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2017 Global Rates Outlook

European Rates Strategy January 2017

AC Indicates certifying analyst. See last page for analyst certification and important disclosures.

Fabio BassiAC

(44-20) 7134-1989 fabio.bassi@jpmorgan.com J.P. Morgan Securities plc

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Euro area: less QE, more reflation and political risk

US: Fed hikes & less easing from DM CBs

UK: Brexit, risk premia and reflation

Japan: challenges to Yield Curve Control

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Euro rate strategy We forecast higher Bund rates in 2017 with a 10Y Bund target of 60bp by 2Q17 and 90bp by 4Q17 J.P. Morgan interest rate forecast; German benchmarks unless otherwise stated; %

We expect intra-EMU spread to compress until 1Q17 but the widening trend will eventually resume J.P. Morgan forecast of 10Y EMU curve-adjusted spread to Germany*; bp

* Adjusted for maturity mismatch by taking the difference in maturity-matched swap spreads.

** Weighted peripheral spread computed against Germany for Greece, Ireland, Italy, Portugal and Spain (weighted by the size of their outstanding bond market).

06-Jan 1Q17 2Q17 3Q17 4Q17

Austria 23 20 20 25 30Belgium 43 35 35 40 45Finland 22 20 20 25 30France 52 45 35 40 45Ireland 69 65 65 70 75Italy 166 160 165 170 180Netherlands 18 15 15 20 25Portugal 377 300 300 330 350Spain 125 120 120 130 140Wtd. peri. spread** 163 150 153 161 171

06-Jan 1Q17 2Q17 3Q17 4Q17

ECB depo -0.40 -0.40 -0.40 -0.40 -0.402Y -0.74 -0.70 -0.70 -0.65 -0.605Y -0.48 -0.35 -0.25 -0.15 -0.1010Y 0.29 0.45 0.60 0.75 0.9030Y 1.06 1.25 1.40 1.55 1.752s/10s (bp) 104 115 130 140 15010s/30s (bp) 76 80 80 80 85

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Main drivers of our forecasts In our central scenario, the ECB will be the most important market driver in 2017 J.P. Morgan view on market drivers

What? When? View Impact ECB Early 2017 Problems in the repo

markets will be dealt with more efficiently

Bearish on short maturities

ECB Late 2017 Proper tapering announcement is a real

possibility

Steeper German curve; wider intra-EMU spreads

Euro area macro outlook Throught the year Above potential growth, but slow pick up in core

inflation

Even if consensus it takes the ECB closer to

tapering

External macro outlook Throught the year Trumpenomics generally postive for

growth; oil prices peak in the middle of the year

Adds to bearish durations bias

Political risks Through the year Broadly benign Excessive uncertainty might get priced into the

event

Supply/demand 1Q17 Heavy 10Y+ supply 10s/30s steepening in Germany and other

countries

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The ECB has delivered a very comprehensive set of new measures ECB announcements on size of QE, scarcity and lending facilities on 8 December

ECB December meeting and market impact

Item ECB announcement Bonds Swap spreads VolatilitySize of QE 9M extension at €60bn per month with

possibility to increase size and durationBear steepening, wider intra-EMU

spreadsNarrower long and ultra-long

end

Steeper vol curve

Scarcity Eligible maturity bucket to 1-31Y from 2-31Y

Modestly bullish Schatz and Bobl widening

bi

Lower front-end implieds

Scarcity Removal of depo rate floor but option to buy below the depo rate floor

Pivot steepening of German curve Flattening of swap spreads

curve

Lower front-end implieds; wider govie/swaption

Scarcity Changes to the issue and issuer limit was discussed but eventually rejected

No segmentation between non-CAC and CAC bonds

- -

Scarcity No statement on changes to the capital key allocation framework

Disappointing for the periphery - -

Lending facilities

Up to €50bn of cash for collateral allowed, rate will be equal to the lower

between depo rate -30bp (current -70bp) and prevailing market rate

Higher German rates especially at the short end

Tightening bias across the

curve

Lower vol

Expected market impact

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We estimate that the scarcity measures announced by the ECB increase the capacity of purchases in Germany to as much as September 2018 if fully implemented J.P. Morgan estimate of when issue limit will be reached in Germany under different 10Y yield scenarios, under the new PSPP framework of 1-31Y purchases with or without depo rate floor; # of months

ECB & scarcity after the December announcement: the Euro-system will be forced to buy bonds trading below the depo rate

* We shock the current 10Y Bund yield level and assume it to remain at that level going forward. For the rest of the German central, regional and agency universe we use the recent 3M beta to 10Y Bund to estimate the yield and price level under different 10Y Bund yield levels. Current beta for 2Y is around 45%, 5Y is around 63% and 30Y is around 130% for German central government debt.

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Depo floor, 2-31Y No depo floor, 1-31Y

10Y Bund yield; bp

Oct18

Dec17

Aug18

Jan18

Aug17Oct17

May17

Sep17Jul17Jun17

Current level

Sep18 The new measures alleviate the scarcity problem for

German bonds but force central banks in the smaller countries to further reduce the pace of purchases

The rejection of the possibility to go beyond the 33% issue limit and the refusal to discuss changing the country allocation are important in limiting the scope for further extensions in 2018

J.P. Morgan official forecast: net purchases will stop in the middle of 2018, announcement of proper tapering towards the end of 2017

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ECB & scarcity after the December announcement

If fully implemented, the new measures would cause a decent reduction in 10Y+ purchases in Germany,… J.P. Morgan estimate of monthly 10Y+ German conventional notional PSPP purchases under various scenarios; €bn bp

…even before taking into account potential issue limit pressures J.P. Morgan estimate of German conventional notional purchases up to 9 December 2016; % of outstanding

3.8

2.6

1.2

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1.0

1.5

2.0

2.5

3.0

3.5

4.0

10Y Bund lows (Jul16), €80bn, 2-31Y with depo

floor

Pre-ECB (7-Dec), €80bn, 2-31Y, depo

floor

Post-ECB (9-Dec level), €60bn, 1-31Y, no floor

0%

5%

10%

15%

20%

25%

30%

2016 2021 2026 2031 2036 2041 2046

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Euro area activity and inflation

Our Euro macro forecasts are quite close to those of public sector institutions and consensus 2017 real GDP growth and HICP inflation forecasts for Euro area; %oya

Grow th Inflation Grow th + InflationJ.P. Morgan (Nov -16) 1.5 1.4 2.9IMF (Oct16) 1.5 1.3 2.8OECD (Jun16) 1.7 1.2 2.9EC (Nov 16) 1.5 1.4 2.9ECB (Sep16) 1.6 1.2 2.8Consensus Economics (Nov 16) 1.6 1.3 2.9Av erage ex JPM 1.6 1.3 2.9Source: IMF, OECD, EC, ECB, Consensus Economics, J.P. Morgan

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The Euro area political calendar is quite packed List of key political events in the Euro area until the first quarter of 2018;

Political risk: the calendar is quite packed but our baseline is fairly reassuring

Source: Media articles and J.P. Morgan

When? Where? What? Importance11-Jan-17 Italy Constitutional Court ruling on labour market

reform referenda**

13-Jan-17 Italy DBRS rating update **22-Jan-17 France First round of Socialist primaries *24-Jan-17 Italy Const. Court (preliminary ) ruling on

electoral law for Low er House**

29-Jan-17 France Second round of Socialist primaries *12-Feb-17 Germany Presidential election *15-Mar-17 Netherlands General elections **26-Mar-17 Germany Election in Saarland *Spring Italy Local elections **23-Apr-17 France First round of Presidential election **07-May -17 France Second round of Presidential election ***07-May -17 Germany Election in Schlesw ig-Holstein *14-May -17 Germany Election in North-Rhine Westphalia *September 2017? Spain (Illegal) independence referendum in

