Global Fixed Income Weekly Deutsche Bank Markets Research

Transcription

Deutsche Bank
Markets Research
Global
Rates
Credit
Date
10 October 2014
Francis Yared
Global Fixed Income Weekly
Strategist
(+44) 020 754-54017
[email protected]
Dominic Konstam

Two strong themes have emerged from our tri-annual bottom-up top trade
selection: (1) yield curves are excessively flat and the current combination
of expected policy normalisation in the US and the UK and depressed
inflation expectations cannot be sustained (2) carry remains king in Europe
thanks to an ECB which is ultimately determined to do “whatever it takes”.

Draghi stepped up the dovish rhetoric, but the risk remains that the market
will challenge the ECB first. We recommend being long USD5Y5Y
breakeven vs. EUR. We also maintain the EUR10s30s flattener and
recommend a EUR3M30Y receiver spread as a hedge against further
stresses in risky assets.

The current combination of slow progress in some of the leading indicators
of wage inflation and pressure on commodity prices is for now giving the
Fed more time without invalidating the views of the dovish centre of the
committee.

We think the market will completely price out the Fed for 2015. Until it
does we think risk assets remain on their back foot and the dollar tends to
be stronger as part of generalized risk aversion.

The markets will return to equilibrium in our view with 5s closer to 1 ¼
percent; stocks maybe another 5-10 percent lower, breakevens slightly
lower and 10s having touched 2 percent tending to stabilize back in the
current range of 2 ¼ to 2 ½ percent. Near term this favors buying on dips
but especially 5s for an eventual and more persistent (bull) steepening.



Research Analyst
(+1) 212 250-9753
[email protected]
Table of contents
Bond Market Strategy
Page 02
US Overview
Page 07
Treasuries
Page 18
Spec short positions in Eurodollars have always been vulnerable and no
more so than now. Real money credit longs and short duration positions
should also be hedged in our view.
Derivatives
Page 24
Mortgages
Page 28
Euroland Strategy
Page 46
The good news is that this means the Fed is more likely able to normalize
rates as they start later. Risk assets better priced to fundamentals and
fundamentals that have more time to improve with less downside tail risk
represent a “pause that refreshes”. Investors who disagree tend not to
recognize the weakness in the recovery and the risk that a strong dollar
poses to inflation. We emphasize that profits, that are growing at best
slowly, are “bad” profits and the tail risk suggests they may become “no”
profits if inflation falls. A model fitted to a sample since 2007 suggests a
swing of 100 bps on goods inflation related to another 4 percent
appreciation in the USDTWI.
Covered Bond and Agency
Update
Page 50
UK Strategy
Page 52
Japan Strategy
Page 55
Dollar Bloc Strategy
Page 59
Global Inflation Update
Page 62
Inflation Linked
Page 65
Contact
Page 67
We suspect the FOMC minutes are likely an opening salve in the unfolding
of a more dovish (delayed) Fed. Whether they realize it or not, they neither
want to raise rates prematurely to reverse later, nor worse still, have to
restart QE that is about to end. We suspect taper will be completed but
considerable period stays perhaps even into 2015. Either way the market
should discount a drop in the dots come December as a means to finding
some equilibrium in risk assets and dollar consistent with the bull
steepener. If we are wrong on the Fed, risk off may have further to go.
________________________________________________________________________________________________________________
Deutsche Bank AG/London
DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014.
10 October 2014
Global
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Bond Market Strategy



Two strong themes have emerged from our tri-annual bottom-up top trade
selection: (1) yield curves are excessively flat and the current combination
of expected policy normalisation in the US and the UK and depressed
inflation expectations cannot be sustained (2) carry remains king in Europe
thanks to an ECB which is ultimately determined to do “whatever it takes”
Draghi stepped up the dovish rhetoric, but the risk remains that the market
will challenge the ECB first. We recommend being long USD5Y5Y
breakeven vs. EUR. We also maintain the EUR10s30s flattener and
recommend a EUR3M30Y receiver spread as a hedge against further
stresses in risky assets
The current combination of slow progress in some of the leading indicators
of wage inflation and pressure on commodity prices is for now giving the
Fed more time without invalidating the views of the dovish centre of the
committee
Bipolar trading for a bipolar world
ECB: taking control over its balance sheet
After a mildly hawkish parenthesis at the last ECB meeting, Draghi has again
stepped up the dovish rhetoric in his intervention at the Brookings Institute.
More specifically, he endorsed expanding the balance sheet towards the 2012
levels as being an estimate of what is necessary for the ECB to achieve its
inflation mandate. He also highlighted that the ECB has not been so far in a
position to adopt an explicit balance sheet target as it was only passively
controlling its size. But it is now gradually shifting towards a more active
management of its balance sheet, i.e. it will increasingly rely on asset
purchases rather than TLTROs.
Francis Yared
Strategist
(+44) 020 754-54017
[email protected]
Jerome Saragoussi
Strategist
(+33) 1 4495-6408
[email protected]
Abhishek Singhania
Strategist
(+44) 207 547-4458
[email protected]
Soniya Sadeesh
Strategist
(+44) 0 207 547 3091
[email protected]
George Saravelos
Strategist
(+44) 20 754-79118
[email protected]
Markus Heider
Strategist
(+44) 20 754-52167
[email protected]
Meeting the EUR1trn target with the existing measures remains a tall order.
We remain of the view that the ECB will do “whatever it takes”, but the
process to get there may involve first the market challenging the central bank.
This is particularly the case as the data in Europe has generally continued to
disappoint. We thus maintain the EUR10s30s flattener discussed last week but
also enter a long USD5Y5Y breakeven vs. EUR. The latter is discussed in more
details in the Global Linkers section. The EUR10s30s flattener should also
benefit from rising risk aversion as a decline in equities could increase the
pressure on ALM investors and the long end of the curve. Alternatively, one
could consider a 3M30Y receiver spread 10bp/40bp for a running premium
around 5-6bp hence a 5:1 to 6:1 leverage ratio.
We remain constructive on peripheral debt and the assets more directly
targeted by the ECB in particular. However, given the positive view on the
front-end of the core euro curve, the decline in the ex-post Sharpe ratio at the
long-end of the curve, and the risk of the market challenging the ECB in the
short-term, we have reduced the risk and rotated the BTP-Bund tightener
recommended 4 months ago into an outright long in 5Y BTP.
Page 2
10 October 2014
US: Good domestic growth vs. low inflation and downside risks from Europe
The FOMC minutes were more dovish than the corresponding FOMC’s
projections and press conference. This has led to a sharp rally in the front-end
of the US curve which was favourable to the steepening bias expressed last
week. Ultimately the Fed will be data dependent and we evaluate whether the
incoming information indicates a material deviation from the FOMC’s
expectations on growth and inflation.
On the growth front, the domestic data are in line (if not ahead) of the FOMC’s
projections. Consensus expectations for Q3 GDP remain around 3% and the
hard data so far (as summarized by the Atlanta Fed tracking GDP) seem to be
consistent with this expectation. The soft indicators have been more optimistic
with the composite ISM for Q3 at a decade high. On the job front, the latest
NFP was better than expected and the unemployment rate is already through
the year-end Fed forecast. Importantly, the reduction in the pace of fiscal
tightening is starting to be reflected in GDP data and should continue to be
supportive in the quarters ahead. Thus the risk on the growth front comes
primarily from external factors as the data in Europe continues to disappoint.
ISM data suggests that the momentum in Q3 remains
The reduction in the pace of fiscal tightening is
robust
supportive of domestic demand
5.0
1.0
ISM Implied
Real Gross Domestic Product (SA 4QMA, %Chg)
Implied by July ISMs
4.0
0.8
3.0
0.6
2.0
0.4
1.0
0.2
0.0
0.0
-1.0
-0.2
-2.0
-0.4
3
Estimated fiscal impulse from IMF
(change in fiscal drag, rhs)
2
1
0
-1
-0.6
-3.0
-2
-0.8
-4.0
-5.0
2004
Contribution of public sector to
real GDP growth YoY
-1.0
2005
2006
2007
2008
Source: Deutsche Bank, Bloomberg Finance LP
2009
2010
2011
2012
2013
2014
-3
07
08
09
10
11
12
13
14
15
On the inflation side, the dynamics are more negative, but not (as yet)
threatening the FOMC’s central scenario. Wage inflation remains weak, and
indicators of labour market slack (part-time, quits and hires) which are good
leading indicators of wage inflation are improving only slowly. Some of these
metrics (e.g. quits) are within a touching distance of the levels observed ahead
of the start of the last tightening cycle. Others (such as part time) are lagging
behind. On the basis of these indicators (and their respective lead in
forecasting wage inflation), ECI (private industries) wage inflation should
converge to a 2.20-2.35% YoY run rate (0.55-0.60% on a QoQ). For reference,
ECI averaged 2.65% in 2004 when the Fed hiked, and reached a trough of
1.4% in 2009.
Page 3
10 October 2014
Slow progress in the measures of labour market slack
Part Time
Hires
Quits
Avg Q2 03 - Q1 04
3.2
4.2
2.1
Crisis trough
5.9
3.2
1.4
Q4-13
5.1
3.7
2.0
Q1-14
4.7
3.8
2.0
Q2-14
4.8
3.8
2.0
Q3-14
4.7
3.9
2.1
45%
68%
88%
Last 4q (quarter
averages)
% Normalisation done
Correlation with ECI
Leading ECI by
92%
89%
91%
1 - 2 quarters
3- 4 quarters
2 - 3 quarters
The decline in commodity prices could push headline inflation to a trough of
1% in March 2015 assuming some stabilization of energy prices until February.
It will also generate (with a lag) some downward pressures on core inflation.
Given the currently available data, core CPI is likely to slowly increase to
slightly more than 2% at the end of 2015. Allowing for the usual core PCE-CPI
wedge, this would be consistent with a slightly below 2% core PCE in Q4 2015
(around 1.75%) (see graphs below). This is broadly in line with the September
FOMC forecasts on core inflation (headline will be lower at current level of
commodity prices).
The decline in oil and food prices has been significant, but as long as they
reflect supply factors or USD strength rather than demand factors, the
negative impact on inflation will be mitigated by the positive impact on
growth. The behavior of industrial metals is arguably a better metric on which
to evaluate the extent of a negative demand shock. Industrial metal can be
explained by the USD and the global output gap. Industrial metal prices seem
to be currently in line with these two drivers. Of the ~6% decline in industrial
metal prices since the end of July, 75% (~4.5%) can be attributed to the USD
strength and 25% (~1.5%) to weaker global growth. Thus, while there is
certainly some loss of momentum at the global level, the 15% decline in WTI
crude oil prices possibly overstates how much of that is due to lower global
demand vs. USD strength and supply factors.
Projected headline and core CPI YoY
4.5%
Metal prices vs. USD and the global output gap
600
Headline CPI YoY - DB forecasts
Metal price (S&P GSCI
Industrial Metals)
Core CPI YoY - DB forecasts
4.0%
500
3.5%
Model (log real metal vs.
global output gap and log
USDTWI)
400
3.0%
300
2.5%
2.0%
200
1.5%
100
1.0%
0.5%
Dec-09
-
Dec-10
Source: Deutsche Bank
Page 4
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15
89
91
93
95
97
99
01
03
05
07
09
11
13
10 October 2014
Overall, while there are downside risks to growth emanating from Europe,
inflation remains for now the key binding constraint. The current combination
of slow progress in some of the leading indicators of wage inflation and
pressure on commodity prices is for now giving the Fed more time without
invalidating the views of the dovish centre of the committee. For instance both
Dudley and Williams have reiterated that they still see a lift-off mid 2015, while
expressing to varying degrees concerns about growth in Europe and the
inflation momentum. From a market perspective, given the extreme flatness of
the curve and the current pricing in the front-end, we favour a 5s10s steepener
hedged with a short position in 2s (beta weighted), discussed in more details in
our recent Top Trades publication.
Top trades for the end of the year
Yesterday we published our Top Trades for the end of the year. In this
publication1, each participating DB analyst has identified the best trades in his
or her markets, unconstrained by a top-down macro view. Two strong themes
have emerged from this bottom-up process: (1) yield curves are excessively flat
and the current combination of expected policy normalisation in the US and
the UK and depressed inflation expectations cannot be sustained (2) carry
remains king in Europe thanks to an ECB which is ultimately determined to do
“whatever it takes”.
First, on almost any metric, yield curves are too flat in the US, the UK and
Australia. The market is pricing both policy tightening in the US and depressed
inflation levels. Something will have to give. There are several (non-mutually
exclusive) ways the curve could normalise back. First, inflation breakevens
could normalise from depressed levels, and we express this with a long
USD2Y2Y breakeven. Second, the front-end of the US curve could rally as the
market prices a delay in the normalisation of monetary policy in the US, and
we express this via a USD3M5Y receiver spread. Third, one could be agnostic
about what will drive the normalisation and we express this via a GBP5s10s
steepener. Fourth, one could hedge the directionality of the curve with frontend rates and trade the excess flatness more directly. We express this view
with a USD 5s10s steepener vs. a (beta weighted) short in USD2s. The latter
trade happens to also be an efficient way to position for a widening of
breakevens. Finally, one can trade the normalisation of the USD curve via other
markets and we express this via AUD 6M fwd 1Y vs.3Y steepener which has
flattened as 10Y UST yields have rallied over the past few months.
Second, the theme in Europe remains very much focused on carry, with a
particular emphasis on the impact of the forthcoming ECB intervention. The
ECB is unlikely to reach its implicit balance sheet target with the measures
announced so far. Its willingness to try and ultimately to do “whatever it takes”
(reiterated by Draghi at the IMF meetings), has nonetheless important
implications. Given the relative reluctance to cross the public QE Rubicon at
this stage, the ECB is likely to be more aggressive in implementing its private
asset purchase programmes. This should support the targeted assets, and we
recommend being long the weaker covered bonds in Spain and Italy and new
issue CMBS focusing on the front pay level, where liquidity is greatest and
spreads range from around 90bps Dutch CMBS to around 125bps for Italian
CMBS. We also favour being long single-B credit which are the current sweet
spot for buy and hold credit investors with an aggregate spread above 600bp.
Also, the front-end of the euro curve is only pricing a marginal increase in the
overall size of the ECB’s balance sheet. Even if the ECB is unable to increase its
balance sheet by the advertised EUR1trn, it should manage to accumulate
more than the ~EUR200bn implied by the Eonia market. We thus recommend
1
https://gm.db.com/global_markets/publications/fixed_income_special/specialreport_9oct14.pdf
Page 5
10 October 2014
being long June-16 Eonia. Finally, the combination of lower front-end core
rates and tighter peripheral covered bonds should together imply lower
peripheral bond yields. The latter is also supported by favourable funding
dynamics thanks to positive current accounts and the support of the ECB via
the TLTRO. We thus recommend being long 5Y BTPs outright.
The full list of trades below is discussed in more details in the publication.

US: Buy 3m5y -25/-50 receiver spread

US: Sell FVH5 puts vs. payer swaptions

US: USD5s10s steepeners hedged by paying 20%2s

Eurozone: Receive June-16 Eonia

Eurozone: Long 1.5% BTPS Aug-19

UK: GBP5s10s Steepener

Japan: JGB20Y asset swap wideners

Dollar Block: AUD 6M1Y-3Y steepeners

Inflation: Long USD2Y2Y breakevens

Corporate Credit: Long EUR single-B credit

Covered Bonds: Long Multi-Cedulas IMECDI 4% Mar 2021 (A1/-/A-) versus
single Cedulas BBVASM 3.5% Oct 2020; Buy Multi-Cedulas AYTCED
4.75% May 2027 (A3/BB/BBB) versus single Cedulas SANTAN 4.625% May
2027 (A1/-/AA); Buy OBG MONTE 2.875% July 2024 (Baa3/-/A) versus OBG
UCGIM 3% Jan 2024 (A2/-/AA-); Buy OBG BANCAR 3.875% Oct 2018
(Ba1/-/BBB+) versus UCGIM 1.875% Jan 2019 (A2/AA/AA-)

CMBS: Long DECO 2014 GNDL A, MODA 2014-1 A, DECO 2014- TLPX A,
WSTSTR CORP
Page 6
10 October 2014
United States
Rates
Gov. Bonds & Swaps
Rates Volatility
US Overview




Dominic Konstam
Research Analyst
(+1) 212 250-9753
[email protected]
Aleksandar Kocic
Research Analyst
(+1) 212 250-0376
[email protected]
We think the market will completely price out the Fed for 2015. Until it
does we think risk assets remain on their back foot and the dollar tends to
be stronger as part of generalized risk aversion.
Alex Li
The markets will return to equilibrium in our view with 5s closer to 1 ¼
percent; stocks maybe another 5-10 percent lower, breakevens slightly
lower and 10s having touched 2 percent tending to stabilize back in the
current range of 2 ¼ to 2 ½ percent. Near term this favors buying on dips
but especially 5s for an eventual and more persistent (bull) steepening.
Stuart Sparks
Spec short positions in Eurodollars have always been vulnerable and no
more so than now. Real money credit longs and short duration positions
should also be hedged in our view.
The good news is that this means the Fed is more likely able to normalize
rates as they start later. Risk assets better priced to fundamentals and
fundamentals that have more time to improve with less downside tail risk
represent a “pause that refreshes”. Investors who disagree tend not to
recognize the weakness in the recovery and the risk that a strong dollar
poses to inflation. We emphasize that profits, that are growing at best
slowly, are “bad” profits and the tail risk suggests they may become “no”
profits if inflation falls. A model fitted to a sample since 2007 suggests a
swing of 100 bps on goods inflation related to another 4 percent
appreciation in the USDTWI.

We suspect the FOMC minutes are likely an opening salve in the unfolding
of a more dovish (delayed) Fed. Whether they realize it or not, they neither
want to raise rates prematurely to reverse later, nor worse still, have to
restart QE that is about to end. We suspect taper will be completed but
considerable period stays perhaps even into 2015. Either way the market
should discount a drop in the dots come December as a means to finding
some equilibrium in risk assets and dollar consistent with the bull
steepener. If we are wrong on the Fed, risk off may have further to go.

We have updated our forecasts and now expect the 10y Treasury yield to
end 2014 at 2.35% and end 2015 at 2.80%. We see scope for the 5y
Treasury to fall to as low as 1.25% in the short run, ending 2014 at 1.40%
and 2015 at 2.25%. This forecast is consistent with markets pricing the
Fed to delay lift-off until 2016 as well as with a lower equilibrium or
terminal cyclical rate.

We recommend investors buy 3m5y OTM receiver spreads to position for
5y outperformance. Currently 3m5y -25/-50 receiver spread structures
offer payoff ratios of 7.5:1.

