. We’ll add the curve
   1.3                                                                  3.2
                                                                              flattener to this trade when we are closer to the point we
   1.2                                                                  3.0   think expectations for the OCR are likely to push higher.
   1.1                                                                  2.8
   1.0                                                                  2.6   As far as the level of 10Y NZGBs is concerned, an earlier
  0.9                                                                   2.4   chart showed how important the direction of the US
  0.8                                                                   2.2   continues to be. If the US sell-off continues then the 10Y
    Jan-10        M ar-10        M ay-10   Jul-10   Sep-10    No v-10         NZGB will inevitably push above 6%. Alternatively, a US
Source: Deutsche Bank, Reuters                                                rally from this point will pull the 10Y NZGB back below
                                                                              5.5%. Our current forecasts for 2011 have the 10Y NZGB
Given that the NZ curve is back to its high for the year                      yield heading back under 5.5% in the first half of the year
there is a strong temptation to consider the curve flattener                  – but this depends critically on the 10Y UST dropping well
at this point. Curve flatteners incur negative carry and roll-                back below 3% over this period.
down in NZ, however. To illustrate this, the 3M forward
2Y/10Y NZD swap slope is currently 157bp – this is 10bp                                                                     David Plank, (61) 2 8258 1475
flatter than the spot slope, i.e. the curve gets steeper as it
rolls down.

Thus we simply can’t put the curve flattener on and wait
and see. We need to be confident that either the US long-
end is set to rally or the NZ front-end is about to sell-off.
Given the just released statement by the RBNZ and the
risk of a negative GDP outcome for Q3 given the
disruption caused by the NZ earthquake we think it is too
early to put in place bearish front-end rate trades. Thus
the flattener makes sense at this point in time only if we
think the US long-end is going to rally.

Page 108                                                                                                                              Deutsche Bank AG/London
10 December 2010        Fixed Income Outlook 2011

Dollar Bloc Relative Value

Last week, we published our year-ahead thoughts on the            Vol fades European concerns the second time around
AUD/USD basis swap spread. This week, we outline our              The downward trend in implied vol through the year was
view on the AUD vol market and curve relative value               interrupted on two significant occasions. The first came
across the Dollar Bloc for 2011, as discussed in the              in May, when implied vol across the surface jumped in
Australian RV Monthly published on 9 December.                    response to the first flare-up in European sovereign
                                                                  concerns. This eventually began to dissipate late in July,
     The sustained hawkishness of the RBA and
                                                                  and vol slipped away to low levels for the year at many
     associated flattening of the yield curve over the
                                                                  points on the surface. The reprieve was short lived,
     course of the year have kept AUD swaption vol
                                                                  however, because in late September the surface was
     heading downward during 2010. However, implied
                                                                  marked sharply higher again on the back of speculation
     vol remains very rich at many sectors in the belly
                                                                  about QE2 in the US at the same time as very hawkish
     of the curve. We think that volatility will continue
                                                                  RBA commentary. However, with the RBA resuming its
     to decline through 2011 as the curve flattens,
                                                                  tightening cycle at the November meeting and details of
     looking to use ratio payers and receiver trades to
                                                                  QE2 released, volatility has once again begun to slide
     target turning points in rates at the extremities of
                                                                  away, despite an intensification of the debate around
     the trading range
                                                                  European sovereign debt through the remainder of the
     Australia and Canada both have forward starting              month.
     swap slopes at the same level as spot starting
     slopes. With central banks in both countries                 In many sectors implied vol remains expensive
     expected to increase rates through next year,                Although there has been a significant fall in implied
     curves are likely to be significantly flatter and            volatility through the course of 2010, we can see from the
     these steep forward start curves offer attractive            chart below that there are many sectors where implied vol
     low-carry flattener positions.                               remains materially more expensive than 50-day realised
                                                                  volatility. Although 1Y and 2Y tenors, especially at shorter
     We recommend a 1Y forward 2Y/5Y AUD swap
                                                                  maturities are priced close to fair value, several points at
     curve flattener trade, taking advantage of the low
                                                                  the 2Y and 3Y maturities are currently realizing 1.5bp per
     rolldown on the position as well as the lower
                                                                  day less than implied by the vol market. 3Y*4Y vol is an
     exposure of the 5Y to a US long end selloff.
                                                                  example of a sector of the curve where vol is currently at
                                                                  a very rich level relative to implied volatility.
Volatility trends downwards through
                                                                  50-day realised minus implied volatility (PPD)
                                                                                                   1y     2y      3y      4y      5y      7y     10y
From early 2007 to early 2009, AUD swaption vol in the
gamma portion of the AUD swap implied rates surface               1m                         0.06       -0.04   -0.46   -0.56   -0.49   -0.81   -0.69

(less than 1Y maturity) increased by an average of 150%           3m                        -0.14       0.09    -0.34   -0.59   -0.44   -0.82   -0.73
whilst longer maturity vol increased by 61%. During               6m                        -0.34       0.13    -0.33   -0.62   -0.57   -0.81   -0.67
2009, this began to reverse, and the downward trend               1y                         0.35       -0.20   -0.62   -0.99   -0.94   -1.08   -0.72
continued through 2010.        Nevertheless, despite the
                                                                  2y                        -1.06       -1.22   -1.34   -1.68   -1.36   -1.08   -0.81
extended downward trend, implied vol remains an
                                                                  5y                        -1.30       -1.30   -0.98   -0.66   -0.13   -0.25   -0.57
average of 40% above January 2007 levels across the               Source: Deutsche Bank, Reuters
entire surface.
                                                                  Volatility looks set to continue to cheapen into 2011
Change in implied normalized vol since Jan 2010                   Our expectation is that the Australian yield curve will
                          1Y     2Y     3Y     5Y     7Y    10Y   flatten over the coming year. As a result, we expect a
3M                      -26%   -25%   -22%   -24%   -24%   -25%   steeper vol surface and an overall lower level of volatility.
6M                      -23%   -26%   -23%   -22%   -22%   -24%   However, our bearishness on volatility is slightly weaker
                                                                  than it was twelve months ago, because declines in
1Y                      -23%   -20%   -19%   -16%   -16%   -21%
                                                                  volatility this year have meant that the overall level of vol
2Y                      -19%   -19%   -17%   -15%   -17%   -18%
                                                                  is now closer to the low levels reached in 2007. We
5Y                      -13%   -8%    -9%    -11%   -12%   -7%
                                                                  continue to see the 2007 levels as a likely floor for
Source: Deutsche Bank
                                                                  volatility in Australia, because the conditions that allowed

Deutsche Bank AG/London                                                                                                                   Page 109
10 December 2010                   Fixed Income Outlook 2011

volatility to drop so low at that time are unlikely to be                                $-Bloc curve relative value outlook
repeated in the next year.
                                                                                         Rolling forward curves
We think that the relatively rich parts of the surface
                                                                                         Three different factors stand out on Dollar Bloc rolling
identified earlier in this discussion are compelling parts of
                                                                                         forward curves at present. The first is the steepness of
the surface to sell volatility. Identifying short vol trades to
                                                                                         the Australian forward curve through the 1Y to 5Y sector
mesh with a rates view through this part of the curve can
                                                                                         relative to the longer end of the curve, and the slight
be challenging, but conditional cross market trades can be
                                                                                         richness of forward rates around the 8Y forward sector
a useful strategy in some circumstances when vol
                                                                                         which has been developing for several months. This has
differentials between the two countries are favourable,
                                                                                         become more exaggerated as rates have sold off over the
such as selling AUD payers against buying USD payers as
                                                                                         past few months.
a bearish AUD/USD spread compression trade.                 Of
course, directly selling vol via straddles in this portion of
                                                                                         As an outright AUD trade opportunity the prospects for a
the curve could also be an attractive, albeit higher risk
                                                                                         correction here are limited. But combining this with the
trade, but investors with a view of stable rates into next
                                                                                         relative cheapness of the long end of the New Zealand
year could find this attractive.
                                                                                         forwards curve relative to Australia – the second point
                                                                                         which attracts our attention – could be more compelling.
The level of vol is linked to the shape of the curve                                     This has kept the 5Y*5Y NZD swap above the AUD 5Y*5Y
                           3Y/10Y futures slope
                           3M*10Y 50 day realised vol
                                                                                    16   swap in recent weeks (although the 9 December RBNZ
                           3M*2Y 50 day realised vol                                14   meeting has seen the NZD 5Y*5Y dip below the AUD
                                                                                    12   5Y*5Y rate). Given what we think are weaker growth
                                                                                         prospects for New Zealand relative to Australia, a decline
                                                                                         in the NZD 5Y*5Y relative to Australia seems possible
                                                                                         during the coming year.
         0                                                                          6

    -50                                                                                  AUD and NZD 3M rolling forward swap rates
                                                                                    2      7.5

  -100                                                                              0      7.0

         Jan-00     Oct-01       Jul-03      Apr-05   Jan-07     Oct-08   Jul-10           6.5
Source: Deutsche Bank, Reuters

Ratio payers and ratio receivers                                                           5.5

We have recommended ratio payer and receiver trades at                                     5.0
various points over the rate cycle in the past year. These
trades are attractive when volatility is high because the
trade can be struck with a relatively wide profitable payoff
region.     We think that the combination of relatively                                    3.5
expensive implied volatility and prolonged range-trading in                                3.0

longer end rates will continue to favour ratio payer and                                      Dec-10           Dec-12     Dec-14   Dec-16    Dec-18

ratio receiver trades through 2011 as rates approach the                                 Source: Deutsche Bank, Reuters

bottom and top of the yield ranges respectively.
                                                                                         The third point in the rolling forwards that we find
                                                                                         interesting is the richness of CAD ratesets through the
3M rolling forward rates
   8.0                                                                                   belly of the curve. This means CAD long forward start
                                                                                         swaps appear rich relative to USD and GBP markets.
                                                                                         Investors with a more hawkish view on the CAD economy
                                                                                         relative to the US could find opportunities in these
                                                                                         forward start swap positions during 2010. The 5Y*5Y
                                                                                         cross market spread has exposure to the affected
                                                                                         markets. 5Y*5Y swap has the advantage of being a more
                                                                                         liquid node for a long maturity forward start swap trades –
   1.0                                       AUD               NZD            USD        some other tenors might offer better scope for
                                             EUR               GBP            CAD
   0.0                                                                                   normalisation at the expense of lower liquidity, and higher
      Dec-10           Nov-12             Nov-14      Nov-16         Nov-18              volatility for more leveraged options.
Source: Deutsche Bank, Reuters

Page 110                                                                                                                           Deutsche Bank AG/London
10 December 2010           Fixed Income Outlook 2011

Forward start curves                                                   If the RBA hikes in 2011 we expect the 2Y/5Y slope to
As is to be expected in a market pricing further increase to           be flatter than currently priced by the market
the cash rate in coming years, the 3Y and longer forward
                                                                           160                AUD 2Y/5Y slope                                          2.5
starting swap slopes in Australia at present tend to be
                                                                           140                Current 1Y forward 2Y/5Y slope                           3
much flatter than spot starting swap slopes. However,                                         Cash
                                                                           120                                                                         3.5
some forward slopes out to the 1Y maturity are at the
                                                                           100                                                                         4
same slope as spot slopes. With the market pricing very
                                                                             80                                                                        4.5
little movement from the RBA over the next twelve
                                                                             60                                                                        5
months, we think that there are opportunities for forward
                                                                             40                                                                        5.5
start flattener trades.
                                                                             20                                                                        6
                                                                                0                                                                      6.5
AUD forward starting swap slopes
                                                                            -20                                                                        7
   90                              1Y / 2Y Slope       2y / 5Y Slope
                                                                            -40                                                                        7.5
   80                              2Y / 10Y Slope      2Y / 7Y Slope
                                                                                Jan-03        Jul-04     Jan-06      Jul-07        Jan-09    Jul-10
                                                                       Source: Deutsche Bank, Reuters
                                                                       Looking at the Canadian forward starting slopes, it can be
                                                                       seen that, similar to Australia, forward starting swap
                                                                       slopes out two years are at the same level as the spot
                                                                       starting slopes. Like Australia, the key to any correction in
                                                                       these relative slopes will be the pricing – or occurrence –
                                                                       of rate hikes by the BoC over the course of the next year.
          0m     6m 12m 18m 24m 30m 36m 42m 48m 54m 60m 66m 72m
                                Forward start                          CAD forward start swap slopes
Source: Deutsche Bank                                                                                             1Y / 2Y Slope             2Y / 5Y Slope
                                                                         180                                      2Y / 10Y Slope            1Y / 5Y Slope
We find the AUD 1Y forward 2Y/5Y slope particularly                      160

attractive – this curve has steepened to the steepest                    140
levels since July in recent weeks. Although we are                       120
hesitant to enter curve flattener trades at this point, we               100
think that the 1Y forward 2Y/5Y slope at +47bp is steep,                  80
considering that that the spot 2Y/5Y slope has only been                  60
that steep during the rapid rate cutting cycle of late 2008               40
and during the subsequent recovery. We think that once
the market resumes pricing rate hikes through next year
this curve will flatten. These trades also have minimal
                                                                                    0m   6m    12m 18m 24m 30m 36m 42m 48m 54m 60m 66m 72m
rolldown because the forward and spot slopes are                                                           For war d st ar t

identical.                                                             Source: Deutsche Bank, Reuters

With the 2Y/5Y less exposed to a US long end sell-off than             New Zealand forward start slopes, in comparison, are in
the 2Y/10Y slope, we recommend this trade now –                        line with what expect in an economy where we expect
especially after the very strong Australian employment                 the central bank to increase rates over the next year –
data released on 9 December.                                           forward starting slopes are progressively flatter than spot
                                                                       starting slopes. This means that forward starting curve
                                                                       trades in NZD face comparatively expensive rolldown. As
                                                                       a result, we don’t see any long-term strategic trades in
                                                                       New Zealand at present.

