Barclays Global Rates Weekly Making It Easier

Interest Rates Research 25 April 2013

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 67

Global Rates Weekly

Making it easier The decline in inflation and signs of a global slowdown give room for central banks

to ease monetary policies further. We believe that forward expectations of policy rates will be anchored at their low levels and term premia will stay compressed. We maintain our curve flattener view in the US.

Following weak economic data this week, we think ECB will deliver a 25bp refi rate cut next week. While the outright market implications of this are likely to be limited, we hold on to our short Bobl ASW versus 30y ASWs position in Germany.

Relentless Italian and Spanish bond performance has continued on less near-term political uncertainty in Italy and yield-hunting appetite from investors. While short-term profit taking could lead to limited re-widening, we continue to believe the periphery will remain resilient in the medium term.

Global

Making it easier 2 The decline in inflation and signs of a global slowdown give room for central banks to ease monetary policies further. We believe that forward expectations of policy rates will be anchored at their low levels and term premia will stay compressed because of excess liquidity and the scarcity of fixed income investments available to investors.

United States

Treasuries: No free lunches 7 We continue to like curve flatteners, given room for long-term real yields to decline. Recent experience suggests that the market has become more efficient in absorbing refunding long-end supply, and steepeners from this stage have not been profitable. We also recommend shorting a weighted 5s10s20s fly to position for a decline in the term premium embedded in the back end and the relative richening of the 20y sector.

Euro Area

The case for further tightening 20 We still believe Spanish and Italian bonds can tighten vs. Germany for several reasons, eg, positive central bank activity; likely positive economic data surprises; and the continued search for yield. These outweigh potential negatives in Cyprus/Slovenia.

UK

George and the fiscal deficit dragon 29 With the government and the IMF seemingly at odds over the pace of fiscal tightening, a medium-term correction of the fiscal position requires the government to make some hard choices on welfare reform, given its own weak receipts forecasts.

Japan

A second look at JGB yield drivers 48 The correlation between JGB and other markets is partially recovering. However, the correlation with USTs remains broken, and there is asymmetry in linkages with stocks. If there is still some correlation with fundamentals, then JGB yields may rise over Jul-Oct.

Views on a Page 6

Trade Portfolio Update 51

Global Supply Calendar 64

Global Bond Yield Forecasts 66

United States

TIPS: Demise of inflation hedging calls are premature 10

Swaps: FV-TY invoice spread curve steepeners remain attractive 13

Volatility: Limited long 15

Money Markets: The other repo suppliers 17

Europe

Swaps: EUR ASWs not cheap yet 23

Money Markets: Refi cut Limited effect on markets rates 26

Covered Bonds: Spanish bank restructuring and Multi-Cdulas 32

Scandinavia: Inflation suggests room for cuts, but systemic risks remain a key concern 39

Euro Inflation-Linked: Positioning for slowing y/y euro HICPx 41

UK Inflation-Linked: Keep the faith 43

Volatility: Range-bound rates 46

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Barclays | Global Rates Weekly

25 April 2013 2

GLOBAL THEMES

Making it easier The decline in inflation and signs of a global slowdown give room for central banks to ease monetary policies further. We believe that forward expectations of policy rates will be anchored at their low levels and term premia will stay compressed because of excess liquidity and the scarcity of fixed income investments available to investors.

Rates have remained in a very tight range globally over the past few weeks after stabilizing at close to the lowest levels of the year. Economic data showed continuing softening. Manufacturing PMIs (47.9 v 49 consensus) in Germany were weak, suggesting that weakness is spreading to core European countries. UK Q1 GDP came in slightly higher than expectations (0.3% v. 0.1% consensus q/q), but US durable goods data were disappointing (-1.4% for durables ex-transportation v. 0.5% consensus). The manufacturing sector in Asia also appears to be weakening, with the April flash PMI reading in China lower than expectations (50.5 v. 51.5). US Q1 GDP will be released on 26 April, and the key number to watch will be consumption growth, which we expect to surprise to the downside (Barclays forecast of 2.3% v 2.8% consensus).

Policy meetings at all the major developed central banks will be in focus over the next two weeks: the BoJs on 25 and 26 April, the FOMCs and ECBs next week and the BoEs the following week. The declines in inflation in most developed markets, falling commodity prices and subdued growth give central banks more room to ease. Figure 1 shows 5y5y real swap rates, which are a reflection of the monetary policy stance in the major global economies. We believe that the loosening of global monetary policy should continue to exert downward pressure on rates, especially in countries with higher forward real rates such as Japan and the US.

In the UK, the BoE and the UK treasury announced an expansion of the Funding for lending scheme on 24 April. The period under which participants can access under the scheme was extended by one year, and incentives were introduced to promote lending to small and medium enterprises, as opposed to the earlier focus on households. Lending volumes in the UK have so far not picked up meaningfully because of the FLS scheme, but the intent of the BoE to ease financial conditions is clear. In addition, with Governor Carney set to take up the

Rajiv Setia

+1 212 412 5507 [email protected]

Amrut Nashikkar +1 212 412 1848 [email protected]

Cagdas Aksu +44 (0)20 7773 5788

[email protected]

FIGURE 1 5y5y real rates in the US, Europe and Japan still high, given the potential for further easing of monetary policy

FIGURE 2 Core PCE inflation has been declining in the US, giving the Fed room to keep purchasing assets at the current pace

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We think declining inflation and signs of a slowdown in global markets give central banks room to announce more accommodative policies in the next few weeks


25 April 2013 3

reins in two months, our UK economists believe that some changes in policy such as moving to a forward rate guidance or QE in other asset classes may be possible (see No revolution, not much evolution, April 19).

In Japan, the BoJ releases its forecasts for inflation and growth on Friday and is widely expected to use the communications channel to increase inflation expectations. Our Japanese economists believe that to maintain credibility, the BoJ will need to communicate the mechanism through which inflation is expected to pick up (see Long and winding road to inflation, April 25).

The BoJ faces challenges along this front. For a sustainable pickup in inflation, wages need to grow. This requires demand-side pressures in the labor market caused by output growth. Similar to other developed markets, the relationship between base money and money supply is weak, given banking system constraints, as well as a lack of credit demand. For BOJ balance sheet expansion to lead to a pickup in output, other channels are needed, such as the wealth effect from rising stock prices and the devaluation of the yen. However, these channels are too weak, by themselves, to lead to higher inflation under realistic expectations for equity market or currency moves. Our Japanese strategists expect the BoJ to announce further easing measures in H2 13. This should keep downward pressure on long-term JGB yields.

In the US, it is now apparent that the debate in the FOMC is again shifting from tapering to extending asset purchases. Since early February (see Opportunity knocks, February 1, 2103), when we urged investors to buy the dip in bonds, we have argued that concerns about stopping QE were misplaced. Growth expectations for 2013 appeared too high, and we expected the drop in core PCE inflation eventually to attract attention (Figure 2).

Recent Fed speeches indicate that even notable hawks such as St. Louis Fed president Bullard and Richmond Fed president Lacker seem to be shifting their stance on asset purchases. Indeed, with core PCE likely to trend lower on a y/y basis in the near term, rates investors could soon be wondering what the Fed may do next if inflation stays below its target even as the unemployment rate continues to decline. In such a scenario, the Fed could increase the pace of asset purchases, commit to holding the balance sheet at an expanded size for longer, or lower the 6.5% unemployment threshold for considering rate hikes. We believe that the market should price for a non-trivial probability of this scenario, keeping US yields lower for longer; 10y real yields in the US would therefore have room to rally.

The BoJ faces challenges meeting its inflation target; we expect it to announce further easing measures in H2 13

FIGURE 3 Market already priced for low rates in Europe, suggesting that ECB rate cut will not have an immediate effect on rates

FIGURE 4 Japanese portfolio investors were still selling foreign bonds after the BoJ announcement

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JP portfolio purchases (JPY bn) Source: Barclays Research Source: Barclays Research

In the US, the Feds rhetoric has taken a dovish turn; rates markets should begin pricing in some probability of Fed action, given that it is missing its inflation target from the downside


25 April 2013 4

In Europe, the ECB is also expected to cut the policy rate to provide further accommodation to the economy, especially as the decline in financial market fragmentation means that the monetary policy transmission mechanism has improved. As our European economists have highlighted, the April PMI and survey data indicate that economic weakness is now spreading to the large core economies; further, the recent fall in commodity prices may result in more downward pressure on inflation, providing more room for accommodation. However, the market appears to be priced for a rate cut, which suggests that a cut in itself is unlikely to cause a move lower in yields (Figure 3).