Catalonia*

Late September 2017? Germany General election ***By early 2018? Italy General election ***

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After ECB QE, net issuance will be negative almost everywhere

As has been the case for the past two years German supply after redemptions and QE will be heavily negative J.P. Morgan forecast of 2017 gross conventional issuance, net of redemptions and net of redemptions and ECB purchases of conventionals on a cash basis; €bn

Note: In this analysis we look at the cash value of ECB purchases. Given that most bonds trade well above par notional purchases will be smaller. The ECB will spend €80bn per month until March and €60bn between April and December

GrossNet of

redemptions

Net of redemptions and ECB QE

Germany 152 10 -126France 185 84 -36Italy 175 71 -39Spain 115 31 -47Netherlands 33 -2 -37Belgium 36 8 -14Austria 21 3 -14Finland 14 3 -9Ireland 11 5 -1Greece 2 0 -2Portugal 18 11 4Total 762 223 -320Core 441 106 -235Periphery 321 118 -85

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Maturity-wise, we forecast ongoing reliance on ultralong maturities

In 2017 we forecast the same distribution of supply by maturity bucket compared to 2016, but a touch less frontloading overall J.P. Morgan forecast of 2017 gross conventional issuance by maturity bucket by quarter vs. 2016; €bn

1Q17 2Q17 3Q17 4Q17 TotalShort 35 29 31 28 123 16%Medium 61 61 51 39 212 28%Long 82 61 67 49 259 34%Ultra long 53 46 43 26 168 22%Total 231 198 191 141 762

30% 26% 25% 19%

1Q16 2Q16 3Q16 4Q16 TotalShort 39 31 31 17 119 16%Medium 61 59 53 40 214 28%Long 92 59 62 44 257 34%Ultra long 45 53 38 35 171 22%Total 237 202 185 136 760

31% 27% 24% 18%

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Syndicated deals: heavier than usual first quarter?

1Q is typically heavy in terms of syndicated deals List of 1Q conventional syndicated deals by country and J.P .Morgan forecasts for 1Q17;

Source: DMOs, J.P. Morgan

2010 2011 2012 2013Austria 7Y Jan 10Y Jan 10Y, 50Y JanBelgium 10Y Jan, 5Y Mar 10Y Jan, 5Y Mar 10Y Jan, 5Y, 20Y Mar 10Y Jan, 5Y FebFinland 10Y Mar 10Y Feb 15Y JanFrance 50Y Mar 30Y MarGermanyIreland 10Y Jan 10Y MarItaly 15Y JanNetherlands (DDA) 10Y Feb 10Y Mar 10Y Feb, 20Y MarPortugal 10Y Feb 5Y FebSpain 10Y Jan, 15Y Feb 10Y Jan, 15Y Mar 10Y Feb 10Y Jan

2014 2015 2016 2017fAustria 10Y & 30Y (dual tranche) Feb 10Y Jan or FebBelgium 10Y Jan, 20Y Mar 10Y Jan, 15Y Feb 10Y Jan, 30Y Mar 10Y Jan, 15Y or 40Y MarFinland 10Y Jan 10Y Mar 10Y Mar 30Y Jan or FebFrance 30Y OAT or Green bondGermanyIreland 10Y Jan 7Y Jan, 30Y Feb 10Y Jan 10Y or 15/30Y 1QItaly 30Y Jan and 15Y Mar 30Y Feb 15Y or 30Y 1QNetherlands (DDA) 30Y Feb, 10Y Mar 10Y Mar 5Y Mar 10Y FebPortugal 10Y, 30Y Jan 10Y Jan 7Y or 10Y Jan/FebSpain 10Y Jan 10Y Jan, 15Y Feb 10Y Jan, 30Y Mar 10Y and 15Y 1Q

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2Y Schatz in 2016: a lot more than repricing of easing expectations, with yield levels more driven by funding considerations 2Y Schatz yield and 2Y EONIA OIS with J.P. Morgan forecast; %

Short end: many moving parts, cap at -70bp

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-0.30

-0.20

Jan 16 Apr 16 Jul 16 Oct 16 Jan 17 Apr 17 Jul 17 Oct 17

2Y Germany 2Y OIS rate

forecast

The overall impact of ECB’s announced measures is quite ambiguous for the short end of the curve Drivers of short end of the curve and the likely impact on them from ECB’s announcements; Driver New information and impactExpectations about depo rate floor More hawkish ECB but unlikely to change monetary

policy trajectory for the next 2Y; small negative

Increase in excess liquidity driving repo GC-OIS spreads

Beginning of soft tapering earlier than expected at the margin small negative for 2Y

Changes to the ECB lending facilities More aggressive delivery than consensus; negative for 2Y

Removal of the depo rate floor with optionality Unclear how the optionality works but in general positive for 2Y

Source: ECB, J.P. Morgan

Schatz yield will likely be very close to the repo rate. The market rate, in turn, should be lower than -70bp to reflect the following, which should put a cap on Schatz yield Some probability that the €50bn w ill not be sufficient

Some probability of aggressiv e purchases of short dated bonds by the ECB

The fact that the new facility w ill not kick in unless the market repo rate is below -70bp

2017 outlook for slightly higher Schatz yields hinges on the assumption of effective measures to deal with repo problems

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Initiate long in Schatz outright as we see 2Y yields capped at -70bp but do not chase further outperformance in 5Y

How to track below depo purchases in Germany

1. The current list of ISINs published by the Bundesbank does not contain the four 2018 Schatz. The list gets updated on a weekly basis with a 1-week lag.*

2. The first Monday of the month the ECB publishes the average maturity of purchases by jurisdiction. The average maturity of the 1-31Y bucket is 7.9 years, that of the bonds above the depo rate is 12.6 years (conventionals only).**

List of ISINs published by the Bundesbank and the average maturity of monthly purchases in Germany can be used to track whether Germany is buying bonds trading below depo rate Ways to track below depo purchases in Germany

* Purchases by the ECB account for 10% of the total and monitoring is less relevant for scarcity and trading purposes.

** To be precise total weighted average maturity including inflation-linked, regional and agency bonds should be compared to the published number.

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Jan 16 Mar 16 May 16 Jul 16 Sep 16 Nov 16 Jan 17

Germany swap

impact of depo rate floor removal

The 5Y sector has repriced the removal of the depo rate floor; do not chase further outperformance 50:50 2s/5s/10s German and swap flies; par rates used; bp

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Securities lending: some central banks have added cash against collateral facilities; the devil in the detail

Source: ECB,NCBs, J.P. Morgan

Securities lending: The lack of standardisation is apparent Main details of securities lending programmes; based on available information as of 1 January

Securities lending programme through agent Bilateral lending

Cash for collateral (max €50bn) total Fails mitigation programme through

ECB Deutsche Bank - Deutsche Bank EuroclearGermany Clearstream (ASL, ASL+) under EMA under EMA ClearstreamFrance Euroclear under GMRA Euroclear as part of bilateral lendingItaly Clearstream (ASL, ASL+) - - ClearstreamSpain - under GMRA bilateral Iberclear (Spanish govts, CSPP),

Euroclear (Spanish agencies, supras)

Netherlands - under GMRA bilateral Euroclear, repo facility provided by DMO

Belgium - under GMRA bilateral Repo facility provided by DMOAustria BNP Paribas (PSPP, CBPP),

Deutsche Bank (SMP)- - ?