                                                                                                        Kenneth Crompton, (612) 8258 1361

Deutsche Bank AG/London                                                                                                                        Page 111
10 December 2010     Fixed Income Outlook 2011

Global Linkers Update
Europe inflation outlook

    With yields moving lower, 2010 was a good year           9% over the whole year (chart 1). BTPei underperformed
    for inflation-linked assets globally; outside Europe     as rising euro area sovereign debt concerns weighed.
    linkers outperformed nominals. With debt
    concerns weighing, EUR underperformed.                   1. Linkers performed in 2010
    In EUR, we see room for B/Es to widen. Sovereign           10%                     linker to tal return 2010

    debt concerns and the ECB’s penchant for policy                                    relative to no minal
    normalization may keep inflation risk premia at             6%
    sub-par levels, but valuations are low and rising
    spot inflation, a resilient economy and improving
    pension fund solvency should be supportive.                 2%

    With below 1.4% inflation priced in between 2012
    and 2015 and 5y forward B/Es 20bp below the                -2%

    ECB’s target the 5y sector sticks out as cheap on          -4%
    the curve. Across issuers, BTPei look cheap vs
    nominal BTP as well as vs OATei/DBRei.
                                                                          USD         FRF           ITL        GBP         JPY         AUD          SEK            CAD
    Front-end OATi B/Es are attractive vs CPI                Source: Deutsche Bank

    forecasts. While sovereign concerns are a clear
    negative, EUR/FRF B/E spreads are too narrow             In most cases outside EUR, linkers also outperformed
    from a fundamental perspective and a normalising         nominal bonds (chart 1). The correlation between
    spot inflation differential should provide some          breakevens and risk assets remained positive, with linkers
    support. After the outperformance of FRCPI               benefiting from the trend higher in oil prices since end
    swaps over OATi B/Es, OATi ASWs look cheap.              August (chart 2). Actual inflation trends were uneven, with
                                                             EUR and GBP inflation higher than expected at the end of
    In GBP, we are also positive on B/Es into 2011.
                                                             last year, while US (core) inflation was somewhat lower
    Fundamentals in our view remain supportive,
                                                             than forecast. Still, US B/Es outperformed UK and EUR
    with spot inflation sticky at above-target levels,
                                                             ones, not least because of widening inflation risk premia
    survey inflation expectations rising and the
                                                             in the wake of the Fed’s decision to engage in another
    monetary policy stance suggesting that medium-
                                                             round of Treasury purchases.
    term inflation risks are on the upside. Meanwhile,
    given more clarity about the RPI-CPI pension
    indexation switch and an expected improvement            2. Correlation with risk assets still positive
    in schemes’ funding levels, conditions seem in              01
                                                               1 .5          USD linker o utperfo rmance                                                             1
                                                                             WTI (rhs)
    place for LDI demand to pick up.                            01
                                                               1 .0
                                                                             SP X (rhs)                                                                              1
    To express the constructive view on B/Es we               100.5

    would prefer cash at the front-end and swaps at           100.0                                                                                                  105
    the long end. In RV, we find 20y-25y UKTi ASW
    rich relative to nominal ASW.                                                                                                                                    100

                                                               98.5                                                                                                  95
Global 2010 performance                                        98.0
2010 was generally a good year for inflation-linked assets     97.5
as a progressive downgrade in monetary policy
                                                               97.0                                                                                                  85
expectations led to a decline in yields between spring and        Dec-09           Feb-10        A pr-10        Jun-10         A ug-10        Oct-10         Dec-10
autumn. With (US) economic data improving, real yields       Linker outperformance is the total return of the linker index relative to that of the nominal index
sold off again through Q4, but on an absolute basis linker   Source: Deutsche Bank

indices outside the euro area returned between 4% and

Page 112                                                                                                                     Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

Despite the upside surprise in euro area growth and                                   Economic fundamentals: Supportive for B/Es
inflation, euro area breakevens had a very difficult year.                            Economic growth and inflation turned out to be higher
Rising concerns about sovereign solvency and the                                      than expected in 2010. The December 2009 consensus
associated widening in core/non-core spreads proved to                                forecasts for 2010 GDP and HICP were 1.3% and 1.2%,
be a negative for valuations (chart 3), not only because of                           which compares to likely outcomes of 1.7% and 1.6%
the typical underperformance in situations of market                                  respectively. Positive data surprises have however
stress, but also because the resulting fiscal consolidation                           brought little support for breakevens; they have not
efforts were seen as a negative for growth and inflation in                           translated into higher real yields either, as rising sovereign
the coming years.                                                                     debt concerns as well as weaker US data prevented an
                                                                                      upward revision of policy rate expectations (chart 5).
3. Sovereign spread widening weighed on EUR B/Es
                                                                                      5. Real yields immune to better EUR data
  99.0                                                                                                                                                          1.8
                                                                                                               EUR eco no mic data surprise index
                                                                              -70        150
                                                                                                               EUR 1 real swap rate (rhs)                       1.6
  98.0                                                                        -90        100
                                                                              -1 0
  97.0                                                                                    50
                                                                                           0                                                                    1.0
  96.0                                                                        -150
                                                                                         -50                                                                    0.8
                        ITL linker o utperfo rmance                                     -100                                                                    0.6
                                                                                           M ay-09        Sep-09     Jan-10      M ay-10      Sep-10
                        DB Rei-20/B TP ei-1 real yield spread (rhs)
  94.0                                                                        -210
                                                                                        100                            USD eco no mic data surprise index       1.7
     M ar-10            M ay-10       Jul-10          Sep-10       No v-10
                                                                                         80                                 0y
                                                                                                                       EUR 1 real swap rate (rhs)
Source: Deutsche Bank                                                                                                                                           1.5
                                                                                         40                                                                     1.3
At the end of the year, 10y breakevens in GBP and FRF
are close to historical averages again, while US and in                                                                                                         1.1
particular EUR valuations remain sub-par (table below).
                                                                                        -20                                                                     0.9
4. 10y breakevens in 2010 & vs historical averages                                      -60
                                  TIPS10y      HICPxt10y       UKTi10y   FRCPIxt10y     -80                                                                     0.5
1-Dec-09                             2.18             2.37        2.74         2.47       M ay-09         Sep-09     Jan-10      M ay-10       Sep-10
                                                                                      Source: Deutsche Bank
6-Dec-10                             2.19             1.97        2.89         2.26
LT mean (since 2005)                 2.33             2.21        2.91         2.23
Source: Deutsche Bank
                                                                                      Leading indicators of economic growth have remained at
                                                                                      levels consistent with above trend growth at the end of
With economic growth and inflation recovering and                                     this year. We would expect some slowdown in activity
valuations in many cases at attractive levels we enter                                not least because fiscal policy is being tightened, but
2011 with a positive bias on B/Es globally, in particular at                          global growth and monetary policy in particular remain
the short end. We discuss the outlook for the main                                    very supportive at least for now (chart 6). This should keep
markets in more detail below.                                                         euro area economic growth afloat if at slightly lower levels
                                                                                      than this year.

EUR Inflation Outlook
While economic adjustment in peripherals may continue
to weigh on inflation risk premia, we expect
fundamentals—from spot inflation at above-average levels
and robust global growth, to accommodative monetary
policy—to be supportive for breakevens in the coming
months. The supply/demand mix could also improve
somewhat and we see scope for B/Es to widen, in
particular at the shorter end.

Deutsche Bank AG/London                                                                                                                                     Page 113
10 December 2010                  Fixed Income Outlook 2011

6. Real rates are supportive for economy                                                   8. Pick-up in spot inflation supportive for B/Es
   5                                                                                  65      8
                                                                                                               HICP inflatio n, % 3m, ar

   4                                                                                                           HICP xt ZC swap, 5y (rhs)
                                                                                      60                                                                                   2.6
                                                                                              4                                                                            2.4

   2                                                                                  55
   1                                                                                  50
                                                                                              0                                                                            1.8
               2y real yield, EUR (average nom yield less core infl)                  45     -2
  -1                                                                                                                                                                       1.4
               ECB policy real rate
  -2           PMI composite (rhs)                                                    40     -4                                                                            1.2
   Jan-97           Jan-00           Jan-03          Jan-06         Jan-09                    A pr-04     A pr-05       A pr-06   A pr-07   A pr-08   A pr-09    A pr-10

Source: Deutsche Bank                                                                      Source: ECB, Deutsche Bank

Inflation has started to normalise in 2010. After the                                      While growth and inflation trends in our view should
exceptionally low levels recorded in 2009, headline                                        hence be supportive for B/Es, the assessment of the
inflation has risen steadily, from 1% y/y in January to                                    balance of risks to the outlook appears to be less
1.9% in November. Core inflation, after having trended                                     favourable for inflation risk premia than elsewhere. Fiscal
lower since Q4 2008, appears to have reached a turning                                     consolidation and economic adjustment and the resulting
point in mid-2010, edging slightly higher again through H2.                                divergence within the euro area continue to be downside
Economic indicators suggest that this trend should remain                                  risks to the growth outlook. Meanwhile, the ECB appears
in place for now (chart 7).                                                                much less willing to accept inflation risks than central
                                                                                           banks elsewhere and has been leaning towards the exit of
7. Business surveys consistent wit rising core                                             unconventional policy. We expect that a solid growth
                                                                                           performance in core countries will put progressive
  135                   EC eco no mic sentiment, 1 lead (lhs)
                                                  2m                              2.0
                                                                                           pressure on the ECB to start raising interest rates towards
                        co re inflatio n, 1 change in % y/y (rhs)
  125                                                                             1.5      the middle of the year. Our economists see 75bp of rate
                                                                                           hikes next year, which would put upward pressure on real
  15                                                                                       yields from Q2 in particular.
                                                                                  0.0      9. Broad money & ECB liquidity
                                                                                  -0.5       160
                                                                                                      A ug-08=100                 EUR
   75                                                                             -1.5
                                                                                                                           mo netary base
   65                                                                             -2.0
    Jan-91 Jan-94           Jan-97   Jan-00    Jan-03     Jan-06    Jan-09   Jan-12
Source: EC, Deutsche Bank

Trends in spot inflation should be supportive for B/Es in
the coming months. With food prices rising, oil prices                                       60
close to USD90 and the EUR having weakened, headline
inflation could reach 2.2% in December and stay above                                        40
2% in the following months. At current FX and crude oil                                        Jan-03               Jan-05             Jan-07           Jan-09
forwards, headline inflation could average 2% next year.                                   Source: ECB, Deutsche Bank

With inflation around target, B/Es look low (chart 8).
                                                                                           Exceptional liquidity provision measures may need to stay
                                                                                           in place for now to support the banking system, but
                                                                                           government bond purchases are sterilised and tender
                                                                                           terms can, at least in principle, be normalised quickly. A
                                                                                           normalisation of the monetary base could hence in theory
                                                                                           be achieved in a short period of time and inflation risks

Page 114                                                                                                                                        Deutsche Bank AG/London
10 December 2010                      Fixed Income Outlook 2011

from a potential sharp pick-up in broad money growth                                           share in total bond issuance has recovered back towards
appear low (chart 9).                                                                          10%, while BTPei supply was somewhat lower than
                                                                                               expected. Taking into account the redemption of the
10. B/Es & the balance of risk for inflation outlook                                           EUR16bn BTPei-10, net BTPei issuance has actually been
   10                                                                                    3.0
        %                SP F, skew: pro b o f infl. >=2.5% - <1.5% 5Y ahead
                         EUR 5y5y B /E inflatio n (rhs)
                                                                                         2.8   With public sector deficits expected to come down (but
                                                                                               redemptions rising in Germany and France), we see linker
                                                                                         2.6   supply stabilising around current levels in 2011 (see table).
   0                                                                                           We would expect new 30y (Germany) and 15y
                                                                                         2.4   benchmarks. Ireland has announced that it intends to
   -5                                                                                          issue a first linker next year and inflation supply from
                                                                                         2.2   Spain looks possible as well.
                                                                                               12. Supply outlook
                                                                                                                                                                          2008                          2009                    2010 (e)                        2011 (e)
  -15                                                                                    1.8
                                                                                               Public sector deficit, % GDP*
    2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
                                                                                               EUR                                                                          2.0                               6.3                            6.3                     4.6
Source:, Deutsche Bank
                                                                                               France                                                                       3.3                               7.5                            7.7                     6.3

With growth risks high, an underlying hawkish ECB bias                                         Italy                                                                        2.7                               5.3                            5.0                     4.3

and inflation risk from unconventional policy relatively low,                                  Germany                                                                     -0.1                               3.0                            3.7                     2.7

inflation risk premia could remain somewhat below                                              ILB issuance (EURbn)
average for now. Indeed, professional forecasters                                              EUR                                                                            43                               34                             45                      47
continue to see longer-term inflation risks skewed to the                                      France                                                                     15.3                           11.8                             19.3                        20
downside (chart 10). In our baseline scenario of inflation                                     Italy                                                                      16.9                           16.9                             14.5                      15.5
around 2% and solid global growth, we would expect the                                         Germany                                                                      7.0                               5.0                         11.0                        12
risk distribution to become more balanced in the course of                                     * Forecasts are from the European Commission
                                                                                               Source: European Commission, Deutsche Bank
next year.
                                                                                               Demand for EUR inflation-linked assets has been subdued
Supply stabilizing, demand prospects improving                                                 through this year. The focus on public debt sustainability
Relative supply and demand trends have been a negative                                         and widening sovereign spreads as well as limited
for breakevens this year. With financing needs still high,                                     inflation concerns have meant that specialised EUR
linker issuance has risen markedly from the depressed                                          inflation mutual funds and ETFs did not attract new
2009 levels, reaching EUR45bn, from EUR34bn in 2009;                                           inflows on average (chart 13).
only 2004 has seen higher EUR linker supply (chart 11).
                                                                                               13. EUR linker funds struggled in 2010
11. Supply has picked up in 2010
                                                                                                 300                           inflows into EUR inflation ETFs                                                                                                      1.9
 30     linker issuance, EURbn                                                           60
                                                                                                                               funds invested in EUR inflation-linked ETFs (rhs)
                                 FR                  IT                 DE                       200                                                                                                                                                                1.7
                                 GR                  EUR (rhs)                                   100                                                                                                                                                                1.5
 20                                                                                                    0                                                                                                                                                            1.3