Given the increasingly accommodative monetary policy backdrop, expectations of the forward path of short-term rates in developed markets should stay anchored and low for longer. In addition, given the decline in realized inflation globally, coupled with ample liquidity and decreasing fixed income supply, the term premia embedded in long-term bond yields should also remain compressed well below historical norms. Real yields globally have room to decline, especially in the US and Japan.

As we highlighted last week, core European countries such as France rallied sharply on expectations of Japanese portfolio purchases. Such purchases are likely to be slow in coming (as Figure 4 shows, even a week after the BoJs announcement, Japanese portfolio holders were net sellers of foreign securities), and we expect these purchases to favour US fixed income at current valuations. As a result, we maintain our recommendation to buy 10y US and Japan versus France.

Periphery to hold on to its recent gains with the ECB likely to cut next week The main focus of the week in the European markets has been the strong performance of the peripheral markets, with Spanish and Italian 10y yields rallying to levels not reached since 2010 in outright terms. And yield spreads vs. Germany for Italy are at the lows triggered by the ECB LTROs in early 2012, while for Spain they are a few bp above this level. Positive sentiment from the high likelihood of a new coalition government in Italy following the reappointment of Napolitano as president, the covering of short positions by investors and yield-hunting appetite have been the main drivers of the strong periphery performance.

With spreads to Germany now either back or close to their tightest levels in the wake of the 3y LTROs announcement, further performance seems likely to be at a more measured pace. Indeed, following the recent sharp tightening, some short-term profit-taking could lead to limited re-widening. Nevertheless, we believe that several factors support even tighter spreads, including likely positive economic data surprises, central bank activity, and the search for yield alongside flows and positioning, outweigh the potential negatives (see the Euro Strategy section of this publication).

Elsewhere, data in Europe were generally weak and showed signs that economic softness is now also spilling over to Germany (this weeks MPIs and Ifo). At the same time, the bank lending survey still highlights that credit flow to SMEs in Europe is a concern. As such, our economists expect the ECB to cut the refi rate 25bp (no change in the deposit facility rate) next week. A refi rate cut has been talked about by the market for a long time, and following the recent substantial rally in rates, we do not think it will have a big effect on the market. As we discuss in the Euro Money Markets section, at this stage, a refi rate cut has much more relevance in terms of counteracting any possible passive tightening of liquidity conditions than in providing stimulus to the real economy, owing to the frictions in monetary policy transmission.

Indeed, with all the weak data and now a very likely possibility of a refi rate cut from the ECB next week, Bunds traded in a 2bp range the whole week. We continue to expect this outright low volatility to remain in EUR rates. Instead, in EUR ASWs, volatility has been higher than Bunds recently, but we still think that EUR ASWs are not cheap outright and

Easy policy and excess global liquidity mean that forward expectations of policy rates should remain anchored at the current low levels and term premia embedded in long-term yields have room to compress.

Relentless Italian and Spanish bond performance continues on less political uncertainty in Italy near term and yield-hunting appetite

Weak PMIs and bank lending data increase the prospects of a refi cut by the ECB...

... but the rate market implications are likely limited


25 April 2013 5

hold on to our short Bobl ASW on the 5s/30s ASW box trade (see the European Swaps section of this publication).

In the UK, the two main pieces of news were the Q1 13 GDP release, which surprised to the upside at +0.3% q/q, and the announcement from the Bank of England of modifications to its Funding for Lending Scheme. The extension of the scheme to 2015 and clear skew towards encouraging SME lending (the weakness of which has been a concern to policy makers) have been welcome. But with much of detail reported in the press ahead of the release, the market effect was relatively muted. The latest set of public finance data shows that government borrowing remains stubbornly high. In the UK rates piece, we look at some of the longer-term trends in the public finances and see that without some politically difficult decisions about welfare reform, it would seem that the fiscal position may remain weak. In UK inflation, we remain bullish on the very long end of the linker curve. We think that the flatness of the breakeven curve is inconsistent with potentially sizeable pent-up hedging demand from the pensions community. However, we are not particularly negative on 10y breakevens at present, which are still at least 20bp cheap to fair value, in our view.

FIGURE 5 Foreign ownership in Spain (Ex ECB) and 10y Spain-Germany yield spread

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Spanish Bonos held by foreigners (ex ECB, LHS)

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Source: Spanish Tesoro, Barclays Research


25 April 2013 6

VIEWS ON A PAGE

US EUROPE JAPAN

Direction Economic data in the US remain modest, with the fiscal deal and the sequester likely to exert significant drags.

The larger-than-expected easing by the BoJ is likely to be supportive of US yields as well.

We remain neutral on duration.

Next week all eyes will be on the ECB meeting. We expect a 25bp cut only in the refi rate. Markets reaction is likely to be limited, as rates are already low and probably already incorporate expectations of a cut. In the EGB market some temporary profit taking after the recent rally is likely but should not undermine the resilience on the peripheral market. The focus will remain on Italy as a new government could be formed in the next few days.

Though volatility has declined, liquidity still has not recovered to the extent hoped. We suspect investors will be wary of buying actively and do not foresee any rapid fall-off in yields. However, with the worsening economic outlook worldwide, yields are being encouraged downward by a growing number of factors, and we anticipate buying on dips if 10y JGB yields reach the 0.6% level. Direction-wise, we recommend a cautious long position.

Curve/ curvature

We maintain 7s30s curve flatteners given room for long-term real yields to decline.

We maintain our long front-end Tsy vs. OIS view, given improving financing conditions. The 4y sector looks cheap.

We recommend shorting a weighted 5s10s20s fly to position for a decline in term premium.

Shorten on the Cs STRIPS curve into the 10-12y area; switch out of rich 20y Tsy P STRIPS to 20y REFCO P STRIPS.

Hold on to receive EUR 5y5y/5y10y/5y15y fwds. UK: Longer-dated nominal gilt yields remain rich,

underpinned by low real rates. Reset Gilt 5/30s or Gilt 10/30s steepeners into Q2 13 supply. Declining realised volatility supports carry-and-roll structures carry: vol ratios are at their cheapest in the 10-15y part of the curve.

5x5-10x10 flattener. 2s5s flattener. 5x2-7x3 flattener.

Swap spreads

Neutral on 30y spread wideners, considering risks from risky asset underperformance.

1y1y Libor-OIS tightener hedged with 1y1y 3s1s widener.

EUR: Hold on to short Bobl ASW on Ger 5s/30s ASW box. GBP: APF transfer may improve the fiscal position, but

fundamentals remain poor. We remain negative on 10y gilt ASW. Long 5y ASW versus OIS or versus 10y (both versus 6mL).

20s30s box (20y long).

Other spread sectors

We continue to favor long-end agency-Treasury spread tighteners but find the most upside potential only in the super-long end. 7s have underperformed along the curve and now offer more than 20bp of spread pick-up to Treasuries; shorten duration to 10s with no spread give-up.

We remain constructive on Canadian covered bonds, given their relative isolation from Europe and continued significant spread pickup to agencies. Pockets of value persist in USD SSA space.

SEK: Hold SEK/EUR 10y tighteners in swaps and longs in SEK Sep 13 3m FRA tighteners.

Hold Spain and Italy 2s/5s/10s. Hold Spain 5s/10s/30s. Long 5-8y Netherlands versus France. Long FRTR Oct 19/Oct 22/Apr 26 fly.

Pay USD/JPY 1yx1y basis. Pay USD/JPY 4y basis.

Inflation Sell the belly of Apr17-Jul20-Jan23 real yield fly. April14s are about 60bp cheap versus our CPI forecast; we will look to be long April14s energy hedged at 80bp cheap.

The recent uncertainty argues for lower real yields, given the slower payroll growth and low realised inflation.

Should risk aversion increase, we would expect April18s to richen versus Jan18s as the real yield curve flattens and the floor on April18s richens.

Long 10y Euro HICPx swaps. Selling 5y 1% y/y floors versus 0% in zero cost structure is attractive as a hedge against low inflation.

Long linkers stand to benefit from pension de-risking demand, which has been dormant so far this year.