Finland Euroclear - Euroclear EuroclearIreland - under GMRA bilateral EuroclearPortugal Euroclear - - Euroclear

The up to €50bn cash for collateral scheme kicked in in mid-December but did not prevent a massive decline of repo rates into year-end. Germany’s European Master Agreement is not popular

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The market is pricing about 8bp of hikes by the end of 2018 and 25bp by the end of 2019: stay long greens EONIA EONIA curve, estimated deposit rate, and estimated probability of 10bp hike in deposit rate priced under the assumption that EONIA fixings will be 5bp above the deposit rate; %

Policy rates will remain on perma-hold: fade early tightening priced in at the front end of the curve by receiving greens EONIA

Greens EONIA are trading more than 20bp above the ECB deposit rate, a level exceeded only during the Bund VaR shock last year and the disappointment post the ECB meeting last December: we recommend longs in greens on attractive valuations and slide characteristics Spread between greens EONIA and ECB deposit rate and risk adjusted carry for longs in greens EONIA; since 1 Jan 2015; bp

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0.00.10.20.30.40.50.60.70.80.91.01.1

Jan 15 Apr 15 Jul 15 Oct 15 Jan 16 Apr 16 Jul 16 Oct 16

Risk-Adj. carry in Greens EONIA HV (lhs)Greens EONIA - depo rate spread (rhs)

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250%

300%

350%

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-0.10

Jan1

7

May

17

Jul17

Nov1

7

Jan1

8

May

18

Aug1

8

Oct1

8

Jan1

9

May

19

Jul19

Oct1

9

EONIA (lhs)Depo (lhs)Prob 10bp hike (floor -35bp) (rhs)

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10Y Bund valuation framework: vs. money markets The 10Y Bund QE premium is not large, consistent with soft tapering Estimated 10Y Bund QE premium*; bp

* Estimated as subset of the residual of Bund yields vs. money market reports. Model = -0.01*1Y Eonia OIS spot + 0.85*1Y Eonia OIS 3Y forward + 0.64; R*squared: 98%; January 2007 – current.

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Shifting Fed expectations have been well correlated with intermediate forwards on the German curve and will remain an important driver in 2017 5Y 5Y German forwards regressed against 1M forward USD OIS rate starting in December 2017; as of 22 November 2016; %

10Y Bund valuation framework: vs. global drivers German intermediate forwards have been tracking closely the US forwards until recently 5Y 5Y forward Germany regressed against 5Y 5Y forward US; par rates used; %

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0.4 0.6 0.8 1.0 1.2 1.4 1.61M US OIS rate starting in Dec17; %

y=1.25x + -0.32R2 = 79%

1.701.902.102.302.502.702.903.103.303.50

0.200.400.600.801.001.201.401.601.802.00

Jan 16 Mar 16 May 16 Jul 16 Sep 16 Nov 16

Germany 5Y 5Y US 5Y 5Y rhs

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The 10Y Bund is trading dear on our macro fair value models Residual from 1) 10Y Bund fair value macro model 1* (black line) and 2) 10Y Bund fair value macro model 2** (grey line); bp

10Y Bund valuation framework: vs. global drivers

If our forecasts are realised the modest pick up in core inflation and Brent prices will push the fair value higher in 1H17 J.P. Morgan Bund macro fair value model; bp unless stated

* 10Y Bund fair value macro model 1 = 0.02*Brent + 0.68*3M MA core HICP + 0.06*Euro area composite PMI – 4.5; R-squared: 84%

** 10Y Bund fair value macro model 2 = 1.71*5Y 5Y HICP + 0.77*3M moving average core HICP + 0.08*Euro area composite PMI – 1.72. Coefficients on core HICP and PMI from regression above.

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Jan 15 Apr 15 Jul 15 Oct 15 Jan 16 Apr 16 Jul 16 Oct 16 Jan 17

Beta T-stat Current 2Q17 fcst. 4Q17 fcst.

Brent ($) 0.02 69.4 56.9 61.0 53.0

3M MA core HICP (%oya) 0.57 11.9 0.80 1.01 1.09

Composite PMI (index) 0.07 12.3 54.4 54.0 54.0

Intercept -4.6 -14.4

Std. error (%) 0.24

R-squared (%) 86%

Fair value (%) 0.56 0.74 0.62

Spot (%) 0.27

Vs. spot (bp) 29

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Go short Bund vs. US Treasuries on valuations & supply in Euro and positions & weak seasonal activity in US

The 10Y US-Germany spread reached record wides before retracing: enter 10Y Bund shorts vs. US Treasuries 10Y US – German benchmark yield spread; bp

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1987 1992 1997 2002 2007 2012 2017

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10s/30s German curve has been strongly directional exhibiting a bull flattening/bear steepening dynamics: we expect this directionality to continue 10s/30s German curve regressed against 10Y Germany; par rates used; past 18M; bp

German curve: 10s/30s is no longer too flat vs. the level of 10Y but we keep steepener

10s/30s: expected supply pressures and carry support 10s/30s steepeners, RV no longer in favour

10Y is still cheap vs. 5Y and 30Y 50:50 5s/10s/30s German fly regressed against 10Y Germany; par rates used; past 2Y; bp

4045505560657075808590

-0.20 0.00 0.20 0.40 0.60 0.8010Y Germany; %

Latest

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-0.40 -0.20 0.00 0.20 0.40 0.60 0.80 1.00 1.2010Y German yield; %

Latest

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Our bias remains for a steeper curve: hold greens/15Y outright on carry and relative value considerations

Keep a medium term steepening bias and hold greens/15Y swap curve steepener which is attractive on RV and carry considerations Residual from regressing greens/15Y EUR swap curve against 2s/10s EUR swap curve; past 1Y; bp

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Jan 16 Apr 16 Jul 16 Oct 16 Jan 17

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Intra-EMU spreads Most intra-EMU spreads will tighten until 1Q17 but will then widen during most of 2017, reversing the multi-year tightening trend that started the with OMT announcement J.P. Morgan 10Y weighted peripheral spread to Germany fair value model*; bp

* J.P. Morgan 10Y weighted peripheral spread to Germany fair value model: - 25.5*Euro composite PMI + 21.6*3M MA Core-periphery PMI + 1532.0; R-squared: 84%. Regression period: Jan11-Jun14.