We think it prudent for investors to hedge for wider spreads at higher rates.
The idea is that a more hawkish Fed will exacerbate weak profits,
undermining spread product valuations. If the market behaves as it did
during the Taper Tantrum, spread product hedging flows are likely to push
spreads wider. We like selling OTM FVH5 puts versus like-structured
swaptions for zero premium for a zero strike spread that is modestly better
than the forwards.
Research Analyst
(+1) 212 250-5483
[email protected]
Research Analyst
(+1) 212 250-0332
[email protected]
Daniel Sorid
Research Analyst
(+1) 212 250-1407
[email protected]
Steven Zeng, CFA
Research Analyst
(+1) 212 250-9373
[email protected]
Page 7
10 October 2014
Putting the Fed to Bed until 2016
We think the market will price the Fed out until 2016. Spec shorts in
Eurodollars remains vulnerable to a squeeze. Real money risk asset longs are
vulnerable to weaker pricing and wider spreads, compounded by the rate side
rallying. Upper left volatility shouldn’t soften as this is part of a transition for all
assets to be better aligned with the fundamentals and realized volatility should
tend to rise. Breakevens should remain pressured and the dollar strong until
the Fed acquiesces to further accommodation. Fed capitulation will allow a
partial unwind of dollar strength, some recovery in risk and higher inflation
expectations. The curve is likely to be slightly steeper/parallel shifting near
term and on Fed capitulation can resteepen bearishly. We suspect 10s can
easily trade through 2 ¼ near term with 5s heading towards 1 ¼ percent. Later,
10s can revert to 2 ½ percent. We have freshened up our forecasts to reflect
these emerging dynamics accordingly.
We interpret the FOMC minutes as an important shift in Fed concern for the
recovery. To the extent the minutes were massaged to reflect concerns for
global growth and excess dollar strength makes the minutes even more
important. However precisely because confusion now reigns as to whether the
dots are more important than the minutes means the markets will fumble
towards resolution ahead of the 29th October FOMC and possibly until the
December meeting with new dots and forecasts. In our view we think the Fed
should quickly move to consolidate a more dovish tone if it wants to forestall
more dollar strength and risk asset weakness. Equally though if they want
more volatility, which we think they have wanted, they could reasonably
decide to move more slowly and only be forthright dovish in December. By
then risk assets will be cheaper and better aligned to fundamentals. This would
include taking DBHYSDM (high yield) back to the 2013 highs of over 500 bps
and RTY 2000 down another 10 percent or so for example, to be better aligned
with profit growth (and lack of for the past few years).
We suspect the Fed will tend to move slowly: probably keeping considerable
period through October statement and maintaining concern for global growth
but still completing taper and allowing for ambivalence towards the timing of
rate hikes (2 to 12 months!?). Come December we suspect the dots will be
lower and greater emphasis placed on a likely 2016 start date for normalization.
Fundamentally the Fed wants to finish QE. It wants to raise rates towards
neutral. It thinks neutral is “high” around 3 3/4 percent. If it has any hope of
even getting to 2 ½ percent where the Cleveland Fed Taylor rule model would
currently estimate neutral, it has a better chance of starting later. If it starts
early not only does it risk having to reverse rate hikes but it might need in
desperation to resort to QE again. An early start to tightening could become a
spectacular own goal.
The problem the Fed faces is two-fold. As we have consistently argued, the
recovery is sub par. It is over reliant on labor input at the expense of
productivity. We highlighted last week’s payrolls as being problematic because
thanks to recent output data, productivity doesn’t appear to be strengthening.
Labor input (hours worked) has anyway been softer than payrolls and at
around 2 ½ percent, if productivity remains well below 1 percent, there is no
guarantee that GDP growth is sustaining a higher pace. In general the
constraint of low productivity means that once full employment is reached jobs
will slow to underlying potential of around 100k since business will not bid up
wages that are not “paid for” by productivity UNLESS they can pass wage
rises on into higher prices. The second problem is that pricing power is a little
weak and looks like weakening further thanks to a stronger dollar and
generalized global disinflation. This represents a fattening “tail risk” to Fed
normalization. In terms of profits, currently decent profit levels albeit virtually
Page 8
10 October 2014
stagnant growth, should be characterized as “bad” profits because they are
not supported by productivity but instead supported by low wages and
constrained by so so pricing. The danger – or tail risk – is that bad profits
become falling or “no” profits because pricing weakens and forces business to
raise productivity the “wrong” way by firing labor. The Fed if it moves to
normalize too quickly emphasizes the tail risk through the stronger dollar
whilst also not giving further time to perhaps allow for a recovery in
productivity the right way i.e. investment led capital deepening.
The charts below tell the story. We also highlight the importance of the 1994
tightening cycle as a checklist of what to watch for as there are both important
similarities and differences to the current stage of the cycle.
The first point is to highlight the strong link between productivity growth and
profit change with the exception of 1994 when profits were equally weak as
now despite a rise in productivity. This reflected strong wage growth with
pricing power being crimped (Greenspan’s “opportunistic disinflation”). Note
the pricing contribution was not very strong – about 8-9 bps to profit change
versus the current 5-6 bp, but came on the back off inflation being a fairly high
2 ½+ percent. Wage inflation was thus absorbed by strong productivity to
allow a downward drag on inflation as the Fed crimped demand through
normalization. This cycle could eventually see the same only if productivity
picks up but also with a caveat that inflation is still below target and pricing
power is weaker. So the Fed needs anyway to be more tolerant of any rise in
wages, especially if it front runs a rise in productivity.
Productivity contribution to NIPA profit growth
0.3
0.5
profit change
0.25
profit change
prody contribution
0.2
0.15
0.4
price contribution
0.3
0.1
0.2
0.05
0
0.1
-0.05
0
-0.1
-0.15
19611
Pricing contribution to NIPA profits
19761
Source: Haver and Deutsche Bank
19911
20061
-0.1
19611
19761
19911
20061
Page 9
10 October 2014
Core CPI vs. price contribution to profit change
Russell 2k yoy change (4 qtr average) vs. Profit yoy
14
0.45
50
0.4
40
Profit change yoy+2 qtrs
12
0.35
30
Russell 2k yoy 4q av
0.3
20
0.25
10
0.2
0
core CPI yoy
10
price contribution
rhs
8
6
4
0.15
-10
0.1
-20
2
0.05
-30
0
19611
0
-40
19883
19761
19911
20061
19943
20003
20063
20123
Additionally the strong dollar is clearly a risk to less pricing power going
forward, hence the FOMC minutes. Below we highlight two sub indices of core
CPI, “high” volatility components that mainly cover core goods and “low”
volatility components that mainly cover services excluding OER. We fit a
model based on unit labor costs using a monthly GDP proxy as well as
aggregate hours in the goods and service sector. In the case of goods the fit is
good but note that unit labor costs are actually negatively correlated along
with the dollar. So far from pricing being a mark up on cost, higher costs have
been associated with less inflation presumably because the strength of the
dollar in the tradable goods sector dominates. In the case of the service sector
unit labor costs alone drive most of the correlation with prices with higher
costs raising prices. We show in the fitted equation for each CPI a trajectory
for the ongoing trend in costs but also a further strengthening in the dollar TWI
by another 4 percent. The lags on the dollar are only to 6 months and the
model suggests that high vol (goods) inflation could drop to – ½ percent year
over year or by around 100 bps all else equal. There are the usual warnings
around reading too much into this in that the model fits well only over the past
7 years. Before the crisis it is much weaker and the lags longer. That said also
note that as we have shown earlier, inflation is more global post crisis (the first
two components in a PCA analysis account for over 90 percent of global
inflation correlation versus 70 percent or less pre crisis. This suggests greater
globalization and the transfer of (dis)inflation via currency adjustments taking
on more prominence.
Page 10
10 October 2014
Goods cpi (hi vol) vs. fitted
High vol CPI vs. unit labor cost proxy and USDTWI
4.0
10
4.75
5
4.70
-
4.65
(5)
4.60
(10)
4.55
3.5
3.0
2.5
2.0
1.5
1.0
0.5
high vol cpi
(0.5)
(1.0)
2007-Mar
2010-Mar
fitted
2013-Mar
(20)
2007-Mar
4.45
2013-Mar
Low vol CPI yoy vs. service ulc proxy
7
4
fitted
low vol inflation
6
5
4
service unit labor cost proxy-12m
3.5
low vol inflation
3
4
3
2.5
2
3
2.5
2
2
1
1.5
0
1
-1
1.5
1
2008-Mar
2010-Mar
4.50
Service sector (ex OER) CPI “Low volatility” vs. fitted
3.5
high vol cpi
goods ULC proxy
log USDTWI rhs
(15)
2011-Mar
2014-Mar
-2
0.5
-3
2008-Mar
0
2011-Mar
2014-Mar
So far we have made the case that the rate normalization process is hamstrung
by the nature of the profit cycle and dollar led disinflation tendencies. We can
now emphasize this point in the context of traditional “late cycle” dynamics.
About a year ago we suggested that the US economy was exhibiting late cycle
tendencies in that productivity was very weak and labor input very strong
versus potential. Tongue-in-cheek we suggested that if the Fed wanted to raise
rates it better do so quickly because it was going to have to cut rates before
too long as it was. The empirical evidence is quite persuasive. If we consider
years where labor input is stronger than productivity relative to potential, on
average the subsequent two years sees labor input falling by around 1 percent.
Of course this more often than not is because the Fed is raising rates as labor
markets are tightening and rising unit labor costs are tending to raise inflation.
The chart below highlights again the early 1990s where there is an exception:
the labor input-productivity “gap” was persistently negative into the tightening
as productivity was initially slow to rise during the recovery but then as it rose
labor input was still slow to fall, despite Fed tightening, because productivity
was rising for the right reasons i.e. investment led growth. This allowed labor
input to stay stronger for longer. The Fed in the 1994 tightening cycle can be
Page 11
10 October 2014
viewed as being almost supportive to the recovery – it allowed the recovery to
be extended by encouraging capital labor substitution through disinflation rather than bringing it to an end. Of course part of the explanation is that
investment needed to be done thanks to the technology revolution. Business
needed to invest to apply new TMT and TMT itself was going through major
development. The Fed may have been an enabler by forcing business to adopt
new technology to boost productivity and to sustain profit growth.
It is possible the same could occur this time with robotics or perhaps 3D
printing. However if the “secular stagnationists” have their way and say
technology change isn’t quite what it has been, then the cycle may still be
doomed to end. Labor input falls from 2015. The risk is of course still larger if
profits are squeezed further so if there is any hope of a 1995/6 repeat the Fed
again is best to be silent for longer and buy more time for investment led
productivity growth. Note expectations for investment spending remain robust
(Philadelphia Fed index) and general corporate optimism is high (NFIB). This is
a recovery that seems extendable despite the raw empiricism. Hence Fed delay
is more about a pause that refreshes rather than a reflection of worst to come.
A reason to buy stocks for a recovery trade rather than deeply wedded to
ongoing risk off. The tail risk of an overzealous Fed however is clear – the risk
being a recession wouldn’t be hard to engineer and could easily see yields
much lower. Similarly it is a warning to the ECB that there is no solution via a
collapsing euro. Capital flight from Europe might be good for a weaker euro
and global bond yields but it won’t do risk assets any good whatsoever.
Labor input-Productivity “gap” vs. future labor input
15
Labor input vs. productivity relative to potential
gap rhs
labor input 2 yr forward
10
8
5
3
0
-2
-5
-7
-10
6
4
4
3
2
2
0
1
-2
0
-4
-1
-6
-2
labor input vs. potential
-8
-15
-12
1961
1973
1985
1997
2009
-3
productivity vs. potential rhs
-10
1961
1973
1985
1997
-4
2009
Rally in rates has been consistent with past QE experience
The recent market rally is consistent with past QE experience. Contrary to
conventional wisdom that rates could rise following the Fed exit, the market
rallied towards the end of QE1 and QE2, which were October 2009 and June
2011, respectively. Note that the Fed ended Treasury purchases in QE1 at the
end of October 2009, while it continued MBS purchases a few months
afterwards. During the three-month period prior to the end of QE1, the ten-year
yield dropped about 10bp, and the 5s-30s curve steepened. TIPS breakevens
widened along with higher equity prices.
The rates and curve movements towards the end of QE2 were more significant
than those at the end QE1. 10s rallied 28bp during the three-month period
leading to the end of QE2, and the 5s-30s curve steepened about 30bp. The
Page 12
10 October 2014
curve bull steepened from 5s to 30s probably because the market was
concerned about the economic recovery after QE2.
In the current market, 5s remain cheap on the curve. 5s-10s are too flat by
more than two standard deviations on our fair value model that incorporates
funds rate, 2s-funds and inflation expectations.
The recent market rally is consistent with past QE experience; 10yr Treasury
yield dropped towards the end of QE1 and QE2
QE1 End
QE2 End
4.25
Twist End
QE3 End
3.75
3.25
2.75
2.25
1.75
1.25
7/1/2009
7/1/2010
7/1/2011
7/1/2012
7/1/2013
7/1/2014
Source: Bloomberg and Deutsche Bank
Ten-year yield around the end of prior QEs
100
10Y Treasury yield
Yield change in bp
50
0
-50
QE1
-100
QE2
Twist
125
115
95
105
85
75
65
55
45
35
25
5
15
-5
-15
-25
-35
-45
-55
-65
-75
-85
-95
-105
-115
-125
-150
Trading days relative to end of each operation
Change in rates, equities and FX during the three month period prior to the
end of QEs
Yield
Curve
TIPS BE
Equities
FX
10s
5s-30s
10Y
SPX
DXY
Change in yield(%) or indices (%)
QE1
QE2
Twist
QE3
-0.10%
-0.28%
0.07%
-0.16%
0.13%
0.31%
-0.04%
0.08%
0.24%
-0.07%
0.02%
0.02%
4.9%
-0.6%
-2.7%
-2.5%
-2.6%
-2.4%
-0.3%
-0.1%
For QE3, the changes are for the period from September 29, 2014 to October 9, 2014. Source: Bloomberg and Deutsche Bank
Page 13
10 October 2014
Actual and model predicted 5s10s slope
1.60
1.40
Percent
1.20
Regression residual
5s-10s actual
40
Fitted to Fed funds, 2s-Funds, and
Michigan 5y infln
30
1.00
0.80
0.60
0.40
0.20
(0.20)
(0.40)
Sep-90 Sep-93 Sep-96 Sep-99 Sep-02 Sep-05 Sep-08 Sep-11 Sep-14
bp
Model residual
+2 standard errors
20
10
0
(10)
(20)
(30)
-2 standard errors
(40)
(50)
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
Sep-13
Sep-14
Credit: Hard to say goodbye
Quantitative easing has been in the backdrop of credit markets for so long that
its looming end will undoubtedly raise some uncomfortable questions: Does
the final stretch of QE herald the end of ‘reach for yield’ buying of credit? Will
Treasury yields spike causing mutual fund outflows? We look below at the
period leading up to the end of four asset purchase programs to see if there is
a pattern in market performance as QE ends approach, using our DB credit
indices as proxies. First, as noted above, Treasury yields do not actually tend to
jump as Treasury purchase programs come to a close. This should help to calm
those concerned about a sudden spike in yields. Second, there is no clear
pattern to spread performance in the final stretches of earlier asset purchase
programs, although perhaps QE2 is the most apt comparison to current
circumstances -- given that it ended amid expectations that the Fed was all
finished. And spreads did indeed widen as QE2 ended, as we discuss more
fully below. Our US Credit Strategy team remains constructive on credit
markets, but we still find it reasonable to assign at least some of the blame for
recent credit market weakness to the budding anxiety over the end of QE.
Investors may be fretting – as they did last May – that a world in which the Fed
is not buying billions of Treasuries at a clip, forcing investors out the credit
spectrum, is one in which demand for risky assets will decline. Yet one should
not so easily conclude that the Fed is leaving the picture entirely. It will
continue to reinvest in order to maintain a $4.2 billion portfolio of securities,
and remains a “considerable” period away from raising rates. A more apt
comparison, and one described in our Credit Strategy publication in March,
considers spreads in the context of the 1994 and 2004 hiking cycles. And
corporate bond spreads performed well in the lead-up to the first hike in rates,
and continue to tighten, though more modestly, into the new regime as rates
begin to rise. And as Fed officials begin to emphasize the gradual nature of
future rate hikes, and their plans to continue reinvestments to maintain $4
trillion in securities holdings, we would highlight that gradual increases in
Treasury yields are actually associated with spread tightening. That said, the
“QE is ending!” narrative is one worth considering, and in the analysis below
we use a) the three months leading up to the end of each of the below asset
purchase programs and b) spreads in the period between asset purchase
programs (when markets did not anticipate a further round of easing). We
focus below on pure Treasury purchases, and provide a quick review of what is
now well-known history:
Page 14
Changes in OAS in 3m prior to end
of asset purchase program
3 months
ended
Oct
2009
June
2011
Dec Sep 302012 Oct 9
2014
QE1
QE2
Twist
IG
-53
+17
-13
+1
HY
-152
+53
-33
+13
IG Fins
-84
+20
-18
0
IG Nonfins
-36
+5
-10
+1
AAs
-34
+13
-6
-1
As
-49
+12
-16
+0
BBBs
-77
+10
-21
+2
BBs
-89
+48
-35
+9
Bs
-137
+85
-43
+15
CCCs
-235
+70
-82
+26
+4.9%
-0.6%
-2.7%
-2.5%
SPX
QE3
Source: Deutsche Bank; all units in bps for bonds and % change
for SPX
10 October 2014

QE1: Crisis-era purchases of $300 bn in Treasuries that began in March
that lasted through October 2009. (MBS purchases continued into 2010.)

QE2: Amid a decline in inflation expectations, the Fed announced a
second-round of $600 bn in asset purchases that began in November 2010
and ended in June 2011.

QE Interregnum: The period between QE2 and Operation Twist lasted from
the end of June to the end of August 2011.

Operation Twist: Maturity-extension program announced in September
2011 that ended December 2012.

QE3: Third round of unsterilized asset purchases announced in September
2012 and the last asset purchases would be set to wrap up in December.
We analyze at the period from Sept 30 to Oct 9.
As noted above, Treasury yields have tended – perhaps counter to supplydemand logic -- to decline in the lead-up to the end of asset purchases. In the
three months before the end of Treasury purchases in QE1 and QE2, yields on
10-year Treasury notes fell 10 bps and 28 bps, respectively. As QE3 ends,
yields are also 16 bps lower. In credit, the story is more mixed. Spreads
tightened in the lead-up to the end of QE1 and at the end of Twist, but widened
as the end of QE2 approached. Which is a better comparison? Each QE
program began and ended under different circumstances. QE1 is probably a
poor comparison, because its completion coincided with the restoration of
relative normalcy in financial markets. Financial IG corporate spreads tightened
84 bps leading up to the end of QE1, while non-financials tightened 36 bps.
QE2 may be a more apt comparison, if only because the program ended
cleanly and no other asset purchase program was expected to begin. (When
Operation Twist ended, QE3 asset purchases were starting up.) In the lead-up
to the end of QE2, spreads widened 17 bps and 53 bps, respectively, in IG and
HY. The widening was much more pronounced in financials, suggesting that
the underperformance could be attributed more to other coincident events –
such as stress in the Eurozone periphery.
OAS changes over periods between
asset purchase programs
3/31-10/29/10
6/30-9/30/11
Between QE1*
& QE2
Between QE2
and Twist
IG
+20
+92
HY
+10
+233
IG Fins
+16
+150
IG Nonfins
+11
+60
AAs
+13
+70
As
+14
+98
BBBs
+18
+101
BBs
+10
+204
Bs
+26
+249
CCCs
+73
+559
Source: Deutsche Bank; QE1 Treasury purchases only
One comparable period worth considering would be the period between QE2
and Twist, when no asset purchases occurred. In this period, credit badly
underperformed, widening 92 bps in IG and 233 bps in HY, although again,
events unfolding in Europe at the time are likely more directly related to these
moves. Yet the absence of Fed asset purchases may have increased the
fragility of credit markets when shocks did occur.
Forecast update
The market rally following last week's release of the September Fed minutes
was the first of what we think will be substantial 5y outperformance going
forward. Interestingly, last week's rally saw greens/blues steepen. This is
suggestive of a delay in the first hike, but with blues stickier at high levels due
to the language of optimal control. That is, the market continues to reflect
expectations of an ultimate Fed catch up to a relatively high terminal rate. A
market revision of that terminal rate lower could allow more significant 5y
richening on the curve and would likely see greens/blues flatten as both rates
fall. We have revised our official forecasts to reflect this dynamic. We have
lowered our 10y forecast to 2.35% for year-end 2014 and to 2.80% for yearend 2015. We now forecast the 5y yield to end the year at 1.40%, with scope
to trade as low as 1.25% in the near term.
Page 15
10 October 2014
Treasury yield forecasts
10s30s 2s5s10s
*
2Y
5Y
10Y
30Y
5s10s
Current
0.43
1.54
2.29
3.02
75.1
73.0
18.0
2014 H2
0.50
1.40
2.35
3.05
95
70
-2.5
2015 H1
0.95
1.70
2.60
3.25
90
65
-7.5
2015 H2
1.55
2.25
2.80
3.30
55
50
7.5
* 5y -0.5*(2y+10y)
The key near term dynamic in our forecast is 5y outperformance on the curve.
This would be consistent with markets pricing for a delay of Fed lift-off until
2016, a lower implicit terminal cyclical rate, or some of both. The steepening
of the curve keeps the 5y5y forward rate anchored in a 3.25%-3.75% range.
The relatively low level of yields in our forecasts is driven by our estimate of a
2.75% equilibrium Fed Funds rate and a Fed that is unable to normalize to
normalize rates even to this level rapidly, or even mechanistically. This in turn
is driven by our view that profits are vulnerable given low pricing power and
low productivity growth, and that risk markets are not yet ready for higher real
yields. As a result, we reckon that Fed rate hikes will have to be gradual and
smaller in magnitude than in past cycles, with longer pauses to refresh and
ascertain the effect of tightening policy on risk assets.
Trades
Buy 3m5y OTM receiver spreads
Investors can achieve 7.5:1 payout ratios by buying 3m OTM receiver spreads
on 5y tails. Both the 2y1y and 3y1 rate look cheap on the curve from the
perspective of a DV01 and curve neutral butterfly with risk weights derived
from 10y of history.

Buy 3m5y -25/-50 receiver spread for 16 bp up front.
Given the strike spread and premium the payout ratio is 7.5:1. The maximum
loss is the premium outlay. The maximum profit is the strike spread (adjusted
to up front terms) less the premium outlay.
Cheapness in the 5y sector: curve neutral 2y/2y2y/4y2y butterfly
80
60
Curve neutral fly
40
BP
20
0
-20
-40
-60
-80
If we are right that risk asset valuations aren’t yet “ready” for tighter policy –
for example the coefficient of (log) S&P500 prices on real yields from a
regression versus breakevens, real yields, and DXY has turned negative and
Page 16
10 October 2014
increasingly so post crisis – then the Fed will at best be forced to hike haltingly
and at worst will be prevented from “normalizing” fully even to our 2.75%
estimate of equilibrium funds. This would lead the market to re-price the
terminal rate lower and would favor the 5y sector of the curve, in our view.
Sell FVH5 puts versus payers swaptions
A more aggressive Fed might carry on with what we perceive as attempts to
increase risk premia and raise volatility to smooth the impact of prospective
rate hikes.
If risk assets are not able to withstand higher rates, then the reaction could be
a wobble in valuations akin to that of late spring/early summer 2013. . During
the Taper Tantrum of 2013 investors hedging spread product used swap
spreads as a hedging vehicle, and given the lower volatility of swap spreads
relative to corporate spreads, were obliged to over-hedge from the perspective
of notional principal versus the underlyincg asset being hedged. The result
could be a sharp and (bearish) directional widening of spreads much like that
experienced during the Taper Tantrum. Such a market dynamic would be
conducive to conditional spread wideners such as selling FV puts and buying
the analogous swaption with maturity matched underlying rate.
: Correlation of swap spreads and IG OAS during Taper Tantrum
160
USD IG OAS, bp
150
IG USD OAS
USSP5
25
20
140
130
120
15
10
110
100
5y swap spread, bp
170
5
90
80
0

Sell 1,000 FVH5 117 puts versus buy $117mm 2.155% payers expiring
February 20, 2015 into swap commencing April 6, 2015 and maturing May
31, 2019 for zero premium.
At the time of writing the FVH5 strike was just over 23 bp OTM. Due to the vol
premium of FV over swaptions, the zero premium strike spread of 10.8bp is
1.75bp better than the invoice spread, which was 12.6 bp.
The risk to the trade is that spreads tighten in a sell off. The maximum loss
and maximum gain are in theory unlimited provided strikes are crossed. If
strikes are not crossed, i.e. the market rallies, then both options expire
worthless. We recommend observing a stop level of 8bp in terms of the
underlying invoice spread targeting 10 bp of spread widening.
Page 17
10 October 2014
United States
Rates
Gov. Bonds & Swaps
Alex Li
Steven Zeng, CFA
Research Analyst Research Analyst
(+1) 212 250-5483 (+1) 212 250-9373
[email protected] [email protected]
Treasuries

conventional wisdom that rates would rise following the Fed exit, the
market rallied towards the end of QE1 and QE2.