Breakevens have started to rise even with negative carry intact, and we expect this trend to continue for now. Over the short term, there is probably an opportunity for capital gains. However, it is difficult to determine where levels will settle over the medium to long term. In establishing long positions over such an horizon, we recommend paying attention to levels.

Volatility Sell 1y*10y straddles to benefit from range-bound rates and supply from callables.

Long 3y*2y vs 3E and 4E mid curve straddles as a limited-loss way to benefit from a tight range in rates.

Long 3x13 Libor cap-floor vs 3y10y swaption straddle to position for a steepening of the vol surface.

Buy EUR1y*30y 100bp wide risk reversal (long receivers) to hedge a risk flare in the eurozone.

Buy 1y*5y receivers funded with 1y SL 5-30y curve cap to benefit from EUR rates staying low for long.

Buy EUR 6y*5y versus 1y*(5y5y) to position for steepening of the vol surface and monetise the range in rates.

Look to long vol when the market stabilises later in May.

Source: Barclays Research


25 April 2013 7

UNITED STATES: TREASURIES

No free lunches We continue to like curve flatteners, given room for long-term real yields to decline. Recent experience suggests that the market has become more efficient in absorbing refunding long-end supply, and steepeners from this stage have not been profitable. We also recommend shorting a weighted 5s10s20s fly to position for a decline in the term premium embedded in the back end and the relative richening of the 20y sector.

The Treasury market traded in a tight range around 1.7%, even as risk aversion declined amid mildly weaker economic data. Survey indicators continued to surprise to the downside with a negative Richmond Fed print, and durable goods were weaker than expected, as well. On the other hand, initial claims fell more than expected. Our economists tracking estimate of Q1 real GDP growth declined marginally, to 2.9%. While the headline number is largely in line with the consensus, we believe personal consumption is likely to surprise to the downside, as consensus estimates are close to 2.8%, versus our forecast of 2.3%. With the focus on the effects of tax hikes on consumer spending, such a miss should have a significant effect on the markets. Meanwhile, there are no signs of risk aversion yet. Italian and Spanish yield spreads to Germany are already close to the lows of the past two years. The levels of S&P and VIX also indicate little fear embedded in the market.

With central banks globally looking to ease in this backdrop, rates should remain pegged with risks to the downside, especially as real yields have room to decline. The FOMC is scheduled to meet next week and is likely to acknowledge the weakness in the labor market data since the last meeting and the continued decline in underlying inflation. The minutes from recent FOMC meetings have focused on when to taper asset purchases but given the underlying inflation trends, we believe the attention should instead shift to the potential for further accommodation, which may involve increasing the monthly pace of purchases, holding securities for longer (ie, reinvesting maturing securities for longer than currently planned) or modifying the forward guidance. All of these should lead to lower real yields. Figure 1 shows that 5y5y real yields have not kept pace with the market, pushing out expectations of the hiking cycle and suggesting that concerns about paring back purchases are still elevated, which, in our view, is not warranted.

Anshul Pradhan


Vivek Shukla +1 212 412 2532 [email protected]

Real yields further out the curve look high, given the potential for further accommodation

FIGURE 1 5y5y real yields have not declined in line with the hiking cycle being pushed out

FIGURE 2 Steepeners ahead of bond auctions have become less profitable

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25 April 2013 8

FIGURE 3 Recently, steepeners even the week prior to the bond auctions have not been profitable

FIGURE 4 Additional supply in refunding auctions has been easily absorbed

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At these yields levels, with a low risk premium priced into the front end, we have argued that investors should consider curve flatteners (please see Opportunity knocks twice, April 18). While this may seem at odds with the upcoming refunding long-end auctions, we believe that auction-related steepening has been pulled so far away from the actual auction date that it may deter investors from participating in such strategies. Figure 2 shows that in 2011, the 10s30s curve steepened 5bp on average through the five business days heading into the bond auction. However, more recently, it has begun steepening even before the 7y auction, and the steepening is over a week before the bond auction. It seems that as the strategy has become popular, investors have tried to initiate and exit such trades before they become crowded. Figure 3 shows the average P/L in 10s30s steepeners initiated before the 7y auction and unwound before the bond auction over a rolling 6m window. As can be seen, over the past six months, the entire P/L would have been generated by the day after the 7y auction; the trade was not profitable over the second half. For instance, in March, the curve was at its steepest on the 7y auction date, and those who were late in exiting were likely stopped out following the BOJ announcement (Figure 2).

Given this experience, the curve is unlikely to steepen much from now on, and while the upcoming refunding auctions are larger, we believe the market has become more efficient in absorbing this additional supply. Figure 4 shows that refunding auctions tailed by 3bp during 2009-11, compared with non-refunding ones clearing close to WI, but over the past year or so, they have also cleared close to WI levels.

Our rationale for curve flatteners remains. Underlying inflation is muted, with core PCE running at 1.25% y/y; the decline in commodities should also give the Fed comfort in pursuing asset purchases for longer (or at a higher pace), which should suppress term premium. Another way to express the view that the term premium should decline is via being short the 5s10s20s fly as the 10s20s curve is looking too steep, given the 5s10s curve (Figure 5); the regression coefficients suggest shorting a 0.4:1.4:1.0 5s10s20s fly.

The trade should benefit from an unwind of the cheapening of the 20y sector as well. Figure 6 shows that controlling for the general richening of long-end ASWs, the 20y sector has underperformed on the ASW curve. We believe this may have been due to the Feds allocating a smaller share of purchases in the 10-20y sector in QE3. However, in our view, what should matter is the stock of Fed holdings. Figure 7 shows that the Fed holds 42% in the 10-20y sector (vs 39% in the 20-30y sector) and by the end of the year it should still

Auction related steepeners initiated over the week prior to the bond auction have not been profitable over the last six months

Market has become more efficient in absorbing the extra supply during refunding auctions

Shorting a weighted 5s10s20s fly is an attractive alternative to position for a decline in term premium


25 April 2013 9

have a higher allocation in the 10-20y sector at 46% (vs 45% in the 20-30y sector). Another reason may have been the talk of the Treasurys issuing more long-end paper, potentially in the 20y sector. We believe the Treasury is comfortable with the current pace of terming out of debt and, given the uncertainty about the deficit outlook, is unlikely to make any changes to the auction calendar (Figure 8). The absence of issuance in the 10-20y sector, coupled with a smaller float, argues for higher scarcity premium.

Overall, we continue to like 7s30s curve flatteners as an alternative to long duration views and also recommend shorting a weighted 5s10s20s fly to position for a decline in term premium and the richening of the 20y sector.

FIGURE 5 10s20s curve looks too steep, given the 5s10s curve. Short the 5s10s20s fly (0.4:1.4:1.0)

FIGURE 6 20y sector has cheapened on the asset swap curve as well

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FIGURE 7 Fed more dominant in the 10-20y sector

FIGURE 8 Terming out should continue without any increase in long-end nominal supply

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25 April 2013 10

INFLATION-LINKED MARKETS: UNITED STATES

Demise of inflation hedging calls are premature Despite reports of a mass exodus from the inflation market, buyers have emerged and breakevens are again largely in line with fundamentals. We recommend selling the belly of an April17s-Jul20s-Jan23s real yield fly and keeping an eye on TIIApr14s.

Reports of my death have been greatly exaggerated -Mark Twain The TIPS market was under significant pressure last week in the hours following the largest ever auction. The 5y breakeven ended down 13bp following the 7bp auction tail, and the 5y5y broke its post-September 2012 range and fell to 2.64%. We thought the former made sense because the market had not priced in an auction concession nor increased headwinds to near-term inflation. However, the decline in longer forwards was unjustified, in our view, because the Feds response to downward near-term inflation pressures, as highlighted in comments from relative hawks Bullard and Lacker, is more stimulus, which should lead to heightened medium-term inflation risks. The sell-off (along with the decline in breakevens since mid-March, which we argued reflected only carry and the decline in gasoline), led many (WSJ: Advisers Dump TIPS as Inflation Threat Wanes, Barrons: TIPS Confirm Commodities Deflationary Signal, MarketWatch: TIPS dive as investors dump inflation hedges) to indicate that investors have been making a structural shift out of the asset class because the near-term inflation outlook had softened. While there has been selling from TIPS funds starting in late January on duration concerns and more recently on the fall in gasoline and weakening economic outlook, we believe this has been on a tactical rather than structural basis. In fact, buyers have emerged, and while the 5y is still justifiably well off its March highs, it has bounced back to pre-auction levels, and the 5y5y has moved back to the middle of its range just above 2.8%. Just as homeowners buy home insurance despite no imminent threat of a fire, structural TIPS investors seem to understand the value of an inflation hedge within their fixed income portfolio, despite no imminent threat of high inflation.