Source: Markit, J.P. Morgan

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2011 2012 2013 2014 2015 2016 2017

Actual Model

Forecast

GreeceGlobal risk-off

Out of sample

2017 outlook: 1) macro component gives neutral signal; 2) political risks, 3) tapering risks, will be the main drivers

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J.P. Morgan sovereign risk index* and its components; lower-than-average risk in grey;

Sovereign risk index: Spain tighter than Italy

* Calculated as weighted average of cross-sectional z-scores**; debt/GDP ratio accounts for 33% of the weight, other variables have equal weight. *** Sign adjusted so that negative number indicates lower-than-average risk. Model: 10Y spread = exp (2.0*sov. risk index + 4.2); R-squared: 68%. We exclude Greece while running the model. Source: IMF, Eurostat, EC, ECB, National Central Banks, World Economic Forum, Markit, J.P. Morgan

Core spreads are in general too tight whereas peripheral spreads are broadly cheap

Ireland in the periphery and the Netherlands in core offer the best value at current levels

The fair value spread between Italy and Spain is around 30bp (before taking other factors like political risk into account)

2017 debt (% of GDP)

2017 budget

balance (% of GDP)

Age-related expenditure in 2060 (%

of GDP)

Total private

debt/GDP (latest)

Bank reliance on

ECB funding (% of GDP)

Macro activity index**

Unemployment rate (latest)

2017 GDP per-capita (EU15=100)

2017 current account

balance (% of GDP)

Net international investment

position (latest, % of GDP)

Global competitiveness

index

Austria 81 -1.3 33 143 3 0.5 6.3 124 2.9 3 5.22Belgium 107 -2.3 34 231 3 0.3 8.0 114 0.6 61 5.25Finland 67 -2.5 36 172 2 0.4 8.6 117 -0.9 1 5.44France 97 -2.9 32 184 3 0.1 9.6 101 -2.3 -16 5.20Germany 66 0.4 31 106 2 0.8 6.0 115 8.7 49 5.57Netherlands 61 -0.3 30 234 2 0.6 5.7 123 8.0 64 5.57Greece 179 -1.0 27 125 41 -0.4 23.1 50 0.2 -135 4.00Ireland 74 -0.5 26 315 3 0.3 7.7 175 7.7 -208 5.18Italy 133 -2.4 28 115 11 0.2 11.5 83 2.5 -24 4.50Portugal 130 -2.2 30 192 12 1.0 10.8 55 0.8 -109 4.48Spain 100 -3.8 27 169 12 0.7 19.3 74 1.5 -90 4.68

Sov . risk index * 21-Nov Model bp %Austria -0.5 -0.3 0.8 -0.6 -0.5 -0.3 -0.8 -0.6 -0.1 -0.5 -0.4 -0.38 25 31 -6 -18%Belgium 0.2 0.5 1.2 0.8 -0.5 0.3 -0.5 -0.3 0.6 -1.1 -0.5 0.10 39 80 -41 -51%Finland -0.9 0.6 1.7 -0.1 -0.5 0.0 -0.4 -0.4 1.0 -0.4 -0.8 -0.26 22 39 -17 -43%France -0.1 0.9 0.5 0.1 -0.5 0.9 -0.2 0.1 1.3 -0.2 -0.4 0.14 44 88 -43 -50%Germany -0.9 -1.7 0.3 -1.2 -0.6 -1.0 -0.8 -0.3 -1.6 -1.0 -1.1 -0.91 - - - -Netherlands -1.1 -1.1 -0.1 0.9 -0.6 -0.5 -0.9 -0.6 -1.4 -1.1 -1.1 -0.79 16 13 2 18%Greece 2.2 -0.6 -1.0 -0.9 2.8 2.2 2.2 1.5 0.7 1.1 2.0 1.40 - - - -Ireland -0.7 -1.0 -1.3 2.2 -0.5 0.2 -0.5 -2.0 -1.3 1.9 -0.3 -0.41 71 28 43 151%Italy 0.9 0.5 -0.8 -1.1 0.2 0.5 0.2 0.6 0.1 -0.1 1.0 0.38 176 141 35 25%Portugal 0.8 0.4 -0.1 0.2 0.3 -1.5 0.0 1.3 0.5 0.8 1.0 0.48 343 172 172 100%Spain 0.0 1.7 -1.2 -0.2 0.3 -0.7 1.5 0.8 0.3 0.6 0.6 0.26 131 111 20 18%

Difference

Data

Sov ereign risk z-score***

Fiscal Banking/private credit Competitiveness/external sectorMacro

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Intra-EMU curve: limited RV opportunity on cross market basis

Cheapness of the short end and expensiveness of the long end of the peripheral spread curve have broadly corrected over the past monthResidual from regressing weighted spreads to Germany against 10Y weighted spread to Germany*; 1Y regression; bp

* e.g. 3Y weighted periphery spread to Germany regressed against 10Y weighted periphery spread to Germany, 3Y weighted core spread to Germany regressed against 10Y weighted core spread to Germany.

3Y 5Y 30YPeripheryCurrent -2 -1 -11M ago 12 9 -103M high 20 13 63M low -7 -3 -10

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Intra-EMU: trading recommendations Country selection:

The balance of risk favours Italy’s outperformance in the weeks after the 4 December vote if our political analysis proves correct.

We upgrade Greece to OW as we expect an agreement to be reached on second bailout leading to QE purchases in 1Q17. We also hold OW in Cyprus.

We remain underweight France and Netherlands on political risk but the risk reward is not as good as before.

Ireland remains the cheapest country from a fundamental point of view but we expect intermittent concerns about hard Brexit to temporarily reverse the tightening trend.

We expect relative Italy underperformance in the second part of the year on the back of ECB tapering and the proximity of the 2018 general elections.

Risk-on trades/biases: Long 2Y Spain vs. Germany Long 2Y Ireland vs. Germany Long 5Y Italy vs. Germany Long 5Y Cyprus Long 20Y Greece Long 7Y NRW vs. Germany

Risk-off trades: Short 2Y Italy vs. Spain Short 10Y France vs. Germany Long 7Y Belgium vs. France Long 4Y Finland vs. Netherlands Short 6Y and 25Y Netherlands vs. Germany Short 4Y Ireland vs. France Short 3Y France vs. KfW Short 8Y and 10Y Slovenia vs. Ireland Long 30Y Ireland vs. France Short 30Y Finland vs. Germany

26

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We recommend Mar17 Schatz OIS swap spreads widener on funding pressure and ECB buying below the depo rate

The changes to the PSPP lending facilities announced by the ECB at the December meeting did not prevent the development of funding pressure around year end with German RFR repo index EONIA specialness moving over 450bp Statistics of German RFR repo index specialness to EONIA around month end, quarter end and year end; bp

Fix ing (ex lbd of

each

Month End

Month end v alue ex quarter

Quarter End

Quarter End (ex

y ear end)Year End

Av erage 2013 -8 -13 -11 -16 -14 -22

Std dev 2013 2 4 2 4 1 -

Av erage 2014 -6 -15 -10 -26 -30 -14

Std dev 2014 4 13 6 16 17 -

Av erage 2015 -12 -16 -10 -28 -16 -65

Std dev 2015 4 15 3 21 3 -

Av erage 2016 -25 -65 -25 -146 -43 -455

Std dev 2016 13 118 10 179 14 -

Av g 2013-2015 -9 -15 -10 -24 -20 -34

Std dev 4 12 4 16 12 22

Av g 2013-2016 -13 -27 -14 -54 -26 -139

Std dev 10 64 9 105 16 183

RFR Germany Spread over EONIA

At the front end of the curve we expect Schatz OIS swap spread to remain supported above 35bp and would use the recent retracement as an opportunity to implement outright Mar17 Schatz OIS swap spread widener Front Schatz OIS swap spreads; past 3M; bp

25

27

29

31

33

35

37

39

41

43

45

Oct 16 Nov 16 Dec 16 Jan 17

35

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We expect ESM-related paying flows to support wider swap spreads but take tactically profit in Mar17 Bund OIS widener

10Y German b/m swap spreads are trading marginally wide in our fair value model vs. Bund yields and swaption volatility 10Y German b/m swap spreads regressed against 10Y German b/m yield, 3Mx10Y EUR swaption volatility and ECB QE dummy*; since January 2014; bp

Mar17 Bund OIS swap spread has widened sharply and is now close to the levels seen in the December contract going into the rolling period: we tactically take profit on Bund OIS swap spread widener Dec16 and Mar17 Bund OIS swap spread levels; bp