                                                                                                -100                                                                                                                                                                1.1
  15                                                                                     40

                                                                                         35     -200                                                                                                                                                                0.9
                                                                                         30     -300                EURm                                                                                                                                            0.7
                                                                                         25     -400                                                                                                                                                                0.5








   0                                                                                     20
        2003      2004       2005     2006    2007    2008   2009     2010        1
                                                                               201 (e)
                                                                                               Source: Bloomberg Finance LP, Deutsche Bank
Source: Deutsche Bank

                                                                                               Moreover, lower yields and the weak trend in equities
German linker issuance in particular has picked up and has
                                                                                               through much of the year have meant that pension fund
become more regular (EUR3bn per quarter). We would
expect this trend to continue in 2011. In France, the linker

Deutsche Bank AG/London                                                                                                                                                                                                                                    Page 115
10 December 2010                   Fixed Income Outlook 2011

funding ratios have deteriorated markedly which has                                               The break vs these models occurred in late spring as
weighed on inflation hedging demand (chart 14).                                                   sovereign debt concerns intensified and B/Es have shown
                                                                                                  a strong correlation with changes in sovereign spreads
14. Pension fund funding ratios recovering                                                        since then.
  6      EURbn            D ut c h P F inv e s t m e nt in IL a s s e t s                   160
                                                                                                  16. …other market prices…
  5                                                                                         150
                                          Investment into IL assets, 2qma
  4                                       funding ratio (rhs)                               140               %
                                                                                                                                                                                        OA Tei 15
                                                                                            130     2.6
                                                                                                                                                                                        fitted, f(market variables)
                                                                    estimated current
   1                                                                                                2.1
                                                                                            100     1.6

 -2                                                                                         90
 -3                                                                                         80
        07Q3       08Q1         08Q3         09Q1         09Q3         10Q1          10Q3
Source: DNB, Deutsche Bank                                                                           Jan-07                       Jan-08                          Jan-09                              Jan-10                           Jan-11

                                                                                                  Source: Deutsche Bank
We would expect demand trends to improve next year.
Normalising spot inflation should be supportive, while the                                        To some extent, this is likely to be due to the typical
recent back-up in yields together with rallying equities                                          underperformance of linkers in times of market stress and
should have led to a noticeable improvement in pension                                            partly it may reflect lower demand for linker benchmarks
fund solvency ratios (chart 14). Altogether, we would                                             which include non-AAA paper. More fundamentally, it is
expect a better demand/supply mix for EUR inflation next                                          however also likely to be related to concerns about
year.                                                                                             necessary fiscal consolidation and economic adjustment
                                                                                                  weighing on growth and inflation in peripherals and
                                                                                                  keeping aggregate euro area inflation at sub-par levels in
Market outlook: Long B/Es                                                                         the medium term.
Breakevens have underperformed markedly this year and
now look cheap vs most valuation measures. Regressions                                            17. …as well as vs inflation forecasts
vs fundamentals—indicators of economic activity, spot
inflation, policy rates—(chart 15) or other market
variables—oil prices, equities, money market slope and
VIX—(chart 16) point to 20-30bp cheapness in 5y and 10y

15. B/Es cheap vs fundamentals…
          %              1 B /E
                          0y                                                                        -70                                                                                                 B /E belo w fo recasts

  2.6                    fitted based o n fundamentals                                              -80
                                                                                                                       Difference between market B /E and expected inflatio n
  2.4                                                                                                                  adjusted fo r duratio n mismatch
                                                                                                           OATei 12

                                                                                                                                 OBLei 13

                                                                                                                                                       OATei 15

                                                                                                                                                                                                                 OATei 20

                                                                                                                                                                                                                                       OATei 22
                                                                                                                      BTPei 12

                                                                                                                                            BTPei 14

                                                                                                                                                                  DBRei 16

                                                                                                                                                                             BTPei 17

                                                                                                                                                                                           BTPei 19

                                                                                                                                                                                                      DBRei 20

                                                                                                                                                                                                                            BTPei 21


  1.8                                                                                             Source: Deutsche Bank

                                                                                                  We would agree that underlying domestically generated
                                                                                                  inflation will remain at moderate levels for some time.
  1.2                                                                                             Some of the weakness in peripherals should however be
      M ar-02   Jun-03       Sep-04    Dec-05      M ar-07      Jun-08      Sep-09    Dec-10      offset be relatively higher inflation in core countries such
Source: Deutsche Bank                                                                             as Germany (See “Passing the baton”, DBIR 3-December
                                                                                                  2010). Moreover, government measures will add to
                                                                                                  inflation and imported inflation may well remain high given

Page 116                                                                                                                                                                                Deutsche Bank AG/London
10 December 2010                Fixed Income Outlook 2011

the weaker euro, recent commodity price trends and                                BTPei up to the BTPei-23 look very cheap (chart 19; chart
rising inflation in EM countries. Assuming inflation close to                     17 suggests the same). This should support ASW demand
2% in 2011, 1.75% in 2012 and then to converge towards                            for BTPei and we would expect some convergence in
1.95% in 2015 yields cumulative inflation significantly                           valuations in early 2011.
above current B/E valuations (chart 17).
                                                                                  19. BTPei up to 13y cheap vs BTP and OATei/DBRei
Inflation risk premia, even if below historical averages,                                                   linker rich/cheap vs no minal bo nd curve
should add another 10bp at least at the 5y point (see DBIR
                                                                                                                                                                 linker cheap
26-November 2010). Altogether, we believe B/Es offer                                   50                                                        FRF
                                                                                                                                                                 vs no minal
fundamental value at current levels, and given the                                     40                                                        ITL             bo nd curve
expected macro-backdrop described above, we see scope                                                                                            DEM
for B/Es to perform in 2011. Another downside shock to
growth or escalation in sovereign tensions is a risk, but in                           20
our view may be better hedged away from inflation                                         10

Along the curve, shorter-end B/Es in particular should                                 -10
benefit from the expected rise in spot inflation in the near                          -20
term. We see most potential in 5y B/Es which have
underperformed markedly this year; in cash we like both,
                                                                                           2011               2016              2021    2027       2032              2038
the OBLei-13 and OATei-15 B/Es; the forward B/E
                                                                                  Source: Deutsche Bank
between the OATei-12 and OATei-15 for example stands
at around 1.35%, which looks very low. Similarly, in                              OATi B/Es: cheap on ASW
HICPxt swaps, the 5y (and 20y) sectors stick out as                               We see French inflation rising slightly in the near term as
particularly cheap against our inflation expectations and                         food and energy—oil and non-oil—prices look likely to
risk premia estimates (chart 18). 4y1y forwards for                               move higher given commodity and FX trends as well as
example remain around 20bp below the ECB target and                               government measures. Core inflation should also continue
50bp below historical averages.                                                   to recover gradually, as capacity utilisation rises, import
                                                                                  costs have gone up and business surveys show that firms
18. 3y-5y & 20y B/Es cheap                                                        are feeling increasingly confident about lifting output
   0.3%                                                                           prices. We see (CPI) inflation at 1.6% in 2011 and around
                 HICP xt swaps vs mo del
                                                                                  similar levels in 2012. Under these assumptions, short-
   0.2%                                       ZC rich/cheap
                                                                                  end OATi B/Es are cheap (chart 20) and should be able to
                                              y/y fwd rich/cheap
                                                                                  benefit from the expected near-term rise in spot inflation.
                                                                                  After a 20bp rally since the end of November, longer-term
   0.0%                                                                           B/Es look about fair in our view.
                                                                                  20. Short-end OATi B/Es cheap
                                                                                    40         Difference betw market B/E and consensus expected inflation

  -0.3%                                                                             30         adjusted for duration mismatch

            1    3      5   7   9   11   13   15   17   19   21 23   25 27   29
Source: Deutsche Bank

At the long end, the OATei-40 B/E at 2.1% and the 30y                              -20                                                             B/E below forecast
HICP swap at 2.2% should attract interest if broader                               -30
macro conditions normalize, although we lttle scope for                            -40
10y30y B/E steepening in the short run.                                            -50
                                                                                                  OATi 11

                                                                                                                      OATi 13

                                                                                                                                       OATi 17

                                                                                                                                                       OATi 19

                                                                                                                                                                            OATi 23

Across issuers, the end-of-year low liquidity environment
has created some opportunities, with BTPei B/Es
underperforming significantly. Using HICP swaps to uplift                         Source: Deutsche Bank

cash-flows and comparing linker valuations to the
respective underlying nominal bond curve shows that

Deutsche Bank AG/London                                                                                                                                                   Page 117
10 December 2010                  Fixed Income Outlook 2011

In terms of EUR/FRF breakeven spreads, this year’s                                           23. OATi relatively cheap on ASW
widening in core/non-core bond spreads has been a clear                                                         linker rich/cheap vs no minal bo nd
(EUR) negative (chart 21), as economic re-balancing is
likely to mean somewhat lower (relative to historical                                            40                                 FRF (EURHICP )           linker cheap
                                                                                                                                                             vs no minal
averages) inflation in peripherals and relatively higher                                         35
                                                                                                                                    FRF (FRCP I)             bo nd curve
inflation in core countries.                                                                     30

21. EUR/FRF B/Es vs core/non-core real yield spread
   -20                                                                                           10
   -70                                                                                            0
  -120                                                                                                2011       2016        2021        2027         2032       2038
                                                                                       -30   Source: Deutsche Bank

  -170                                                                                 -40
                   DB Rei-16/B TP ei-1 real yield spread
                                      7                                                      A notable recent development has been the
                                                                                             outperformance of FRCPI swaps over OATi B/Es,
  -220             5y B /E spread: EUR HICP less FRF CP I swap (rhs)                   -60
                                                                                             especially when compared to trends in EUR inflation (chart
     Jan-08        Jul-08      Jan-09        Jul-09     Jan-10         Jul-10
                                                                                             22). As a result of the swap richness, when swapped to a
Source: Deutsche Bank
                                                                                             fixed rate bond OATi look very cheap, not only relative to
                                                                                             the nominal OAT curve, but also vs OATei (chart 23). In
The downward pressure on EUR/FRF B/E spreads from
                                                                                             par ASW, for example, the OATi-23 is some 15bp cheaper
sovereign debt concerns has been exacerbated in H1 by a
                                                                                             than the OATei-22.
negative spot inflation differential. This has however
started to change in recent months and we would expect
the latter to stay closer to historical averages through
2011; this should help EUR/FRF B/E spreads to widen                                          GBP Inflation Outlook
(chart 22).
                                                                                             In the UK, we believe that fundamentals remain
                                                                                             supportive for breakevens. Spot inflation looks set to
22. EUR/FRF B/E spread vs inflation differential                                             remain sticky at above-par levels, surveys suggest that
   0.8                                                                                 30    inflation expectations are rising and the monetary policy
                                                                     CP I fo recasts
                                                                                             stance and bias suggest that medium-term inflation risks
                                                                                             are skewed to the upside, which should be positive for
   0.4                                                                                       inflation risk premia. Meanwhile, after emerging clarity
                                                                                             about the RPI-CPI switch for pension indexation and the
   0.2                                                                                 -10   resulting improvement in schemes’ funding levels,
   0.0                                                                                 -20   conditions seem in place for LDI demand to pick up. We
                                                                                             maintain a positive bias on UK B/Es into 2011.
                   inflatio n differential (lhs)                                             Economic fundamentals: Favourable B/Es
                   EUSWI5 FRSWI5 spread                                                -50   Fundamentals should continue be supportive for
  -0.6             OA Tei-15/OA Ti-17                                                  -60   breakevens in the coming months. We expect growth to
     Jan-05     Jan-06      Jan-07    Jan-08       Jan-09   Jan-10      Jan-11               remain resilient despite some slowdown at the start of
Source: Deutsche Bank                                                                        the year on the back of tightening fiscal policy. Global
                                                                                             demand remains supportive especially against the
While demand for FRF inflation appears to be more                                            backdrop of a significantly weaker exchange rate relative
resilient and further tensions in government bond markets                                    to pre-crisis levels. Indeed, business surveys in
a distinct possibility, we would have a cautiously positive                                  manufacturing remain at levels consistent with above-
bias on EUR/FRF spreads in H1 2011. 5y and 10y spreads                                       trend growth; similar levels of business sentiment were in
at between -30bp and -40bp look too narrow from a                                            the past associated with upward pressure on prices and
fundamental perspective (even taking into account euro                                       B/E valuations markedly above current levels (chart 1).
area rebalancing) and a normalising spot inflation
differential should provide some support.