Shorty youre my angel While we have now turned neutral on 5y and 5y5y breakevens, the short end is again starting to look interesting. In our daily Inflation Forwards Packet, we recently began to include a rich/cheap analysis of short TIPS versus Barclays NSA CPI forecasts with and without an adjustment for energy futures moves since the forecasts were last updated. We

Michael Pond


Chirag Mirani +1 212 412 6819 [email protected]

5y breakevens have recovered post-auction

FIGURE 1 5y5y breakevens back in the range

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Barclays 5y5y BE Source: Barclays Research


25 April 2013 11

find that TIIApr14s are about 60bp cheap to the Barclays forecast adjusted for the move in gasoline futures since mid-April (Figure 2). They have cheapened recently as the market has gone from pricing 1y ex-energy inflation from about 2.2% to 1.3% (Figure 4). While this may seem quite cheap, we do not recommend going long just yet. First, we find that 1y CPI swaps, which generally trade fairly close to 1y breakevens, have been cheap by about 70bp on average since 2004 versus subsequently realized CPI (Figure 3). Therefore, the TIIApr14s are less cheap than the average at the 1y point and, as an added headwind, are about to fall out of most TIPS indices. While we do not expect the full issue size of about $15bn to be for sale at month-end next Tuesday, sales from some passive index investors may weigh on performance in the coming week. We recommend watching this issue closely and buying on an energy-hedged basis if they get to 80bp cheap.

FIGURE 2 Front-end breakeven cheapness (versus forecast and versus energy adjusted forecast)

TIPS maturity

TIPS real yield BE

BE versus Barclays CPI

forecast BE (bp)

BE versus Barclays CPI forecast BE (bp),

crude adjusted

BE versus Barclays CPI forecast BE (bp),

gasoline adjusted

Jul-13 -1.22 1.28 -21 -21 -28 Jan-14 -1.01 1.13 -36 -57 -46 Apr-14 -0.99 1.13 -54 -69 -63 Jul-14 -1.67 1.84 -37 -49 -43 Jan-15 -1.41 1.63 -42 -49 -48 Source: Barclays Research

and as I looked up a fly went by Over the past few years, we have looked at 3s-5s-7s, 5s-7s-10s and 7s-10s-13s real yield flys to detect relative value along the TIPS curve and to see whether 5s and/or 10s have cheapened ahead of the auction. Ahead of the April five-year auction, we noted the relative richening of 3s5s7s (Figure 5) real yield fly to highlight that the sector had not set up ahead of the largest ever TIPS auction. Subsequently, the auction tailed by about 7bp. The TIPS market has recovered in less than a week after the sell-off, and 5y breakevens have widened more than 10bp. Similarly, after the 10y reopening in March (Figure 5), the 7s10s13s real yield fly looked cheap, but then it richened as the 19s and Jan25s cheapened relative to the 10s. Figure 6 shows that on March 15, the 7s10s13s fly traded at its cheapest levels, right before the 10y reopening.

April14s are now 60bp cheap versus our CPI forecast; however, we would wait for 80bp of cheapness before going long energy-hedged, given some index outflow next week

FIGURE 3 Short-end CPI swaps have on average traded about 70bp cheap versus realized inflation

FIGURE 4 Ex-energy April14 breakevens (seasonally adjusted) have declined sharply over the past month

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25 April 2013 12

Trade Idea: Sell the belly of Apr17-Jul20-Jan23 spot real yield fly The z-spread ASWs curve (Figure 7) indicates that Jul20s are significantly rich versus April17s and Jan23s. The richening in Jul20s is confirmed in our latest forwards packet (page 2). We constructed a real yield fly to see whether Jul20s are indeed rich versus April17s and Jan23s. Because of the larger effect of carry on the shorter end of the curve, we like to look at TIPS flys on a forward basis to avoid any carry bias. We use Jan14s as the fwd anchor and construct a fwd fly using Apr17fwdJan14s, Jul20fwdJan14s, and Jan23fwdJan14. A forward yield is constructed using weighted modified duration (ie, Apr17FwdJan14= (Apr17ModDur*Apr17Yield Jan14ModDur*Jan14Yield)/(Apr17ModDur-Jan14ModDur)).

Figure 8 shows a significant richening in the Apr17-Jul20-Jan23 real yield fly over the past month. It is also rich versus comparable July issues; as such, the richening is not due to any seasonality correction in Jul20s (Figure 8). We think the fly is likely to correct and recommend being short the belly of April17-Jul20-Jan23 spot real yield fly. We initiate the fly at -16bp (0.5:1:0.5 weights) and look to close the trade at -5bp, with a stop-loss at -22bp.

FIGURE 5 5s did not cheapen ahead of 5y supply

FIGURE 6 10y has normalized from cheap levels post-March supply

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FIGURE 7 Jul20s look rich versus April17s and Jan23s versus z-spread ASWs

FIGURE 8 Sell the belly of the Apr17-Jul20-Jan23 real yield fly

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Proceeds ASWs

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-18-16-14-12-10-8-6-4-202

02468

101214161820


Jul17 Jul20 Jul22RY FWD Fly

Apr17 Jul20 Jan23 RY FWD Fly (RHS) Source: Barclays Research Note: Fwd fly created using Jan14s Source: Barclays Research

April17-Jul20-Jan23 real yield fly is trading at significantly rich levels; we recommend selling the belly of it


25 April 2013 13

UNITED STATES: SWAPS

FV-TY invoice spread curve steepeners remain attractive The richness of the FV futures contract makes structures such as an FV-TY invoice spread steepener and receiving the belly of the TU-FV-TY invoice spread fly attractive from a carry perspective, despite the move in these trades so far.

Over the past two months, spreads in the 5y sector have tightened relative to spreads further out the curve, as well as at the front end. Figure 1 shows the FV-TY invoice spread curve, which is trading at historically high levels, as well as the TU-FV-TY invoice spread fly, which has tightened to levels seen last June, when European sovereign stress had caused a blowout in front-end spreads. One question that gets asked is whether this steepening of the FV-TY spread curve can continue.

We believe there is room for the FV-TY invoice spread curve to steepen further, and for the TU-FV-TY fly to tighten, purely as the futures contracts come closer to expiration. Roll-down until last delivery date on the former is 1.5bp, while that on the latter is nearly 2bp. Further, these trades may get an added boost next month when the futures roll comes up.

We think that the main driver of these trades is the relative richness of the FV contract that is evident in the high CTD implied repo rates relative to TY. While the implied repo rate for the June FV contract is trading upwards of 20bp, that for the corresponding TY contract is below 0bp. Furthermore, since April 4, the implied repo on the FV contract has increased 8bp, while that on the TY has declined marginally.

Part of the difference between the FV and TY implied repo rates is because the actual repo rates on the FV CTD has been somewhat higher than the TY CTD. However, even if we look at the difference between the implied repo and actual CTD repo, the FV contract stands out as rich. For the FV contract, this repo differential is still ~20bp greater than the differential for the TY (Figure 2).

Amrut Nashikkar +1 212 412 1848 [email protected]

Vivek Shukla +1 212 412 2532

[email protected]

The FV-TY invoice spread curve has room to steepen

and the roll-down profile is attractive

The FV contract looks rich, even after accounting for its higher CTD repo rate, relative to TY

FIGURE 1 The FV-TY invoice spread curve is trading at historical highs, driven by the richness of the FV contract

FIGURE 2 The FV contract looks richer than the TY contract, even after taking into account its higher CTD repo rates

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25 April 2013 14

Not only is the FV contract rich relative to its CTD, but its CTD is flat relative to its neighbors, while the CTD of the TY contract is cheap. Figure 3 plots the FV and TY CTDs flys versus neighboring securities of the same series. Since mid-April, the TY CTD fly has cheapened more than the FV CTD fly. As the RV community sets up for the next calendar roll, one would have expected more cheapening pressure on the FVM3 CTD than TYM3, given that in the previous few rolls the FV calendar has cheapened more than the TY.