*ECB QE dummy as 1 for dates after 21 Jan 2015 and 0 before that

y = 6.40x2 - 15.56x +2.26 *(10Y swaption vol)

+9.70 *(QE dummy)+ 21.17

R² = 91%

0

5

10

15

20

25

30

-0.50 0.00 0.50 1.00 1.50 2.0010Y German benchmark yield; %

10

12

14

16

18

20

22

24

23-Nov-16 03-Dec-16 13-Dec-16 23-Dec-16 02-Jan-17

Dec16 Bund OIS

Mar17 Bund OIS

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Initiate Bund/Buxl OIS swap spread curve flattener as alternative to 10s/30s German b/m curve steepener

With the ECB expected to buy below the depo rate we expect much less support to wider swap spreads at the ultra long end of the curve and with likely heavy supply coming we recommend Bund/Buxl OIS swap spread curve flattener Front Bund/Buxl OIS invoice swap spread curve regressed against 1) 10s/30s German benchmark curve and 2) Dec16 Futures roll date dummy*; past 6M; bp

y = -0.57*(10s/30s) + 4.7*(Futures roll dummy*) + 37.61R² = 85%

-10

-5

0

5

10

15

40 50 60 70 80 9010s/30s German b/m curve; bp

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We recommend short gamma at the front end via 1Yx2Y

Our bullish front-end duration bias supports lower front-end implieds 1Yx2Y implieds regressed against 1) 1Yx2Y swap yield and 2) ECB dummy*; past 3M; bp/day

Short gamma in 1Yx2Y straddles offer large positive gamma carry 1Yx2Y implied vol and 1M and 3M delivered volatility of 6Mx2Y swaps; past 2Y; bp/day

*ECB QE dummy as 1 for dates after 8 December and 0 before that

y = 2.37*(1Yx2Y yield) - 0.16*(ECB Dummy*)+ 1.91R² = 88%

1.4

1.5

1.6

1.7

1.8

1.9

2.0

-0.20 -0.15 -0.10 -0.05 0.00 0.051Yx2Y swap yield; %

0

1

2

3

4

5

Jan 15 May 15 Sep 15 Jan 16 May 16 Sep 16 Jan 17

1Yx2Y implied vol1M delivered vol3M delivered vol

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Sell 112.40/112.30 Mar17 unhedged Schatz strangles

ECB’s PSPP lending facility has put a cap on Schatz yield at -0.70%. Sell 112.40/112.30 Mar17 unhedged Schatz strangle Front Schatz CTD spot yield and breakeven levels; past 6M; %

-1.00

-0.90

-0.80

-0.70

-0.60

-0.50

Jul 16 Aug 16 Sep 16 Oct 16 Nov 16 Dec 16 Jan 17

Upper breakeven: -0.65%

Lower breakeven: -0.90%

Cap on Schatz yield: -0.70%

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Buy 3Mx10Y gamma; close 2s/10s vol curve steepeners

Our bearish duration bias in the 10Y sector is supportive of higher 10Y implieds. Switch long gamma exposure from 2s/10s vol curve steepeners to outright long gamma in 3Mx10Y 3Mx10Y implied vol regressed against 10Y swap yield; past 6M; bp/day

y = 1.62x + 2.60R² = 87%

2.8

3.0

3.2

3.4

3.6

3.8

4.0

4.2

0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.9010Y swap yield; %

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Euro area: less QE, more reflation and political risk

US: Fed hikes & less easing from DM CBs

UK: Brexit, risk premia and reflation

Japan: challenges to Yield Curve Control

1

32

44

53

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Key 2017 themes The backdrop is likely to remain bearish for Treasuries in 2017: the Fed is likely to tighten twice, other DM

central banks are unlikely to ease aggressively as they did in 2016, and the fiscal balance is set to deteriorate further

However, the move to higher yields should pause temporarily: tightening in financial conditions leaves downside risk to growth in 1Q17, data tend to disappoint relative to expectations in the new year, and positions technicals are stretched to the short side

Ten-year yields should decline toward 2.45% early in the new year, before rising to 2.80% by year-end 2017

Budget deficits are on the rise, and Treasury supply will increase commensurately, but largely through T-bills in 2017. More near-term, debt ceiling dynamics will force T-bill supply to turn negative into 1Q17 . Demand technicals should remain mixed: we project modest increases to foreign and pension/insurance demand, but banks will likely take a step back

Next year, we expect core CPI inflation to firm from 2.2%q4/q4 in 2016 to 2.4% in 2017, while headline inflation should reach 2.3%

After a pause in 1Q17, we expect breakevens to move higher over 2017 as nominal yields, headline inflation, and oil prices rise and credit spreads tighten; we target 10-year breakevens to reach 225bp by mid-year and 230bp by year-end

Look for 2- through 10-year swap spreads to narrow, but 30-year spreads to widen Wider deficits, foreign reserve outflows, and prime fund flows are all a narrower; convexity flows are not

large enough to provide a real offset The contraction of VA liability durations are the crucial flow in the long end; pension fund receivers and

deficit expectations are only a partial offset

We expect short-dated volatility to remain elevated, and the tail curve to steepen

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We expect the Fed to tighten twice next year and little further easing from other DM CBs, leaving room for Treasury yields to rise in 2017

Distribution of investor responses to the following question in our J.P. Morgan US Fixed Income Markets Investor Survey: “How much additional Fed tightening do you expect in 2017?”; %

Average G7 ex-US policy rate versus G7 ex-US 1y3m OIS rates*; %

Source: J.P. Morgan * GDP weighted Source: J.P. Morgan

Large-scale non-traditional easing from other DM central banks was a support for Treasuries in 2016, and that is unlikely to be the case in the coming year

Markets should be less hesitant to price in Fed tightening, given rising realized inflation, expectations of expansive fiscal policy, and the composition of the FOMC is likely to turn less dovish in future years

1%

32%

40%

21%

5%

0%

10%

20%

30%

40%

50%

None 25bp 50bp 75bp 100bp ormore

-0.4

-0.2

0.0

0.2

0.4

0.6

Nov 11 Nov 12 Nov 13 Nov 14 Nov 15 Nov 16

Policy rate

1y3m OIS rate

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We expect rising inflation and budget deficit expectations to prevent the long end from flattening materially over the next year

Rolling 3-year partial beta with respect to 5yx5y inflation swap rates in our 10-year Treasury fair value model*

Rolling 2-year partial beta of 10s/30s Treasury curve with respect to 1-year ahead budget deficit expectations ($bn), after adjusting for 2y3m OIS rates (%) and 5y5y TIPS breakevens (bp)

Source: Blue Chip Economics, J.P. Morgan

Treasury yields remain sensitive to inflation expectations, and further widening in TIPS breakevens should bias yields higher, particularly after 1Q17

We expect the Fed to tighten in December and twice in 2017, but with inflation expectations likely to rise further and budget deficit expectations increasing, we think there will be limited room for the curve to flatten at the long end over the coming year

* Our 10-year fair value model regresses 10-year Treasury yields on 5yx5y inflation swap rate (%), 1y ahead consensus growth forecast (%), 1yx3m OIS rate (%), Fed forward guidance (months), G7 ex-US avg 1yx3m OIS rate (%), and CFTC positions (3y z-score)

Source: J.P. Morgan

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

Nov 11 Nov 12 Nov 13 Nov 14 Nov 15 Nov 16 -0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

Nov 01 Nov 04 Nov 07 Nov 10 Nov 13 Nov 16

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Investors expect a more outsized move to higher yields in 1H17, while we think economic data could disappoint early in the year…