In the current market, 5s remain cheap on the curve. There is a lot of carry
and roll in 5s. 5s-10s are too flat by more than two standard deviations on
our fair value model that incorporates funds rate, 2s-funds and inflation
expectations.

In the latest COT data, specs added net long positions in the ultra, while
cutting net short positions in TU.
Consistent behavior
conventional wisdom that rates could rise following the Fed exit, the market
rallied towards the end of QE1 and QE2, which were October 2009 and June
2011, respectively. Note that the Fed ended Treasury purchases in QE1 at the
end of October 2009, while it continued MBS purchases a few months
afterwards. During the three-month period prior to the end of QE1, the ten-year
yield dropped about 10bp, and the 5s-30s curve steepened. TIPS breakevens
widened along with higher equity prices.
Ten-year yield around the end of prior QEs
100
5s-30s curve around the end of prior QEs
60
10Y Treasury yield
0
-50
QE1
-100
QE2
Yield change in bp
50
Yield change in bp
5s-30s Treasury spread
40
20
0
-20
-40
Twist
QE1
-60
Source: Bloomberg Finance LP and Deutsche Bank
Twist
-80
-125
-115
-105
-95
-85
-75
-65
-55
-45
-35
-25
-15
-5
5
15
25
35
45
55
65
75
85
95
105
115
125
-125
-115
-105
-95
-85
-75
-65
-55
-45
-35
-25
-15
-5
5
15
25
35
45
55
65
75
85
95
105
115
125
-150
QE2
The rates and curve movements towards the end of QE2 were more significant
than those at the end QE1. 10s rallied 28bp during the three-month period
leading to the end of QE2, and the 5s-30s curve steepened about 30bp. The
curve bull steepened from 5s to 30s probably because the market was
concerned about the economic recovery after QE2.
Page 18
10 October 2014
In the current market, 5s remain cheap on the curve. 5s-10s are too flat by
more than two standard deviations on our fair value model that incorporates
funds rate, 2s-funds and inflation expectations.
5s remain cheap on the curve
0.8
First rate hike in the
2004-2006 tightening
0.6
0.4
0.2
0.0
-0.2
Avg = -6.5bp
-0.4
-0.6
2s-5s-10s
-0.8
-1.0
7/1/03
7/1/05
7/1/07
7/1/09
7/1/11
7/1/13
Source: Bloomberg Finance LPand Deutsche Bank
In the latest COT data, specs added net long positions in the ultra (now at
+27,571 contracts), while cutting net short positions in TU (-79K contracts).
Specs are net long the ultra long bond futures
Specs have cut net short in TU
300,000
40,000
Net spec in TU
Net spec in WN
30,000
200,000
20,000
100,000
10,000
0
0
-10,000
-100,000
-20,000
-200,000
-30,000
-40,000
7/1/12
1/1/13
7/1/13
1/1/14
7/1/14
-300,000
1/1/04
1/1/06
1/1/08
1/1/10
1/1/12
1/1/14
Auction update: 3s, 10s, and 30s
The market supply included $61 billion of notional through three- and ten-year
notes and 30-year bond auctions this week. The ten-year note auction had a
tail, but the 3s and 30s witnessed good customer participations. The indirect
bidders took down 40.9% of the combined notional supply as compared to
their prior-year average of 39.6%. The direct bidder participation however fell
below the average 17.9% to 14.6% from 18.2% in previous month. The
combined buyside takedown was also down to 55.4% from 60.8% in
September and compares with its trailing twelve month average 57.5%.
3-year note
Page 19
10 October 2014
The indirect participation increased from 33.1% to 35.5% and remained above
the prior-year average 32.9% for the fourth straight month. The direct bidder
takedown however dropped below the average 18.8% to 17.4% from 20.3% in
September. The combined buyside takedown declined a touch to 53% and
compares with its prior-year average 51.8%. The bid-to-cover ratio jumped
past the average 3.31 to 3.42, the highest since February, from 3.17 in the
previous month. And the auction stopped through by 0.3 basis points.
3-year note auction statistics
Size
($bn)
1yr Avg
$29.0
Primary
Dealers
Direct
Bidders
48.2%
Indirect
Bidders
18.8%
32.9%
Cover
Ratio
Stop-out 1PM WI
Yield
Bid
BP Tail
3.31
-0.1
Oct-14
$ 27.0
47.0%
17.4%
35.5%
3.42
0.994
0.997
-0.3
Sep-14
$ 27.0
46.6%
20.3%
33.1%
3.17
1.066
1.064
0.2
Aug-14
$ 27.0
44.8%
19.0%
36.2%
3.03
0.924
0.925
-0.1
Jul-14
$ 27.0
49.1%
12.7%
38.2%
3.38
0.992
0.998
-0.6
Jun-14
$ 28.0
54.1%
19.4%
26.5%
3.41
0.930
0.928
0.2
May-14
$ 29.0
47.3%
24.5%
28.1%
3.40
0.928
0.926
0.2
0.1
Apr-14
$ 30.0
48.8%
24.0%
27.3%
3.36
0.895
0.894
Mar-14
$ 30.0
54.6%
15.5%
29.9%
3.25
0.802
0.800
0.2
Feb-14
$ 30.0
41.3%
16.6%
42.0%
3.42
0.715
0.718
-0.3
Jan-14
$ 30.0
49.4%
22.6%
28.0%
3.25
0.799
0.796
0.3
Dec-13
$ 30.0
49.6%
12.0%
38.4%
3.55
0.631
0.637
-0.6
Nov-13
$ 30.0
47.3%
19.4%
33.3%
3.46
0.644
0.645
-0.1
Source: US Treasury and Deutsche Bank
10-year note, re-opening
The ten-year note auction had a tail. The combined customer participation
dropped to 51%, the lowest since May 2013, from 66.5% in September and
compares with its prior-year average 62.6%. The direct bidder takedown hit the
lowest level of 6.6% since August 2012 and compares with its trailing twelvemonth average of 17.2%. The indirect bidder participation also fell a full
percentage point below the average to 44.4% from 53% in September. The
bid-to-cover ratio of 2.52 was the lowest since August last year and compares
with the about average 2.71 level in previous auction.
10-year note auction statistics
Size
($bn)
1yr Avg
$ 22.0
Primary
Dealers
Direct
Bidders
Indirect
Bidders
Cover
Ratio
37.4%
17.2%
45.4%
2.70
Stop-out 1PM WI
Yield
Bid
BP Tail
0.1
Oct-14 $
21.0
49.0%
6.6%
44.4%
2.52
2.381
2.366
1.5
Sep-14 $
21.0
33.5%
13.5%
53.0%
2.71
2.535
2.532
0.3
Aug-14 $
24.0
37.9%
15.1%
47.0%
2.83
2.439
2.437
0.2
Jul-14
$
21.0
46.5%
13.9%
39.6%
2.57
2.597
2.585
1.2
Jun-14 $
21.0
44.5%
19.4%
36.1%
2.88
2.648
2.639
0.9
May-14 $
24.0
29.1%
21.6%
49.3%
2.63
2.612
2.615
-0.3
Apr-14 $
21.0
40.1%
15.2%
44.7%
2.76
2.720
2.71
1.0
Mar-14 $
21.0
29.1%
27.5%
43.4%
2.92
2.729
2.742
-1.3
Feb-14 $
24.0
34.1%
16.2%
49.7%
2.54
2.795
2.801
-0.6
Jan-14 $
21.0
39.8%
13.6%
46.6%
2.68
3.009
3.008
0.1
Dec-13 $
21.0
40.4%
10.6%
48.9%
2.61
2.824
2.815
0.9
Nov-13 $
24.0
33.8%
18.6%
47.7%
2.70
2.750
2.755
-0.5
Page 20
10 October 2014
30-year bond, re-opening
Both the direct and indirect bidders were strong for the third consecutive
month and the combined customer participation went up a touch to 67.8%
(avg. 61.2%). The indirect bidders increased their takedown from 45.5% in
September to 46.2% (avg. 44.3%) whereas the direct bidder participation
declined slightly to 21.5% (avg. 16.9%). The bid-to-cover ratio however
dropped from 2.67 to 2.40 and compares with its prior-year average of 2.44.
The auction generated a small tail of 0.3 bp.
30-year bond auction statistics
Size
($bn)
Primary
Dealers
Direct
Bidders
Indirect
Bidders
Cover
Ratio
1yr Avg
$14.0
Oct-14
$ 13.0
Sep-14
Stop-out 1PM WI
Yield
Bid
BP Tail
38.8%
16.9%
44.3%
2.44
32.2%
21.5%
46.2%
2.40
3.074
3.071
0.3
$ 13.0
32.8%
21.8%
45.5%
2.67
3.240
3.261
-2.1
Aug-14
$ 16.0
29.8%
24.4%
45.9%
2.60
3.224
3.245
-2.1
Jul-14
$ 13.0
35.7%
11.1%
53.2%
2.40
3.369
3.361
0.8
-0.1
Jun-14
$ 13.0
26.5%
21.8%
51.8%
2.69
3.444
3.468
-2.4
May-14
$ 16.0
51.2%
8.4%
40.4%
2.09
3.440
3.404
3.6
Apr-14
$ 13.0
38.8%
17.9%
43.3%
2.52
3.525
3.524
0.1
Mar-14
$ 13.0
48.6%
12.6%
38.8%
2.35
3.630
3.615
1.5
Feb-14
$ 16.0
40.8%
13.9%
45.3%
2.27
3.690
3.696
-0.6
Jan-14
$ 13.0
38.1%
17.5%
44.4%
2.57
3.899
3.905
-0.6
Dec-13
$ 13.0
41.4%
12.5%
46.0%
2.35
3.900
3.892
0.8
Nov-13
$ 16.0
46.5%
18.3%
35.3%
2.16
3.810
3.794
1.6
Allotments update
Treasury released the allotments data for the September two-, five- and sevenyear notes and the two-year floating rate note (FRN) auctions this week.
Investment funds were allotted 37% of the combined fixed coupon supply
versus their 40% share in August but slightly above their average 35%
allotment share of 35.4%. The allotment share to the foreign and international
investor remained above its average 14.7% level for the fourth consecutive
month at 16.9% although it declined from 18% in the previous month. The
combined share allotted to the two investor classes was down from 57.6% in
August to 54%, but it was still strong as compared to its average of 50%.
2-year floating rate note (FRN)
The foreign and international investor allotment share subsided to 30.6% from
the record 42.6% in the previous month. The allotment share to investment
funds fell further to a paltry 0.6% from 3.5% and compares with 13.2%, the
average in the all actions so far. And the combined share allotted to the two
investor classes dropped to 31.2% (avg. 37.9%), the lowest in last five months,
from the record 46% in previous auction. Notably, 23% of the supply was
awarded to investors classified as “other”.
2-year note
The allotment share to foreign and international investors increased from
18.6% in August to 24.7% (avg. 14.8%), the highest in about three years. The
share allotted to investment funds however fell from 28.4% to 26.7% and
compares with its one-year average of 27.1%. The combined allotment share
of the two classes of the investors rose from 47% in August to the six month
high of 51.3% and compares with the average 41.9%.
Page 21
10 October 2014
5-year note
The investment funds were allotted 41.3%, up from 40.7% in August, of the
supply versus their average allotment share of 37.4%. The allotment share to
foreign and international investors dropped to 14.1%% from 18.6% in the
previous month, but was in line to its average. The combined 55.4% allotment
share to the two investor classes was above its average 51.6% for the third
straight month, though it declined from 59.4% in August.
7-year note
The allotment share to investment funds fell from 49.3% in August to 42.2%
but remained slightly above its average of 41.6%. The foreign and international
investors were allotted 12.4% (avg. 15.4%) of the supply, which compares with
their 16.7% share in previous month. And the combined allotment share to the
two investor classes dropped below the average 57% to 54.7% from 66% in
August.
Fed buyback
The Fed plans to remove about $2.2 billion of notional Treasuries worth $3
billion in ten-year equivalents from the markets through three buyback
operations next week. Tuesday’s purchases are targeted at the long-end of the
curve whereas the 4 to 4.75 and 10 to 17 year maturity sectors, respectively,
will be in focus over the next two days. Recent three buybacks operations in
10-17 year sector had strong bid-to-cover ratios; the latest operation on
September 18 had a coverage ratio of 14.24.
Fed buyback schedule for October 13-17
Date
Operation type
14-Oct
15-Oct
16-Oct
Treasury
Treasury
Treasury
Expected
Avg.
par ($bn) Duration
Maturity range
2/15/2036
10/31/2018
11/15/2024
8/15/2044
6/30/2019
2/15/2031
Total
0.95
1.05
0.2
17.0
4.1
9.5
2.20
10.18
Avg.
DV01
19.75
4.30
13.46
11.81
10yr Equiv Sub/cover
($bn)
(Last 4 avg)
2.14
0.51
0.31
4.87
5.25
11.23
2.96
Source: Deutsche Bank, New York Fed.
Two-year floating rate note (FRN) auction allotments
Settle Date
1 Yr Avg
9/26/2014
8/29/2014
7/31/2014
6/27/2014
5/30/2014
4/30/2014
3/28/2014
2/28/2014
Total
(less Fed)
$bn
14
13
13
15
13
13
15
13
13
Federal Reserve
$bn
%*
0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0%
0%
0%
0%
0%
0%
0%
0%
0%
Dealers and Brokers
$bn
%
7.9
5.9
6.9
8.6
7.8
7.6
9.8
8.7
7.8
58%
46%
53%
57%
60%
58%
65%
67%
60%
Investment
Funds
$bn
Foreign and
International
$bn
$bn
%*
$bn
1.8
0.1
0.4
0.9
1.2
1.5
2.5
2.9
4.0
3.4
4.0
5.5
5.0
4.0
3.6
2.2
1.3
1.0
0.5
3.0
0.1
0.5
0.1
0.3
0.5
0.0
0.2
4.0%
23.2%
0.6%
3.4%
0.5%
2.3%
3.5%
0.1%
1.3%
13.2%
0.6%
3.5%
6.1%
8.9%
11.5%
16.5%
22.7%
30.8%
Other
24.8%
30.6%
42.6%
33.4%
30.8%
28.0%
14.5%
10.0%
7.7%
* Percentage as of total less Fed SOMA
Page 22
10 October 2014
Two-year note auction allotments
Settle Date
1 Yr Avg
9/30/2014
9/2/2014
7/31/2014
6/30/2014
6/2/2014
4/30/2014
3/31/2014
2/28/2014
1/31/2014
12/31/2013
12/2/2013
10/31/2013
Total
(less Fed)
$bn
31
29
29
29
30
31
32
32
32
32
32
32
32
Federal Reserve
$bn
%*
0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.1
0.0
0.0
0.0
0.0
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Dealers and Brokers
$bn
%
17.7
13.8
15.0
18.5
18.1
19.5
20.4
13.6
16.9
18.6
18.6
20.4
18.6
57%
48%
52%
64%
60%
63%
64%
43%
53%
58%
58%
64%
58%
Investment
Funds
$bn
Foreign and
International
$bn
$bn
%*
$bn
8.4
7.7
8.2
6.8
6.2
7.6
7.9
13.0
9.9
6.2
11.7
8.8
6.8
4.6
7.2
5.4
3.3
5.5
3.4
3.5
4.8
4.4
6.8
1.6
2.6
6.3
0.4
0.3
0.3
0.4
0.2
0.5
0.2
0.6
0.8
0.3
0.1
0.3
0.3
1.1%
1.0%
1.2%
1.3%
0.6%
1.6%
0.5%
1.8%
2.6%
1.0%
0.4%
0.8%
0.9%
27.1%
26.7%
28.4%
23.6%
20.6%
24.5%
24.8%
40.6%
30.9%
19.4%
36.6%
27.5%
21.4%
14.8%
24.7%
18.6%
11.3%
18.5%
11.1%
10.9%
15.0%
13.7%
21.4%
5.0%
8.0%
19.7%
Other
Five-year note auction allotments
Settle Date
1 Yr Avg
9/30/2014
9/2/2014
7/31/2014
6/30/2014
6/2/2014
4/30/2014
3/31/2014
2/28/2014
1/31/2014
12/31/2013
12/2/2013
10/31/2013
Total
(less Fed)
$bn
35
35
35
35
35
35
35
35
35
35
35
35
35
Federal Reserve
$bn
%*
0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.1
0.0
0.0
0.0
0.0
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Dealers and Brokers
$bn
%
15.4
15.4
14.0
10.2
14.7
15.3
14.1
10.4
15.4
17.7
24.2
15.9
17.4
44%
44%
40%
29%
42%
44%
40%
30%
44%
51%
69%
45%
50%
Investment
Funds
$bn
%
Foreign and
International
$bn
%
$bn
%
13.1
14.5
14.3
13.1
13.7
14.1
12.6
14.0
14.5
12.4
6.0
14.5
13.6
5.0
4.9
6.5
6.1
3.7
5.3
5.0
5.5
4.9
4.6
4.7
4.5
3.7
1.6
0.2
0.2
5.6
2.8
0.3
3.3
5.1
0.2
0.2
0.1
0.2
0.3
4.4%
0.6%
0.6%
16.0%
8.1%
0.9%
9.4%
14.6%
0.6%
0.6%
0.4%
0.5%
0.9%
37.4%
41.3%
40.7%
37.3%
39.3%
40.2%
36.0%
40.0%
41.5%
35.6%
17.1%
41.3%
38.9%
14.2%
14.1%
18.6%
17.6%
10.7%
15.2%
14.3%
15.7%
13.9%
13.3%
13.3%
12.8%
10.5%
Other
Seven-year note auction allotments
Settle Date
1 Yr Avg
9/30/2014
9/2/2014
7/31/2014
6/30/2014
6/2/2014
4/30/2014
3/31/2014
2/28/2014
1/31/2014
12/31/2013
12/2/2013
10/31/2013
Total
(less Fed)
$bn
29
29
29
29
29
29
29
29
29
29
29
29
29
Federal Reserve
$bn
%*
0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.1
0.0
0.0
0.0
0.0
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Dealers and Brokers
$bn
%
11.9
13.0
9.7
11.6
13.5
11.6
10.0
8.4
11.0
10.9
14.6
16.7
12.0
41%
45%
33%
40%
47%
40%
34%
29%
38%
38%
50%
58%
41%
Investment
Funds
$bn
Foreign and
International
$bn
$bn
%*
$bn
12.1
12.2
14.3
12.3
10.3
13.8
11.9
11.4
12.6
14.4
9.7
9.1
12.6
4.5
3.6
4.8
4.9
4.8
3.5
7.0
4.5
5.2
3.6
4.5
3.0
4.1
0.6
0.2
0.2
0.2
0.4
0.2
0.2
4.6
0.2
0.1
0.2
0.2
0.2
1.9%
0.6%
0.6%
0.6%
1.2%
0.6%
0.6%
15.9%
0.8%
0.4%
0.5%
0.6%
0.8%
41.6%
42.2%
49.3%
42.4%
35.6%
47.6%
41.1%
39.4%
43.3%
49.7%
33.4%
31.5%
43.5%
15.4%
12.4%
16.7%
17.0%
16.5%
12.0%
24.0%
15.6%
18.0%
12.3%
15.5%
10.2%
14.2%
Other
Page 23
10 October 2014
United States
Rates
Gov. Bonds & Swaps
Rates Volatility
Aleksandar Kocic
Research Analyst
(+1) 212 250-0376
[email protected]
Derivatives

Bull steepeners are fully awake after a while. Reaction of the surface to the
Fed minutes was somewhat out of character, with intermediate expiries
experiencing the sharpest decline (led by the short tenors), while short
covering of the risk reversals was supportive for gamma.

In the context of several years of accommodation with excessive
transparency, low volatility and complacency, the Fed is facing a high level
of addiction liability in the face of possible policy unwind. This could
become a sensitive issue when risky assets are concerned, as possible
unwind of positions could disrupt the Fed’s exit and in general restrict its
maneuvering space if market conditions improve significantly. Thus, return
of volatility to the market is an essential step in unwinding monetary policy.

It feels like the Fed wants to shake things up, but is afraid of shaking them
up too much (as happened in 2013). If, after all is said and done, rates
reprice delayed hikes and vol moves higher in the short-run, this can be
interpreted as a successful maneuver by the Fed.

We would position to benefit from a limited rally in the belly of the curve.
Most significant repricing in gamma should be at the front end, led by the
green and blue sectors, while 10Y and longer would be less affected. Once
the market calms down and positioning is squared, vol would resume its
directionality. It is likely to see some compression of the risk premia along
the curve while gamma remains supported. This would bring curve closer
in line with vol. In that context, continued decline in vol since the mid-2013
would be justified ex-post as a correct view.