Over the past few weeks, the FV-TY invoice spread curve has steepened because the rally was driven by the 7y sector (Figure 4), which caused spreads in the sector to widen overall. Over the next few weeks, we think the move should continue but for a different reason: because of the financing advantage of the FV invoice spread position through its higher implied repo rate. Any rally in rates should only help, in our opinion. For investors who hesitate in taking the spread curve risk that FV-TY entails, especially given the steepness of the 5s-7s spread curve, we would recommend a FV invoice spread tightener against a headline 5y spread widener.

The main risk, in our opinion, is from a sell-off in rates, which would cause TYM3 to underperform and tighten TY invoice spreads. However, with central banks continuing to increase accommodation, and the Fed now worried about missing its 2% inflation target from the downside, we believe that the risk of a sell-off over the next few weeks is small.

FIGURE 3 FV CTD is flat relative to its neighbors, while the CTD of the TY contract is cheap

FIGURE 4 CTD asset swap spreads themselves have widened for TY compared with FV

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TY-FV CTD ASW Source: Barclays Research Source: Barclays Research

We expect more cheapening pressure on the FV front CTD than TY

The main risk to our recommendation is a sell-off in rates, which we think is unlikely over the next few weeks


25 April 2013 15

UNITED STATES: VOLATILITY

Limited long We recommend buying a 3m*30y receiver vs. USM3 call calendar spread to position for rates staying low for longer than is priced by the market. The trade also benefits from a steep curve, wide long-end swap spreads and relatively high board vol.

Trade details

Long $100mn 3m*30y ATM receiver (=2.88%) Short 12001 Premium outlay = $1.5mn

USM3 Call 148 (ref. USM3 = 147-28)

To understand the moving parts, we break the trade into a swaption calendar spread (1m*30y versus 3m*30y) and a bull flattener (USM3 versus 1m*30y).

3m*30y vs 1m*30y calendar spread There are four reasons to like a calendar spread.

First, this is a limited loss trade. The longer-dated option will always have the same intrinsic value and more time value compared to the shorter-dated option. As a result, any losses would be limited to the premium outlay. In practice, over one month, the structure would not lose even half the premium outlay if the 30y swap rate was within 2.45-3.1%, a range the long end swap rate has not broken in the past six months.

Second, the entry level is attractive. Figure 1 plots the entry cost of ATM 1m*30y versus 3m*30y receiver calendar spread over the past five years. As shown, the calendar spread has required a premium outlay of 111-312cts and an average of 167cts over the period. The current cost of 130cts is at the lower end of its trading range. Lower premium outlay reduces the potential for significant losses if the 30y rate moves outside the six-month range.

1 30y swap dv01 = 20.1; USM3 dv01 = 16.75; so the hedge ratio for 100mn 3m*30y is 20.1/16.75 *1000 =1200

Piyush Goyal


FIGURE 1 Entry level for 1m vs. 3m*30y receiver spread is attractive

FIGURE 2 Barring 30y tails, implied vol is at premium to delivered vol

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1m vs 3m30y recr spread (cts)

Imp Vol 2y 5y 10y 30y 1m 17 40 59 68 3m 19 41 61 69 6m 23 48 67 71 1y 32 57 73 75 20d rlzd vol 2y 5y 10y 30y 1m 11 34 57 77 3m 12 35 57 78 6m 15 39 60 79 1y 22 46 65 81 Imp/rlzd 2y 5y 10y 30y 1m 1.61 1.18 1.04 0.89 3m 1.58 1.19 1.07 0.88 6m 1.52 1.22 1.11 0.90 1y 1.46 1.23 1.13 0.92

Source: Barclays. As of 4/25/13 Source: As of 4/24/13

Entry levels for 1m vs. 3m*30y calendar spread are good


25 April 2013 16

Third, gamma on 30y is cheap. As Figure 2 shows, implied vol is at a premium to delivered vol for all expiries and tails, except for 30y. This matters, as investors looking to own vol given the absolute low implied volatility, will likely concentrate on long-tail gamma as only the 30y tail is able to recoup the time decay. The calendar spread being long vega would benefit from a rise in implied vol.

Fourth, rates are already quite low. Nominal yields did not respond to the recent upheaval in the commodity market. This suggests that a significant decline in yields may need help from the Eurozone, perhaps in the form of a risk flare similar to that of May 2012. Given the absence of any catalyst in the near term, the one-month receiver will likely expire worthless and the investor can own the upside potential from an eventual decline in long end yields.

1m*30y vs USM3 calls Furthermore, selling USM3 calls instead of 1m*30y receivers is better in our opinion, for a couple of reasons.

Currently, the exchange vol is ~ 5% expensive to comparable swaption vol. For example, USM3 and US3 options are priced at about 67bp/y and 70bp/y, premiums of 7% and 5%, respectively, to the comparable swaption. Such pricing reflects that swap spreads are priced to widen in a rate rally and vice-versa, something that has not played out in a while. Specifically, over the past six months, long-end swap spreads have widened even as rates first ratcheted higher and then fell. As a result, a long swaption position versus short US option position likely did well. Price action in swap spreads is likely to remain uncorrelated to rates. Also, rates should stay more or less range-bound. Consequently, board options that are priced for larger moves should continue to underperform swaption.

Moreover, the long-end curve is steep and long-end spreads quite wide. The 10-30y swap curve at 96bp is a couple of basis points away from the steepest levels in more than two years. At the same time, 30y swap spreads are the widest they have been since the 2008 crisis.

A 1m*30y vs USM3 bull flattener takes advantage of the above: ie, relatively higher board vol, a steep yield curve and the widest swap spreads since the 2008 crisis. As a result, we like the trade standalone.

The calendar spread and bull flattener put together is: long 3m30y vs USM3 calls. The main risk to the trade is a further easing by the Fed. In such a scenario, rates would likely sell off and the curve steepen more. However, the losses would be limited to the premium outlay; if the curve sells off ~ 30bp in one month, the remaining 3m*30y receiver would still be worth about 70cts; implying losses of about 80cts only. The losses would likely be smaller, however, as vol on 30y would be higher in a rising rate scenario. Given the risk/reward, we like the trade and recommend it to investors who expect rates to remain low for longer than is currently priced by the market and expect to earn a windfall in a significant rally few weeks down the line.

Curve is steep and swap spreads wide

3m*30y receiver vs. USM3 call takes advantage of good levels and positions for rates to remain low for longer


25 April 2013 17

UNITED STATES: MONEY MARKETS

The other repo suppliers Money market funds hold nearly $600bn in repo and supply nearly one-third of the cash in the tri-party repo market. But over the past two years, the mix of collateral suppliers has shifted, moving toward large, non-primary dealer banks.

Collateral sourcing has shifted in the past two years. Although most money fund repo is done with the 21 primary dealers, the share from outside this group is rising.

Non-primary dealers tend to do proportionally more Treasury repo and less other collateral than primary dealers. The rates they pay on government collateral, however, are similar.

There is a significant rate differential in other collateral between primary and non-primary dealers, which most likely reflects differences in the underlying collateral.

Primary and non-primary dealer holdings of other collateral repo declined abruptly in June 2012 and have not recovered.

Restricted balance sheet capacity, along with market de-concentration, suggests that non-primary dealer activity will continue rising. However, we suspect that regulatory pressure will keep other repo collateral holdings in money market funds from rising.

Primary dealers The bulk of taxable money fund repo is done with the 21 primary dealers those large bank institutions that are the Feds counterparts in monetary policy operations. At the end of March, money market funds had approximately $400bn worth of repo on with primary dealers, although this amount declined roughly $80bn from February. Indeed, in August 2011, it appears that the quarter-end decline in all money fund repo holdings originated from the primary dealers balance sheet reporting pressures. These, plus a similar corporate calendar across firms probably pushed the banks to curtail their repo borrowings sharply in the weeks leading up to quarter-end.

Joseph Abate


FIGURE 1 MMF repo with non-primary dealers (% total MMF repo)

FIGURE 2 Collateral composition (% total repo)

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NonPrimary Primary Source: imoney.net Source: imoney.net


25 April 2013 18

Curiously, these same balance sheet-driven supply pressures are much less evident in the money fund activity with non-primary dealers. These institutions include the US branches of several large Canadian and Japanese banks, as well as some large US custody banks. Although some repo leaking away from primary dealers seems to flow toward non-primary dealers, the amount is relatively small generally under $10bn and is certainly not sufficient to absorb the reduced supply from primary dealers (of roughly $75bn per quarter-end).