Distribution of investor responses to the following question in our J.P. Morgan US Fixed Income Markets Investor Survey: “Where do you expect 10-year yields to be at the end of 2Q 2017?”; %

Economic Data Surprise Index (EDSI) in six months following year-end, average of the last five years; unitless

Source: J.P. Morgan

Nearly half of the investors we surveyed see 10-year yields above 2.50% by mid year

Over the near term, the recent tightening in financial conditions poses some downside risk to our 1Q17 GDP forecast. Moreover, data tend to disappoint relative to expectations early in the year

Source: J.P. Morgan

3% 5%

10%

35%

47%

0%

10%

20%

30%

40%

50%

<1.75% 1.75% -1.99%

2.00% -2.24%

2.25% -2.49%

2.50% orhigher

-0.15

-0.10

-0.05

0.00

0.05

0.10

0 1 2 3 4 5 6Months after year-end

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…and coupled with stretched position technicals, this suggest yields could fall in 1Q17

Rolling 1y z-score of non-commercial longs in ED and UST futures, 10y UST yields, and 3m carry on 10y UST, around local troughs and peaks in 10y UST yields prior to large sell offs* and large rallies**

Non-commercial net longs in ED and UST futures around local troughs** and peaks*** in UST yields before a sharp reversal in Treasury yields, rolling 1-year z-score

Source: CFTC

Investor positions remain significantly shorter than their average over the last year. Using recent history as a guide, this suggests Treasury yields could decline in the coming months

* Yield trough dates used: 7/24/12, 5/2/13, 4/17/15, 7/8/16 ** Yield peak dates used: 3/19/12, 12/31/13, 9/18/14, 5/18/16 Source: CFTC, J.P. Morgan

Yield trough

CFTC positions, 1y zscore

10y yield, 1y zscore

10y UST carry, 1y zscore

Next 3m yield move

24-Jul-12 2.2 -2.2 -2.1 3602-May-13 0.7 -0.7 -0.2 10917-Apr-15 2.4 -1.7 -1.9 5008-Jul-16 1.5 -2.6 -2.3 38

Avg 1.7 -1.8 -1.6 58

-2.0

-1.5

-1.0

-0.5

0.0

0.5-0.5

0.0

0.5

1.0

1.5

2.0

-20 -10 0 10 20 30 40

Troughs

Peaks

Yield peak

CFTC positions, 1y zscore

10y yield, 1y zscore

10y UST carry, 1y zscore

Next 3m yield move

19-Mar-12 -0.7 -0.1 -0.3 -7931-Dec-13 -1.6 1.6 1.4 -2018-Sep-14 -0.7 -0.1 -0.3 -453-Dec-15 -2.4 1.2 0.8 -42

18-May-16 -0.8 -1.0 -0.1 -32Avg -1.2 0.3 0.3 -44

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Our interest rate forecast projects yields moving lower in 1Q17 before rising over the rest of the year, with the 2- to 5-year underperforming

J.P. Morgan Interest Rate Forecast; %

Actual 1m ahead 1Q17 2Q17 3Q17 4Q1716 Dec 16 16 Jan 17 31 Mar 17 30 Jun 17 30 Sep 17 31 Dec 17

Rates (%)Effective funds rate 0.66 0.65 0.65 0.90 0.90 1.153-mo LIBOR 0.99 1.05 1.05 1.25 1.30 1.502-yr Treasury 1.25 1.30 1.15 1.45 1.60 1.803-yr Treasury 1.59 1.60 1.40 1.75 1.90 2.105-yr Treasury 2.06 2.10 1.85 2.10 2.25 2.407-yr Treasury 2.40 2.45 2.25 2.45 2.60 2.8010-yr Treasury 2.60 2.65 2.45 2.60 2.70 2.8530-yr Treasury 3.18 3.20 3.05 3.15 3.25 3.35Spreads (bp)Fed funds/3m Libor 33 40 40 35 40 35Fed funds/2yr 59 65 50 55 70 652s/10s 134 135 130 115 110 1052s/5s 81 80 70 65 65 605s/10s 53 55 60 50 45 455s/30s 112 110 120 105 100 952s/30s 193 190 190 170 165 155

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We expect both core and headline CPI inflation to firm in 2017, and we think risks around our forecast are biased to the upside

Year-over-year % change in headline CPI (nsa) and projection for 11/16-12/17 based on our inflation swap curve; %

Blue Chip Consensus forecast for average year-over-year % change in headline CPI 6-10 years forward versus dispersion in the forecasts*; both axes %

Source: BLS, J.P. Morgan * Dispersion is calculated as the top 10 average minus the bottom 10 average forecast

Source: Blue Chip Economic Indicators

We expect core CPI will firm from 2.2% (q4/q4) in 2016 to 2.4% in 2017, while we think headline CPI inflation will rise to 2.3% (q4/q4) in 2017

The potential for fiscal expansion and more-restrictive trade policies add upside risk to our forecasts. We think inflation risk premium should be biased higher

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

2.1

2.2

2.3

2.4

2.5

2.6

2003 2005 2007 2009 2011 2013 2015

Longer-term inflation forecast

Dispersion

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Jan 17

Projected

40

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We expect demand for TIPS to be strong next year Weighted expected change in exposure* for various asset classes according to our J.P. Morgan US Fixed Income Markets 2017 Outlook Survey

Foreign holdings of TIPS (left axis; $bn) versus holdings as a percentage of TIPS outstanding (right axis; %)

* To calculate the weighted expected change in exposure for each asset class, we assigned values of 1, 0, and -1 to responses of add, maintain, and reduce exposure, respectively, and then we summed the values and divided by the number of responses. We then scaled the values for each asset class by the percentage of non-N/A responses for that asset class. See Cross Sector Overview for more details. Source: J.P. Morgan

* Source: US Treasury, Treasury International Capital System

Our 2017 Outlook Survey of investors indicated a clear preference to add exposure to TIPS next year

Although we think retail demand may moderate, we think foreign demand for TIPS will remain strong

0.20

0.14 0.140.08

0.03 0.03 0.02 0.02 0.01

-0.03 -0.03-0.04

-0.13-0.14-0.2

-0.1

0.0

0.1

0.2

TIPS

IG C

orpo

rates

Equit

ies

Comm

oditie

s

Agen

cy M

BS EM ABS

High

Yiel

d

CMBS

Cash

Agen

cy de

bt

Non-

agen

cy M

BS

Dura

tion r

isk

Trea

surie

s

168206

289

342

431

508

25%

30%

35%

40%

45%

50%

50

150

250

350

450

550

2010 2011 2012 2013 2014 2015

Foreign holdings

% of TIPS outstanding

41

2 0

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We expect breakevens to move higher over 2017 as nominal yields, headline inflation, and oil prices rise and credit spreads tighten

Statistics for our fair value model for breakevens*

Level of 1-month forward breakevens and 1-month forward real yields as of 12/15/16, breakeven targets*, and real yield levels based on those targets; units as indicated

* Model is 1-month forward breakevens* (bp) regressed against closest-maturity on-the-run Treasury yields (bp), 1-year moving average of year-over-year headline CPI (nsa), lagged 1 month (bp), JULI (our high grade credit index) portfolio spread to Treasuries (bp), and the 3-month percent change in rolling front Brent oil futures contract prices (%); model uses daily data over the past three years. We use 1-month forward breakevens to mitigate the effects of near-term carry Source: BLS, J.P. Morgan