We are buyers of 1X2 receiver spreads and 1X2 curve caps spreads. We
recommend:

Buy $100mn 3M10Y ATMF vs sell $200mn 3M10Y 17bp OTM receivers at
zero net costs

Buy $1bn 3M 5s/10s ATMF vs. sell $2bn 3M 5s/10s 7.5bp OTM curve caps
at zero net cost
Vol was right all along
Rates are down for the week with 5s leading the way in a steepening rally and
most of the repricing coming from the green and blue sectors. After 9M of
practically uninterrupted flattening, led by the long end and supported by
resilience of the belly, the market could be on the verge of revising its view of
rate hikes. If the strong USD (vs. EUR) story is experiencing a setback, this
could further undermine the viability of the US shorts in the belly. Bull
steepeners are fully awake after a while, a mode familiar in the context of
economic slowdown and dovish Fed. Reaction of the surface was somewhat
out of character, with intermediate expiries experiencing the sharpest decline
(led by the short tenors), while covering of duration shorts initiated through
risk reversals was supportive for gamma.
Page 24
10 October 2014
Figure 1: Repricing of forwards: changes since Oct-1
Figure 2: Repricing of vol: changes since Oct-1
0
5
4
-4
3
-6
Vol change (bp)
Rate change (bp)
-2
-8
-10
1Y
-12
5Y
-14
10Y
-16
30Y
-18
0
1
2
3
4
5
Fwd (y)
6
7
8
9
10
2
1
0
1Y
-1
-2
5Y
10Y
-3
-4
30Y
-5
0
1
2
3
4
5
Expiry (y)
6
7
8
9
10
We find the expression of disappointment with the Fed after the minutes
somewhat puzzling. The post FOMC impression of a hawkish Fed was based
primarily on the interpretations derived from higher median dots, which seem
to have been one of the main points of confusion since the market started
following them. There are several points that we want to clarify in this context.
Dots are individual forecasts of the short rate collected from the Fed members.
When a dots chart is rotated by 90 degrees, it represents a histogram of the
forecasts. There seems to be an underlying tendency to think of these
histograms as a pricing distribution and construct some kind of “pricing”
framework along the lines of “yield = median dots”. We see no basis for this
type of thinking – there is nothing that should force actual yields to track any
of the dots or their mean or median. Therefore, shifting of the median up or
down should have little bearing on actual yield levels. Reshuffling these points
higher or lower does not change much as it does not represent formation of
consensus. It is a stretch to interpret shifts in the median as hawkish or dovish.
At this point, the main information contained in the dots is their dispersion. As
an indication of sentiment within the Fed, a median cannot be representative,
at least not yet, because practically no one agrees on where the short rates
would be. The dominant pattern that the dots convey is an extremely wide
dispersion -- 17 members have 8 different views regarding the level of short
rate in 2015 and 12 different views for 2016. Such a broad dispersion of views
and the absence of consensus suggest an absence of any radical decision on
the horizon. It would be very odd if there were a single voice in the Fed that
bullies the rest to agree to any particular plan of action if the majority is against
it -- if that were the case, dots would make even less sense. The bottom line is
that, as long as there is such a wide dispersion, the likelihood of seeing a
significant shift in monetary policy is relatively low, irrespective of where the
mean or median resides. Formation of consensus is the first indication that we
are approaching a decision time. Only then would median become relevant.
In the context of several years of accommodation with excessive transparency,
low volatility and complacency, the Fed is facing a high level of addiction
liability in the face of possible policy unwind. This could become a sensitive
issue when risky assets are concerned, as possible unwind of positions could
disrupt the Fed’s exit and in general restrict its maneuvering space if market
conditions improve significantly. Thus, return of volatility to the market is an
essential step in unwinding monetary policy. It feels like the Fed wants to
shake things up, but is afraid of shaking them up too much, along the lines
what happened in 2013, so they had to take it back.
Page 25
10 October 2014
If, after all is said and done, rates reprice delayed hikes and vol moves higher
in the short run, this can be interpreted as a successful maneuver by the Fed.
In that context, we would position to benefit from a limited rally in the belly of
the curve. Most significant repricing in gamma should be at the front end, led
by the green and blue sectors, while 10Y and longer would be less affected.
Once the market calms down and positioning is squared, vol would resume its
directionality. It is likely to see some compression of the risk premia along the
curve while gamma remains supported. This would bring curve closer in line
with vol. In that context, continued decline in vol since mid-2013 would be
justified ex-post as a correct view.
Trades
Going into last week, our trades were centered on bull steepening of the curve.
As addition to that, we are buyers of short-term 1X2 receivers with preference
to 10Y sector and 5s/10s curve caps.
1X2 receiver spreads:

Buy $100mn 3M10Y ATMF vs sell $200mn 3M10Y 17bp OTM receivers at
zero net costs
With fwd at 2.54% and spot at 2.45%, the max payout is 9bp below the
current spot. Breakeven is at 33bp below the forward, i.e. at around 2.20% on
swaps corresponding to roughly 2.05% on 10Y UST yield. Ageing and P&L
profile are shown in Fig 3. The trade has a positive carry and is vulnerable to
rally below breakeven with theoretically unlimited downside.
Figure 3: Ageing and P&L profile for 1X2 3M10Y receiver spreads
1.50
1.00
0.50
0.00
Today
in 1m
-0.50
in 2m
-1.00
-0.40%
near Mat.
-0.30%
-0.20%
-0.10%
0.00%
0.10%
0.20%
0.30%
IR curve parallel shift (curve rolls to Spot)
An alternative trade is a 1X2 3M5Y ATMF/16 costless, and 3M3Y ATMF/13
costless. As we go to shorter tenors, steep forwards imply that rates need to
sell off in order to realize maximum profits. For example, for 3M3Y, forward is
at 1.31% and spot at 1.14%. Maximum upside is at 13bp below forwards
which means at 1.18%, i.e. 4bp above the spot. Also, breakevens at 26bp
below the forwards is at 1.05%, i.e. only 10bp below the spot. While shorttenor 1X2 receiver spreads are attractive from a terminal point of view, their
mark-to-market could be more problematic as all of them are short gamma. If
repricing of the Fed is indeed in the pipeline, this means potentially short
covering and even capitulation on the shorts on the Eurodollar strip, which
Page 26
10 October 2014
could be a very volatile event. 10s, on the other hand, have already rallied and
are likely to experience less turbulence either way. In that sense, we see them
as a better choice from an MTM perspective.
5s/10s curve caps

Buy $1bn 3M 5s/10s ATMF at 6.5bp
With forward at 65.5bp and spot at 70.7bp, breakeven is at 72bp, a 1.3bp
above the spot. The trade has a limited downside with maximum loss equal to
the options premium. Alternatively, a limited steepening view could be
expressed through1X2 curve cap spreads

Buy $1bn 3M 5s/10s ATMF vs. sell $2bn 3M 5s/10s 7.5bp OTM curve caps
at zero net cost
This is almost a perfect carry trade. Maximum profit is at 73bp, only 2bp away
from the spot. So, roll to spot is an optimal outcome. The breakevens are at
81bp which is roughly the summer levels of the 5s/10s. Beyond this level, the
trade becomes vulnerable with theoretically unlimited downside.
Page 27
10 October 2014
United States
Credit
Securitization
Steve Abrahams
Research Analyst
(+1) 212 250-3125
[email protected]
Mortgages
Originally published on October 8 in The Outlook in MBS and Securitized
Products.
Pitching the curve
Among the assets that sit in any US fixed income portfolio as a pool of
liquidity—cash, Treasuries or MBS—relative value has depended significantly
in the last year on the shape of the yield curve. A steep curve in the second
half of 2013 made it almost impossible for MBS to compete against the return
that intermediate Treasury debt picked up simply by repricing day-by-day
closer to maturity. But as the curve has flattened and looks set to flatten more,
relative value keeps shifting to MBS.
Steven Abrahams
Research Analyst
(+1) 212 250-3125
[email protected]
Christopher Helwig
Research Analyst
(+1) 212 250-3033
[email protected]
MBS now looks likely to outperform the Treasury curve under most plausible
simple rate scenarios over the next year. In particular:

If Treasury yields follow implied forward rates—a plausible and probably
the most likely path—then the combination of roughly 107 bp of extra yield
in the MBS and the poor price performance of Treasuries on the flatter
curve put 30-year Fannie Mae 3.0%s ahead by a projected 62 bp and
3.5%s by a projected 91 bp

If rates stay constant over the next year and Treasuries benefit from rolling
down the curve, better yield is still enough to push projected MBS
performance ahead in 3.0%s by 16 bp and in 3.5%s by 30 bp

And against parallel shifts in today’s yields where rolling down the curve
helps Treasuries and negative convexity hurts MBS, MBS still has better
projected returns, depending on coupon, against shifts of 25 bp to 35 bp
lower in yields and 50 bp higher
Ian Carow
Research Analyst
(+1) 212 250-9370
[email protected]
Jeff Ryu
Research Analyst
(+1) 212 250-3984
[email protected]
Figure 1: Projected hedged returns in near-par 30-year MBS
1-Year Scenario Returns (%)
Security
$Amt
Price
Mkt Val
OAS
OAD
-100
-50
Unch
Fwd
50
100
FNCL 3.0
100
99.27
99.3
9
6.8
7.67
5.88
3.12
0.8
-0.01
-3.25
5Y Tsy
-47
100.27
-47.1
-18
4.8
6.54
4.6
2.68
0.06
0.78
-1.09
10Y Tsy
-52
99.57
-52.2
-15
8.7
11.21
7.13
3.17
0.29
-0.7
-4.48
0
-1.37
-0.08
0.16
0.62
-0.01
-0.37
FNCL 3.5
100
102.79
102.8
1
5.6
5.24
4.69
3.01
1.01
0.48
-2.42
5Y Tsy
-81
100.27
-81.3
-18
4.8
6.54
4.6
2.68
0.06
0.78
-1.09
10Y Tsy
-22
99.57
-21.5
-15
8.7
11.21
7.13
3.17
0.29
-0.7
-4.48
0.2
-2.08
-0.3
0.3
0.91
0.02
-0.67
Total
0
Total
0
Note: Projected returns assume a linear rate move over 1-year, reinvestment at 1-month LIBOR and repricing at the horizon at a constant OAS.
All market levels as of 06 Oct 2014 close.
The world is never simple, of course, so other factors weigh in the balance:

Supply and demand, which have proven very difficult to judge this year but
nevertheless seem to favor MBS for now with low net supply—likely lower
Page 28
10 October 2014
in the winter—and marginal demand from banks and, increasingly, money
managers starting to rebalance asset allocation from underweight MBS to
neutral

Financing, where the lingering impact of Fed buying stands to keep the
dollar roll at least modestly special into 2015, adding to the returns
projected for any simple scenario

Volatility, which should reach its lows at the end of QE and poses a
modest risk to MBS performance
At this point, MBS looks compelling against most liquid US fixed income
alternatives. Portfolios can disagree about the amount of liquidity needed, of
course. Investment grade corporate debt trades at spreads only 19 bp tighter
than MBS and rolls down its own yield curve even better than Treasury debt.
But while Treasury debt, excluding TIPS, traded $479 billion on an average day
in the week ending September 24 and MBS traded $193 billion, investment
grade corporate debt, excluding commercial paper, traded only $14 billion. It’s
a different game with different risks. To the extent portfolio want liquidity,
MBS looks like it’s right where it wants to be in October.
***
Housing: more room to run for prices
Rising US home prices over the next few years should keep lifting both the
mortgage-backed securities markets and the broader economy, although the
pace of appreciation is set to slow. Nevertheless, the impact should show up in
both credit and prepayments.
The average US home should appreciate in 2014 by 9.3% and in 2015 by 6.9%,
according to Deutsche Bank’s latest forecasts published here as a special
report, US housing: steady appreciation. But the pace slows after 2015 as
housing glides back towards normal after the 2008 financial crisis.
For the broader economy, rising home prices should continue rebuilding
household wealth and encouraging consumer spending. They also should
eventually encourage normal rates of new home building, although that still
looks several years away. While the current and prospective pipeline of
mortgage delinquencies works its way through the legal system, homebuilders
still face competition from properties rolling out of foreclosure. For the next
few years, housing should have its most powerful effect on GDP indirectly
through consumer spending rather than directly through new residential
investment.
For the mortgage-backed securities markets, the price rebound should keep
reducing loan defaults and losses. It also should lift borrower equity, allowing
all borrowers to either move or, if rates allow it, refinance more easily.
This issue’s special report offers an updated outlook for US housing and lays
out details in a few key areas:

The path of average US home prices in the next few years, and the
dispersion across local markets

The forecasting performance of the model

The forecast for serious delinquencies over the next five years

One way to optimize portfolios of residential real estate, and

The ways that local house prices move together over time, or not
***
Page 29
10 October 2014
The view in rates
It seems increasingly likely that the US will end up with a relatively flat yield
curve over the next 3- to 5-years with rates in the neighborhood of 3.0% to
3.5%. Both US growth and inflation seem muted. Inflation expectations in the
US, at least those embedded in the spread between 10-year TIPS and notes,
started September at 215 bp and now stand around 192 bp. The
unemployment rate has fallen to 5.9%, but wage inflation is nowhere to be
found. Core CPI has recently fallen from 2.0% to 1.7%. Core PCE stands at
1.47%. In Europe, deflation has become a greater concern than inflation, and
deflation is emerging as a concern in China
Although the Fed keeps reading from a script that has Fed funds rising in mid2015, it’s plausible that liftoff will come later. It’s hard to see exactly where the
next increment of US growth will come from. It could come from consumers
as rising home prices and rallying financial assets encourage spending. That, in
turn, could encourage more business fixed investment. But without clear signs
of steady growth and with few signs of inflation, the Fed may choose to wait.
The view in spread markets
Our themes in MBS remain seasonally declining net supply, extended Fed
reinvestment, a generally special dollar roll and the possibility of a flatter curve
all supporting a moderate overweight in MBS. That and other core positions:

Overweight the MBS-Treasury basis

Overweight 30-year 3.5%s and higher, underweight 3.0%s

Overweight 15-year pass-throughs against 30-year

Underweight Ginnie Mae against conventional MBS

Overweight LLB 3.0%s and 3.5%s
The view in mortgage credit
US housing stands to finish 2014 with a mark-to-market gain of 9.3% and
finish 2015 with a gain of 6.9%. Markets in the West should do better than
markets in the East as serious delinquencies tumble. And investors putting
together portfolios of residential real estate may want to look in some unusual
places to optimize their holdings. These and other topics get covered in today’s
special report US housing: steady appreciation.
Sizing up CMO in September
CMO issuance in the month of September continued to be dominated by
banks’ need to satisfy regulatory mandates as well as GSE portfolio issuance.
We look at the current shape of CMO new issue with implications for relative
value in both structure and underlying collateral, namely:

Seasoned conventional 3.0%s remain popular with dealers and the GSEs—
likely reflecting demand for 3.0% coupon sequential as a 15-year 3.0%
surrogate. We highlight FNR 14-74 AE against FNCI 3.0%s below

Otherwise, conventional deals were largely backed by generic or nondeliverable collateral—a trend that also looks likely to continue

Freddie issuance continues to run well ahead of Fannie and Ginnie, but
around 50% was driven by Freddie portfolio deals

Sequentials lead front end issuance in conventional space, PACs in
Ginnie—we illustrate relative value between GN sequential and GN PAC
below
Page 30
Ian Carow
Research Analyst
(+1) 212 250-9370
[email protected]
Christopher Helwig
Research Analyst
(+1) 212 250-3033
[email protected]
10 October 2014
Finally, although IO execution appears to have been more popular than
floater/IIO for stripping coupon, IIO creation remains surprisingly robust in
the face of a potential Fed driven bear flattener in 2015

Below we break down September’s CMO issuance by each issuer across
collateral types and structures.
A look at CMO collateral composition in September
CMO collateral composition in September could be broadly characterized as
generic. Conventional seasoned 30-year 3.0% pools made up the largest share
of issuance, followed by Fannie 4.0% CK jumbos and a smattering of other
non-deliverable stories in CK and high-LTV (Figure 2, Figure 3 and Figure 4).
Traditional pay-up stories like loan balance and low FICO made up less than
25% of total issuance. In spite of lower rates, prepayments and volatility
remain muted and spreads tight—likely driving demand away from those
higher pay-up stories.
Figure 3: FH collateral composition
20%
15%
10%
5%
0%
25%
20%
15%
10%
5%
% Port
% Street
Source: Deutsche Bank, Fannie Mae
FGLMC 3
FGLMC 4 HLB
FGLMC 4
FGLMC 4.5
FGJMT6 4
FGMDMA 4 FICO
FGLMC4.5 HLB
FGLMC 5
FGMDM 3.5 FICO
FGLMC 7 FICO MLB
FGCI 4 SHLB
FGJMT6 3.5
FGMDMA 5 FICO
FGCI 4.5 HLB
FGLMC 5.5 HLB
FGHLU6 4
FGCI 2.5 HLB
FGHLU3.5
FGLMC2.5
FHARM2.4
FGJMT2.5
FNJMCK 4
FNCL 3
FNHLCQ 3.5
FNCL 4
FNJMCK 3.5
FNHLCQ 3
FNCT 3.5
FNAS 2.3
FNCL 4 FICO
FNCL 4.5
FNRE 3.5
FNCT 3
FNCL 5
FNCL 5.5 HLB
FNRE 4
FNCL 6.5 LLB
FNGL 3.5 FICO SHLB
FNCL 4.4
FNHLCQ 4
FNCI 2.5
FNCI 2.5 HLB
0%
% Port
% Street
Source: Deutsche Bank, Freddie Mac
15%
10%
5%
0%
G2SF 4
G2SF 5
G2JM 4
G2SF 3.5
G2JM 3.5
GNSF 4
G2SF 4 MLB
G2JO 3.5
G2SF 5.5
GNSF 5
G2SF 3
GNSF 5.5
G2JO 3.5 SHLB
GNSF 3.5
G2SF 4.5
G2AR 1.9
GNJO 3
G2SF 6.5
G2AR 3.8
G2JM 4.0
G2SF 7
25%
20%
Figure 4: GN collateral composition
% GNR Total Iss
25%
% FHR Tot Iss
% FNR Tot Iss
Figure 2: FN collateral composition
Source: Deutsche Bank, Ginnie Mae
One thing that jumps out immediately is the percentage of Fannie Mae jumbo
issuance relative to Golds. The 3.5% and 4.0% cohorts comprised nearly 25%
of Fannie’s total monthly supply, while jumbos made up less than 5% of Gold
issuance. This is likely just a reflection of greater jumbo issuance in Fannies
coupled with a strong bid for supports backed by jumbo collateral.
Another clear difference is the percentage of issuance coming from Freddie’s
portfolio at around 50%. Portfolio contributions as a percentage of overall
Fannie issuance were far less significant. In Ginnie space, there was
predominant issuance in G2SF 4.0%s, which presumably were stripped down
for banks with LCR needs.
Finally there is the bias in issuance in conventional space towards seasoned
30-year 3.0% pools. Limited extension coupled with shorter average life from
seasoning make these pools an attractive option for structuring sequential
deals.
Shaping up CMO structure
In terms of structure, issuance for both Fannie and Freddie was dominated by
front sequentials and then PACs (Figure 5, Figure 6 and Figure 7). In contrast,
front PACs ran ahead of sequential issuance in Ginnie, although only narrowly.
Page 31
10 October 2014
Figure 6: FH structure summary
35%
25%
% FHR Tot Iss
% FNR Tot Iss
30%
20%
15%
10%
Figure 7: GN structure summary
25%
30%
20%
25%
% GNR total iss
Figure 5: FN structure summary
15%
10%
5%
5%
% Port
Source: Deutsche Bank, Fannie Mae
15%
10%
5%
NAS
AS
PAC2
Front TAC
Other
Inv Supp
Front VADM
LCF SEQ
Long VADM
LCF PAC
SUPP
% Port
15Y Strip PT
Z
PO
IO
IIO
% Street
Floater
Front SEQ
0%
Front PAC
0%
20%
0%
% Street
Source: Deutsche Bank, Freddie Mac
Source: Deutsche Bank, Ginnie Mae
One possible interpretation of that differential is that LCR gets calculated on a
market value basis, and well structured PACs should hold their value better
than sequentials in a rising rate scenario.
The composition of IO relative to floaters and inverse IO is also worth
highlighting against the backdrop of a potential bear flattener scenario in 2015.
That would favor IO over inverse IO—and while IO was a greater percentage of
issuance than inverse IO, the difference was not as substantial as one might
expect. A trend worth following in October.
Relative value implications
Given the shape of CMO issuance in terms of collateral and structural
composition observed above, we consider several relative value propositions.
Front sequential 3.0%s backed by 30-year 3.0% collateral look likely to remain
an attractive alternative to fully valued 15-year 3.0% pass-throughs as net
supply continues to shrink in that sector:

The seasoning curve in conventional 30-year 3.0%s should persist

Front sequentials like FNR 14-74 AE in Figure 8 below can offer increased
spread and yield at similar average life
Figure 8: Comparison of 3x3 front SEQ FNR 14-74 AE as surrogate to FNCI 3.0%s
Issue
Type
Collat
Cpn
WAL
+300
I Sprd
PSA
Px
Yld
OAS
OAD
OAC
FNR 14-74 AE
Front SEQ
FNCL 3.0
3.00
5.0
6.6
75
130PSA
102-21
2.39
-9.1
4.8
-1.1
FNCI 3.0
TBA
FNCI 3.0
3.00
5.2
6.3
55
184PSA
103-19
2.22
-8.7
4.2
-1.4
Note: All levels indicative, as of COB: 10/3/14.
Source: Deutsche Bank, YieldBook, Bloomberg Finance LP
On the front end of the structure curve in Ginnie space, demand competition
between sequential and PAC structures should continue as well—as banks
weigh the relative tradeoffs between spread and average life stability (Figure 9).
Figure 9: Comparison of Ginnie front PAC and front sequential
Issue
Type
Collat
Cpn
WAL
300
Px
Yld
GNR 14-158 DC
Front SEQ
G2SF 3.5
2.50
3.9
6.5
I Sprd PSA
84
207
101-11+
2.10
GNR 14-60 GC
Front PAC
G2SF 4.5
2.50
4.3
7.0
67
295
101-21
2.06
Finally, while front end structures are the bulk of issuance, last cash flows look
somewhat undervalued on OAS terms—at least within the context of the rest
of the structure. For accounts that are willing to add longer duration, last cash
flows like FHR 4103 NW—a 3.0% coupon LCF PAC backed by FGLMC 4.0%s—
can be a way to reduce front-end key rate exposure relative to collateral, while
maintaining MBS exposure (Figure 10).
Page 32
10 October 2014
Figure 10: LCF FHR 4103 NW focuses key rate exposure away from front end
60%
50%
40%
30%
20%
10%
0%
FGLMC 4
KRD30%
KRD20%
KRD15%
KRD10%
KRD7%
KRD5%
KRD3%
KRD2%
KRD1%
-10%
FHR 4103 NW
Source: Deutsche Bank, YieldBook
US housing: steady appreciation
Key points from our forecast

National home prices should rise in 2014 by 9.3% and in 2015 by 6.9%
before moderating in later years.