Rising non-primary dealer activity Beyond the quarter-end seasonality, however, taxable money fund repo balances with non-primary dealers have been rising steadily. In fact, in the last year alone, non-primary dealer repo has increased by nearly 50%, rising to $96bn from $64bn. As a share of overall taxable fund repo holdings, repo with non-primary dealers climbed to 22% in March (Figure 1). But why is that happening?

As we have written before, there has been a significant push toward de-concentration in the tri-party repo market that is, reducing the market concentration of the biggest dealers so that unwinding a large repo borrower is not disruptive and does not spread systemic risk. Since the biggest firms in the tri-party market are generally primary dealers, the push toward de-concentration has probably motivated money funds to seek out alternative supply from non-primary dealers.

Is non-primary dealer repo different? Money market funds report details on their repo holdings (along with their other assets) at least once per month to the SEC. Repo holdings regardless of the cash borrower are split into three major categories: Treasuries, agencies, and an undifferentiated residual called other. By asset type there are slight, but statistically significant, differences in the repo from primary and non-primary dealers. Since June 2012, non-primary dealers collateralized borrowings from money funds have been skewed toward Treasuries more so than they are for primary dealers. Of the non-primary dealer collateral pool, 39.1% is Treasury collateral, compared with 33.3% for primary dealers (Figure 2). By contrast, primary dealers appear to finance proportionally more agency and other collateral with money market funds. Although the collateral mix is slightly different, primary and non-primary dealers finance their government collateral at roughly the same rates. In other words, there does not appear to be a significant difference in perceived counterparty credit.2

2 Keep in mind that most rated money funds cannot look through to the underlying collateral in determining suitability.

FIGURE 3 Other collateral repo rates in MMFs (bp)

FIGURE 4 Other collateral in MMFs ($bn)

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But repo with non-primary dealers is rising

And set to rise further

Non-primary dealer repo is skewed more toward Treasury collateral


25 April 2013 19

Other collateral and non-primary dealers However, there is a large and persistent difference in the other collateral repo rate between primary and non-primary funds. Since June 2012, the non-primary dealer financing rate on this collateral has been approximately 16bp lower than the corresponding rate on transactions with primary dealers (Figure 3).3

Unfortunately, other collateral is not identified any further, although with a yield of 30-50bp, these holdings are at the upper end of the distribution of money fund investment yields. Based on statistics from Fitch Ratings, a portion of the collateral in the other category probably includes structured product (such as ABS and CMOs), along with a fair amount of high grade corporate bonds and other liquid securities.

Since the average tenor of the transactions for both types of dealers is similar, the financing rate differential most likely reflects differences in the underlying collateral mix.

4

Interestingly, other collateral has shrunk sharply, as a share of both money fund assets and their repo holdings. The decline in the volume of this collateral financed by money market funds occurred abruptly, in June 2012 (Figure 4). Moreover, the reduction occurs in primary and non-primary dealer suppliers. It is not exactly clear why (or specifically, what type of) other collateral migrated out of money market financing. But given the abruptness of the decline, we suspect that the move was driven largely by regulatory pressure, although it is also possible that the aggregate supply of other collateral shrank because it might have become cheaper to finance it outside the repo market, perhaps using internal cash.

Without being certain, we suspect that the primary dealers holdings of other collateral are skewed more toward structured products and the non-primary dealers might be financing more liquid non-government securities in this bucket.

In the coming year, we expect repo holdings in money market funds to continue to change. Holdings of non-primary dealer repo are likely to increase as balance sheet capacity at the primary dealers gets increasingly scarce. Likewise we expect the nature of other collateral also ro shift; as non-primary dealer activity becomes larger, the underlying collateral may migrate toward more liquid assets and, corresponding, yields may decline.

3 As we describe later, money fund repo against other collateral declined sharply in June 2012 without an obvious cause. It has not recovered since. For comparison, we do our analysis on the post-June 2012 data. 4 See, A Deep Dive into the Collateral Pool, Fitch Ratings, August 1, 2012.

Collateral differences probably account for the difference in rates


25 April 2013 20

EURO AREA: RATES STRATEGY

The case for further tightening We still believe Spanish and Italian bonds can tighten vs. Germany for several reasons eg, positive central bank activity; likely positive economic data surprises; and the continued search for yield. These outweigh potential negatives in Cyprus/Slovenia.

Yield spreads vs. Germany for Italy are at the lows triggered by the ECB LTROs in early 2012, while for Spain they are a few bp above this level. From here, the question for the bull case is: will spreads stay at current levels or move back down further, to the levels seen prior to the sell-off of H2 11 (ie, the peak of the crisis note that May will be the third anniversary of the euro crisis)? Clearly, in the near term, outright yields are less attractive and active short positioning by hedge funds and dealers is likely to have been closed following recent moves. Thus, further very strong near-term tightening seems unlikely.

FIGURE 1 10y Yield Spreads vs Germany in Italy and Spain since early 2012

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However, is there room for further tightening in the medium term? In our view this is possible, but it would likely take more time; there are three key factors to watch see below.

Political progress While 2012 was a year full of announcements at the national or euro area levels, 2013 will likely be the year of implementation. How the banking union progresses further and how quickly may be important catalysts: the move (by mid-year) towards a Single Resolution Mechanism (and the confirmation of the Single Supervisory Mechanism) is a key step. Similarly, the discussions (scheduled for June) around potential direct bank recapitalizations by the ESM may provide a further impetus towards tightening, if they lead to a lessening of the banks sovereign feedback loops. A lot of things need to fall in place, and expectations are mixed in terms of the scope and speed of implementation. Progress would likely lead to a better performance of peripheral countries.

Economic data While PMIs across the euro area were stable, albeit low, the data for Italy and Spain seem to have stabilized, at least indicating that the worst of the growth was in Q4 12 (Spain GDP declined 0.8% q/q in Q4 12 vs. latest official expectations from the Bank of Spain of -0.5% for Q1 13 while Italy contracted 0.9% in Q4 vs our expectations of 0.5% in Q1 13. For Spain

Laurent Fransolet

+44 (0)20 7773 8385 [email protected]

Huw Worthington +44 (0)20 7773 1307 [email protected]

Cagdas Aksu +44 (0)20 7773 5788

[email protected]

PMIs seem to have stabilized


25 April 2013 21

in particular, the news that the housing market decline was decelerating, with prices falling 0.8% in Q1 13 vs. recent quarterly falls of 2-3% is important given its read across to banks and households. Signs that the recession is lessening will be important for investors, but will probably be relatively slow to appear over the coming weeks and months.

Buying by foreign investors As we have argued frequently, one of the key features of the sell-off in H2 11 was the large liquidations by the more conservative real money investors. These have been absent since Q1 12 and have helped the stabilization of Italian and Spanish debt. Since the Draghi whatever it takes comments in late July 12, foreign participation in Spain has gone back up (both in absolute and relative terms to Italy). These flows have been key in driving market pricing, as evidenced in Figure 2. From here, though, it will be more difficult for foreign ownership to rise as it would involve Italy and Spain having to re-attract some of the foreign investors who left in H2 11, and who are probably the most risk averse. We expect a small pickup in the foreign ownership, as Japanese investors, or some north European investors are likely dragged back in their search for yield. However, the overall level of foreign involvement will likely remain lower than before, because of risk aversion, rating or regulatory constraints, etc. In the coming months we may also see a certain rotation in foreign owners, with some traditional investors replacing some of the US-based buyers from H2 12.

FIGURE 2 Foreign Ownership in Spain (Ex ECB) and 10y Spain- Germany Yield spread

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10yr Spain - Ger (RHS, inverted)

Source: Spanish Tesoro, Barclays Research

Notably, we use foreign ownership in some of our fair value models for 10y peripheral spreads, along with very front-end spreads (1y spread, as an anchor) and the level of debt/GDP. One might argue about the causality, or the predictability of the foreign ownership, as well as using short-end spreads, but the literature shows that using only fundamental variables to explain bond yields or spreads since 2010 is not very satisfactory (these models are unstable and typically unable to explain the large shifts in spreads, due more to sentiment and imbalanced flows). Note that the modelling of a fair value spread in Italy is particularly difficult to relate to fundamentals.