* Targets for breakevens use our model for breakevens and our forecasts for the underlying variables. Our targets for real yields are based on our nominal yield forecasts and breakeven targets Source: J.P. Morgan

5Y 10Y 30YTsy yields (bp) Beta 0.24 0.39 0.32 T-stat 9.6 49.4 65.3Avg YoY CPI (bp) Beta 0.07 0.12 0.11 T-stat 4.3 13.0 15.0High grade spd (bp) Beta -0.60 -0.34 -0.34 T-stat -17.1 -17.5 -22.5Chg in Brent oil (%) Beta 0.28 0.16 0.06 T-stat 9.7 10.6 5.4Intercept (bp) 214 142 148R-sq 82% 95% 97%Std error (bp) 11.1 6.1 4.7

Breakevens (bp)5Y 182 180 210 215 20010Y 194 200 225 230 23030Y 205 210 230 235 235Real yields (%)5Y 0.20 0.05 0.00 0.10 0.4010Y 0.66 0.45 0.35 0.40 0.5530Y 1.13 0.95 0.85 0.90 1.00Curves (bp)5s/10s BE 12 20 15 15 3010s/30s BE 11 10 5 5 55s/10s yld 46 40 35 30 1510s/30s yld 47 50 50 50 45

3Q17 target

4Q17 target

Current level

1Q17 target

2Q17 target

42

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FX reserve outflows, deficit expectations, prime fund flows and issuance-receiving point to narrower front-end & intermediate spreads

Over the long run, budget expectations and EM FX performance are the most important drivers of 10-year swap spreads

Structural changes in the composition and size of actively hedged mortgages reduce the impact of convexity-related flows

Note: 3-month change in the J.P. Morgan Agency MBS index in years. JULI financials subcomponent spread to Treasuries for fixed-rate high-grade corporates. From the Blue Chip consensus survey Using the EMCI index. Source: J.P. Morgan, Blue Chip Economic Indicators

Fair value model for 10-year matched maturity swap spreads; units as indicated

Change in mortgage dollar duration for various dynamic hedgers during the taper tantrum, 2015 VaR shock, over the period from 9/30/16 to 12/15/16, and in a 100 bp further sell-off from current levels; $bn of 10-year equiv.

Note: Banks are modeled using the composition of the J.P. Morgan Agency MBS Index, assuming 15% of their dynamic duration is actively hedged with swaps. GSE retained portfolios assume the index composition as of 2009, with passive paydowns and reinvestment into the current coupon to match reported holdings. REITs are based on coupon, tenor, and spec pool concentrations from AGNC investor presentations, grossed up to the overall size of REIT holdings of agency MBS. The MSR asset is modeled as a 30 bp IO strip off of the index, weighted by the fraction of overall servicing rights owned by the largest four banks. For the taper tantrum we use 5/2 to 7/5/13, for the 2015 VaR shock we use 4/3 to 6/10/15. The 100 bp shock is applied as a parallel shift to the swap yield curve as of 12/15/16. Source: J.P. Morgan, FHLMC, FNMA, Inside Mortgage Finance, Company filings.

CurrFactor Coeff T-stat Coeff T-stat ValueIntercept -97 -75.2 136 72.7JULI financial sprds; bp 0.077 47.9 -0.044 -18.8 157.601Y ahead budget surplus; $bn 0.046 95.0 -0.047 -66.6 ($561)3m chg in mtge durations; yrs 1.60 6.8 -1.47 -4.3 0.63EM FX ccy index 1.45 101.1 -1.68 -80.4 68.57R-squaredStd. error

Swap spreads Treasury/OIS

87%8.5

80%12.4

0

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150

200

250

300

350

400

Taper tantrum 2015 VaRshock

Since 9/30/16 50 bp sell-off 100 bp sell-off

Banks GSEs REITs Servicers∆10Y: 115 bp∆MBS dur: 1.9 yrs

∆10Y: 61 bp∆MBS dur: 1.0 yrs

∆10Y: 102 bp∆MBS dur: 1.6 yrs

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At the long end, contracting VA liabilities should drive a structural widening in swap spreads

Though other factors have dominated at times, VA hedging is once again the most important driver in long-end swaps…

…though other factors provide an offset, this flow should dominate, and we look for a structural richening of 30Y spreads

* Based on a rolling 5-year regression of 30-year matched-maturity swap spreads versus variable annuity liability durations ($bn; X1), 10s/30s Treasury yield curve (bp; X2), 3-month pace of Fed purchases of 10-year and longer maturity Treasuries ($bn; X3), and the funded ratio of the 100 largest defined benefit pension plans (unitless; X4). The most recent regression result is shown in Exhibit 42. Source: J.P. Morgan, FRB, Milliman

Rolling partial beta of 30-year matched-maturity swap spreads versus variable annuity liability durations, adjusted for other factors*; bp per $bn 20-year equivalents

Fair value model for 30-year matched-maturity swap spreads; units as indicated

Note: Based on a 5-year regression. DB pension funded ratios from Milliman data, with most recent reporting as of November 2016. 16Q4 forecasts also include an adjustment to account for somewhat slower reversion to fair value. * Budget adjustment taken from our expectations for the 1-year forward deficit combined with the partial beta from a longer-run regression model (see discussion in 2017 Outlook). † Long-end supply adjustment assumes some of the contraction in VA liability durations is offset by financial issuance in that sector. We assume 25% of their gross issuance of benchmarks in 2017 will have 30-year initial maturities. This is further assumed to be a cumulative effect. Source: J.P. Morgan, Milliman, FRBNY, Blue Chip Economic Indicators

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

09 10 11 12 13 14 15 16

PRDC flows

QE purchases

Factor Coeff T-stat Curr 16Q4 17Q1 17Q2 17YEIntercept 229 24.9VA liability duration; $bn 20Y equiv -0.7 -50.3 200 208 212 206 19310s/30s Treasury curve; bp -24.06 -13.4 0.58 0.75 0.70 0.70 0.803M Fed puch of 10-30Y Tsy; $bn 0.20 9.9 0.0 0.0 0.0 0.0 0.0DB pension funded ratio; % -119 -14.4 0.81 0.79 0.79 0.80 0.82R-squared; %Std. error; bpCurrent levelFair value -25.6 -26.4 -23.3 -19.6Budget deficit expansion adjustment* 1.8 4.0 6.3 7.8Long-end supply adjustement† 0.0 2.6 5.1 10.3Forecast -37.3 -33.0 -34.7 -37.7

Forecast

85%6.7

-43.2-18.3

Drivers

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Euro area: less QE, more reflation and political risk

US: Fed hikes & less easing from DM CBs

UK: Brexit, risk premia and reflation

Japan: challenges to Yield Curve Control

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Summary UK views Brexit timetable: Article 50 trigger by end March 2017, but Supreme Court ruling adds uncertainty on timing

No clear negotiating stance from UK government but looks like will push for a bespoke free trade agreement with the EU

WTO a dangerous last resort option

Transition state needed - exact transitional arrangement is key for evaluating the medium term impact on the UK economy and also the market read across

Expect UK 2017 GDP at 1.3%oya, but CPI close to 3% over 2H17 – BoE to remain on hold

Bearish gilt yields over the medium term – target 1.65% mid 2017 and a steeper 2s/10s gilt curve