Page 118                                                                                                                                        Deutsche Bank AG/London
10 December 2010                     Fixed Income Outlook 2011

1. PMI & breakevens: upside potential                                          Inflation is in our view likely to remain sticky for now.
                                                                               Higher commodity costs, better demand and hence more
  60                                                                     3.5
                                                                               room for wider profit margins, rising household inflation
  55                                                                     3.0
                                                                               expectations (chart 2), increases in utility bills and not
                                                                               least the scheduled VAT-hike in January mean that any
  50                                                                     2.5   easing in inflation from currently high levels will probably
                                                                               be slow. We see RPI inflation remaining above 4% in Q1
  45                                                                     2.0   and above 3.5% on average this year, despite a projected
                                                                               fall in house prices. Above trend inflation should be
                                 manuafcturing P M I
  40                                                                     1.5   supportive for B/Es, in particular at the front-end.
                                 UK 5y B /E (rhs)
  35                                                                     1.0   We also believe that past unconventional policy measures
                                                                               together with the apparent central bank bias away from
  30                                                                     0.5
                                                                               deflation risks mean that the balance of risks on the
    Jan-01 M ay-02 Sep-03 Jan-05 M ay-06 Sep-07 Jan-09 M ay-10
                                                                               medium-term inflation outlook is skewed to the upside.
Source: BoE, Markit, Deutsche Bank
                                                                               Broad money growth remains very slow, but the
                                                                               considerable stock of outstanding central bank liabilities is
Given past rises in (non-wage) production costs as well as
                                                                               a latent exit risk (chart 3). Given that central bank money
better demand firms indeed think more and more about
                                                                               creation has been above all through longer-term Gilt
raising selling prices and 'output price' balances in
                                                                               purchases, a normalisation will not be automatic nor
surveys are at levels well above average in manufacturing
                                                                               straightforward over shorter time periods, which may
and approaching averages again in services.
                                                                               increase the uncertainty about potential inflationary
                                                                               consequences. This should be supportive for inflation risk
RPI (and CPI) inflation were widely expected to recede
through 2010, but again have proved to be much stickier
than expected. RPI has surprised on the upside in six
months through October this year (twice in line) and looks                     3. Money: support for the inflation risk premium
set to average 4.6% (RPIX at 4.7%) which compares to a                           250
December 2009 consensus forecast of 3.0% (for RPIX).                                      A ug-08=100
CPI inflation currently stands at 3.2% vs a Q3 2009 BoE                          220

projection of 1.5%; core inflation in particular is                              190
significantly higher now than forecast at the end of last                                                 mo netary base
year. Moreover, while in 2009 the upside surprises have                          160
                                                                                                          M 4 (excl. intermediate OFC)
mainly come from (tradable) core goods components,
which can probably to a large extent be attributed to
previous exchange rate depreciation, in 2010 the firmer                          100
trend in core inflation was more broad based, with
services inflation rising from 3%-3.8% through the year.                          70

2. Household inflation expectations rising                                         Jan-03              Jan-05         Jan-07             Jan-09
                                                                               Source: Deutsche Bank
  45       UK consumer 1 ahead inflation expectations
                        y                                                5.0
  40                                                                     4.5
  35             European Commission
                 YouGo v/Citi (rhs)
                                                                         4.0   Demand prospects improving, CPI supply ahead
                 BoE/GFK (rhs)                                           3.5   Several factors have weighed on demand for inflation
                                                                               assets this year. The fall in yields and weak trend in
                                                                               equities between spring and autumn has pushed pension
  15                                                                     2.5
                                                                               fund solvency ratios lower which tends to shift the focus
                                                                         2.0   away from inflation hedging. Moreover, the government's
                                                                         1.5   announcement in July of its intention to move towards
                                                                               CPI indexation of private sector occupational pensions has
                                                                               created significant uncertainty which is likely to have led
  -10                                                                    0.5
                                                                               to LDI projects being delayed.
    Jan-05        Jan-06        Jan-07     Jan-08      Jan-09   Jan-10
Source: YouGov, BoE, EC, Deutsche Bank

Deutsche Bank AG/London                                                                                                                           Page 119
10 December 2010                Fixed Income Outlook 2011

4. Pension fund funding levels to improve                                            The concern might be to create a fragmentation of the
   200     A ggregate funding po sitio n o f DB funds, GB P bn
                                                                                     UKTi market, the advantage to provide a better hedge for
                                                                                     the CPI-linked pension liabilities given that RPI and CPI can
   150                                                    estimate based o n
                                                          RP I/CP I switch           at times diverge significantly. We would expect the
   100                                                                               government to lean towards issuance of CPI Gilts.
                                                                                     Given expected issuance volumes a liquid CPI market
                                                                                     could be quickly established and potential demand would
   -50                                                                               seem large enough to justify the creation of a CPI curve.
  -100                                                                               Indeed, deferred pensions have a longer duration than
                                                                                     pensions in payment and deferred members account for
                                                                                     almost 44% of total private sector DB scheme
                                                                                     membership, vs 36% for pensioners (20% are active
  -250                                                                               members). Applying the same share to the stock of
     M ar-03 M ar-04 M ar-05 M ar-06 M ar-07 M ar-08 M ar-09 M ar-10
                                                                                     liabilities, assuming the proportions in the table above and
Source: Deutsche Bank
                                                                                     total inflation-linked liabilities of roughly GBP950bn (or
                                                                                     some GBP760bn for pensions in payment and deferrals)
We think that demand trends could become more positive
                                                                                     would point to a rough estimate of about GBP360bn of
in the comings months. First, pension scheme funding
                                                                                     RPI liabilities and GBP400bn of CPI liabilities.Taking into
ratios had already started to improve as equities rallied in
                                                                                     account actives, for which liabilities grow in line with
September and October (chart 4) and this trend is likely to
                                                                                     earnings, and public sector schemes, potential demand
have remained in place with the recent back-up in yields,
                                                                                     for CPI hedges could even be higher. Of course, it will
making the terms of the equity-rates switch more
                                                                                     take some time for schemes to implement the change
attractive. Perhaps even more importantly, the
                                                                                     while some may chose to continue to use RPI. Also,
government estimates that the switch to CPI indexation of
                                                                                     schemes may be reluctant to change RPI hedges that are
pension liabilities will produce a benefit of GBP76.6bn for
                                                                                     already in place, at least at first. Still, the potential size of
private sector schemes and will hence lead to a significant
                                                                                     outstanding CPI liabilities should make for a strong case in
improvement in funding ratios (diamond in chart 4).
                                                                                     favour of CPI-linked issuance and we would expect the
Finally, this week’s clarification of the government's                               DMO to launch a consultation on the subject next year.
intention concerning the modalities of the RPI-CPI switch
(i.e. to propose not to use law to make CPI applicable for                           Market Outlook: Positive bias on B/Es
pension uplift across the whole industry) ends a period of                           Yields finish 2010 towards the highest levels recorded
uncertainty and confirms that most schemes will in the                               over the past 1.5 years, while the real yield curve has
future still have liabilities tied to RPI. Indeed it seems that                      continued to steepen through most of the year (chart 5). If
70-80% of pensions in payment could continue to be                                   growth remains as resilient as we forecast, monetary
uplifted by RPI, while for most schemes deferrals could                              policy normalisation may shift into focus and recently
be revalued using CPI. The table below shows the                                     emerging flattening pressures could persist. This could
estimated proportion of schemes falling into each                                    also be helped by better hedging demand at the long end.
category, suggesting that around 60% of schemes could
have RPI and CPI liabilities in the future.                                          5. Real yields towards highs, curve started to flatten
                                                                                        1.1                  UKTi-37 real yield                                1.2
Split of RPI/CPI ties                                                                                        UKTi-17/-37 spread (rhs)                          1.0
                                                             RPI   Statutory min
Pensions in             RPI                                20%                 60%    0.8
pay't                                                                                                                                                          0.4
                        Statutory min                       0%                 20%    0.7
Source: DWS, Deutsche Bank                                                                                                                                     0.2
Altogether, better funding levels, pent-up demand as well                                                                                                      0.0

as the ending RPI/CPI uncertainty may well boost hedging                              0.5
demand for linkers in the coming months.                                              0.4                                                                      -0.4

UKTi supply, at just over GBP30bn, has been slightly                                  0.3                                                                      -0.6
higher in calendar year 2010 than in 2009 and is projected                               Jul-09       Oct-09          Jan-10      A pr-10    Jul-10   Oct-10

to stay at similar levels in 2011. One of the main questions                         Source: Deutsche Bank

is whether the government will provide CPI-linked Gilts.

Page 120                                                                                                                                    Deutsche Bank AG/London
10 December 2010                  Fixed Income Outlook 2011

Breakevens rallied into the year, but then mostly                                  LDI demand. We would enter the year with a positive bias
weakened between spring and autumn, before turning                                 on UK breakevens.
higher again more recently. As discussed above, we
believe the macro backdrop is supportive and our                                   8. 5y forward B/Es look low
fundamental model suggests some 20bp of cheapness in
5y and 10y UKTi B/E (chart 6).                                                                                                                                                 y
                                                                                                                                                                            4y1 fo rward RP I swap

6. B/Es cheap vs fundamentals                                                        3.7

  4.2                                                                                3.5
          %                                                                                                                                                                                                                      diamo nd:
                         UK 1 B /E
                                                                                     3.3                                                                                                                                         B o E target
  3.7                    fitted, f(fundamentals)
                                                                                                                                              hist average
  2.7                                                                                2.7

  2.2                                                                                2.5
                                                                                      M ar-09            Jun-09                    Sep-09               Dec-09                 M ar-10                 Jun-10                  Sep-10               Dec-10

  1.7                                                                              Source: Deutsche Bank

  1.2                                                                              Comparing cash to swaps, the long end of the UKTi curve
    Jan-01 M ay-02 Sep-03 Jan-05 M ay-06 Sep-07                Jan-09   M ay-10    and in particular the 20y/25y sector look rich vs swaps
Source: Deutsche Bank                                                              (chart 9). As a result, we would prefer to express long B/E
                                                                                   positions via bonds in the short end and via swaps in the
Shorter-end B/Es are also attractive relative to our RPI                           long end. Swaps may have suffered more from the
forecasts (chart 7).                                                               uncertainty concerning the planned RPI-CPI switch for
                                                                                   pension liabilities and we would expect some recovery
7. Sub-10y UKTi B/Es cheap vs RPI forecasts                                        now that more clarity is emerging.
  0.5          Difference between market B/E and DB expected inflation
               adjusted for duration mismatch                                      9. Long-end swaps cheap vs cash, especially in 20y
  0.3                                                                                4%                                                                                                                                                                      60
                                                                                                                                        P V o f A SW disco unt                                                            linker cheap
                                                                                                                                        RP I swap richness vs UKTi (rhs)                                                                                     50
  0.1                                                                                3%
                                                                                                                                        UKTi A SW disco unt (rhs)                                                                                            40
                                                                                     2%                                                                                                                                                                      30
                                                                  B/E cheap           1%
                                                                                     0%                                                                                                                                                                      0

 -0.5                                                                                                                                                                                                                                                        -10
 -0.7                                                                               -2%                                                                                                                                                                      -30
              UKTi 13

                            UKTi 16

                                          UKTi 17

                                                     UKTi 20

                                                                         UKTi 22

                                                                                           UKTi 13
                                                                                                     UKTi 16
                                                                                                               UKTi 17
                                                                                                                         UKTi 20
                                                                                                                                    UKTi 22
                                                                                                                                              UKTi 24
                                                                                                                                                        UKTi 27
                                                                                                                                                                  UKTi 30
                                                                                                                                                                             UKTi 32
                                                                                                                                                                                       UKTi 35
                                                                                                                                                                                                 UKTi 37
                                                                                                                                                                                                           UKTi 40
                                                                                                                                                                                                                     UKTi 42
                                                                                                                                                                                                                               UKTi 47
                                                                                                                                                                                                                                         UKTi 50
                                                                                                                                                                                                                                                   UKTi 55

Source: Deutsche Bank
                                                                                   Source: Deutsche Bank

The cheapness is illustrated by the y/y RPI swap at the 5y                         In relative value, the 20y-25y sector in particular sticks out
point (4y1y forward); over the medium term one would                               as rich on the UKTi curve. The forward B/E between the
expect inflation to be close to the BoE target, which                              UKTi-27 and UKTi-32 looks rich above 4.6% and on
would translate into RPI inflation of about 2.75% (diamond                         proceeds ASW, the UKTi-30/-32 & -35 are more expensive
in chart 8), and B/Es to trade above that, taking into                             than their nominal comparators (chart 9). We would
account an inflation risk premium. 4y1y RPI forwards                               recommend selling these issues on ASW vs nominal
currently stand at 2.77%, i.e. just at target, which is close                      ASW.
to 40bp below historical averages (chart 8). Given high
spot inflation as well as the unconventional policy                                                                                                     Markus Heider (44) 20 7545 2167
backdrop, we would see scope for wider 4y1y forwards.
Meanwhile, the long-end could benefit from more robust

Deutsche Bank AG/London                                                                                                                                                                                                                      Page 121
10 December 2010     Fixed Income Outlook 2011

TIPS Outlook 2011

   TIPS performed well in 2010 in absolute terms as            sovereign crisis in Europe led to heightened fears of a
   real yields rallied on the back of the deterioration        deflationary double-dip, fostering a new bond market rally
   of the economic outlook and ultimately of the               between April and August 2010. This was followed by the
   implementation of QE2. Breakevens suffered from             Fed’s decision to implement QE2 in order to boost
   the sharp decline of spot inflation and growing             inflation expectations and lower real yields, which
   deflation fears before recovering from August               triggered a second wave of rally for TIPS towards
   onwards. Nonetheless TIPS underperformed USTs.              historically rich levels (around 35bp on the 10Y real yield).
                                                               Since November 2010, data has significantly surprised to
   We expect core inflation to rebound in 2011 on the
                                                               the upside and the market has partially priced out QE2,
   back of the recovery in rent inflation and of the
                                                               hence a back up in yields. The sell-off intensified this
   impact of pipeline inflation pressures on core
                                                               week after the announcement by Obama of an
   goods prices. Recent levels of economic activity
                                                               unexpected $350bn fiscal stimulus plan.
   have been sufficient to trigger a rebound in unit
   labor costs and in core CPI in 2011. The                    All in all, since 1st Jan 2010, TIPS real yields still rallied
   acceleration of food inflation should push headline         substantially across the curve but breakevens are still
   CPI YoY towards 2% by the end of the year.                  lower today than they were at the start of the year. The
                                                               10Y breakeven around 2.20% is now about 20bp lower
   Real yields are now richer than a year ago, the GDP
                                                               than it was at the start of the year, the 20Y BE is about
   outlook is being upgraded for 2011 and deflation
                                                               10bp cheaper, and breakevens in the 5Y sector have
   fears are receding on the back QE2 and new tax
                                                               cheapened by about 45bp. Although TIPS have performed
   cuts. We thus expect further normalization of bond
                                                               well in absolute terms, they have not outperformed UST
   risk premia in H1 2011, which could push the 10Y
                                                               given weak realized inflation accretion and the negative
   real yield towards 1.25%. The 10Y real yield should
                                                               impact of low spot inflation on breakevens. The Fed’s
   underperform 5Y and 30Y sectors. The outlook for
                                                               decision to implement QE2 has been critical though in
   H2 is more uncertain depending on the Fed’s
                                                               limiting the underpeformance of TIPS relative Treasuries.
   decision to expand QE beyond June. We expect
   real yields to trade with a high beta relative to           TIPS returns for 2010 by sector
   nominal yields. Front BEs should outperform.                                            TIP S Ret urns          UST Ret urns      TIP S Out -
                                                                                              in 2 0 1 0            in 2 0 1 0 *    perf ormance
   TIPS breakevens in the 1Y to 3Y sector remain
   particularly attractive vs. our inflation forecasts.        Global mark et                   5 .6 8 %                 7.46%        -1 .7 8 %