Given the recent developments in foreign ownership and short-end spreads these models suggest that 10y spreads are still roughly fair value for both Spain and Italy (if anything they are still a bit cheap). The potential for a very front-end rally is more limited in the near term, we think, but the 1y1y forward spreads (figure 3 and 4) could still rally 100bp over time, worth about 50bp on 10y spreads. Equally, the foreign ownership could increase, but even a 5pp move (towards 35%) would translate into a 25bp move in spreads only from here, on our estimates.

A small pickup in foreign ownership seems likely

Using only fundamental variables-based models produces satisfactory results

10y spreads still fair value or a little cheap for Italy and Spain


25 April 2013 22

FIGURE 3 Selected Forward Yield Spreads: Italy vs Germany, bp

FIGURE 4 Selected Forward Yield Spreads: Spain vs Germany, bp

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5y5yfwd Spain vs Germany

Average 2 to 5y Spain fwd vs Germany


Conclusion We have been bullish for some time now on the prospect for Spanish and Italian bond tightening vs. Germany. With spreads now either back, or close to their tightest levels seen in the wake of the 3y LTROs announcement, further performance from here seems likely to be at a more measured pace.

Indeed with 10y Italy and Spain having tightened by 60bp and 70bp respectively since end March alone (as at the time of writing) some short-term profit-taking could see limited re-widening. Nevertheless, we believe that several factors support even tighter spreads, including likely positive economic data surprises, central bank activity, and the search for yield alongside flows and positioning, outweigh the potential negatives here (seemingly principally focused on Cyprus and Slovenia, given that the impact of the political situation is likely to diminish). As such, any back-up in spreads may now be seen more as an opportunity, as opposed to a threat by investors. In reality investment flows into the periphery from ex euro area foreign investors may take time to come to fruition; however, anticipation of such flows, should mean that shorter-dated bonds and bills, will be the most resilient instruments.

Factors supporting even tighter spreads outweigh the potential negatives, in our view


25 April 2013 23

EUROPE: SWAPS

EUR ASWs not cheap yet A large part of the tightening in EUR ASW since early April was due to the FRAEONIA tightening. We still do not think the EONIAGermany component of EUR ASWs are cheap. We continue to recommend holding onto short Bobl ASWs on the 5s/30s ASW box.

EUR swap spreads have been very volatile since the beginning of the year with the moves again being much larger than the US and UK ASWs. Generally, from the beginning of the year until the end of March, EUR swap spreads have been in a widening trend, with Bobl ASW widening from 30bp to 60bp. From early January until mid March, this was mainly led by fundamental cheapness on ASWs and the subsequent rally in German yields in February, on the back of reduced concerns about quick LTRO repayments and increased uncertainty from Italian elections. Thus, this widening was also driven significantly by EONIABobl, with the basis component of the Bobl ASW (vs Libor) being rather stable. However, the second 15bp widening of the Bobl ASW (from 45bp to 60bp) from mid-end March was largely driven by the basis component (FRA-EONIA) expanding due to concerns about liquidity drying up in the banking system, after the Cyprus bailout.

EUR ASWs have been tightening back again in the past couple of weeks, from their local wides at endMarch, with Schatz, Bobl and Bund ASW tightening by 18bp, 16bp and 12bp, respectively. Nonetheless, notably, the reversal of the basis widening (seen in the second half of March) accounted for a large part of this. For instance, of the 16bp Bobl ASW tightening since early April, around 10bp has been due to FRAEONIA with the remaining 6bp owing to the EONIABobl component. As such, at EONIA +15bp, the EONIABobl component of the Bobl ASW is still much wider than the tights at the beginning of the year (around EONIA +3bp).

Trade views in EUR ASWs from here At the beginning of the year, we had recommended going long Bund and 5y5y fwd ASW on fundamental cheapness and as a hedge versus some political risks likely to arise from the Eurozone debt crisis (see Buy 5y5y fwd ASW on 10 January). We took profit in this trade on 8 March after a notable widening (see Take profit on Bund ASW widener). Following the last

Cagdas Aksu

+44 (0)20 7773 5788 [email protected]

Q1 generally saw EUR swap spreads widening on fundamental cheapness, a German outright yield rally and increased political risks

FIGURE 1 Evolution of German ASWs versus EONIA

FIGURE 2 Bobl ASW - breakdown of its components

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Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13

Schatz EONIA - Ger

Bobl EONIA - Ger

Bund EONIA - Ger

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Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Bobl ASWBobl EONIA - GerBobl FRA - EONIA



25 April 2013 24

leg of the Cyprus-related widening in ASWs, on 28 March, we recommended selling Bobl ASW on the 5s/30s ASW box (See Escape velocity versus Bund yields). Since then the trade has worked very well for two reasons: first Bobl ASW has corrected 15bp from its expensive levels but at the same time, 30y ASWs have remained supported relative to the rest of the that curve, tightening only 5bp during the same period thanks to the BoJ QE announcement of support for long-end ASWs.

We still believe that this trend of long-end ASW outperformance versus Bobl ASW can continue for a while for a few reasons. First, as mentioned earlier, a large part of the tightening in Bobl ASW since early this month has come from the FRAEONIA. While the latter is back to its tightest levels again, it is unlikely to rewiden in the near term as the ECB is likely to cut the refi rate by 25bp without a depo rate cut next week. Second, following limited tightening in the EONIA-Bobl component of Bobl ASWs, fundamentally we still find it expensive and insufficiently cheap to buy outright. We would find fundamental value in Bobl ASW only if it tightens towards 35bp (to around EONIA + 5bp). In the near term, the sentiment for EGB periphery is still strong. While Cyprus has probably increased the necessity for quicker progress on institutional reforms to facilitate banking union, nothing suggests to us a new increase in risk flare, for now.

Lastly, most of the moves post the BoJ announcement were due to anticipation of demand for EGB paper. If and when these flows materialise, we would expect them to go to the 10y and post-10y parts of the curve, given low yields at the belly of the core country curves. This should also support 30y ASWs in relative terms going forward. Therefore, for now, we continue to recommend holding onto short Bobl ASW on the 5s/30s ASWs box. If and when Bobl ASW tightens towards 35bp (versus Libor), we will think about outright longs, depending on the general risk circumstances in the market at that stage.

FIGURE 3 Fair value for Bobl ASW vs EONIA with German and Euro area deficit expectations

FIGURE 4 FRA-EONIA basis is back to its tightest level after some volatility post the Cyprus bailout

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Bobl EONIA - GerPredicted with 1yr fwd Euro deficitPredicted with 1yr fwd German deficit

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Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13

EUR 1y1y fwd Libor - EONIA

Source: Consensus Economics, Barclays Research Source: Barclays Research

We do not believe that EUR ASWs are outright cheap yet

and continue to recommend being short Bobl ASW on 5s/30s ASW box


25 April 2013 25

FIGURE 5 ASW changes since 28 March: 30yr ASWs have been a relative outperformer

FIGURE 6 We expect more relative cheapening of Bobl ASW versus 30yr ASWs

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25 April 2013 26

EUROPE: MONEY MARKETS

Refi cut: limited effect on markets rates We expect a 25bp cut only in the refi rate at next weeks ECB meeting. The markets reaction is likely to be limited, as the very short rates are already low and probably already incorporate expectations for a cut.

As discussed in ECB Watching: Ready to act, 24 April, we have changed our ECB call from on hold to a 25bp cut in the refi rate (but not in the deposit facility rate) as early as at the ECBs meeting on 2 May. Our view is underpinned by the economic weakness that has started to spread also to the core economies of the euro area, with some signs of disinflationary pressures supported by lower oil prices. Moreover, we noted that several ECB members over the last few days have focused on the possibility of a refi rate cut.

We also expect President Draghi to remark that monetary policy stance will remain accommodative as long as needed, with liquidity conditions remaining consistent with such a stance. However, we do not believe the ECB will announce a new LTRO at this stage. ECB members latest comments on this topic do not seem to support expectations of an imminent announcement. Also, the latest Bank Lending Survey showed a general easing of tightening in euro area credit conditions, although the economic uncertainty and weakness of demand continue to weigh. Interestingly, the survey indicates less pressure on the funding side for banks, and this could make the announcement of new LTROs at the current juncture less urgent5

Since the ECBs April meeting we have highlighted the possibility of the ECB taking action on the refi rate, as at the meeting President Draghi left the door open for a policy rate cut, should the economic weakness persist.

.