The West should outperform other regions through 2015.

Serious delinquencies should return to normal levels by 2018, and, with
that, home prices should return to normal rates of appreciation of less than
5%.

A review of model performance shows that it continues to capture pricing
in major housing markets.

Investors looking to optimize their portfolio of residential real estate might
find themselves holding property in a surprising set of locations.
Overview
Rising prices for US homes over the next few years should keep lifting both the
broader economy and the mortgage-backed securities markets, although the
pace of appreciation is set to slow. The price of the average US home should
rise in 2014 by 9.3% and in 2015 by 6.9%, but the pace slows from there as
housing glides back towards normal after the 2008 financial crisis.
Steven Abrahams
Research Analyst
(+1) 212 250-3125
[email protected]
Richard Mele
Research Analyst
(+1) 212 250-0031
[email protected]
Ying Shen
Research Analyst
(+1) 212 250-1158
[email protected]
Doug Bendt
Research Analyst
(+1) 212 250-5442
[email protected]
For the broader economy, rising home prices should continue rebuilding
household wealth and encouraging consumer spending. They also should
eventually encourage normal rates of new home building, although that still
looks several years away. While the current and prospective pipeline of
mortgage delinquencies works its way through the legal system, homebuilders
still face competition from properties rolling out of foreclosure. For the next
few years, housing should have its most powerful effect on GDP indirectly
through consumer spending rather than directly through new residential
investment.
For the mortgage-backed securities markets, the price rebound should keep
reducing loan defaults and losses. It also should lift borrower equity, allowing
all borrowers to either move or, if rates allow it, refinance more easily.
Page 33
10 October 2014
The rate of house price appreciation should eventually slow to an annual pace
of less than 4% or lower as the supply of distressed property falls to
equilibrium levels. Since the supply of these properties varies dramatically
across local markets, the prospects for housing across these markets should
vary, too. Nevertheless, at equilibrium, if broad terms of financing remain
stable, the price of the average home should rise in line with inflation.
This updated outlook for US housing lays out details in a few key areas:

The path of average US home prices in the next few years, and the
dispersion across local markets

The forecasting performance of the model

The forecast for serious delinquencies over the next five years

One way to optimize portfolios of residential real estate

The ways that local house prices move together over time, or not
Forecasts
Following a gain of 11.2% for 2013 and 5.7% for the first half of 2014 on the
CoreLogic US home price index, home prices should rise 9.3% in 2014, 6.9% in
2015, and 5.9% in 2016 (Figure 11). These forecasts follow largely from the
expectation that the supply of loans delinquent by 60 days or more will fall
from 6.1% of outstanding mortgage principal at the end of 2013 to 3.7% at the
end of 2016. Sales of distressed homes, often to investors since 2011, takes
supply off of local markets and allows the price of all homes to rise. Rising
home prices accelerate the drop in this distressed supply, which, in turn, lifts
home prices further in a reinforcing cycle.
Figure 11: National historical and projected house price annual returns
20
15
9.3
HPA (%)
10
5
6.9 5.9
4.9 4.4
0
-5
-10
-15
-20
Actual
Projected
Source: Deutsche Bank, CoreLogic
Local outcomes over the next one-to-two years should vary significantly as
each area works through varying levels of distressed properties at various
speeds. We saw that last year. Among the Top 25 markets, returns in 2013
varied from 25.3% in Las Vegas to only 3.2% in Philadelphia (Figure 12).
However, forecast returns three years out are converging toward a 3% to 4%
annual pace similar to the national forecast.
Page 34
10 October 2014
Figure 12: Local returns (historical and projected) vary widely among the Top 25 markets
30
25
HPA (%)
20
15
10
5
0
2013 Actual
2014
2015
2016
Note: Actual returns are used for the first half of 2014.
Areas in the West should outperform over the near term although not all of
them because of declining delinquencies (Figure 13):

San Francisco should gain 13.0% over the next year and 34.5% over the
next three years. This is on top of gaining 56.4% since prices reached their
trough in 2012. Prices are already 17.7% above their 2007 peak.

Oakland should gain 11.5% over one year and 25.8% over three years. This
is on top of gaining 60.4% since prices reached their trough in 2012
although prices still remain 15.4% below their peak in late 2005.

San Jose should gain 11.2% over one year and 23.9% over three years.
Prices are already up 58.6% since their trough in 2009 and up 7.8% since
their peak in 2006.
The boom in technology has lifted all of these markets in the San Francisco Bay
area.
Other markets should lag:

Baltimore should gain 1.1% over one year and 10.6% over three years.
Prices are up only 11.5% since their trough in 2012 and still remain 17.2%
below their peak in 2006.

Philadelphia, where prices only declined 16.8% peak to trough, is expected
to gain 3.7% over one year and 14.5% over three years. Prices are up 8.6%
since their trough in 2012 and still remain 9.6% below their peak in 2006.
The recovery has been uneven across local markets. In nominal terms 18% of
the 100 largest MSAs have fully recovered their former peak prices. Another
23% of the 100 largest MSAs only have 10% appreciation or less to reach their
former peaks. But still 17% of the 100 largest MSAs are 30% or more below
their former peak prices.
Page 35
10 October 2014
Figure 13: Distressed supply in the West has declined the most and this is expected to continue. Consequently prices
in the West are expected to continue to outperform
10
16
9
Serious Delinquencies (%)
18
14
HPA (%)
12
10
8
6
4
2
8
7
6
5
4
3
2
1
0
0
National
2013 Actual
West
2014
Midwest
2015
2016
Northeast
2017
South
National
2018
West
SD now
Midwest
South
Northeast
SD forecast in 3 years
The differences across markets largely reflect differences in distressed supply.
Serious delinquencies in the West, as of June 2014, stand at 4.6% of
outstanding mortgage principal compared to 9.1% in the Northeast, and those
delinquencies in the West are clearing the market faster than anywhere else
(Figure 14). In the West serious delinquencies dropped by 1.8% representing a
28.1% drop in distressed supply. In the Northeast serious delinquencies
dropped by 1.2% representing only a 11.7% drop in distressed supply. REO
declined slightly in the West and Midwest regions and increased in the South
and Northeast regions.
Figure 14: Changes in distressed supply by region over the last 12 months
0.20
0.15
-0.5
REO Change
Serious Delinquency Change
0.0
-1.0
0.10
0.05
-1.5
0.00
-2.0
-0.05
National
West
Midwest
South
Northeast
National
West
Midwest
South
Northeast
The regional difference in distressed supply and the rate at which it clears is
reflected in our forecast (Figure 13). In the West distressed supply is expected
to drop by 52.6% with serious delinquencies declining 1.8% from 4.6% to 2.2%
in three years. In the Northeast distressed supply is expected to drop by 40.7%
with serious delinquencies declining 1.2% from 9.1% to 5.4%. Areas in the
West are should have significantly higher returns over the next two years while
returns in the Northeast areas should be more moderate.
Page 36
10 October 2014
Figure 15: HPA forecasts and related data (sorted by balance)
Area
Los Angeles
New York
Washington
Chicago
Atlanta
Santa Ana
Oakland
San Diego
Riverside
Long Island
San Francisco
Phoenix
San Jose
Houston
Seattle
Baltimore
Minneapolis
Dallas
Philadelphia
Denver
Sacramento
Portland, OR
Tampa
Miami
Las Vegas
Balance
($BB)
449
383
297
261
196
190
176
171
163
155
150
142
139
138
137
120
119
116
112
105
97
87
79
74
69
Level
5.1
10.0
4.8
8.1
4.9
3.7
3.8
3.9
6.0
12.5
2.3
3.1
2.9
3.3
5.0
7.2
3.4
3.6
5.5
2.5
4.0
5.2
13.5
19.2
11.7
Serious Delinquency
Actual 1Y Resolution Resolution
Change
Pace
Pace (%)
-2.2
1.0
19.6
-1.7
1.4
14.2
-0.9
0.4
9.3
-3.0
1.4
17.0
-1.6
0.7
14.7
-1.9
0.7
18.0
-1.9
0.8
21.9
-1.8
0.7
18.5
-2.8
1.1
18.4
-1.4
1.6
12.6
-1.1
0.5
21.0
-1.6
0.3
8.6
-1.5
0.6
21.3
-0.5
0.4
11.7
-2.1
0.9
17.5
-1.0
0.6
8.3
-1.1
0.4
12.4
-0.5
0.4
9.9
-0.6
0.5
8.8
-0.9
0.3
10.4
-2.1
0.8
19.5
-1.2
0.9
16.6
-3.8
1.8
13.6
-7.6
2.3
12.0
-3.9
1.9
16.4
REO
Actual 1Y
Level
Change
0.22
-0.08
0.16
0.06
0.36
0.13
1.29
0.14
0.36
-0.04
0.11
-0.08
0.17
-0.10
0.15
-0.07
0.36
-0.03
0.18
0.07
0.10
-0.08
0.30
-0.05
0.07
-0.05
0.19
-0.01
0.40
-0.01
0.87
0.60
0.58
-0.21
0.18
-0.02
0.46
0.13
0.13
-0.08
0.28
-0.04
0.36
0.15
1.57
0.70
2.44
0.62
0.71
0.32
HPA
Actual 1Y
11.5
8.3
4.2
8.2
10.6
7.8
13.5
9.0
16.0
5.1
14.5
6.5
10.3
11.3
9.8
2.5
5.6
7.8
1.1
8.2
10.1
10.0
6.2
10.2
11.4
1Y Projection 3Y Projection
10.7
6.2
4.1
9.2
8.6
11.0
11.5
9.9
11.2
3.7
13.0
7.4
11.2
7.7
9.9
1.1
7.8
7.4
3.7
7.6
10.1
7.6
4.3
7.5
7.5
28.6
20.1
13.0
26.1
22.1
28.7
25.8
22.5
22.6
13.0
34.5
15.8
23.9
18.5
25.5
10.6
22.8
18.3
14.5
17.0
21.4
20.0
18.1
28.8
20.1
Figure 16: HPA forecasts and related data (sorted by 3Y projection)
Area
San Francisco
Miami
Santa Ana
Los Angeles
Chicago
Oakland
Seattle
San Jose
Minneapolis
Riverside
San Diego
Atlanta
Sacramento
Las Vegas
New York
Portland, OR
Houston
Dallas
Tampa
Denver
Phoenix
Philadelphia
Long Island
Washington
Baltimore
Balance
($BB)
150
74
190
449
261
176
137
139
119
163
171
196
97
69
383
87
138
116
79
105
142
112
155
297
120
Level
2.3
19.2
3.7
5.1
8.1
3.8
5.0
2.9
3.4
6.0
3.9
4.9
4.0
11.7
10.0
5.2
3.3
3.6
13.5
2.5
3.1
5.5
12.5
4.8
7.2
Serious Delinquency
Actual 1Y Resolution Resolution
Change
Pace
Pace (%)
-1.1
0.5
21.0
-7.6
2.3
12.0
-1.9
0.7
18.0
-2.2
1.0
19.6
-3.0
1.4
17.0
-1.9
0.8
21.9
-2.1
0.9
17.5
-1.5
0.6
21.3
-1.1
0.4
12.4
-2.8
1.1
18.4
-1.8
0.7
18.5
-1.6
0.7
14.7
-2.1
0.8
19.5
-3.9
1.9
16.4
-1.7
1.4
14.2
-1.2
0.9
16.6
-0.5
0.4
11.7
-0.5
0.4
9.9
-3.8
1.8
13.6
-0.9
0.3
10.4
-1.6
0.3
8.6
-0.6
0.5
8.8
-1.4
1.6
12.6
-0.9
0.4
9.3
-1.0
0.6
8.3
REO
Actual 1Y
Level
Change
0.10
-0.08
2.44
0.62
0.11
-0.08
0.22
-0.08
1.29
0.14
0.17
-0.10
0.40
-0.01
0.07
-0.05
0.58
-0.21
0.36
-0.03
0.15
-0.07
0.36
-0.04
0.28
-0.04
0.71
0.32
0.16
0.06
0.36
0.15
0.19
-0.01
0.18
-0.02
1.57
0.70
0.13
-0.08
0.30
-0.05
0.46
0.13
0.18
0.07
0.36
0.13
0.87
0.60
HPA
Actual 1Y
14.5
10.2
7.8
11.5
8.2
13.5
9.8
10.3
5.6
16.0
9.0
10.6
10.1
11.4
8.3
10.0
11.3
7.8
6.2
8.2
6.5
1.1
5.1
4.2
2.5
1Y Projection 3Y Projection
13.0
7.5
11.0
10.7
9.2
11.5
9.9
11.2
7.8
11.2
9.9
8.6
10.1
7.5
6.2
7.6
7.7
7.4
4.3
7.6
7.4
3.7
3.7
4.1
1.1
34.5
28.8
28.7
28.6
26.1
25.8
25.5
23.9
22.8
22.6
22.5
22.1
21.4
20.1
20.1
20.0
18.5
18.3
18.1
17.0
15.8
14.5
13.0
13.0
10.6
Page 37
10 October 2014
Other key influences on home prices show promising trends:

Census data shows that median household income fell during 2009 and
2010 but has been rising since then.

Unemployment should continue to decline based on forecasts from the
Fed and the CBO.

Mortgage rates should rise but higher rates should have little influence in
light of other factors.