   10Y and 20Y BEs are close to fair value in absolute         1 Y -3 Y sect or                 1 .8 5 %                 2.29%        -0 .4 4 %
   terms but we now find some richness of the 10Y              3 Y -5 Y sect or                 3 .9 5 %                 5.83%        -1 .8 8 %
   BE vs. the 5Y and 30Y wings. The market has                 5 Y -7 Y sect or                 5 .8 1 %                 8.18%        -2 .3 7 %
   switched from long term deflation fears to long             7 Y -1 0 Y sect or               6 .8 6 %                10.45%        -3 .5 8 %
   term inflation fears and 10Y10Y vs 5Y5Y CPI swap            >1 0 Y sect or                   7 .7 9 %                 8.89%        -1 .1 1 %
   slope is currently too flat. 30Y BE is cheap vs. 20Y
                                                               * duration neutral vs. TIPS
   BE. TIPS 2025 BE is cheap vs. 10Y and 20Y BE. We            Source: Deutsche Bank, Performance from 1st Jan 2010 to 8 Dec 2010

   recommend monetizing the rich inflation vol.
                                                               We decompose the total return of a 5Y TIPS into three
                                                               categories: inflation accretion, change in real yield, and
2010, mixed year for TIPS
                                                               accrued interest (see chart below). The TIPS Jan-2015 has
In 2009, TIPS generated remarkably strong absolute             offered a total return of 4.4% since the start of the year.
returns and excess returns vs. nominal Treasuries on the       This good performance in absolute terms was mostly due
back of the normalization of depressed breakevens and          to the real yield rally (+1.9% returns). Inflation contributed
cheap real yields. At the start of 2010, we were worried       mildly to the total return by 1.07% between 1st January
that TIPS returns could suffer from the limited scope for      2010 and 7th December 2010. Expectations of QE2
further real yield rally and from low levels of inflation      between early September and the November FOMC
accretion. We were partly right: on the one hand realized      meeting boosted the total return from about 3% to about
inflation was soft around 1.2% in headline terms between       6.6% but the latest bond market sell-off affected the
October 2009 and October 2010, on the other hand we            performance negatively by -2.2% over the past month.
underestimated the ability of real yields to rally further.
The continuous softening of core inflation, the persistently
high rate of unemployment and the worsening of the

Page 122                                                                                                                Deutsche Bank AG/London
10 December 2010                    Fixed Income Outlook 2011

Decomposition of 5Y TIPS returns in 2010                                                    However when the Fed confirmed the implementation of
  7%                                                                                        QE2 during the September FOCM meeting, we observed
                    Cumulative to tal return o n TIP S Jan-2015
                                                                                            a sharp jump in the probability of experiencing high
  6%                Co ntributio n o f inflatio n indexatio n
                    Co ntributio n o f accrued interests                                    cumulative inflation over the next 10 years (priced in by
  5%                Co ntributio n o f the real yield change                                the 10Y 3.5% zero-coupon CPI cap), and an acceleration
                                                                                            of the decline of long term deflation risk priced in by the
                                                                                            deflation floor market.
                                                                                            The correlation between real yields and market pricing of
                                                                                            deflation probability has gone through several different
   1%                                                                                       regimes over the past few months, as shown by our
                                                                                            regression analysis using the five-year tenor as an
                                                                                            example. Prior to QE2 expectations, mostly from May to
  -1%                                                                                       August 2010, real yields were falling on weakening
     Jan-10        M ar-10         M ay-10         Jul-10       Sep-10      No v-10
                                                                                            growth expectations, while deflation fear (as measured by
Source: Deutsche Bank – returns from 01/01/10 to 12/08/10
                                                                                            cumulative deflation probability) was rising. The probability
                                                                                            of 5-year cumulative deflation peaked during the summer
                                                                                            at about 24%. The correlation was negative. Following
Long term inflation outlook:
                                                                                            Chairman Bernanke’s August 27th Jackson Hole speech,
From deflation fears to inflation fears                                                     real yields kept falling, but the deflation probability
The implementation of QE2 by the Fed has been positive                                      reversed its rising trend. So QE2 had been successful in
for TIPS in two distinct ways. First, Fed purchases of TIPS                                 lowering real yields and removing deflation fears even
and Treasuries have helped and should keep helping the                                      before the actual purchase operations began. The 5yr real
market absorbing the upcoming supply of US debt,                                            yields hit a trough of about -60bp in October to early
mitigating the magnitude of the sell-off in US rates.                                       November, which made some inflation investors wonder
Second, the announced objective of QE2 was to increase                                      how the Treasury would be able to sell a new 5yr TIPS in
dangerously low inflation expectations and to lower real                                    April 2011 with a zero coupon and negative real yields.
rates in order to boost risky assets and support the
                                                                                            5Y TIPS real yields (y-axis) vs. cumulative 5-year
economic recovery. This naturally helped the widening
                                                                                            deflation probability implied by ZC CPI floor (x-axis)
and normalization of breakevens since the end of August
and the decline in deflation risk priced in by the market. As
soon as Bernanke suggested on August 27th in Jackson
Hole that the Fed would consider providing additional
monetary accommodation to reduce disinflationary
pressures, the market started pricing out the ever-growing
probability of cumulative deflation over the next 10 years
(in the 0% zero-coupon CPI floor market). However the
probability of experiencing high inflation in the long run did
not increase immediately (see chart below).

Main tail risk shifted from deflation to high inflation
  16%                P ro bability o f 10Y     Jackso n                               35%
                                                                     QE2 anno un.
  15%                deflatio n (lhs)             Ho le              Sep FOM C              Source: Deutsche Bank
                                                Speech                                30%
  14%                P ro bability o f high
                     inflatio n (1 infl >
                                  0Y                                                        That concern turned out to be premature. The sell-off in
                     3.5%/year, rhs)                                                  25%   bonds over the past one month has put the 5Y real yield
                                                                                            back to positive territory, as real yields have moved in a
   1%                                                                                 20%
                                                                                            high yield beta together with nominal Treasury yields. The
  10%                                                                                       deflation fear has continued to wane, albeit at a slower
   9%                                                                                       pace. The deflation probability that we have tracked using
   8%                                                                                       ZC CPI options is now in the low end of the range in 2010.
   7%                                                                                       We think deflation risks will remain low in 2011, given the
   6%                                                                                 5%    continuing Fed balance sheet expansion, the proposed tax
     M ar-10            M ay-10           Jul-10            Sep-10       No v-10            cuts and some rebound in core inflation. Chances of a
Source: Deutsche Bank                                                                       return of heightened deflations fears are remote in our

Deutsche Bank AG/London                                                                                                                         Page 123
10 December 2010                 Fixed Income Outlook 2011

The continuous expansion of the Fed’s balance sheet and                                  Money multiplier not normalizing yet
the resulting difficulty in implementing a timely and                                       2,200                                                                                12
                                                                                                                    US M o netary base
efficient exit strategy in the next few years was itself                                    2,000                   US M 2 (scaled)
stimulative for long term inflation uncertainty and for the                                 1,800
                                                                                                                    US Excess Reserves
                                                                                                                    M o ney multiplier (rhs)                                     10
inflation risk premium. The fact that the Fed considered                                    1,600
implementing a price-level inflation target in order to                                     1,400
increase inflation expectations also lowered the Fed’s                                      1,200                                                                                8
credibility as an inflation safeguard going forward. The                                    1,000                                                                                7
chart below shows the strong link between long term                                           800
inflation uncertainty as measured by the standard                                             600
deviation of 10-year-ahead inflation forecasts from the                                                                                                                          5
Survey of Professional forecasters released by the                                            200                                                                                4
                                                                                                       $ bn
Philadelphia Fed, and the 5Y5Y inflation swap as a                                                -                                                                              3
measure of long term inflation expectations.                                                      Dec-05          Dec-06        Dec-07         Dec-08        Dec-09      Dec-10
                                                                                         Source: Deutsche Bank
Higher long term inflation uncertainty has boosted
the inflation risk premium                                                               Inflation being ultimately a monetary phenomenon, the
                   US SP F: stdev o f fo recasts fo r inflatio n o ver next 10y
                                                                                  4.0%   risk will become more palpable once we start seeing a
                   US 5Y5Y CP I Swap                                              3.8%   transfer of this excess liquidity into the real economy via
                                                                                  3.6%   an increase in lending by US banks. Credit creation should
  0.7                                                                             3.4%   start normalizing the money multiplier and thereby boost
                                                                                  3.2%   the growth of broad money aggregates assuming the Fed
                                                                                  3.0%   fails to reduce its balance sheet on time and to control
                                                                                  2.8%   excess reserves via higher rates paid on excess balances.
                                                                                  2.6%   The recent Senior Loan Officer surveys show that US
  0.4                                                                             2.4%   commercial banks are increasingly willing to lend and that
                                                                                  2.2%   demand for loans has marginally increased, particularly for
                                                                                  2.0%   C&I loans by large corporates. SLO survey results have
  0.2                                                                             1.8%   been good leading indicators of subsequent realized loan
    Jan-07              Jan-08          Jan-09            Jan-10             Jan-11      growth and C&I loan growth could turn positive at the end
Source: Deutsche Bank
                                                                                         of 2011 (see chart below).

                                                                                         Senior Loan Officer survey: credit growth to pick up
Like the market, we believe the risk of experiencing high
                                                                                           35%                                                                               100
inflation at some point in the long run is significant.                                                          Yo Y gro wth o f C&I lo ans by co mmercial banks
                                                                                           30%                   Lo o ser lending standards fo r C&I lo ans, 18M lead
However, persistently high levels of inflation are unlikely                                                                                                                  80
                                                                                           25%                   Stro nger demand fo r C&I lo ans (12M lead, rhs)
to be realized in the next few years. While the creation of                                                                                                                  60
a very large amount of central bank money should on its                                     15%
own raise the risk of higher inflation in the future, this risk                             10%                                                                              20
will only materialize if/once the money multiplier starts                                    5%                                                                              0
normalizing.                                                                                 0%                                                                              -20
So far the increase of the monetary base experienced                                                                                                                         -40
since 2008 has not led to a comparable growth of broader                                   -15%
monetary aggregates; it has mostly offset the destruction                                  -20%                                                                              -80
of private credit and stabilized M2. US commercial banks                                   -25%                                                                              -100
have not used the proceeds of Fed purchases to boost                                              94     96         98     00     02     04      06     08      10      12
lending to the private sector but have simply hoarded                                    Source: Deutsche Bank

them as excess reserves. Similarly, QE2 is likely to lead to
further increases in the excess reserves held by US                                      While survey results are encouraging for C&I loans, they
commercial banks at the Fed but is unlikely to trigger by                                are not as positive for other forms of loans. The elevated
itself a normalization of the money multiplier and a sharp                               unemployment rate, the negative outlook for house prices
increase in M2 growth (see chart below).                                                 and the fragility of US consumers may prevent demand
                                                                                         for consumer loans and mortgage loans from picking up
                                                                                         significantly next year. Moreover, potential losses relative
                                                                                         to MBS put-back could mildly weaken the balance sheet
                                                                                         of US banks and slow down the recovery in lending.