At this stage, a refi rate cut has much more relevance in terms of counteracting any possible passive tightening of liquidity conditions than in providing stimulus to the real economy owing to the frictions in monetary policy transmission. This is because a reduction would reduce the reference level for short rates in a context of a lower liquidity surplus. The likelihood of such a scenario is not negligible in our view, especially if the reimbursement of the 3y LTRO liquidity continues at the same pace of the last few weeks6

Moreover, the decline in the cost of borrowing at the ECB could reduce the incentive for banks to repay the 3y LTROs. At the margin, the decreased cost of ECB liquidity borrowing should make the 3y ECB liquidity more convenient, especially for those banks that borrowed for lending or carry-trade purposes. Maybe, for banks that borrowed for precautionary reasons, a 25bp reduction in the cost of parking liquidity (because the deposit facility rate is zero) would not make any particular difference (although such banks have likely already repaid a large part of their 3y liquidity). Here, important indications on the likely banks behaviour might come from the announcement on 26 April of the 3y LTRO repayment next week (on 2 May, the settlement day of the MRO). If the benefit of lower cost of borrowing would prevail in banks decision, a low amount of repayment will likely be announced (note that banks already informed the central bank of their decisions on Wednesday, 24 April).

.

In terms of markets impact, we expect a limited reaction, as rates are already low and probably already incorporate expectations of a refi rate cut. Indeed, it is hard to extract from the current market prices an accurate estimate of the expectations on the ECBs actions, as there is no accurate estimate of the fair level of the spread of the money market rates vs. the refi rate in such an environment of abundant liquidity. After the sharp rally since the

5 See Focus II in the April 22 Euro Money Markets Weekly The ECBs options 6 See Focus I in the April 22 Euro Money Markets Weekly The ECBs options

Giuseppe Maraffino

+44 (0)20 3134 9938 [email protected]

Laurent Fransolet +44 (0)20 7773 8385 [email protected]

We expect a 25bp cut only in the refi rate Commitment to an accommodative stance but no announcement yet of a new LTRO

Refi rate cut: more important to counteract any passive tightening than to provide stimulus to the real economy

Decline in cost of ECB borrowing could reduce the incentive to reimburse the 3y LTROs

Market impact is likely to be limited


25 April 2013 27

beginning of the year, we believe that white contracts on the Euribor strips already incorporate a high chance of a 25bp cut by June. Here, it is worth noting that the June Euribor contract has richened 3bp since the ECBs April meeting to 18bp currently. We see very limited room for a further rally, based on our expectations for a fair level of 15bp for the 3m Euribor from 20.6bp currently. The decline in the fixing would be the result of a further tightening of the FRA/Eonia rather than a reduction in OIS rates.

We do not believe the refi rate cut will affect the Eonia fixing, which is driven more by the level of the deposit facility rate (which we expect will be left unchanged at zero). Therefore, we continue to envisage the Eonia fixing moving at around 8bp, as long as the liquidity surplus will stay above the psychological level of 200bn7

Figure 1 summarises our view on the potential impact from a 25bp cut in the refi rate (with the depo rate remaining at zero) on short rates. In general the ECBs decision should continue to support the carry-trade driven bull flattening of the curve, apart from some initial temporary volatility mainly driven by profit-taking. Indeed, expectations that the policy rate cut could be the beginning of a series of measures to counteract the passive tightening of liquidity conditions should reduce the term premium currently priced at the long tenors on the money markets curve, which is based on the uncertainty around liquidity conditions after the natural maturities of the two 3y LTROs in January and March 2015.

. We expect also the daily volatility that has characterized the fixing over the past few weeks to remain high. This is because in a context of low EONIA (reported) volume, the fixing has become more sensitive to a particular flow reported by panel banks. OIS rates should remain broadly stable, reflecting the low Eonia fixing.

Here, the ECBs report Financial Integration in Europe April 2013contains an interesting chart (chart 37 EONIA-ECB deposit rate spread evolution in a low interest rate context). This shows the EONIA-ECB deposit rate spread over various time periods, which take into account particular events (eg, allotment of the first 3y LTRO, the policy rate cut in July 2012, the first repayment of the 3y LTRO). The main message is that the spread level seems to be a function of time that has passed, suggesting a gradual adjustment of rates to a change in excess liquidity conditions and to the new level of policy rates. In general, this could be related to the fact that the compression of market margins and spreads encourage the search for yield (or the exit from the market in some cases), with a corresponding increase in risk exposure or maturity extension. The speed of such adjustment in market rates depends on several factors like credit risk policy and may take time. This supports our bull-flattening view on money market rates and on the front end of the peripheral curves.

FIGURE 1 Expected impact on money market rates from a possible 25bp cut in the refi rate

ECB decision Eonia Fixing Eonia curve Euribor strip 3m FRA/EONIA 3m Euribor

25bp cut in the refi rate, depo rate

unchanged at zero

No impact on Eonia: the fixing should stay at

about 8bp

3m OIS: Stable at about 7/8bp. Gradual flattening of the curve

Continuation of the carry trade driven by

bull flattening

Gradually to 8bp on reinforcement of ECBs accommodative stance

Moving towards 15bp


Indeed, the reduced cost of ECB borrowing should make the carry trade on the peripheral curve even more attractive, despite the recent decline in yields, thus leading some banks in the peripheral countries to postpone their 3y LTRO reimbursement. Due to the particular steepness of the 3m-3y parts of the Italian and Spanish curves, the 1y1y forward and the 1y 2y forward at 2.32% and 2.9% respectively, still look quite interesting even if they are close to their historical low level. Room for a further richening led by yield hunting is likely, in our view.

7 See April 22 Euro Money Markets Weekly, Focus I repayment and risks of passive tightening for an in depth analysis of EONIA movements under different reimbursements scenarios

Likely no impact on EONIA and marginal effect on Euribor

Carry trades on the peripheral curves could become more attractive


25 April 2013 28

Notably, the very front end of the peripheral EGB curves have been supported over the past few months by stable demand both from domestic and international accounts, which use bills up to the 6m area as deposits for liquidity with interesting pick-up vs. the core and semicore bills. This explains the sharp drop of the T-bill yields in general with the 3m yields on the Italian and Spanish curves to about 20bp (approximately the same level of the 3m or 6m GC rates). Assuming no richening of the repo rate, a structural decline of the 3m BOT to below such a level is unlikely. More likely in our view would be an extension of duration, with investors searching for a yield pick-up in maturities beyond 6m and 12m. For the 1y tenor, which is a bit more volatile than shorter maturities on the T-bill curve, 50bp (ie, the main refinancing rate in case of a cut) could be a floor.

We would not expect repo rates to be affected much by a reduction in the refi rate because the core collateral already trades at close to zero, thus limiting room for a possible richening in the Eonia spread. Peripheral collateral (Italy and Spain) trades at about 8-10bp spread vs. the core. Any richening, in our view, would be more related to increased support from domestic banks rather than to a refi rate cut.

However, activity in the repo market might be affected by a refi rate cut. Indeed many banks over the last few months decided to replace their ECB borrowing, especially at short maturities like MRO, with repo borrowing (less expensive compared with the main refinancing rate). This has been the case especially for Spanish banks, which since last summer have reduced their ECB borrowing, particularly at the MRO, as shown in the Bank of Spain data, and have increased their usage of the domestic repo market as confirmed by the MEFF data. In this case a 25bp refi rate cut could reduce the convenience of using the repo market, especially at long tenors.

In summary, we believe a reduction in the refi rate would have more relevance in terms of counteracting any possible passive tightening of liquidity conditions than in providing stimulus to the real economy. The Eonia fixing should be not affected with only a marginal impact on the 3m Euribor. In general we expect the bull flattening trend of the money markets curve to continue in anticipation of more actions by the ECB to keep the monetary policy stance accommodative. Repo market activity could be affected by the reduced cost of borrowing at the ECB operations, which would make the carry trade at the front end of the peripheral issuers curves even more attractive.

The very front end is already quite rich any further richening would depend on the GC rate

Repo market: no impact on rates but activity probably could be affected by the lower cost of ECB funding

Bull-flattening trend in the money markets curve likely to continue in anticipation of more ECB actions

FIGURE 2 3y LTRO payback: weekly and cumulative repayment

FIGURE 3 3m Euribor future: bull flattening, with minor changes in whites contracts since ECBs April meeting (%)

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Source: ECB, Barclays Research Source: Barclays Research


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Documents

Barclays Global Rates Weekly Making It Easier