Household formation is expected to continue to grow.
Detailed forecasts and related data for the top 25 markets are listed in
Figure 15 and Figure 16. Actual levels are reported as of the end of June 2014
and projections are from June 2014 onward.
Model forecast performance
Figure 17 shows the 1-year home price appreciation forecasts published in
October 2013 compared to the actual realized returns from CoreLogic (see US
housing: A resilient rebound). At the national level we forecasted that house
prices would grow by 7.0% from June 2013 to June 2014. This compares well
with the actual growth rate of 7.3%.
Across the Top 25 markets the differences between actual and forecasted
returns are larger. However, the largest market, Los Angeles, with $449 billion
in outstanding mortgage balance, was forecasted to grow by 11.5%, which
matched the actual growth rate exactly. In another large market, Atlanta, we
forecasted 10.9% and the actual return was 10.6%. Figure 18 shows a bubble
plot of the actual returns versus the forecasted returns, with the bubble size
corresponding to the mortgage balance in each market. The model is
calibrated using mortgage balance weighting so we expect to forecast larger
areas more accurately than smaller areas. Although the equal weighted R^2 is
low, the mortgage balance weighted R^2 of the actual returns versus
forecasted returns is 76% for the Top 25 markets.
Figure 18: Actual returns versus previously published returns for the Top 25
markets
20
Actual 1Y Return (%)
18
16
14
12
10
Figure 17: Previously published
forecast returns and actual returns
Area
National
Los Angeles
New York
Washington
Chicago
Atlanta
Santa Ana
Oakland
San Diego
Riverside
Long Island
San Francisco
Phoenix
San Jose
Houston
Seattle
Baltimore
Minneapolis
Dallas
Philadelphia
Denver
Sacramento
Portland, OR
Tampa
Miami
Las Vegas
Balance Forecast Actual
8,573
7.0
7.3
449
11.5
11.5
383
2.8
8.3
297
7.7
4.2
261
1.6
8.2
196
10.9
10.6
190
11.5
7.8
176
10.6
13.5
171
10.4
9.0
163
8.4
16.0
155
-1.6
5.1
150
13.5
14.5
142
13.8
6.5
139
12.7
10.3
138
7.2
11.3
137
8.2
9.8
120
1.6
2.5
119
10.1
6.3
116
9.3
7.8
112
3.1
1.1
105
5.4
8.2
97
15.3
10.1
87
5.6
10.0
79
1.6
6.2
74
3.8
10.2
69
6.1
11.4
8
6
4
2
0
-5
0
5
10
15
20
Forecasted 1Y Return Published October 2013 (%)
Page 38
10 October 2014
Serious delinquencies
House price returns continue to closely track the change in serious
delinquencies (Figure 19). In 2013 serious delinquencies fell 21.7% (from 9.0%
to 7.0%) nationally while house prices rose 11.2%. During the first half of 2014
serious delinquencies fell another 12.5% (from 7.0% to 6.1%) while house
prices rose another 5.7% Locally serious delinquencies in Oakland fell 33.5%
and prices rose 13.5% over the last 12 months. Meanwhile, serious
delinquencies in Philadelphia only fell 9.9% and prices only rose 1.1%.
Figure 19: HPA tracked serious delinquencies for the Top 25 markets over the
last 12 months
18
16
Actual 1Y HPA (%)
14
12
10
8
6
4
2
0
-40
-35
-30
-25
-20
-15
-10
-5
0
Actual 1Y Change in Serious Delinquencies (%)
We define serious delinquency as loans that are 60+ days delinquent, in
foreclosure, or held as REO (Figure 20). From 2000 to 2006, serious
delinquencies were relatively stable around 2% of loan balances. However,
during the house price run up just prior to 2006 serious delinquencies were on
a slight downtrend. In 2006 the housing market peaked and starting dropping
rapidly. At the same time serious delinquencies made a rapid rise reaching a
peak of 12.9% in 2010. Since then serious delinquencies have been on a
gradual path downward while the trajectory of house prices turned up.
Figure 20: Serious delinquencies and sub-components
14
Delinquency (%)
12
10
8
6
4
2
0
DQ60
DQ90
FCL
REO
Page 39
10 October 2014
We expect serious delinquencies to continue to decline at its current pace,
driving our expectation for home prices up for the next few years. We also
expect the decline in serious delinquencies to eventually moderate as the stock
of distressed properties diminishes (Figure 21). Once serious delinquencies
stabilize we expect that income, population growth and other local factors will
become the main drivers of house price appreciation. For now serious
delinquencies will continue to be important in forecasting HPA.
Figure 21: Serious delinquency history and projection
Serious Delinquency (%)
14
12
10
8
6
4
2
0
Actual
Forecast
Note: Actual data used for first half of 2014.
Optimizing a real estate portfolio
Since 2000, despite the crisis and the slow start of the recovery, house prices
have averaged 3.8% annual growth at the national level and had an average
volatility of 9.2%. At the state level, Nevada experienced the highest volatility
at 17.1% and Iowa experienced the lowest volatility of 2.2%. Projected returns
also vary widely from 1.4% in New Mexico to 11.25% in Michigan (Figure 22).
Investors usually want to put their money where returns look likely to be
highest. But there is a trade off. In general, areas historically delivered higher
Figure 22: Projected 1-year returns versus the historical return volatility for the states and the national level
12
MI
Projected 1 Year Return (%)
10
MA
8
OH
6
SD
NC
TN
IN
TX
WI
OK KY
IA
KS MS
ND
NE
AK
AR LA
AL
4
2
ME IL
GA NH
MTNY MN UT
CO
SC
MO
PA
VT
WY
CA
WA
US
OR
DE
WV DC NJ
CT
NV
RI
ID
FL
HI
AZ
VA
MD
NM
0
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Volatility
Page 40
10 October 2014
returns also experienced higher volatility. Recently investors have actively
bought properties in California, Florida and Arizona, all of which have relatively
high volatility. The projected 1-year price return in California is still a high 10%
but the volatility is 13.8%. Investors could buy property in Michigan and earn a
higher return with lower risk. Also, using leverage, investors have the
opportunity to earn a much higher return on equity for the same level of risk as
California. Assuming a funding rate of 4.25% investors could buy property in
Ohio using 70.5% debt. The volatility would still be 13.8% but the return on
equity climbs to 15.2%. This strategy works best in areas where returns in
excess of funding is highest per unit of risk such as South Dakota, Ohio,
Colorado, Michigan and Washington.
Using diversification investors can further improve the risk to reward ratio.
Figure 23 shows a portfolio of properties in Michigan (15.7%), Ohio (59.6%)
and Washington (24.7%). The return of the portfolio is a weighted average of
the returns of each individual area. However, because diversification lowers
the portfolio volatility, the reward per unit of risk is higher than any of the
individual areas.
Figure 23: Diversification enables investors to attain a higher reward per unit
of risk
Michigan
Ohio
Washington
Portfolio
Financing
4.25
4.25
4.25
4.25
Return
11.3
7.5
10.1
8.7
Volatility Reward / Risk
9.4%
0.75
4.1%
0.80
8.2%
0.71
5.3%
0.84
Holding
15.7%
59.6%
24.7%
100.0%
Investors can form many different property portfolios that yield the same risk.
The portfolio with the highest return for a given level of risk is the most
efficient. Figure 24 plots the highest portfolio return attainable for each level of
risk that forms the efficient frontier.
Furthermore investors can leverage their returns and risk up or down by either
borrowing or lending cash. Optimally investors should choose the portfolio
Figure 24: The optimal portfolio of properties that has the highest reward per unit of risk can be levered up or down to
achieve any desired level of risk
16
Projected 1 Year Return (%)
14
12
MI
10
MA
8
CO
OH
TX
SD
TN
IN WI MO
PA
KY
OK
VT
KS MS
IA
ND
NE
AK
AR LA
AL
NC
6
4
2
CA
WA
MEGAIL
US
MN UT
MT NY NH
SC
OR
DE
DC NJ
WV
WY
CT
NM
NV
RI
ID
HI
FL
AZ
VA
MD
0
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Volatility
1Y Projected Return
Efficient Frontier
Optimal Portfolio with borrowing and lending
Page 41
10 October 2014
with the highest reward per unit of risk, which happens to be the portfolio
shown in Figure 23. The dashed line in Figure 24 plots the expected returns if
the optimal portfolio is combined with various levels of borrowing or lending.
This analysis focused only on the risk and reward of house prices. Investors
can also expect to earn higher returns from net rental yield and they also face
other risks such as operational risk and funding risk.
How local is house price appreciation?
Everyone knows that house prices are a local phenomenon. But to some extent
they do move together. In the recent crisis most of the large markets
experienced peaks around mid-2006 and troughs around 2011 and 2012.
Figure 25 shows a correlation of monthly house price returns since 2003.
Some markets, such as Los Angeles, Santa Ana, Riverside and Sacramento,
are highly correlated with each other with correlations over 90%. Other
markets such as Philadelphia and Houston have only a 34% correlation.
Baltimore
Chicago
Dallas
Denver
Houston
Las Vegas
Long Island
Los Angeles
Miami
Minneapolis
New York
Oakland
Philadelphia
Phoenix
Portland OR
Riverside
Sacramento
San Diego
San Francisco
San Jose
Santa Ana
Seattle
Tampa
Washington
Atlanta
Baltimore
Chicago
Dallas
Denver
Houston
Las Vegas
Long Island
Los Angeles
Miami
Minneapolis
New York
Oakland
Philadelphia
Phoenix
Portland OR
Riverside
Sacramento
San Diego
San Francisco
San Jose
Santa Ana
Seattle
Tampa
Washington
Atlanta
Figure 25: Correlation matrix of local house price returns
1.0
0.7
0.9
0.8
0.8
0.7
0.6
0.5
0.7
0.7
0.8
0.5
0.8
0.5
0.6
0.7
0.6
0.7
0.7
0.7
0.8
0.6
0.7
0.7
0.7
0.7
1.0
0.8
0.5
0.5
0.5
0.7
0.8
0.8
0.7
0.8
0.7
0.7
0.7
0.7
0.8
0.7
0.7
0.7
0.6
0.6
0.7
0.8
0.8
0.8
0.9
0.8
1.0
0.6
0.7
0.7
0.6
0.7
0.7
0.6
0.9
0.5
0.7
0.6
0.5
0.7
0.5
0.6
0.6
0.6
0.6
0.6
0.7
0.7
0.7
0.8
0.5
0.6
1.0
0.7
0.8
0.6
0.4
0.6
0.6
0.6
0.3
0.8
0.4
0.5
0.7
0.6
0.6
0.6
0.6
0.7
0.6
0.7
0.6
0.6
0.8
0.5
0.7
0.7
1.0
0.7
0.5
0.4
0.6
0.5
0.7
0.3
0.8
0.4
0.5
0.6
0.5
0.7
0.6
0.7
0.8
0.6
0.6
0.6
0.6
0.7
0.5
0.7
0.8
0.7
1.0
0.5
0.5
0.6
0.6
0.6
0.3
0.7
0.3
0.5
0.6
0.6
0.6
0.6
0.6
0.6
0.5
0.6
0.6
0.6
0.6
0.7
0.6
0.6
0.5
0.5
1.0
0.7
0.9
0.8
0.7
0.7
0.8
0.5
0.8
0.7
0.9
0.9
0.9
0.7
0.7
0.9
0.7
0.8
0.8
0.5
0.8
0.7
0.4
0.4
0.5
0.7
1.0
0.7
0.7
0.7
0.8
0.6
0.6
0.7
0.7
0.7
0.7
0.7
0.5
0.5
0.7
0.6
0.7
0.7
0.7
0.8
0.7
0.6
0.6
0.6
0.9
0.7
1.0
0.8
0.8
0.7
0.9
0.6
0.8
0.8
0.9
0.9
0.9
0.7
0.8
0.9
0.8
0.9
0.9
0.7
0.7
0.6
0.6
0.5
0.6
0.8
0.7
0.8
1.0
0.7
0.7
0.8
0.5
0.8
0.7
0.8
0.8
0.7
0.7
0.7
0.7
0.7
0.9
0.8
0.8
0.8
0.9
0.6
0.7
0.6
0.7
0.7
0.8
0.7
1.0
0.6
0.8
0.5
0.6
0.7
0.7
0.7
0.7
0.6
0.7
0.7
0.7
0.7
0.7
0.5
0.7
0.5
0.3
0.3
0.3
0.7
0.8
0.7
0.7
0.6
1.0
0.6
0.5
0.7
0.6
0.7
0.6
0.6
0.5
0.5
0.6
0.6
0.7
0.6
0.8
0.7
0.7
0.8
0.8
0.7
0.8
0.6
0.9
0.8
0.8
0.6
1.0
0.5
0.8
0.8
0.8
0.9
0.9
0.8
0.9
0.8
0.7
0.8
0.8
0.5
0.7
0.6
0.4
0.4
0.3
0.5
0.6
0.6
0.5
0.5
0.5
0.5
1.0
0.5
0.6
0.4
0.5
0.5
0.4
0.4
0.5
0.5
0.6
0.6
0.6
0.7
0.5
0.5
0.5
0.5
0.8
0.7
0.8
0.8
0.6
0.7
0.8
0.5
1.0
0.7
0.8
0.8
0.7
0.7
0.8
0.7
0.7
0.9
0.8
0.7
0.8
0.7
0.7
0.6
0.6
0.7
0.7
0.8
0.7
0.7
0.6
0.8
0.6
0.7
1.0
0.7
0.7
0.7
0.7
0.7
0.7
0.9
0.8
0.7
0.6
0.7
0.5
0.6
0.5
0.6
0.9
0.7
0.9
0.8
0.7
0.7
0.8
0.4
0.8
0.7
1.0
0.9
0.9
0.7
0.7
0.9
0.6
0.8
0.8
0.7
0.7
0.6
0.6
0.7
0.6
0.9
0.7
0.9
0.8
0.7
0.6
0.9
0.5
0.8
0.7
0.9
1.0
0.9
0.7
0.8
0.9
0.7
0.8
0.8
0.7
0.7
0.6
0.6
0.6
0.6
0.9
0.7
0.9
0.7
0.7
0.6
0.9
0.5
0.7
0.7
0.9
0.9
1.0
0.7
0.8
0.9
0.6
0.7
0.8
0.7
0.6
0.6
0.6
0.7
0.6
0.7
0.5
0.7
0.7
0.6
0.5
0.8
0.4
0.7
0.7
0.7
0.7
0.7
1.0
0.9
0.7
0.8
0.7
0.7
0.8
0.6
0.6
0.7
0.8
0.6
0.7
0.5
0.8
0.7
0.7
0.5
0.9
0.4
0.8
0.7
0.7
0.8
0.8
0.9
1.0
0.7
0.8
0.7
0.8
0.6
0.7
0.6
0.6
0.6
0.5
0.9
0.7
0.9
0.7
0.7
0.6
0.8
0.5
0.7
0.7
0.9
0.9
0.9
0.7
0.7
1.0
0.7
0.8
0.8
0.7
0.8
0.7
0.7
0.6
0.6
0.7
0.6
0.8
0.7
0.7
0.6
0.7
0.5
0.7
0.9
0.6
0.7
0.6
0.8
0.8
0.7
1.0
0.7
0.7
0.7
0.8
0.7
0.6
0.6
0.6
0.8
0.7
0.9
0.9
0.7
0.7
0.8
0.6
0.9
0.8
0.8
0.8
0.7
0.7
0.7
0.8
0.7
1.0
0.8
0.7
0.8
0.7
0.6
0.6
0.6
0.8
0.7
0.9
0.8
0.7
0.6
0.8
0.6
0.8
0.7
0.8
0.8
0.8
0.7
0.8
0.8
0.7
0.8
1.0
Undoubtedly some of the correlation differences can be explained by
geographic proximity. Using principal component analysis we can find other
commonalities.
Factor #1: Affordability
The most powerful link between all these markets since 2003, not surprisingly,
is affordability—especially affordability facilitated by pre-crisis subprime and
Alt-A lending. Figure 26 shows the factor loadings and factor scores for the
first principal component. Las Vegas has the largest exposure to the first factor
and Dallas has the least exposure. The weightings of markets on this first
component correspond roughly to the incidence in the last decade of
affordability lending. The factor scores have a correlation of 96% with national
Page 42
10 October 2014
0.15
1.5%
0.30
0.10
1.0%
0.25
0.05
0.5%
0.20
0.15
0.00
0.0%
-0.05
-0.5%
-0.10
-1.0%
0.05
-0.15
-1.5%
0.00
-0.20
-2.0%
-0.25
-2.5%
0.10
First Factor
National Appreciation % (rhs)
Monthly HPA
0.35
Factor Score
Factor Loadings
Figure 26: The first factor explains 75% of the variance of monthly house price appreciation
First Factor
house price appreciation. This makes sense because the first factor explains
75% of the variance of the 25 largest markets.
Where affordability lending entered, boom, bust and delinquency often
followed. Figure 27 shows the relationship between the loadings of the first
factor and the peak to minimum range of serious delinquencies in each market.
The correlation is a high 80%.
Figure 27: The first factor loadings are highly correlated to the range of
serious delinquencies in each local area
0.40
y = 0.0069x + 0.0964
R² = 0.6379
0.35
Factor Loading
0.30
0.25
0.20
0.15
0.10
0.05
0.00
0
5
10
15
20
25
30
35
40
Serious Deliquency Minimum to Peak Difference
Factor #2: Seasonality
There is a season for everything, but it doesn’t seem to have the same effect
everywhere (Figure 28). The second factor, which explains 6% of variance,
appears to be a localized seasonal effect countering or amplifying the overall
seasonal effect that is already captured by the first factor. The second factor
has an absolute correlation of only 18% with national house price appreciation
as this factor is explaining how local prices move in different directions.
Page 43
10 October 2014
0.05
0.04
0.03
0.02
0.01
0.00
-0.01
-0.02
-0.03
-0.04
-0.05
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5%
Second Factor
Monthly HPA
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
Factor Score
Factor Loadings
Figure 28: The second factor, which explains 6% of variance, appears to be a localized seasonal effect countering or
amplifying the overall seasonal effect that is already in the first factor
Second Factor
Figure 29: The second factor loadings have a 33%
correlation to latitude that affects seasonality
0.5
35
y = -0.0125x + 0.426
R² = 0.1101
0.4
0.3
30
Percent of All Sales
Second Factor Loading
Figure 30: Distressed sales have been elevated since
2008
0.2
0.1
0
-0.1
-0.2
25
20
15
10
5
-0.3
0
-0.4
-0.5
25
30
35
40
45
50
Latitude of MSA
REO Sales
Short Sales
Third Factor
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
-0.01
-0.02
-0.03
-0.04
3.0%
2.0%
1.0%
0.0%
Monthly HPA
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
Factor Score
Factor Loadings
Figure 31: The third factor explains 4% of the variance of monthly home price appreciation
-1.0%
-2.0%
Third Factor
Page 44
10 October 2014
Figure 29 shows the relationship between the loadings of the second factor
and the latitude of each market that affects seasonality. The second factor
loadings have a weak 33% correlation to the North/South location of each
market. But the second factor is also 65% correlated to the peak to minimum
range of serious delinquencies in each market. This seasonal effect is
particularly evident from 2008 onward corresponding to the period when
distressed sales became elevated (Figure 30).
Figure 32: The third factor loadings are highly correlated to the East/West
location of the MSA
0.5
y = -0.0078x - 0.8071
R² = 0.5362
Third Factor Loading
0.4
0.3
0.2
0.1
0
-0.1
-0.2
-0.3
-0.4
-0.5
-130
-120
-110
-100
-90
-80
-70
Longitude of MSA
Factor #3: East-West
Figure 32 shows the relationship between the loadings of the third factor and
the longitude of each market. The third factor loadings have a 73% correlation
to the East/West location of each market. This factor explains only 4% of
variance and is not correlated to national house price appreciation. San Jose,
San Francisco and Oakland have the largest positive exposures while Chicago,
Baltimore and Philadelphia have the largest negative exposures.
Page 45
10 October 2014
Europe
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Abhishek Singhania
Strategist
(+44) 207 547-4458
[email protected]
Euroland Strategy

The “whatever it takes” mantra has been replaced with “we will do exactly
that”. However, market pressure might have to increase before the ECB
coalesce around the next steps. We therefore maintain the EUR 10s30s
flattener and also recommend going short EUR 5Y5Y inflation breakevens
vs. the US 5Y5Y breakevens

The ECB’s analysis of the usage of the TLTRO suggests that it is likely to
be used by banks to reduce their funding cost rather than to expand their
balance sheet. Further, the flow of loans to the real economy from banks in
the periphery suggests that their capacity to borrow at the TLTROs starting
from Mar-15 is limited and there is a risk that they may be forced to repay
all their TLTRO money by Sep-16, unless the pace of deleveraging slows
down post AQR

This could increase the pressure to actively manage the size of its balance
sheet as mentioned by Draghi at the Brookings Institute. This would also
imply that the peak of the ECB balance sheet is likely to happen later than
mid-2015 as is currently priced in. We maintain a Jun-15/Jun-16 Eonia
flattener as well as an outright received position in Jun-16 Eonia

The elevated correlation between the euro fx and the front-end of EUR and
EUR-USD rates differentials implies fx returns are likely to dominate fixed
income returns given the low level of yields of shorter-dated bonds. In fact,
this can already be seen in the recent Yen denominated returns of OATs vs.
USTs and consequently in Japanese investor flows

The recent decline in the ex-post sharpe ratio of peripheral government
bond returns, increased volatility of longer-dated peripheral govt. bonds
and the limited YTD buying from domestic banks leads us to prefer the
front-end of the periphery. We recommend outright buying of 5Y BTPs
“Whatever it takes” to “We will do exactly that”
Draghi highlighted the fundamental change in the nature of the ECB’s
monetary policy framework from a passive provision of liquidity to a more
active management of the ECB’s balance sheet. The tensions inherent in a
move from a passive to an active management of the balance sheet is,
apparent by the fact that the ECB does not as yet appear to be willing to
recognize the increasingly likely failure of the measures announced to achieve
the EUR 1trillion balance sheet expansion. In fact, not surprisingly some of the
hawkish members of the council have highlighted concerns about the risk
being borne by the ECB due to the measures announced so far let alone the
prospects of pursuing a government bond QE. Over the last couple of years
the ECB has delivered eventually. The “whatever it takes” mantra has been
replaced with “we will do exactly that” in reference to lifting inflation from its
excessively low levels. However, despite delivering previously the ECB still
lacks credibility and the market pressure might have to increase. We therefore
maintain the EUR 10s30s flattener and also recommend going short EUR 5Y5Y
inflation breakevens vs. the US 5Y5Y breakevens (see Global Inflation Update).
Page 46
10 October 2014
TLTRO Update
The October ECB monthly bulletin2 provided some additional information about
the September TLTRO take-up. First, in the ECB’s assessment there were
probably a number of reasons for banks to defer their use of the first two
TLTROs until December and therefore a full assessment of the usage of the
TLTROs would be possible only after the December TLTRO. Second, an initial
analysis suggests that banks have probably used the TLTRO funds to replace
other expensive sources of funding, i.e. the TLTRO usage is likely to be a
liability management exercise rather than a way to fund additional assets. This
along with recent comments from various ECB speakers indicating that there is
no stigma attached to the use of the TLTRO facilities would suggest that the
aggregate take up should be reasonably large purely based on economic
considerations. The cost of 4Y funding via the TLTROs at 15bp remains
attractive given the level of 4Y swap rates (35bp) and iTraxx senior financial
spreads (66bp). Third, a large majority of the smaller institutions who used the
Sep TLTRO have fully used their allowance which would indicate that a large
take-up in aggregate would depend on the behaviour of the larger banks.
In addition to the two TLTROs in September and December, the ECB will also
conduct 6 more quarterly TLTROs starting in Mar-15. Banks can borrow 3x the
amount by which their net lending is above the benchmark level. For banks
with positive net lending in the 12M to Apr-14 the benchmark level is zero
while for banks with negative net lending in the 12M to Apr-14 the benchmark
level is equal to the cumulative net lending over the 12M to Apr-14.
The development in the flow of loans to the real economy excluding
mortgages as of August-14 is not particularly encouraging as far as banks
additional capacity to borrow at the subsequent TLTROs and the ability of
banks to retain the TLTRO funding beyond Sep-16 is concerned. For Italy and
Spain the deleveraging from May-14 to Aug-14, i.e. over 4 months, has been
40% and 19% of their benchmark level (the data has not been seasonally
adjusted and hence the numbers might overstate the pace of deleveraging).
This reduces the likelihood that the banks will have any reasonable borrowing
capacity at the 6 TLTROs staring in March and more importantly they might be
forced to repay their TLTRO funding in Sep-16.
By Q1 2015, unless there is a meaningful change in the pace of deleveraging
post the AQR, the inability of the ECB to expand the balance sheet via the
remaining TLTROs will become increasingly obvious. This will increase the
pressure on the ECB to expand the balance sheet via asset purchases. The
eventual expansion of the ECB balance sheet which was further stressed on by
Draghi in his address and discussion at the Brookings Institute would favour
being long June-16 Eonia (see Top Fixed Income Trades for the Autumn).
However, the delay in the expansion of the balance sheet should also favour a
flattening of the Eonia curve. We maintain our Jun-15/Jun-16 Eonia flattener
recommended last week.
2
http://www.ecb.europa.eu/pub/pdf/mobu/mb201410en.pdf
Page 47
10 October 2014
Lending to real economy excluding mortgages: Benchmark level for TLTROs
and developments from May-14 to Aug-14
Country
Flow of loans May-13 to
Apr-14 (EUR bn)
Benchmark level
(EUR bn)
Flow of loans May-Aug 14
(EUR bn)
France
5.3
0
8.3
Finland
4.6
0
1.4
Belgium
3.8
0
-0.1
Slovakia
2.5
0
1.3
Estonia
0.2
0
0.2
Latvia
0.0
0
0.0
Malta
-0.3
-0.3
0.1
Luxembourg
-0.4
-0.4
-0.2
Austria
-1.6
-1.6
3.2
Cyprus
-1.5
-1.5
-0.1
Slovenia
-3.4
-3.4
-1.4
Netherlands
-6.0
-6.0
-1.3
Ireland
-6.7
-6.7
-4.7
Greece
-5.9
-5.9
-1.8
Portugal
-6.3
-6.3
-2.3
Germany
-10.7
-10.7
-1.3
Italy
-42.3
-42.3
-17.1
Spain
-81.3
-81.3
-15.8
Source: Deutsche Bank, ECB
Rally in core rates and euro depreciation a double edged sword
The move lower in EUR rates over the past few weeks has been accompanied
by the move lower in euro currency. The latest FOMC minutes suggest that the
Fed is concerned about the appreciation of the dollar and while it is debatable
whether this is material enough to alter the course of the Fed’s normalisation it
is worth noting the elevated correlation between the FX and front-end EUR
rates outright and EUR - USD rates spread. Given the probability of further
declines in excess liquidity until the December TLTRO the very front-end of the
EUR curve could be vulnerable to a short-term correction in the FX. This would
be consistent with our recommendation of a June-15/ June-16 Eonia flatteners.
Correlation between EURUSD and EUR rates
Correlation between EURUSD and EUR-USD rates
spread
2Y
1.0
5Y
10Y
30Y
2Y
1.0
0.8
0.8
0.6
0.6
5Y
10Y
30Y
0.4
0.4
0.2
0.2
0.0
0.0
-0.2
-0.2
Note: We plot the 13 week rolling correlation between weekly changes in FX and rates
Page 48
Jul-14
Oct-14
Jan-14
Apr-14
Jul-13
Oct-13
Apr-13
Jan-13
Oct-12
Jul-12
Apr-12
Jan-12
Oct-11
Jul-11
Jan-11
Oct-14
Jul-14
Apr-14
Jan-14
Jul-13
Oct-13
Jan-13
Apr-13
Jul-12
Oct-12
Jan-12
Apr-12
Jul-11
Oct-11
-1.0
Apr-11
-0.8
-0.8
Jan-11
-0.6
-0.6
Apr-11
-0.4
-0.4
Note: We plot the 13 week rolling correlation between weekly changes in FX and rate spreads
10 October 2014
Japanese investors shy away from Eurozone govt. debt
With core and semi-core Eurozone sovereign bond yields, especially at the very
front-end, at levels which do not leave room for a further rally and the prospect
that a further rally can only come if accompanied by a decline in the euro
means that investors with global mandates could increasingly shift their
exposure to other fixed income markets. The total return performance of
French govt. bonds and USTs denominated in JPY shows a significant
outperformance of USTs largely because of the currency developments in
recent weeks. Against this backdrop it is not surprising that the Japanese
ministry of finance data shows the first evidence of a move away from core
Eurozone sovereigns into UST in recent months. Although this is not
representative of all international investors it nevertheless serves to highlight
the risk that the inflows into core/semi-core Eurozone might reduce given the
low level of yields and the prospect of further depreciation of the euro.
Recent underperformance of France vs. UST returns
denominated in JPY
30%
Reduced inflows into core Eurozone sovereign bonds
from Japanese investors (Monthly flow, in 100 mn Yen)
40,000
France 1Y+ index 3M total return (JPY denominated)
25%
20,000
15%
10,000
10%
0
5%
-10,000
0%
-20,000
-5%
-30,000
-10%
-40,000
Jul-14
May-14
Mar-14
Jan-14
Nov-13
Sep-13
Jul-13
Jan-14
May-13
Jan-13
Mar-13
Jan-12
Jan-13
Jan-11
US
30,000
UST 1Y+ index 3M total return (JPY denominated)
20%
-15%
Jan-10
Eurozone
Source: Deutsche Bank, Ministry of Finance Japan
Increased volatility in periphery argues for limiting exposure to the front-end
Peripheral government bonds are increasingly coming under pressure due to
stretched valuations, weakening economic data and the lack of structural
reforms which are increasing debt sustainability concerns over the mediumterm while reluctance from the ECB to announce broad based asset purchase
implies that there could be some shakeout of weaker positions. This is
reflected in the increased realised volatility of realised returns which has
reduced the sharpe ratio of the periphery in recent weeks. Within the periphery,
the lower volatility of realised returns on the front-end is likely to make the
front-end more attractive especially given that domestic banks’ holdings of
government securities have remained broadly unchanged YTD.
Sharpe ratio for the periphery has
Increased volatility of long-end
declined
returns
6.0
5.0
Italy 1Y+ index ex-post sharpe ratio (Annualized
6M returns and vol)
4.0
16%
14%
2014
Italy 3Y-5Y annualized 6M returns volatility (LHS)
10%
-1.0
-3.0
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
46
36
22
20
5%
0
0%
-20
2%
0%
Jan-08
53
39
40
4%
-2.0
Spain
60
6%
0.0
94
EUR bn
80
15%
8%
1.0
100
Italy
20%
10%
2.0
25%
Italy 7Y-10Y annualized 6M returns volatility (RHS)
12%
3.0
Limited buying by domestic banks in
4 6
10
9
46
32
15
14
6
0
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
2007
2008
2009
2010
2011
2012
2013
2014
YTD
Source: Deutsche Bank, ECB
Page 49
10 October 2014
Global
Credit
Covered Bonds
Bernd Volk
Strategist
(+41) 44 227-3710
[email protected]
Covered Bond and Agency Update

CIBC issued the tightest ever Canadian covered bond, a EUR 1bn 5Y issue
at ms flat, confirming that CBPP3 also supports EUR covered bonds issued
by non euro area banks. With 54%, bank buying was strongly supported
by the Level 2A LCR status of non-EU covered bonds, confirmed by the
publication of Delegated Act by the European Commission this week.