Page 124                                                                                                                                        Deutsche Bank AG/London
10 December 2010               Fixed Income Outlook 2011

All in all the risk of a significant growth in broad money                 2011 towards 2% YoY. Taking a look back at the dynamics
aggregates remains possible down the road as the                           of Shelter CPI and OER CPI QoQ over the course of 2010,
economic recovery unfolds and US commercial banks                          it is pretty clear that rent inflation started bottoming out
resume lending, growing their balance sheets. Whether                      about 6 months ago (see chart below).
the Fed will be able to implement a timely and efficient
exit strategy to avoid excessive money growth and                          Rent inflation has bottomed out in mid 2010
subsequent inflation is unclear given the extraordinary                       2.0%
                                                                                                          Shelter CP I SA Qo Q
nature of the exercise. This justifies in our view the                                                    Owner's Equivalent Rents SA Qo Q
presence of a steadily high inflation risk premium at the
long end of the TIPS breakeven and inflation swap curve.                      1.2%

Core inflation outlook for 2011
Core inflation collapsed from 1.8% YoY in December 2009
towards 0.6% YoY in October 2010, in line with our                            0.0%

forecasts. The drop in core inflation was a two-stage
process. Until May 2010 most of the slowdown in core
inflation was due to the continuous decline in shelter                       -0.8%
inflation (mainly OER and Primary Rents CPI) a lagged                                   01        02      03     04        05    06    07        08    09         10

reaction to the past collapse of house prices. The chart                   Source: Deutsche Bank

below shows the strong correlation between OER CPI
YoY and core CPI YoY historically as shelter inflation                     Rent inflation tends to react with a strong lag (of about 18
represents about 43% of the core inflation index. Beyond                   months) to the path of house prices YoY. The small
May, shelter inflation stabilized and most of the decline in               recovery and stabilization of the housing prices between
core inflation was driven by slower core goods inflation, a                H2-09 and H1-10 should lead to the normalization of rent
lagged reaction to the decline in production costs in 2009.                inflation in 2011. We also find that the recent recovery in
We believe both rent inflation and core goods inflation will               personal spending YoY is good leading indicator of the
rebound in 2011, leading to a normalization of core CPI. In                upcoming rebound in rent inflation (see chart below).
the section below we give the details of our 2011
                                                                            Housing market and personal spending lead rents
forecasts for core inflation, using a bottom up approach.
                                                                              5%                                                                                       30%
 Rent inflation remains a key driver of core inflation                        4%                                                                                       20%
  4.0%                                                               6%       3%
                        US Core CPI YoY (lhs)                                                                                                                          10%
  3.5%                  OER CPI YoY (rhs)                                                                                                                              5%
                                                                     5%       2%
  3.0%                                                                        1%                                                                                       -5%
                                                                     4%                                                                                                -10%
                                                                                                         Shelter CP I Yo Y
  2.5%                                                                        0%                                                                                       -15%
                                                                                                         Ho use P rices Yo Y (18M lead)
                                                                     3%                                                                                                -20%
  2.0%                                                                       -1%                                                                                       -25%
                                                                     2%            00        01    02     03   04     05    06   07   08    09    10   11    12
                                                                             6%                                                                                        12%
   1.0%                                                                      5%                                                                                        10%

                                                                     0%      4%                                                                                        8%
  0.0%                                                               -1%                                                                                               4%
          98 99 00 01 02 03 04 05 06 07 08 09              10   11           2%
Source: Deutsche Bank                                                        1%                        OER CP I Yo Y
                                                                             0%                        P erso nal Co nsumptio n                                        -2%
Core CPI should rebound over the course of 2011                                                        Expenditures Yo Y (15M lead)
                                                                             -1%                                                                                       -4%
In order to forecast core inflation, we decompose core                             87        89    91     93   95     97    99   01   03    05    07    10    12

CPI into two subcomponents: shelter CPI on the one hand                    Source: Deutsche Bank

(mostly rent inflation through the OER component), and
core inflation ex shelter on the other hand, which                         The Quarterly Survey of Apartment Market Conditions,
corresponds to inflation for core goods and services.                      released by the National Multi Housing Council, also
                                                                           suggests that we have experienced a widespread
Shelter inflation: We find multiple evidences that Shelter                 improvement in the apartment rental market. Their Market
inflation has bottomed out and that it will accelerate in

Deutsche Bank AG/London                                                                                                                                      Page 125
10 December 2010                 Fixed Income Outlook 2011

Tightness Index has increased significantly over the past                                since last year from about 0.7% to about 1.5% and the
few quarters, as a growing majority of respondents have                                  trend should continue in the next few months given still
been reporting a tighter rental market in the form of lower                              high pipeline inflation pressures as reflected in the high
vacancy rates and/or higher rents. Historically, the Market                              growth rate of PPI Core Crude Materials and of PPI Core
Tightness Index has been a good leading indicator (15M                                   Intermediate Materials YoY.
forward) of the trend for rent inflation (see chart below).
                                                                                         Core CPI ex Shelter should stabilize and recover
Tighter apartment rental market suggests higher rents                                      4.0%                                                                                    7%
                                                                                                              Co re Go o ds/Services CP I Yo Y (Co re CP I ex shelter)
  7%                                                                               140
                        OER CP I Yo Y                                                      3.5%               P P I Co re Finished Go o ds Yo Y (rhs, 12M lead)                    6%
  6%                                                                               120                                                                                             5%
                        M arket Tightness Index by NM HC (measure o f                      3.0%
  5%                    changes in o ccupancy rates and rents) 15M lead                                                                                                            4%
                                                                                   100     2.5%
  4%                                                                                                                                                                               3%
                                                                                   80      2.0%
  3%                                                                                                                                                                               2%
                                                                                   60      1.5%
                                                                                   40                                                                                              0%
                                                                                           0.5%                                                                                    -1%
  0%                                                                               20
                                                                                           0.0%                                                                                    -2%
  -1%                                                                              0              02     03        04    05     06    07       08        09        10        11
        04      05        06      07     08       09      10         11       12
                                                                                         Source: Deutsche Bank
Source: Deutsche Bank

                                                                                         The strong increase in industrial commodity prices has
Finally the recent increase in effective apartment rents                                 driven most of the pipeline inflation in 2010. ISM Prices
reported by REIS Inc (see chart below) confirms that rent                                Paid has remained elevated recently, suggesting that
inflation should recover in 2011 and ultimately boost core                               manufacturers continue to experience higher production
CPI YoY. The observed lag between rent inflation as                                      costs and plan to transfer some of these costs onto retail
reported by the BLS and measures of effective rents                                      prices. Recent levels of ISM Prices Paid suggest that PPI
comes from the fact that the BLS calculate and smoothes                                  Core Finished Goods YoY will continue to increase over
rent inflation using a kind of 6-month moving average.                                   the next 3 quarters and keep upward pressure on core
 Effective rents suggests rent inflation will pick up                                    goods inflation down the road (see chart below).

  7%                    CP I P rimary Rents (Qo Q annualized, lhs)                 9%    High ISM Prices Paid suggests further increase in PPI
  6%                    REIS effective apartment rents (rhs, 6M lead)                      120                                                                                     6%
                                                                                   7%                            ISM P rices P aid (9M lead)
                                                                                            10                   1-year change in P P I Co re Finished Go o ds Yo Y                5%
  5%                                                                               6%
                                                                                   5%      100                                                                                     4%
  4%                                                                               4%       90                                                                                     3%
                                                                                   3%       80                                                                                     2%
                                                                                            70                                                                                     1%
  2%                                                                               1%
                                                                                            60                                                                                     0%
   1%                                                                              -1%      50                                                                                     -1%
                                                                                   -2%      40                                                                                     -2%
                                                                                   -3%      30                                                                                     -3%
  -1%                                                                              -4%
                                                                                            20                                                                                     -4%
    Oct-05        Oct-06       Oct-07      Oct-08      Oct-09        Oct-10
                                                                                            10                                                                                     -5%
Source: Deutsche Bank
                                                                                                 00    01     02    03    04    05   06    07       08        09        10    11
                                                                                         Source: Deutsche Bank
Core Goods and Services inflation: Beyond the
upcoming recovery of rent inflation, we also expect
                                                                                         As far as inflation for core services is concerned (Services
inflation for core goods and services to bottom out in the
                                                                                         ex Energy ex Rents) we expect some mild acceleration in
next quarter and to increase gradually until the end of
                                                                                         2011. Core Services CPI YoY has been ranging between
2011. Inflation for core goods tends to lag PPI Core
                                                                                         2.3% and 3.2% in 2010. The ISM non-manufacturing
Finished Goods YoY by about 12 months (see chart
                                                                                         report on business prices has been a decent leading
below). We believe the recent softness in core goods
                                                                                         indicator of the future change in core services inflation.
inflation has resulted form the past collapse of production
                                                                                         Current levels are consistent with a mild acceleration of
costs a year ago. PPI Core Finished Goods has recovered

Page 126                                                                                                                                       Deutsche Bank AG/London
10 December 2010                     Fixed Income Outlook 2011

prices for core services in the next six months (see chart                                     was mostly the result of the sharp negative demand
below). Moreover medical care costs (included the                                              shock observed in H2 2008/ H1 2009. Core inflation in
calculation of inflation for core services) are expected to                                    2011 will mostly respond to levels of economic activity
increase next year, notably on the back of higher                                              observed in 2010. We observe a strong relationship
premiums (+12.4% for the Federal Employee Heath                                                between the current level of economic activity (proxied by
Benefits Program for instance).                                                                ISM Manufacturing) and the future 12-month change in
                                                                                               the rate of core inflation. Despite a high unemployment
 Core Services CPI YoY should accelerate mildly                                                rate, economic activity in the US has been strong enough
                    ISM No n-M anufacturing - B usiness P rices (6M lead)
                                                                                        4%     in 2010 to trigger an acceleration of core inflation YoY in
                    1-year change in co re services CP I Yo Y                           3%
                                                                                               2011 (see chart below).
   84                                                                                   2%     ISM level suggests acceleration of core CPI YoY
                                                                                                 2.4%                                                                               70
   76                                                                                   1%                                   Y
                                                                                                                            1 change in Yo Y US Co re CP I (lhs)
   68                                                                                             1.8%                      ISM M anufacturing (12M lead)                           65
   60                                                                                             1.2%
   52                                                                                   -1%
   44                                                                                                                                                                               55
   36                                                                                                                                                                               50
                                                                                        -3%      -0.6%
   20                                                                                   -4%      -1.2%
        03       04          05          06    07         08      09        10                                                                                                      40
Source: Deutsche Bank
                                                                                                 -2.4%                                                                              35

Core Inflation: All in all we believe core CPI YoY has just                                      -3.0%                                                                              30

reached its trough at 0.60% in October. It is likely to                                                  91     93     95      97    99     01    03     05    07       09     11
                                                                                               Source: Deutsche Bank
stabilize at this level until the end of the year as shelter
inflation and core goods inflation consolidate around
                                                                                               We also find that the change in unemployment rate (i.e.
current soft levels. It should then rebound gradually over
                                                                                               the monthly pace of job creation) rather than the actual
the course of 2011. Combining our forecasts for shelter
                                                                                               level of unemployment rate has been a good leading
inflation and for core goods and services inflation, we find
                                                                                               indicator of unit labor costs. We do not need to
that core inflation could reach 1% in April 2011, 1.2% in
                                                                                               experience a sharp decline in the unemployment rate to
June 2011, 1.5% in September 2011 and potentially 1.8%
                                                                                               start seeing a normalization of unit labor costs, the
in December 2011 (see chart below). The average rate of
                                                                                               stabilization of the unemployment rate and positive
core inflation in 2011 would be 1.25% relative to 2010.
                                                                                               monthly job creations should be sufficient to support
 Core CPI YoY forecasts                                                                        further increase in unit labor costs (see chart below).
  3.5%                            Co re CP I Yo Y                                              Unit Labor Costs should keep recovering
                                  Fo recasts
  3.0%                                                                                           900      k                                                                   %     7
                                                                                                                        Change in P rivate P ayro lls (12M lead, lhs)
                                                                                                 700                                                                                6
                                                                                                                        Unit Labo r Co sts Yo Y (rhs)
  2.5%                                                                                                                                                                              5
                                                                                  1.5%-1.8%                                                                                         4
  2.0%                                                                           in Q4 201 1     300                                                                                3

                                                                                                  100                                                                               2
                                                                                                 -300                                                                               -1

  0.5%                                              Co re CP I has reached                       -500                                                                               -2
                                                    its tro ugh at 0.6% Yo Y                                                                                                        -3
  0.0%                                                                                                                                                                              -4
         99    00       01   02     03    04   05    06    07   08     09   10     11            -900                                                                               -5
                                                                                                        96 97 98 99 00 01 02 03 04 05 06 07 08 09 10                          1 2
                                                                                                                                                                             1 1
Source: Deutsche Bank
                                                                                               Source: Deutsche Bank

Core inflation: medium term outlook                                                            These top down arguments are therefore compatible with
                                                                                               some rebound of core CPI YoY in 2011. To have a view on
Core inflation is one of the most lagging indicators of                                        core CPI from 2012 onwards, we need to look at the
economic activity. The slowdown of core inflation in 2010                                      expected level of economic activity in 2011 and beyond.

Deutsche Bank AG/London                                                                                                                                                      Page 127
10 December 2010                  Fixed Income Outlook 2011