ASW spreads of iBoxx Netherlands and iBoxx Norway/Sweden confirm the
outperformance of euro area covered bonds. ASW spreads of iBoxx Italy
Covered tightened significantly from 71bp on 3 Sep to 42bp on 9 Oct,
strongly outperforming sovereign bonds. Due to CBPP3 and the ECB likely
being aggressive to source volume, we expect further spread convergence
between covered bonds of weaker and stronger peripheral banks.

The ECB said that only a volume of EUR 600bn of covered bonds in its
database is eligible for CBPP3. We highlight that EUR 1049bn of covered
bonds are categorised by the ECB itself as “eligible for own-use” (i.e. CRR
compliant). Using the 70%/30% limit per ISIN brings down the volume to
around EUR 725bn, i.e. still more than the mentioned EUR 600bn.

Separate covered bond ratings could be an issue. For example, covered
bonds ISPIM Float Aug 2018 do not have a separate rating but are eligible
for ECB repo, likely based on the issuer rating of Baa2/BBB/BBB+.
However, given that CBPP3 says “covered bonds must...have a minimum
first-best credit assessment of credit quality step 3”, the wording suggests
that unrated retained Italian covered bonds would not qualify for CBPP3.

Currently, not all Italian covered bonds programmes used for retained
issues have a separate rating. Due to using a pass-through structure, the
second programme of Banca Carige is rated Baa3 by Moody's, i.e. higher
than the programme used for public issuance (Ba1).

Retained covered bonds are not accounted for as liability under IFRS. In
case the issuer sells the covered bond to the ECB, it has to pay a coupon.
In our understanding, the coupon is accounted for as interest cost (e.g. 3M
Euriobor+75bp in case of ISPIM Float Aug 2018), leading to a burden for
interest income, potentially reducing the incentive to sell retained covered
bonds.

With EUR 74bn of Italian covered bonds in FRN format in the ECB
database, the volume available for CBPP3 (potentially only after structural
changes or getting a rating) seems substantial. For example, Monte Dei
Paschi has a second EUR 20bn covered bond programme used for retained
issuance, with covered bonds under this programme amounting to EUR
8.4bn as of 29 July (backed by EUR 6.7bn residential and EUR 4.48bn
commercial loans).

The European Commission published the Delegated Act regarding LCR. EU
banks need to meet at least 60% on 1 Oct 2015. The Delegated seems is
mainly in line with expectations regarding covered bonds, i.e. Level 1 with
7% haircut and 70% cap in case of ECAI 1 and Level 2A with 15% haircut
and 40% cap in case of ECAI 2. However, also unrated high quality
covered bonds are eligible as Level 2B asset with a 15% cap and a 30%
haircut, confirming elevated regulatory support for legal framework based
covered bonds in the EU.
Page 50
10 October 2014
Figure 1: Outperformance of Dutch covered bonds
versus sovereign bonds and Nordic covered bonds
200
Figure 2: Outstanding volume of publicly issued Italian
EUR benchmark covered bonds per issuer (as of 1 Oct)
iBoxx Euro Norway Covered
iBoxx Euro Sweden Covered
iBoxx Euro Netherlands Covered
iBoxx Euro Finnish Covered
iBoxx Euro Germany Sovereign
iBoxx Euro Netherlands Sovereign
150
100
Bn EUR
16
14
12
10
8
50
6
0
4
2
-50
0
-100
Jul-08
Jul-09
Jul-10
Jul-11
Jul-12
Jul-13
Jul-14
Source: Markit
Source: Markit
Figure 3: Annual public issuance of Italian EUR
Figure 4: Outstanding volume of Italian covered bonds
benchmark covered bonds
based on the ECB collateral database (as of 1 Oct)
Bn EUR
45
Bn EUR
18
FIXED
FLOATING
40
16
14
35
12
30
10
25
8
20
6
15
4
10
2
5
0
0
2005
2006
2008
2009
2010
2011
2012
2013
2014
ytd
Source: ECB, Deutsche Bank
Page 51
10 October 2014
United Kingdom
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Soniya Sadeesh
Strategist
(+44) 0 207 547 3091
[email protected]
UK Strategy
Market update: Core rates rallied sharply over the week, as concerns over the
global slowdown grow; GBP largely tracked USD rates, and both outperformed
EUR rates. The 5Y point was the primary outperformer, as rate hikes were
priced out. This was the last week of BoE reinvestment - in part this may have
helped drive some of the performance, as the last couple of operations had
weak covers.
However, more marked was the decline in inflation; 5Y RPI fell 10.5bp,
steepening the breakeven curve. The beta between nominals and breakevens
has increased of late (on daily changes) suggesting inflation expectations are
increasing in relevance for nominal rates.
B/E Nominal beta rising
0.4
0.4
0.3
0.3
0.2
0.2
0.1
BoE cover soft in last operations
8.00
10Y RPI v Nominals on changes
Rolling Beta
7.00
Cover
6.00
Last Two
5.00
4.00
3.00
2.00
0.1
0.0
1.00
0.00
09
12
Source: Deutsche Bank, BoE
The rally post the FOMC minutes pushed the front end even further, now only
pricing the first hike by August, and only two hikes in 2015, and 2016
(respectively).
While concerns over a global slowdown have been cited by all three major
central banks, these risks are now arguably already priced. UK data so far has
been relatively resilient, the core of the FOMC still indicate that a mid 2015
hike is on the cards (see Dudley’s latest speech) and President Draghi’s speech
highlights the ECB is alert to the risks – action on this or the fiscal front would
enable normalization in the UK.
We like being short Dec 16 short sterling, which is not inconsistent with the
5Y10Y steepener, which will also benefit from a normalization of inflation
expectations, a likely scenario in which rate hikes are repriced.
Page 52
10 October 2014
Dec 15 only pricing 2 hikes now
Forget gradual
4.50
1.30
1.25
Dec 15 OIS
1.20
Live
4.00
100bp/year
3.50
50bp/year
3.00
Terminal Rate 2.5%
Yest
2.50
1.15
2.00
1.10
1.50
1.00
1.05
0.50
07-Oct
05-Oct
03-Oct
01-Oct
29-Sep
27-Sep
25-Sep
23-Sep
21-Sep
19-Sep
17-Sep
15-Sep
13-Sep
11-Sep
09-Sep
07-Sep
05-Sep
03-Sep
01-Sep
1.00
0.00
The rally has also steepened the 10Y30Y curve, back to fair levels (when
considering a recent sample).
Starting to look stretched
10Y30Y steepening back to fair
L Z6
Pre Guidance Peak
99
60
50
98.5
40
Aug IR, Fwd guidance expected
30
98
20
97.5
Fitted
Residual
10Y30Y
10
Taper Tantrum
0
97
-10
RV: 28s have been richening versus surrounding bonds, with the fly moving
2.8bp in last two weeks (z-score -3 on a 6m horizon)
More signs of housing slowing: The latest credit conditions survey revealed a
sharp drop in both the supply and demand for mortgages over Q3 (the survey
was conducted between 13 Aug and 8 Sept).
The fall in credit availability was attributed to be a function of changing risk
appetite and views over house prices. The FPC recommendations as well as
the MMR implementation was said to contribute. Looking ahead, a rebound in
both supply and demand was expected - looking at historical survey
responses, lender expectations generally tend to capture the direction of
changing conditions, but less so the magnitude of the move.
Credit availability tightened
Demand also moderating
50
80
40
Past 3M
30
20
40
10
20
0
Next 3M
0
-10
-20
-20
-30
-40
-40
Mortgage Availability
Oct-08
Mar-10
Jul-11
Dec-12
Mortgage Demand
-60
-50
-60
Jun-07
Past 3M
60
Next 3M
Apr-14
Sep-15
-80
Jun-07
Oct-08
Mar-10
Jul-11
Dec-12
Apr-14
Sep-15
Page 53
10 October 2014
Mortgage approvals have also slowed from Q1 levels, and the latest RICS
survey indicates a slowing in momentum – it also indicates that London in
particular seems to be softening more than regions. This suggests that the
macro prudential policies/valuations/rate hike expectations are having an effect
on the housing market, but much like the PMIs, it is a slowing from elevated
levels.
# Mortgage approvals declining
(Thousands)
BoE
BBA
00_07 Ave
107
69
Q113
53
31
Q213
58
36
Q313
64
40
Q413
70
45
Q114
71
47
Q214
64
42
Q314*
65
42
Latest
64
42
* incomplete, BOE BBA Jul, Aug, CML Jul
House prices moderating
CML
98
39
51
57
60
49
57
68
68
10%
80
QQ% = Halifax, Nationwide, RICS = pice
balance
8%
60
40
6%
20
4%
0
2%
-20
0%
-40
-2%
-60
Halifax
-4%
-100
RICSrhs
-8%
02
-80
Nationwide
-6%
03
04
05
06
-120
07
08
09
10
11
12
13
14
Partly regional convergence?
Mortgage rates still lower than 1Y
ago
150
2Y Fixed
8.50
London-West Midland price balance rhs
100
7.50
50
6.50
0
5.50
-50
4.50
-100
3.50
Base Tracker
SVR
2.50
-150
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
1.50
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
A shift in sentiment
Past 3M Factors Driving Credit Availability
Q113
Q213
Econ Outlook
1.9
2.0
Mkt Share
21.6
34.9
Risk Appetite
8.3
13.1
Funding
7.6
3.9
House Price Exp
-1.8
0.5
Q313
4.8
29.5
-4.8
0.0
1.7
Q413
5.3
20.1
11.5
0.0
17.1
Q114
7.3
0.3
14.8
0.0
3.1
Q214
1.4
9.5
-2.3
2.3
0.7
Q314
0.0
11.4
-25.5
0.0
-10.1
Page 54
10 October 2014
Japan
Rates
Gov. Bonds & Swaps
Makoto Yamashita, CMA
Strategist
(+81) 3 5156-6622
[email protected]
Japan Strategy
Overview

The BOJ's massive bond-buying operations have perhaps convinced many
JGB market participants that ultra-low yields are here to stay, but we
expect high volatility to start generating upward pressure if further yen
depreciation makes the central bank's +2% inflation scenario look
achievable. Non-bank investors have bought up foreign bonds for six
straight months since April, continuing to do so even in September as the
yen weakened. We therefore see potential for a self-fulfilling prophesy
whereby investor expectations of further yen weakness drive the currency
even lower.

It is still possible that the BOJ will announce further monetary easing
measures at the end of October, but some veterans from within the ruling
Liberal Democratic Party (LDP) have actually started to suggest that the
central bank should be moving closer to an exit from Quantitative and
Qualitative Monetary Easing (QQE) as yen depreciation continues to draw
ire from regional voters struggling with higher gasoline prices and smaller
businesses finding it difficult to pass through higher import costs. We
expect to see further opposition to BOJ easing—from both politicians and
the broader public—in the event that the yen continues to weaken, which
suggests to us that there is perhaps only limited room for JGB yields to
decline from their current (already historically low) levels.
JPY rates can't stay ultra-low forever
The 10y JGB yield has dropped back below 0.5% as declines in short- to
medium-term interest rates to almost unfeasibly low levels—with the 2y yield
hitting 5bp—generate downward pressure further out the curve. When
contemplating the sustainability of such ultra-low interest rates it is necessary
to recognize that they reflect (1) a renewed decline in overseas interest rates,
(2) concerns over domestic economic weakness and an increasingly gloomy
global outlook (particularly in the eurozone), (3) the fact that JGB yields rose
only modestly in September even as the yen weakened and equities rallied,
and (4) continued tightening of supply/demand as a consequence of the BOJ's
massive bond-buying operations.
Supply/demand will probably continue to tighten as the BOJ keeps buying up
JGBs for at least the time being, but the bond market landscape has started to
look quite different since September due to higher volatility in the equities and
FX markets. The yen has already weakened quite significantly, but we expect
that USD/JPY will keep rising to around 115–120, thereby raising the possibility
of Japan's core CPI inflation rate—already above +1% even after subtracting
out the consumption tax hike impact—reaching the BOJ's +2% "price stability
target" at some point next year. The final quarter of 2014 is liable to be a
particularly volatile time for global financial markets as the Fed takes further
steps towards its exit from QE3.
Page 55
10 October 2014
Continued investment in foreign bonds will keep driving
the yen lower
Japanese investors were net buyers of foreign bonds (long-term debt
securities) to the tune of JPY1.3 trillion in September. Moreover, banks—who
tend to invest mostly on an FX-hedged basis—accounted for just JPY371.6
billion of this total, meaning that JPY941.4 billion is likely to have reflected
purchases by investors taking on at least some exposure to exchange rate risk.
Life insurers bought JPY653.1 billion more that they sold, while "financial
instruments firms" were net buyers to the tune of JPY760.3 billion. Non-bank
investors have now been net buyers for six straight months since April, with
their total net purchases over this period amounting to some JPY7.5 trillion.
Some might have expected a selloff in September as USD/JPY surged out of its
101–104 range to around 110, but while investment trusts did indeed sell
JPY155.4 billion more than they bought last month, other investors were
seemingly prepared to chase the yen even lower rather than taking profits on
their existing positions.
Figure 1: Banks versus non-bank investors: net purchases of foreign long-term
debt securities
4000
(billion yen)
Banks
Non-bank investors
3000
2000
1000
0
-1000
-2000
-3000
-4000
11
12
13
14
Source: Ministry of Finance, Deutsche Securities
Data on the regional breakdown of investment for August indicate that
Japanese players became net sellers of French bonds after net purchases of
JPY3.1 trillion from April through July, also became modest net sellers of
German bonds, and continued to sell off Italian bonds as eurozone interest
rates declined even further. The UST market appears to have picked up the
slack, attracting some JPY877.5 billion in net purchases. We will not be
surprised if September data show a further shift from Europe to the US
consistent with a continued rise in the USD/JPY exchange rate.
Page 56
10 October 2014
Figure 2: Net purchases of foreign long-term debt securities by region
(trillion yen)
France
Germany
US
13
14
4
3
2
1
0
-1
-2
-3
-4
11
12
Source: Bank of Japan, Deutsche Securities
Political concerns over inflation liable to hinder additional
BOJ easing
It is still possible that the BOJ will announce further monetary easing measures
at its October 31 board meeting. However, the central bank's October 7
statement merely reiterated that "Japan's economy has continued to recover
moderately as a trend", with its overall tone and inflation outlook unchanged
despite an acknowledgment that "industrial production has recently been
showing some weakness, due in part to inventory adjustments". The
September industrial production index (to be published on October 29) will be
the only important economic indicator before that time, and with the yen
having weakened quite significantly of late, it should come as little surprise if
the BOJ sticks to its scenario of +2% inflation despite (perhaps) lowering its
economic growth forecasts for the current fiscal year. In other words, we do
not expect the BOJ's semiannual Outlook for Economic Activity and Prices
report to provide much justification for additional monetary easing at this
juncture.
Recent concerns over yen weakness expressed by a number of policymakers
are also likely to stay the BOJ's hand. The recent rise in USD/JPY has been
driven largely by Fed rate hike expectations and will perhaps continue until and
unless the BOJ shows signs of shifting into tightening mode. By driving up
import prices and raw materials costs, recent yen depreciation has exacted a
significant toll on regional voters who are comparatively big users of gasoline
and smaller businesses that find it relatively difficult to pass through upstream
cost increases. BOJ Tankan results for March did show the business conditions
diffusion index (DI) for small nonmanufacturers—collectively Japan's biggest
employers—rise above zero for the first time since 1990, but subsequent
declines in June and September suggest that the economic recovery might still
be limited mostly to large manufacturers.
Page 57
10 October 2014
Figure 3: Tankan business conditions DI: large manufacturers vs. small
nonmanufacturers
(% pt)
60
Large manufacturers
Small nonmanufacturers
40
20
0
-20
-40
-60
-80
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Source: Bank of Japan, Deutsche Securities
Politicians are likely to be well aware of this state of affairs. According to
Bloomberg, Toshihiro Nikai—chairman of the ruling Liberal Democratic Party's
general council—has indicated that the potential need for the BOJ to consider
an exit strategy was flagged at the council's meeting on October 7. At this
point in time it would appear that a majority of LDP lawmakers are still in favor
of the BOJ maintaining the status quo, but that could quite easily change if
further yen deprecation keeps driving up import prices. Before BOJ Governor
Haruhiko Kuroda took the helm it was common for the government to call for
further monetary easing and the central bank to resist, but the tables could
soon be turned, with the BOJ finding it difficult to take any additional action
unless the global economy slows sufficiently to start driving up the yen once
again. We believe that the BOJ will see little option but to stick with its +2%
inflation scenario for at least the time being, but it is quite possible that
politicians will start questioning the need for that pace of price growth if the
yen should continue to weaken.
Page 58
10 October 2014
Pacific
Australia
New Zealand
Rates
Gov. Bonds & Swaps
David Plank
Macro strategist
(+61) 2 8258-1475
[email protected]
Dollar Bloc Strategy
Ken Crompton
Strategist
(+61) 2 8258-1361

Bonds have rallied in virtually a straight line since 19 September. The
gains over the past week have come despite the better-than-expected US
payrolls report.

If wage growth remains low then we expect the bond market will remain
resilient even in the face of decent US payrolls. Of course there will be
some nervousness of getting behind the curve if the unemployment rate
continues to decline. But the evidence so far this year is that the bond
market is prepared to wait for signs that wage growth is picking up before
it reacts all that much to a declining unemployment rate. This suggests we
shouldn’t be in a hurry to enter into a short duration position. We do,
however, need to take valuation into consideration. The 10Y ACGB is very
close to its low point for the year and now some 40bp below our year-end
target. We think this is sufficient to recommend a modest duration
underweight. A global rally remains the key risk.