Historically we find that a level of real GDP of 2% has                                      Headline inflation outlook for 2011
been necessary to stabilize core inflation and prevent
disinflationary pressures from appearing. In 2011 our                                        Not only do we expect a recovery of core inflation in 2011
central scenario for US real GDP growth is 2.75% with                                        but we also see upside risk to headline inflation in 2011 on
some upside risk the additional rounds of QE and tax cuts                                    the back of further increase in food inflation. The rise in
This pace of growth should generate about +150k of                                           foodstuff commodity prices (around 30% YoY on average
monthly private payrolls on average (see chart below) and                                    over the past 3 months) has already led to a sharp
lower the unemployment rate marginally in 2011. This                                         increase in food PPI and this could ultimately push food
should be enough to prevent any significant relapse of                                       CPI higher towards 4% YoY (see chart below). Given that
core inflation in 2012 after the rebound likely to be                                        food represents about 15% of the overall headline
experienced in 2011. Small downside risk in 2012 could                                       inflation basket, food inflation alone could add up to 0.6%
come from further decline in house prices in the next few                                    YoY to the expected rate of core inflation.
months which would ultimately put downward pressures
                                                                                             Food inflation should accelerate further
on OER and rent inflation.
                                                                                               7%                    CP I Fo o d & B everages Yo Y (lhs)               12%
Real GDP close to 3% could create 150k jobs/month                                                                    P P I Finished Fo o d Yo Y (4M lead)
                                                                                               6%                    P P I fo recast implied by CRB fo o dstuff
   900                        Change in P rivate P ayro lls (3M M A , lhs)
                                                                                       12                                                                              8%
   750                        US real GDP Qo Q (2Q M A rhs, in %)                              5%
                                                                                       10                                                                              6%
   600                                                                                         4%
   450                                                                                                                                                                 4%
                                                                                       6       3%
                                                                                       4                                                                               2%
   150                                                                                         2%
                                                                                       2                                                                               0%
                                                                                       0        1%
  -150                                                                                                                                                                 -2%
  -300                                                                                 -2      0%                                                                      -4%
  -450                                                                                 -4
                                                                                               -1%                                                                     -6%
  -600                                                                                 -6
                                                                                                     95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10              11
  -750                                                                                 -8
                                                                                             Source: Deutsche Bank
  -900                                                                                 -10
          75   78       81   84   87   90    93    96    99    02   05       08   11
                                                                                             Headline inflation YoY will remain very sensitive of course
Source: Deutsche Bank
                                                                                             to the path of energy prices over the course of 2011.
As Bernanke mentioned in its famous speech on deflation                                      Assuming a gradual convergence of the spot crude oil
in November 2002 (Deflation: Making Sure "It" Doesn't                                        price towards it Dec-11 futures prices of $90 per barrel by
Happen Here) the combination of quantitative easing and                                      the end of 2011, we find that headline inflation could
fiscal stimulus is the ultimate weapon against deflation:                                    increase towards 2% YoY by Q4 2011 given our
“In practice, the effectiveness of anti-deflation policy                                     scenario of gradual normalization of core CPI and of
could be significantly enhanced by cooperation between                                       significantly positive food inflation. We expect headline
the monetary and fiscal authorities. A broad-based tax cut,                                  inflation to reach a trough with the Nov-2010 release
for example, accommodated by a program of open-market                                        around 1.05% before rebounding towards 1.20% YoY in
purchases to alleviate any tendency for interest rates to                                    Dec-2010.
increase, would almost certainly be an effective stimulant                                   We perform two extreme symmetric scenarios around our
to consumption and hence to prices”.                                                         central scenario of crude oil prices going to $90 by the
Obama’s plan to extend tax cuts and to lower payroll                                         end of the year. On the one hand we assume a gradual
taxes is mechanically positive for the growth outlook in                                     appreciation towards $110 on the back of continuous
2011 but could also unlock the full positive impact of the                                   signs of improvement in the US economic outlook
Fed’s monetary stimulus on the economy, reducing                                             boosting projections for global GDP growth and demand
further the risk of deflation in 2012 and beyond. The                                        for commodities. On the other hand we assume a gradual
announcement has largely explained the large nominal and                                     decline of crude oil futures prices towards $70 on the
real rates sell-off since the start of the week. Our                                         back of elevated risk aversion levels and disappointing
medium core inflation outlook is positive for short                                          data in the US in spite of the additional monetary and
maturity TIPS breakevens which continue to price in                                          fiscal stimuli, casting shadows on the ability of the US to
depressed inflation rates in 2011 and 2012 in particular.                                    prevent a disinflationary double dip beyond 2011. In the
                                                                                             optimistic scenario ($110), we find that headline inflation
                                                                                             could increase gradually towards 2.7% YoY at the end of
                                                                                             2011. In the pessimistic scenario ($70), we find that

Page 128                                                                                                                                         Deutsche Bank AG/London
10 December 2010                   Fixed Income Outlook 2011

headline inflation would evolve in a 1.1%-1.5% range and                       Real yields remain low historically
finish the year at 1.2% YoY.                                                                                                                      10-year
                                                                                  2.0      TIP S Real yields, centered
                                                                                           aro und average since 2002                             5-year
Scenarios for headline CPI YoY in 2011                                            1.5                                                             30-year
   6%       US Headline CP I
                                                                P ro jected       1.0
   5%                                                          path o f CP I
   4%                                                              Yo Y

   3%                                                                             0.0
   2%                                                                 2%         -0.5
    1%                                                                1.2%
  -2%                                                                            -2.0
                         Central scenario ($ 90)
  -3%                    Crude o il to $ 60
                         Crude o il to $ 1 0                                   Source: Deutsche Bank
     Dec-05 Dec-06            Dec-07 Dec-08 Dec-09    Dec-10    Dec-11
                                                                               Near term stable TIPS BEs and high yield beta
Source:, Deutsche Bank
                                                                               between TIPS and Treasury yields
US CPI in 2011 could thus well range between 1.2% and                          Despite the high volatility in rates over the past few
2.7%, with our central/median scenario at 2%. At the time                      weeks, as the ten-year Treasury yield grinded higher from
of writing TIPS maturing in 2012 are pricing in about 1%                       a trough of around 2.40% in early October to almost
of inflation in 2012, below the bottom of our range and                        3.25% now, TIPS BEs have traded in a relatively tight
well below our central forecast. They therefore offer                          range between 2.00% and 2.20% most of the time. The
strong strategic value in our view (see details in the                         recent increase in Treasury yields have been matched by
relative value section).                                                       rising real rates. The yield beta between the two has been
                                                                               high. The ten-year TIPS real yields are now back to pre-
TIPS outlook 2011, real yields and BEs                                         Jackson Hole level at around 1.00%, about 2.8 times of
                                                                               the trough level 0.36% seen in October 2010. Further rise
TIPS performed particularly well in absolute terms in 2010                     in real yields will need to be warranted by expectations for
because of the rally in real yields. Paradoxically, the real                   a sustained economic expansion, in our view.
yield rally and therefore the good performance of TIPS
was first triggered by disappointing economic data and                         The yield beta between TIPS and nominal Treasuries
growing fears of a deflationary double dip (between April                      has been high during the recent market sell-off
2010 and August 2010) and was then driven by the                                 1.0              Rolling 1m chg in 10yr BE
implementation of QE2 in response to worrisome                                                    Rolling 1m chg in 10yr real yield
disinflationary pressures. Since November, the 10-year                                            Rolling 1m chg in 10yr nominal Tsy
real yields have sold off by about 60bp from historically
rich levels on the back of better data and of the likely                         0.4

implementation of a new fiscal stimulus, but real yields                         0.2
remain particularly low historically (see chart below).                          0.0




                                                                                   Apr-10 May-10 Jun-10 Jul-10        Aug-10 Sep-10 Oct-10 Nov-10 Dec-10
                                                                               Source: Deutsche Bank

                                                                               The high yield beta between Treasury and TIPS yields as
                                                                               bonds sold off was mostly a reversal of the pre-QE2
                                                                               trades. From early September to early November, the
                                                                               drop in real yields exceeded the decline in Treasury yields,
                                                                               consistent with the objectives of QE2 that drive real rates
                                                                               lower and raise inflation expectations. Ten-year TIPS
                                                                               breakevens surged from a low of 1.51% in late summer to

Deutsche Bank AG/London                                                                                                                          Page 129
10 December 2010                  Fixed Income Outlook 2011

a recent peak of about 2.20%. Interestingly enough, QE2                5Y5Y real yield still rich
did its job of boosting inflation expectations during pre-
                                                                                           TIP S 5Y5Y real yield
QE2 operation period. TIPS breakevens being now close
                                                                                           TIP S 10Y20Y real yield
to fair value in the intermediate and long part of the curve,
they could remain “sticky” near term, while the high yield               3.0

beta between Treasuries and TIPS could stay high, in our
view. Investors who are bearish on Treasuries should also                2.5
have a view that real yields are likely to rise further, and
vice versa.
For investors who look at TIPS breakeven seasonals, we
note that breakevens tend to remain stable around year                    1.5
end, but on average tend to rise in January after TIPS
supply. However, the seasonal trades did not work in
early 2010 due to a sharp rally in Treasuries.
                                                                          Dec-05           Dec-06       Dec-07       Dec-08   Dec-09   Dec-10

TIPS breakeven seasonals                                               Source:, Deutsche Bank

                                                                       The 5Y5Y forward real yield would then also be closer to
                                                                       long term expectations of real GDP growth in the US and
                                                                       the real bond risk premium would have normalized.
  0.00                                                                 Interestingly, the 10Y20Y and 10Y10Y forward real yields
                                                                       have already sold off significantly towards the 2.35%-
 -0.25                                                                 2.45% range, above their long term average, and they
                                                                       now look fully aligned with long term expectations of real
 -0.50                                                                 GDP growth. The normalization of 10Y10Y and 10Y20Y
                         2005-2009 Average                             forward real yields has been helped by the extreme
 -0.75                   2003-2007 Average
                                                                       steepening of the 10Y-20Y and 10Y-30Y real slopes in H2
                                                                       2010, in line with the steepening of the 10s30s UST
 -1.00                                                                 nominal slope. We would therefore expect the 10Y real
          0    20       40   60   80 100 120 140 160 180 200 220 240   yield to underperform the 5Y real yield and 30Y real yield
Source: Deutsche Bank                                                  in the sell-off. The 5s10s real yield slope is likely to bear
                                                                       steepen given that front real yields are more anchored by
Real yields could sell-off further in H1 2011                          monetary policy and could richen given the fundamental
                                                                       cheapness of front breakevens (see relative value section
The outlook for real yields is different in 2011 than in
                                                                       below for details). Some bear steepening of the 5s10s
2010: real yields are now richer than a year ago while the
                                                                       real slope would favor the normalization of the 5Y5Y real
GDP outlook is being upgraded for 2011 and deflation
                                                                       yield. Simultaneously the 10s30s real yield slope should
fears are receding on the back QE2 and new tax cuts. We
                                                                       bear flatten in order to avoid an excessive cheapening of
therefore expect the normalization of risk premia in the
                                                                       the 10Y20Y real yield against long term average and long
bond market that resumed in November of this year to
                                                                       term expectations of real GDP growth. All in all we would
continue into next year. Some improvement in the job
                                                                       underweight the 10Y sector against the 5Y and 30Y
market and the mechanical rebound of core inflation may
                                                                       sector in real yield terms in the next few months.
prevent the Fed from expanding QE2 beyond the month
of June. By pricing out QE gradually in the next few
months, the 10Y nominal Treasury yield could sell-off
towards 3.5% and the 10Y real yield towards 1.25% in
H1 2011 assuming a 10Y breakeven close to fair value
around 2.25%.

 Assuming some mild bear-steepening of the 5Y-10Y real
slope this could push the 5Y5Y real yield towards the long
term average of long dated forward real yields around
2.2% (see chart below).

Page 130                                                                                                               Deutsche Bank AG/London
10 December 2010                  Fixed Income Outlook 2011

Strategically underweight 10Y TIPS vs. 5Y and 30Y                                  outlook in the next couple of months. First, Dec CPI
   60          bp
                                                                                   forecasts keep being revised up given the recent increase
                              TIP S 5Y-10Y-30Y real yield butterfly (50/50)
                                                                                   of crude oil prices, which should make negative carry on
                                                                                   TIPS negligible in the next couple of months. Second, the
   40                                                                              market is now increasingly likely to start focusing on the
                                                                                   upcoming positive winter seasonals. Thanks to
                                                                                   seasonality Jan CPI-U NSA is likely to be significantly
   20                                                                              positive between 0.20% and 0.30% MoM, a strong
    10                                                                             acceleration relative to Dec CPI MoM (likely to be
                                                                                   between -0.10% and 0% MoM). The upcoming
                                                                                   acceleration of CPI MoM and resulting improvement in
   (10)                                                                            the carry outlook is typically bullish for front breakevens
   (20)                                                                            Positive winter seasonals to boost front BEs
          01        02   03       04     05      06     07      08      09    10
Source:, Deutsche Bank                                                               400     bp            Monthly change in TIPS 2Y breakeven (lhs)            300
                                                                                                           Monthly change in MA(2M) of CPI MoM (rhs)
Beyond H1 2011, the direction of rates would be more                                                                                                            200
uncertain, ultimately depending upon the policy mix and                              200
the economic outlook. Should data disappoint significantly                                                                                                      100
in H1, the Fed may actually decide to expand QE beyond
                                                                                        0                                                                       0
June, triggering another bond market rally. On the other
hand, strong data, no QE3 and no preemptive fiscal                                   -100
tightening would justify higher rates. In our base case                             -200
scenario, intermediate and long BEs would exhibit little                                                                                                        -200
volatility from current levels which we believe are close to                        -300

fair value (5Y5Y breakeven is close to 2.75% for instance                           -400                                                                        -300
and is pricing in sufficient inflation risk premium, the 10Y                           Jan-06          Jan-07       Jan-08     Dec-08     Dec-09       Dec-10
and 20Y breakeven are about fair against our models, see                           Source: Deutsche Bank

next section for details). Intermediate and long real yields
should move with a high beta relative to 10Y nominal
yields. The outlook for real rates in 2011 is therefore                            Relative value Opportunities
mixed with a bearish bias in the next few months and                               Buy front TIPS 2012 breakevens
a likely underperformance of the 10Y sector against
the 5Y and 30Y sectors. The expected move in real yields                           We continue to believe that TIPS maturing in 2012 are not
is a priori unlikely to generate significant positive returns                      pricing in enough inflation for year 2011, and therefore,
for TIPS in 2011.                                                                  offer value. Despite this week’s widening, the TIPS Jan-
                                                                                   2012 breakeven implying only 1% of inflation between
Favorable environment for front breakevens                                         Oct/Nov 2010 and Oct/Nov 2011, about 100bp below our
On the other hand we are expecting a significant recovery                          forecast. Similarly the forward breakeven implied by TIPS
in core and headline inflation in 2011 and realized inflation                      04/12s and 04/11s breakevens is pricing in 1.05% of
should contribute to a higher share of returns. This                               inflation between Jan/Feb 2011 and Jan/Feb 2012.
inflation outlook is positive for breakevens. However                              Inflation expectations priced in for year 2011 remain very
breakevens beyond the 2017 maturity are already higher                             low historically (see chart below) and particularly low
than 2%, our central forecast for inflation in 2011. In other                      against our 2% forecast Looking at the relative value
words realized inflation accretion may not be enough to                            among TIPS Jan-2012, Apr-2012 and Jul-2012, the three
lead to an outperformance of TIPS vs. UST in the next 12                           issues look fundamentally cheap, but the TIPS 04/12s
months assuming no further widening of breakevens.                                 looks marginally richer than surrounding TIPS, not fully
However short maturity breakevens in the 1Y-5Y sector                              reflecting the negative seasonals of April issues relative to
remain significantly below our inflation forecast, which                           January and July issues.
means that front TIPS can outperform Treasuries in 2011,
benefiting both from realized inflation being higher than
breakeven levels, and from the likely widening and
normalization of BEs from current depressed levels.