The AUD yield curve continues to be highly correlated with the direction of
the long-end, steepening on sell-offs and flattening on rallies. Given our
outlook for the RBA we see no reason why this won’t continue to be the
case. Given that we expect the 10Y yield to finish the year higher we favour
the curve to steepen from here.
[email protected]
10Y yields close to their lows for 2014, but still some way above 2013
$-bloc 10Y bonds have rallied further this week, continuing the gains seen
since the September FOMC statement. 10Y yields are now at or close to their
lows for 2014. This is still some way above the lows for 2013, however.
$-bloc 10Y bond yields
5.0
10Y NZGB (LHS)
10Y ACGB (LHS)
10Y UST (RHS)
10Y CAN (RHS)
4.8
3.2
3.0
4.6
2.8
4.4
2.6
4.2
4.0
2.4
3.8
2.2
3.6
2.0
3.4
1.8
3.2
3.0
Jan-13
1.6
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Oct-14
Source: Deutsche Bank, Datastream
The rally this week has come despite the better-than-expected US employment
report. The focus of commentary seeking to explain the US bond market
reaction has been on the soft wages component. Average hourly earnings
Page 59
10 October 2014
were unchanged for the month and the annual change slowed to 2% from
2.1% in August. Our US fixed income strategists interpret weak wage growth
as reflecting low productivity and the ongoing need to protect profits. This is
not something they expect to change any time soon.
There have also been other factors at play this week. Weak European data,
downbeat commentary from the IMF and ECB and news about Ebola have all
been cited as contributing to the bond market gains over the course of this
week. We think, however, that the soft US wages data has been the main
driver.
If wage growth remains low then we expect the bond market will remain
resilient even in the face of decent US payrolls. Of course there will be some
nervousness of getting behind the curve if the unemployment rate continues to
decline. But the evidence so far this year is that the bond market is prepared to
wait for signs that wage growth is picking up before it reacts all that much to a
declining unemployment rate.
This suggests we shouldn’t be in a hurry to enter into a short duration position.
We do, however, need to take valuation into consideration. The 10Y ACGB is
very close to its low point for the year and now some 40bp below our year-end
target. We think this is sufficient to recommend a modest duration
underweight.
ACGB curve continues to be highly correlated with the 10Y UST
During the first 19 days of September the 3Y/10Y ACGB futures curve
steepened by a little more than 15bp. This was its biggest steepening move in
2014. While the period in question covers a futures roll, in this case the impact
of the roll was essentially zero. The curve has retraced more than half of this
steepening move over the past few weeks.
3Y/10Y ACGB curve since 2013
130
120
110
100
90
80
70
60
3Y/10Y ACGB futures
spread, bp
50
40
Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14
Source: Deutsche Bank, Reuters
The steepening of the curve in September lasted for the duration of the bond
sell-off. This makes it fairly easy to identify the cause of the recent moves in
the curve – the direction of the 10Y UST. While the correlation between the
curve and the US long-end is not perfect in 2014, possibly because of the
impact of events in Europe, we think it is clear that the AUD curve is being
driven by the global long-end (whether that be the 10Y UST or the 10Y Bund)
not the AUD front-end.
Page 60
10 October 2014
Curve vs 10Y UST in 2014
140
3.1
135
3Y/10Y ACGB futures spread, bp (LHS)
130
3.0
10Y UST (RHS)
125
120
2.9
115
110
2.8
105
100
2.7
95
90
2.6
85
80
2.5
75
70
2.4
65
60
Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14
2.3
Jul-14
Aug-14 Sep-14 Oct-14
Source: Deutsche Bank, Reuters
This has been the case for more than two years. This reflects the fact the AUD
front-end has, to all intents and purposes, been stable since mid-2012. This is
not to say the front-end has been completely devoid of volatility, but it has lacked
a trend powerful enough to have a material impact on the yield curve.
Curve vs front-end
1.8
1.6
1.4
0.0
3Y/10Y futures spread (LHS)
1.0
3M rate implied by IR4 - inverted (RHS)
1.2
2.0
1.0
3.0
0.8
4.0
0.6
0.4
5.0
0.2
6.0
0.0
-0.2
7.0
-0.4
8.0
-0.6
9.0
-0.8
-1.0
Jan-98
10.0
Apr-00
Jul-02
Oct-04
Jan-07
Apr-09
Jul-11
Oct-13
Source: Deutsche Bank, Bloomberg Financial LP
Our Australian economics team expects the RBA to be on hold for an extended
period of time, perhaps into 2016. If this view is correct and the market
continues to accept this then the fate of the curve will remain in the hands of the
long-end. And while the 10Y ACGB hasn’t been solely driven by the 10Y UST in
2014, it remains the case that the big moves in the long-end rates over the past
few years have been driven by the US. We see little reason for this to change.
Hence we continue to see the outlook for the curve as highly correlated with the
outright direction of the 10Y bond. Given that we expect the 10Y yield to finish
the year higher than currently we favour the curve to steepen from here. The
biggest risk to this view is a continued rally in the US long-end.
David Plank +61 2 8258 1475
Page 61
10 October 2014
Global
Economics
Rates
Gov. Bonds & Swaps
Inflation
Markus Heider
Strategist
(+44) 20 754-52167
[email protected]
Global Inflation Update
Global
EUR and GBP breakevens continued to tighten in steepening mode this week,
while USD B/Es stabilized after the September FOMC meeting minutes were
perceived as dovish. Agricultural and industrial metal prices rose, equity
markets showed some signs of stabilization—at least in the US—, but oil prices
continued to fall strongly and nominal yields rallied. Economic data were on
balance weaker than expected in EUR, but continue to be robust in the US.
Labour market trends in particular appear to remain strong, and despite only
gradual progress in some metrics such as quits and part-time employment,
leading indicators remain consistent with a progressive increase in US wage
growth in the coming quarters (chart 1). Cross-market trends have been more
consistent with relative data trends, with GBP/USD spreads—which looked too
wide a few weeks ago—now back at the tighter end of their three-month
relationship.
One noteworthy recent trend has been the sharp decline in 5y5y forward TIPS
B/Es, which this week reached levels close to historical lows (chart 4). The
5y10y TIPS B/E curve indeed has steepened less in the recent sell-off than
could have been expected based on typical directionality (see last week’s
update). The 5y10y slope also looks somewhat flat when compared against
economic factors such as oil prices, spot CPI or the ISM (chart 3). As a result,
5y5y TIPS B/Es have fallen well below 2.20% (chart 4), which is probably lower
when compared to implied central bank inflation targets than 5y5y B/Es in the
euro area. While in the euro area the market is concerned about the possibility
of a regime shift in inflation, the risk would appear much lower in the US,
despite the recent FOMC discussions about a possible start to policy rate
normalization; Fed policy has proved quite pro-active in addressing downside
risks since 2008. Some of the cheapness in 5y5y TIPS can probably be
explained by institutional factors, given the recent widening in the swap-cash
basis (chart 2). We see upside for 5y5y TIPS B/Es, for 10y should commodity
prices stabilize, as well as for 5y5y USD/EUR B/E spreads.
3. 5y10y TIPS B/Es steepened less than expected
3.5
5.5
z-scores
5.0
2.5
4.5
1.5
4.0
3.5
0.5
3.0
-0.5
2.5
2.0
-1.5
NFIB exp compensation (10m lead)
umplyt rate (15m lead)
quit rate, priv (10m lead)
hourly earnings, % y/y (rhs)
-2.5
-3.5
1988
1991
1994
1997
2000
2003
1.5
1.0
0.5
2006
2009
2012
2015
2. USD 5y5y swap-cash basis wider
0.8
5y5y USD BEI: swaps - cash
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
Jan-10
Sep-10
May-11
Jan-12
Sep-12
May-13
Jan-14
Sep-14
4. 5y5y TIPS B/Es at lows
4.0
0.80
TIPS implied ZC 5y5y BEI
5y10ys
0.70
1. LI point to rising US wage growth
last
fitted
3.5
0.60
0.50
3.0
0.40
2.5
0.30
0.20
2.0
0.10
0.00
Jan-10
Aug-10
Page 62
Mar-11
Oct-11
May-12
Dec-12
Jul-13
Feb-14
Sep-14
1.5
2003
2005
2007
2009
2011
2013
10 October 2014
EUR
EUR B/Es across all maturities continued their slide lower this week (chart 1).
Oil prices were down another 3%-5%, with brent falling below USD90. The
trend in crude has been putting ongoing downward pressure on near-term
HICP expectations, with both October and November forecasts revised lower
again this week; headline inflation is now expected at only 0.5% y/y in Q4.
Downward revisions to near-term ILB carry projections have pulled 1y B/Es
lower. Recent B/E weakness has however gone beyond what could have been
expected on the basis of commodity price and spot HICP trends alone (chart 2).
Economic data has been a negative as well, with German industrial production
in particular pointing to downside risks to Q3 GDP forecasts, even when taking
into account monthly volatility. While we are expecting some stabilization in
data in the coming months, recent negative momentum raises the downside
risks for forecasts of domestic inflation recovering. In that context, and with
the exchange rate appreciating somewhat and Spain issuing EUR5bn in a new
SPGei19, B/E weakness has been broad-based across maturities (chart 1). 1y
swap rates 1y, 2y or 4y ahead were down about 8bp, while 5y5y fell to new
lows below 1.9%. The decline in 5y5y is likely to reflect in part the shift lower
in the balance of risks to the inflation outlook (chart 3), and with the ECB
apparently in ‘wait-and-see’ mode for now, the risks may still be on the
downside.
1. EUR B/Es decline…
3.0
5y5y
HICPxt swap rates
1y1y
4y1y
2.5
2.0
1.5
1.0
0.5
Jul-12
Dec-12
May-13
Oct-13
Mar-14
Aug-14
2. …more than suggested by spot
HICP, commodities alone
2.5
DEMBE5Y
2.3
fitted, f(oil, agriculture, metals, spot HICP)
2.1
Next week will bring the final September HICP. Domestic CPI data released so
far on their own do not explain the weak euro area core (and in particular
services) flash HICP print, so further domestic core CPI weakness is to be
expected, not least from France. With m/m inflation expected negative (around
0.4%) for French CPI and positive (around 0.4%) for EUR HICP, carry trends
will be significantly more positive for EUR ILBs than for FRF CPI ILBs through
November. We expect inflation to remain relatively subdued in France, and
maintain a preference for EUR over FRF inflation.
1.9
1.7
1.5
1.3
1.1
0.9
0.7
Jan-10
Aug-10
Mar-11
Oct-11
May-12
Dec-12
Jul-13
Feb-14
Sep-14
In RV, 2018 issues in our view look cheap and 2020 issues slightly rich on both
the OATei and DBRei curves. The spread between BTPei and OATei inflation
valuations has continued to narrow, while the SPGei24 is trading in line with
OATei valuations. DBRei and especially OATei B/Es have cheapened against
swaps, with long-end OATei close to the cheapest levels against swaps in one
year (chart 4). We would be neutral on swap-bond B/E spreads.
3. Risks to the inflation outlook shifting to the downside
SPF, skew: prob of infl. >=2% - <1.5% 5Y ahead
60
5y5y forward HICP swap
4. OATei B/Es have cheapened against swaps
40
2.8
50
2.6
ILB rich (-) / cheap (+) vs CPI swaps
spot
30
1y mean
1y max
20
1y min
40
2.4
30
10
0
2.2
20
2.0
10
-10
-20
-30
0
2002
1.8
2004
2006
2008
2010
2012
OATei18
OATei20
OATei22
OATei24
OATei27
OATei32
OATei40
2014
Page 63
10 October 2014
GBP
In RV, up to 15y we find the UKTi19, -24 and -29 cheap against neighboring
issues. At the long-end the new IL58 continues to look cheap on the curve. In
forwards, 5y RPI remains richest 15y forward (around 3.9%) and we estimate
cash 15y5y forward B/Es are above 4%; the low point in RPI (at the long-end) is
30y5y, at below 3.5%.
2
1w change on 9-Oct, carry adj, bp
0
-2
-4
-6
-8
BEI
-10
Real Yld
Nom Yld
UKTi68
UKTi62
UKTi58
UKTi52
UKTi50
UKTi47
UKTi44
UKTi42
UKTi40
UKTi37
UKTi34
UKTi32
UKTi29
UKTi27
UKTi24
UKTi22
-12
UKTi19
We have been neutral on GBP B/Es given the weak trend in spot RPI, subdued
imported inflation and absence of clear signs of a pick-up in domestic inflation.
Economic data have remained relatively resilient however, and leading
indicators continue to point to rising pay growth in the coming quarters.
Moreover, valuations have declined significantly, and in 5y look low against
historical averages (1y z-score below -4.5), baseline RPI forecasts, trends in
commodities, FX or spot RPI (chart 3) or economic indicators (chart 2). While
the near-term RPI risks may remain to the downside—we see headline RPI (as
well as core CPI) inflation easing slightly next week—the risk-reward of being
long B/Es has risen in our view. We would see upside for 5y B/Es at 2.85%
(RPI) and 2.55% (UKTi19).
1. UKTi B/Es lower and steeper again
UKTi17
UK breakevens continued to be under heavy pressure this week, with the B/E
curve steepening significantly again; real yields rallied (chart 1). The re-pricing
of policy rate expectations is a negative for front-end B/Es given lower
expectations for the RPI mortgage interest payment component. Across
markets, GBP B/Es mostly underperformed, and GBP/USD spreads have mostly
moved broadly back in line with our models—in 5y GBP B/Es look even slightly
cheap v USD. The B/E curve has however steepened more in GBP than in USD,
which means that 5y5y B/E spreads remain relatively wide (chart 4); in 5y5y
cash, we would maintain a preference for USD over GBP.
2. 5y BEI looks low v economics…
4.0
3.5
GBP BEI 5y
fitted, f(cost, demand, spot inflation & risk indicators)
3.0
2.5
2.0
1.5
1.0
0.5
2001
2003
2005
2007
2009
2011
2013
2015
3. …and against commodities, FX and spot RPI
3.6
3.4
4. 5y5y GBP/USD B/E spread still wide
1.2
GBPBE5Y
5y5y BEI: TIPS v UKTi
fitted, f(FX, commodities, spot RPI, formula effect dummy)
1.1
3.2
1.0
3.0
0.9
2.8
0.8
2.6
0.7
2.4
0.6
2.2
0.5
2.0
Jan-10
Aug-10 Mar-11
Page 64
Oct-11 May-12 Dec-12
Jul-13
Feb-14
Sep-14
0.4
Feb-13
May-13
Aug-13
Nov-13
Feb-14
May-14
Aug-14
10 October 2014
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
United States
Alex Li
Research Analyst
(+1) 212 250-5483
[email protected]
Inflation-Linked

Inflation markets remained volatile this week, as investors digested the
September FOMC minutes. The minutes were more dovish than expected,
and provided some support to TIPS breakevens.

We like the front end and the long end inflation markets. Our updated NSA
CPI forecast favor the January 2016 TIPS. The 30yr TIPS auction later this
month presents an opportunity to be long 30-year breakevens. We expect
the Treasury to announce a $7 billion reopening of the 2/2044 TIPS on
Thursday, October 16.
Dovish minutes support breakevens
Inflation markets remained volatile this week, as investors digested the
September FOMC minutes. The minutes were more dovish than expected, and
provided some support to TIPS breakevens. The minutes stated: “The
Committee again anticipated that it likely would be appropriate to maintain the
current target range for the federal funds rate for a considerable time after the
asset purchase program ends, especially if projected inflation continued to run
below the Committee's 2 percent longer-run goal, and provided that longerterm inflation expectations remained well anchored.”
In Deutsche Bank’s updated NSA CPI forecast (based on the term structure of
gasoline futures prices), the headline CPI is likely to drop towards 1% by March
2015, which would be a trough before a recovery in the second half of 2015
towards 2%. The core CPI will probably range between 1.7% and 1.8% for
most of the first half of 2015, before rising towards 2% by 2015 yearend.
DB NSA CPI forecast
6
5
4
3
2
1
0
-1
Headline CPI yoy
-2
-3
Jan-00
Jan-02
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
Jan-14
Source: BLS and Deutsche Bank
We like the front end and the long end inflation markets. Our updated NSA CPI
forecast favor the January 2016 TIPS.
Page 65
10 October 2014
Rich/cheap issues in the front end TIPS market
Price date: 10/09/14
BE Inflation
Implied CPI
DB forecast CPI
Rich/ Cheap
TII 1.625% 1/15/2015
TIPS
-1.62%
237.12
236.95
Ri ch: 2 ti cks (-27bp)
TII 0.500% 4/15/2015
-0.37%
237.69
237.23
Ri ch: 6 ti cks (-37bp)
TII 1.875% 7/15/2015
1.00%
239.98
240.19
Cheap: 3 ti cks (11bp)
TII 2.000% 1/15/2016
0.93%
240.97
241.55
Cheap: 8 ti cks (19bp)
The 30-year TIPS auction later this month presents an opportunity to be long
30-year breakevens. We expect the Treasury to announce a $7 billion
reopening of the 2/2044 TIPS on Thursday, October 16. The auction will be a
week later. The 30-year TIPS breakevens are near multi-year lows. Long end
real yields in the US still look attractive relative to those in Europe.
30yr TIPS breakevens near multi-year lows
Source: Bloomberg
Long end real yields in the US still look attractive relative to those in Europe
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
3/1/11
US TIPS 2041 real yield minus French 2040 real yield
3/1/12
3/1/13
3/1/14
Page 66
10 October 2014
Contacts
Name
Title
Telephone
Email
Head of European Rates Research
44 20 7545 4017
[email protected]
EUROPE
Francis Yared
Alexander Düring
Euroland & Japan RV
44 207 545 5568
[email protected]
Global Inflation Strategy
44 20 754 52167
[email protected]
Covered Bonds/SSA
41 44 227 3710
[email protected]
Global RV & Rates Vol
33 1 44 95 64 08
[email protected]
Euroland Strategy/ EUR Govt. bonds
44 20 754 74458
[email protected]
UK Strategy & Money Markets
44 20 7547 3091
[email protected]
Nick Burns
Credit Strategy
44 20 7547 1970
[email protected]
Stephen Stakhiv
Credit Strategy
44 20 7545 2063
[email protected]
Sebastian Barker
Credit Strategy
44 20 754 71344
[email protected]
Conon O’Toole
ABS Strategy
44 20 7545 9652
[email protected]
Paul Heaton
ABS Strategy
44 20 7547 0119
[email protected]
Rachit Prasad
ABS Strategy
44 20 7547 0328
[email protected]
Markus Heider
Bernd Volk
Jerome Saragoussi
Abhishek Singhania
Soniya Sadeesh
US
Dominic Konstam
Global Head of Rates Research
1 212 250 9753
[email protected]
Steven Abrahams
Head of MBS & Securitization Research
1-212-250-3125
[email protected]
Aleksandar Kocic
US Rates & Credit Strategy
1 212 250 0376
[email protected]
Alex Li
1 212 250 5483
[email protected]
Richard Salditt
1 212 250 3950
[email protected]
Stuart Sparks
1 212 250 0332
[email protected]
Daniel Sorid
1 212 250 1407
[email protected]
Steven Zeng
1 212 250 9373
[email protected]
ASIA PACIFIC
David Plank
Head of APAC Rates Research
61 2 8258 1475
[email protected]
Makoto Yamashita
Japan Strategy
81 3 5156 6622
[email protected]
Kenneth Crompton
$ bloc RV
61 2 8258 1361
[email protected]
[email protected]
Sameer Goel
Head of Asia Rates & FX Research
65 6423 6973
Linan Liu
Asia Strategy
852 2203 8709
[email protected]
Arjun Shetty
Asia Strategy
65 6423 5925
[email protected]
Kiyong Seong
Asia Strategy
852 2203 5932
[email protected]
Head of European FX and cross markets
strategy
44 20 754 79118
[email protected]
CROSS-MARKETS
George Saravelos
Page 67
10 October 2014
Appendix 1
Important Disclosures
Additional information available upon request
For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this
research, please see the most recently published company report or visit our global disclosure look-up page on our
website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr
Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition,
the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation
or view in this report. Francis Yared/Dominic Konstam
Page 68
10 October 2014
(a) Regulatory Disclosures
(b) 1. Important Additional Conflict Disclosures
Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the
"Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.
(c) 2. Short-Term Trade Ideas
Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are
consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the
SOLAR link at http://gm.db.com.
(d) 3. Country-Specific Disclosures
Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the
meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively.
Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and
its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is
indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where
at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the
preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for
its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483.
EU
countries:
Disclosures
relating
to
our
obligations
under
MiFiD
can
be
found
at
http://www.globalmarkets.db.com/riskdisclosures.
Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc.
Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau
(Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures
Association of Japan, Japan Investment Advisers Association. This report is not meant to solicit the purchase of specific
financial instruments or related services. We may charge commissions and fees for certain categories of investment
advice, products and services. Recommended investment strategies, products and services carry the risk of losses to
principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value.
Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant
disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this
report are not registered credit rating agencies in Japan unless "Japan" or "Nippon" is specifically designated in the
name of the entity.
Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may
from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank
may engage in transactions in a manner inconsistent with the views discussed herein.
Qatar: Deutsche Bank AG in the Qatar Financial Centre (registered no. 00032) is regulated by the Qatar Financial Centre
Regulatory Authority. Deutsche Bank AG - QFC Branch may only undertake the financial services activities that fall
within the scope of its existing QFCRA license. Principal place of business in the QFC: Qatar Financial Centre, Tower,
West Bay, Level 5, PO Box 14928, Doha, Qatar. This information has been distributed by Deutsche Bank AG. Related
financial products or services are only available to Business Customers, as defined by the Qatar Financial Centre
Regulatory Authority.
Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute,
any appraisal or evaluation activity requiring a license in the Russian Federation.
Kingdom of Saudi Arabia: Deutsche Securities Saudi Arabia LLC Company, (registered no. 07073-37) is regulated by the
Capital Market Authority. Deutsche Securities Saudi Arabia may only undertake the financial services activities that fall
within the scope of its existing CMA license. Principal place of business in Saudi Arabia: King Fahad Road, Al Olaya
District, P.O. Box 301809, Faisaliah Tower - 17th Floor, 11372 Riyadh, Saudi Arabia.
United Arab Emirates: Deutsche Bank AG in the Dubai International Financial Centre (registered no. 00045) is regulated
by the Dubai Financial Services Authority. Deutsche Bank AG - DIFC Branch may only undertake the financial services
activities that fall within the scope of its existing DFSA license. Principal place of business in the DIFC: Dubai
International Financial Centre, The Gate Village, Building 5, PO Box 504902, Dubai, U.A.E. This information has been
distributed by Deutsche Bank AG. Related financial products or services are only available to Professional Clients, as
defined by the Dubai Financial Services Authority.
(e) Risks to Fixed Income Positions
Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise
to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash
flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a
Page 69
10 October 2014
loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the
loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse
macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation
(including changes in assets holding limits for different types of investors), changes in tax policies, currency
convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and
settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed
income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to
FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the
index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended
to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon
rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is
also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be
received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options
in addition to the risks related to rates movements.
Page 70
10 October 2014
Page 71
David Folkerts-Landau
Group Chief Economist
Member of the Group Executive Committee
Guy Ashton
Global Chief Operating Officer
Research
Michael Spencer
Regional Head
Asia Pacific Research
Marcel Cassard
Global Head
FICC Research & Global Macro Economics
Ralf Hoffmann
Regional Head
Deutsche Bank Research, Germany
Richard Smith and Steve Pollard
Co-Global Heads
Equity Research
Andreas Neubauer
Regional Head
Equity Research, Germany
Steve Pollard
Regional Head
Americas Research
International Locations
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Deutsche Bank AG London
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Tel: (44) 20 7545 8000
Deutsche Bank Securities Inc.
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United States of America
Tel: (1) 212 250 2500
Deutsche Bank AG
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Tel: (852) 2203 8888
Deutsche Securities Inc.
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Japan
Tel: (81) 3 5156 6770
Global Disclaimer
The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). The information herein is believed to be reliable and has been obtained from public
sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information.
Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including
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Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change
without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or
subsequently becomes inaccurate. Prices and availability of financial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an offer or a solicitation of an
offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. The financial instruments discussed in this
report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fluctuations and other factors. If a financial
instrument is denominated in a currency other than an investor's currency, a change in exchange rates may adversely affect the investment. Past performance is not necessarily indicative of future results. Deutsche
Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis. Prices are current as of the end of the
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Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the
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Copyright © 2014 Deutsche Bank AG
GRCM2014PROD032979

Global Fixed Income Weekly Deutsche Bank Markets Research

Transcription

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