We actually believe that front breakevens should also
benefit from the upcoming improvement in the carry

Deutsche Bank AG/London                                                                                                                                 Page 131
10 December 2010                 Fixed Income Outlook 2011

1-year inflation implied by TIPS maturing in 2012                              YoY inflation scenario priced in by breakevens
  2.5%                  1 inflatio n implied by 04/1 s and 04/1 B E
                         yr                         1          2s                3.5%            Yo Y inflatio n scenario implied by TIP S B /Es 8-Dec-2010
                         yr                       /1 s     /1
                        1 inflatio n implied by 01 1 and 01 2s B E                                              2.83% 2.85% 2.90%
                                                                                                            2.68%                 2.62%                  2.68% 2.71%
  2.0%                                                                                                                                           2.52%
                                                                                 2.0%              1.73%
   1.0%                                                                          1.5%

                                                                                 1.0% 0.91%

      A pr-09     Jul-09     Oct-09    Jan-10   A pr-10    Jul-10     Oct-10
                                                                                        2010    2012       2014   2016     2018   2020    2022   2024     2026     2028
Source: Deutsche Bank
                                                                               Source:, Deutsche Bank

We also highlight that front end TIPS have tended to
                                                                               The 3-year sector still strikes us as being particularly
underestimate the realized rate of YoY inflation one year
                                                                               cheap, pricing in a very mild inflation scenario in 2011,
later, at least in four out of the past five years. For
                                                                               2012 and 2013, gradually increasing from about 1%
example, in December 2006, the 1/15/2008 TIPS had an
                                                                               towards 1.7% only. The TIPS 01/14s breakeven for
average BE around 2.25%. At the end of 2007, the YoY
                                                                               instance in only pricing in 1.27% of average annualized
headline CPI was north of 4%. The trade did not work
                                                                               inflation over the next three years, about 70bp below our
during the financial market crisis in late 2008, when the
                                                                               forecast. Beyond 2013, the market is pricing in a
actual inflation was less than what was implied by front
                                                                               normalization of inflation towards 2.25% in 2014 and
end TIPS in late 2007.
                                                                               2.7% in 2015, making the 5Y sector less attractive than
One of the reasons why 1/2012 TIPS looks cheap is                              the 3Y sector in relative value terms. We see particularly
probably because the issue is due to be excluded from                          good value in the TIPS 07/13s BE. The slope between the
the index in January 2011. We think this presents an                           07/13s BE and 07/12s BE has flattened back towards 2bp
opportunity for non-index based investors.                                     only and pushing down the forward BE towards 1.23% at
                                                                               the time of writing (expected inflation between Apr/May
Front end TIPS have tended to underestimate the                                2012 and Apr/May 2013). Simultaneously the forward
year-over-year inflation one year ahead                                        breakeven implied by 07/14s and 07/13s is much higher
                                                           Headline CPI        around 1.95%. We would therefore recommend favoring
              Period            TIPS Dec Avg BE               1yr Later        the 07/13s breakeven outright or as a relative value trade
              Dec-05       1/15/2007        1.92                   2.54
                                                                               against the 07/12s BE in a BE steepener (see chart
              Dec-06       1/15/2008        2.25                   4.08
              Dec-07       1/15/2009        2.15                   0.09        below), or against the 07/12s BE and the 07/14s BE in a
              Dec-08       1/15/2010       -5.67                   2.72        50/50 butterfly.
              Dec-09       1/15/2011        0.71                   1.20
Source: Deutsche Bank                                                          TIPS 07/13s BE cheap within the 3Y sector
                                                                                  60     bp
Buy TIPS BEs in the 3Y sector, favor TIPS 07/13s                                                                            2s     3s
                                                                                                                  TIP S 07/1 - 07/1 B E slo pe
Bootstrapping the TIPS breakevens curve, we can extract
the expected path of YoY inflation for every single year
and have a better view of the inflation scenario priced in                        30
by the market. The chart below shows this projected path
of YoY inflation implied by TIPS.


                                                                                    Jul-09         Oct-09         Jan-10      A pr-10      Jul-10         Oct-10
                                                                               Source: Deutsche Bank

Page 132                                                                                                                                Deutsche Bank AG/London
10 December 2010        Fixed Income Outlook 2011

Bearish view favors being long 5Y TIPS BEs                      10Y breakeven close to fair value in absolute terms
Bearish investors should consider being long 5yr TIPS              3.0

BEs. 5yr BEs have traded in a 1.40% to 1.60% range most
of the time since early October, despite of the market sell-
off. In a scenario of further backup in rates, 5yr BEs are
likely to widen at a faster pace. The relationship between
BEs and Treasury yields at the 5yr maturity appears like a         1.5
“hockey stick,” where BEs tend to have little correlation
with Treasury yields in a rally, but widen quickly in further      1.0
sell-off with a high correlation.
                                                                                        TIP S 1 breakeven
5yr TIPS breakevens are likely to rise at a fast pace in                                 0Y
                                                                                        1 TIP S breakeven market mo del

a scenario of further market sell-off                               -
                                                                         02      03        04     05      06      07      08       09     10
                                                                Source: Deutsche Bank

                                                                Any specific upside on the 10Y sector now looks
                                                                particularly limited while the 5Y sector should largely
                                                                benefit from the expected normalization of the 3Y sector.
                                                                The 30Y sector also looks slightly cheap against the 10Y
                                                                and 20Y sector with 10Y20Y BE being 10bp cheaper than
                                                                5Y5Y BE while it should embed the highest inflation risk

                                                                10Y BE looking rich against the 5Y and 30Y wings
                                                                  35      bp
                                                                                            TIP S 5Y-10Y-30Y 50/50 breakeven butterfly

Source: Deutsche Bank

The limited tightening in a rally is related to the deflation
floor embedded in the recently auctioned 5yr issue. We            20
estimate the option is worth about 17bp on the 04/15s
and is almost worthless in the seasoned 01/15s issue.
Sell 10Y BE vs. the 5Y and 30Y wings
The 10Y breakevens has significantly outperformed the
rest of the curve over the past few weeks. In absolute               -
terms the 10Y BE is close to fair value in our view. Our             A pr-09     Jul-09     Oct-09     Jan-10   A pr-10   Jul-10    Oct-10
market model based on energy prices, money market               Source: Deutsche Bank

slope, risk variables, suggests that fair value is close to
2.25% (see chart below). The 5Y5Y BE has also fully             Looking at the 5Y-10Y-30Y BE butterfly (using the TIPS
recovered and now stands around 2.75% using the                 Jan-15, see above chart), we now find that the residual is
07/20s and 07/15s breakevens, in line with the long term        close to the top of the historically range since the start of
average of inflation over the past 20 years.                    2009. The 10Y sector could also suffer from concession
                                                                pricing ahead of the upcoming supply of the new Jan-
                                                                2021 benchmark in January (around $14bn).

                                                                Buy 10Y10Y CPI Swap vs. 5Y5Y CPI Swap

                                                                Our inflation risk premium model suggests the 20Y sector
                                                                is now trading close to fair value against economic
                                                                fundamentals (ISM Manufacturing, core CPI), inflation risk
                                                                variables (volatility of growth and inflation, correlation
                                                                between growth and inflation) and liquidity variables.

Deutsche Bank AG/London                                                                                                                  Page 133
10 December 2010                    Fixed Income Outlook 2011

20Y breakeven at fair value                                                              10Y10Y vs 5Y5Y CPI swap slope should be positive
  3.2%                                                                                       60
                                                                                             40                                                   P re-crisis level
  2.4%                                                                                        0
  1.6%                                                                                      -60                                     .

                               IRP mo del: implied 20Y B E                                 -100
  0.8%                         20Y breakeven                                               -120
                                                                                                           CP I Swap 1 0Y vs 5Y5Y
                                                                                                 2006             2007         2008          2009               2010
          02     03          04      05      06      07      08      09        10
                                                                                         Source: Deutsche Bank
Source: Deutsche Bank

The 20Y breakeven around 2.45% is implying a 10Y10Y                                      Buy TIPS 2025 BE against 10Y and 20Y breakevens
breakeven close to 2.75%, also close to fair value in our                                Off-the-run TIPS in the 15Y to 20Y sector continue to trade
view. The output from the model could increase going                                     at a discount relative to the 20Y benchmark 01/29s. We
forward when we start seeing a material increase in the                                  find the discount embedded in the 15Y sector to be
monthly pace of core inflation but this could be offset by                               particularly significant. The TIPS Jan-2025 BE has recently
some consolidation of ISM below 56. At this stage the                                    cheapened back significantly against the 20Y BE but also
market has fully repriced the inflation risk premium in the                              against the 10Y BE. The 10Y5Y BE is now around 2.40%
20Y sector of the curve (see chart below).                                               only, 35bp below the 5Y5Y and 10Y10Y breakevens. This
                                                                                         dislocation does not make fundamental sense and we
Inflation risk premium in 20Y BE has fully recovered
                                                                                         would expect the TIPS 2025 BE to normalize against the
   1.2%                 Inflatio n risk premium priced in by the market                  wings in the medium run (see chart below).
   1.0%                 Theo retical inflatio n risk premium implied by the mo del
                                                                                         TIPS 2025 BE could richen vs. the wings
                                                                                            12                                     0Y
                                                                                                                    TIP S 2025 vs 1 and 20Y B E butterfly
  0.6%                                                                                             bp
  0.2%                                                                                       6
 -0.4%                                                                                      -2
 -0.6%                                                                                      -4
          02      03          04      05      06       07      08         09        10      -6

Source: Deutsche Bank                                                                       -8

While the market has switched from long term deflation                                     -12
                                                                                             Jun-09        Sep-09    Dec-09    M ar-10   Jun-10       Sep-10      Dec-10
fears to long term inflation fears and 20Y breakevens have
fully normalized, the 10Y10Y vs 5Y5Y CPI swap slope is                                   Source:, Deutsche Bank

currently flat. It should be fundamentally positive in order
                                                                                         30Y BE offers better value than 20Y BE
to price in a substantially positive inflation risk premium.
We would recommend positioning for a steepening of the                                   Despite the recent mild cheapening of the 20Y BE we
10Y10Y vs 5Y5Y CPI swap slope, which should converge                                     believe investors can find better relative value in the 30Y
back towards its pre-crisis level around 30bp in the                                     BE in the long end. The 20s-30s breakeven curve has
medium run.                                                                              flattened from a peak of around +20bp in mid October to
                                                                                         the latest level of about +7bp. The flattening of the BE
                                                                                         curve has been consistent with the flattening of the
                                                                                         nominal 10s-30s Treasury curve. Although we cannot rule
                                                                                         out further flattening of the 10s-30s Treasury curve, and

Page 134                                                                                                                                 Deutsche Bank AG/London
10 December 2010                  Fixed Income Outlook 2011

subsequent flattening of the 20s-30s breakeven curve,                                          Sell inflation volatility
30Y BE does present better relative value than 20Y BE.
                                                                                               Implied inflation volatility has increased sharply over the
20yr to 30yr TIPS breakeven curve has flattened                                                past couple of months, becoming significantly higher than
                                                                                               realized volatility. We recommend monetizing the richness
          bp                                   20Y-30Y B E slo pe                              of inflation options by selling them in 3 different trades.
   21                                                                                          Inflation volatility has increased sharply
   19                                                                                            6.0%

   17                                                                                                                     Inflatio n vo latility (implied
                                                                                                 5.5%                     vo l o f the 2% ZC CP I Flo o r


   9                                                                                             4.5%

   5                                                                                             4.0%
   M ar-10              M ay-10          Jul-10           Sep-10            No v-10

Source: Deutsche Bank                                                                            3.5%

Buy US 5Y deflation floor vs. 10Y deflation floor for a                                          3.0%
premium take-out                                                                                     M ar-10             M ay-10           Jul-10           Sep-10          No v-10
                                                                                               Source:, Deutsche Bank

We recommend purchasing 5Y deflation floors, financed
by selling 10Y deflation floors. Despite a higher risk of                                      Buy 10Y TIPS and sell 10Y 0% ZC floor: holders of 10Y
experiencing subdued inflation levels in the next few                                          TIPS are mechanically long a deflation floor since the
years, rather than over the next 10 years, the trade                                           inflation adjusted principal cannot fall below 100 at
generates a premium take-out (see chart below).                                                maturity. We believe the risk of experiencing negative
                                                                                               cumulative inflation over the next 10 years is negligible
While a deterioration of the economic slack or a decline in
                                                                                               particularly given the strong policy bias against deflation in
house prices could maintain inflation at relatively soft
                                                                                               the US. We would recommend TIPS holders to sell the
levels in the next few years, we believe the sharp increase
                                                                                               deflation floor in the derivatives market in order to
in the Fed’s balance sheet and the clear policy bias
                                                                                               monetize this expensive option for an upfront premium
against deflation make long term deflation risks negligible
                                                                                               around 103cts corresponding to about 11bp running.
and actually increases the risk of experiencing high
inflation in the long run. The trade should provide                                            Buy 5Y covered breakeven: the trade consists in buying
protection if the economy fails to recover and                                                 the 5Y TIPS breakeven and selling a 5Y YoY 4% cap for an
disinflationary pressures reappear again in the short or                                       upfront premium of 270cts. Buying the 5Y BE around
medium run.                                                                                    1.6% generates a gain in a given year if annual realized
                                                                                               inflation is higher than 1.6%.
5Y deflation floor is now cheaper than 10Y floor
                                                                                               P&L profile of the covered BE strategy
                                      Co st o f 5Y deflatio n flo o r vs.                         4%                    P &L o f lo ng 5Y B E
                                      1 deflatio n flo o r
   60                                                                                                                   P &L o f the sho rt 4% Yo Y CP I Cap
                                                                                                  3%                    P &L o f lo ng 5Y co vered B E
  -40                                                                                                                                                                Realized inflatio n
    Oct-09      Dec-09       Feb-10     A pr-10     Jun-10    A ug-10       Oct-10    Dec-10     -2%