1

4-Jan 1Q17 2Q17 3Q17 4Q172Q v s. fw d; bp

4Q v s. fw d; bp

Bank Rate 0.25 0.25 0.25 0.25 0.25 - -3M LIBOR 0.37 0.40 0.40 0.40 0.40 - -2Y 0.13 0.20 0.20 0.25 0.25 6 -125Y 0.51 0.75 0.80 0.80 0.80 6 -1710Y 1.32 1.55 1.65 1.70 1.70 15 530Y 1.96 2.25 2.40 2.45 2.45 35 352s/5s; bp 38 55 60 55 55 -1 -42s/10s; bp 119 135 145 145 145 9 185s/10s; bp 81 80 85 90 90 10 225s/30s; bp 145 150 160 165 165 29 5210s/30s; bp 64 70 75 75 75 19 30

We expect 10Y gilt yields to increase more than priced by the forwards with the 2s/10s curve bear steepening over 1H17 J.P. Morgan gilt yield forecasts; % unless stated

2016 2017 Chg. 2016 2017 Chg.IMF 0.7 2.5 1.8 1.8 1.1 -0.7European Commission 0.7 2.5 1.8 1.9 1.0 -0.9Bank of England* 1.3 2.7 1.5 2.2 1.4 -0.8Average 0.9 2.6 1.7 2.0 1.2 -0.8J.P.Morgan 0.7 2.6 1.9 2.1 1.3 -0.8

CPI GDP

We have a close to consensus view on UK growth and inflation over 2017 J.P. Morgan forecasts for CPI (annual averages) and GDP; %oya

* 4Q16 and 4Q17 modal inflation projections based on market interest rates.

Sources: IMF, EC, BoE, .P. Morgan

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The Brexit process – it’s only just begun

The exact transition arrangement key in evaluating the possible macro and market impact of Brexit negotiations J.P. Morgan estimated Brexit transition paths

Brexit process will continue to be a key driver of UK rate markets not just next year but likely for many years to come

Our bird’s eye view is that episodes of Brexit-related event risk can roil both GBP rate and currency markets in 2017 and that risk premia in intermediate gilts needs to be larger to compensate for the significant Brexit uncertainty.

This will likely intensify around the Article 50 trigger and the start of the two-year ticking clock deadline:

Supreme Court Ruling on Article 50 trigger due January

PM May expected to outline Brexit roadmap in coming weeks and trigger Article 50 by end of March

Exact transitional arrangement is key for evaluating the medium term impact on the UK economy and also the market read across

Hard vs. soft Brexit definitions vague

Stage 1 Stage 2 Stage 3

Process starts Transition Stage Endgame1Q17 2019-2025? 2025 - 2030?

A50 deadline extension

Article 50 Trigger

Smooth transition Bespoke FTA

(e.g. EEA, Single Market member)

Rocky transition(e.g. sector deals,

limited Single Market membership, WTO

only )

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Bearish on 10Y yields – target 1.65% 2Q17

* 2013 taper tantrum: 22 May 13 – 25 Jun13; 2015 Bund VaR shock, 20 Apr 15 – 13 May 15; EU referendum, 23 Jun 16 – 23 Aug 16; Oct16 sell-off, 28 Sep 16 – 27 Oct 16; US election 4 Nov 16 – current

Past 3Y2013 Taper

tantrum2015 Bund VaR shock

EU referendum

Oct16 Sell-off

US election

2Y -0.7 1.3 1.3 0.1 1.3 0.95Y 2.1 1.1 1.0 0.0 1.8 0.510Y 1.6 1.1 1.0 0.3 2.0 0.630Y 1.3 0.7 0.5 1.1 1.4 0.55Yx 5Y 1.2 1.0 1.1 0.7 2.1 0.615Yx 15Y 1.2 -0.1 0.2 1.6 1.0 0.42Y 27% 75% 74% 2% 49% 86%5Y 71% 92% 89% 0% 60% 88%10Y 94% 93% 92% 2% 84% 84%30Y 90% 92% 76% 17% 93% 83%5Yx 5Y 96% 91% 91% 9% 91% 81%15Yx 15Y 74% 7% 35% 53% 82% 86%

Beta

R-s

quar

ed

Aside from the months following the UK's EU referendum, 5Y+ gilts have generally exhibited strong correlation with USTs, although with differing betas; we expect the evolution of US rates to continue to be a background driver for gilt yields over 2017 Beta and r-squared from regressing UK par gilt yields vs. benchmark UST yields over the past 3 years and around selective historical events*

10Y and 30Y gilt yields remain rich on our long-run regression model; we have a bearish view on 10Y yields Residuals from regressing* 1) 10Y gilts vs. 10Y UST and (2Yx1Y GBP OIS – 2Yx1Y USD OIS) and, 2) 30Y gilts vs. 30Y UST and (2Yx1Y GBP OIS – 2Yx1Y USD OIS), May 07 – Jan17; bp

* 10Y par gilt = 0.96 * 10Y UST + 0.64 * (2Yx1Y GBP OIS – 2Yx1Y USD OIS) – 0.02. R-squ: 98%, std. error: 18bp 30Y par gilt = 0.72 * 30Y UST + 0.57 * (2Yx1Y GBP OIS – 2Yx1Y USD OIS) + 0.78. R-squ: 89%, std. error: 27bp

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150

May 07 May 09 May 11 May 13 May 15

10Y 30Y

10Y current = -7bp

30Y current = -26bp

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Market risk scenarios around Brexit process We think gilts need to price additional risk premia for the uncertainty around the Brexit process following a likely Article 50 trigger in 1Q17; despite the post US election sell-off we think risks to 10Y yields from Brexit remain to the upside Estimated impact on 10Y gilt yields and 5Y inflation breakevens due to the UK government following various Brexit transition paths

'Smooth' Transition 'Rocky ' Transition No TransitionArticle 50 trigger Transition State

Single Market membership preserv ed for goods and serv ices

Sector specific Single Market membership transition - increased uncertainty for serv ices

No transition agreement - UK shifts to WTO framew ork in 2019

Inflation profile CPI peaks close to 3% in 2017CPI rises to 3% in 2017 but modest upside risks from currency w eakness

CPI rises to 3% in 2017; large upside risks from ongoing currency w eakness

Grow th profileNo confidence shock impact on GDP in 2018/2019, stable FDI

Increased risks of dow nside grow th shock in 2018/2019 small FDI/asset outflow

Very large grow th shock in 2018/2019, significant potential for FDI/asset outflow

BoE policy trajectory On hold On hold - shift to easing bias? Easing - rate cut, more QEChg. 10Y y ields - current to 2Q17

10-15bp higher 20bp higherUncertain - higher on currency mov e v s. low er on future grow th shock/BoE QE

Chg. 5Y BE - current to 2Q17

Unchanged 15bp higher 25bp higher

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Evaluating Brexit risk premia 10Y gilt – 10Y UST spread in both outright terms and adjusted for the level of money market spreads currently looks too narrow compared to previous periods of UK political stress; we target a 15-20bp underperformance of 10Y gilts vs. 10Y UST 10Y par gilt vs 10Y UST yield spread and money market adjusted 10Y par gilt vs 10Y UST yield spread* around selected periods of key political and monetary policy periods; shaded shows key UK political risk events; bp

Fin. Crisis

QE 12010

Election2014 Scottish Referendum

2015 General election

EU referendum

Current - post US election

Mar 08-Feb 09

Mar 09 - Jul 09

Jan 10 - May 10

Aug 14 - Sep 14

Apr 15 - Jun 15

23 Jun 16 - 23 Aug 16

8 Nov onw ards

Min 43 -7 14 -11 -33 -98 -80Max 139 75 53 19 -14 -28 -61Av erage 96 34 37 2 -22 -62 -73

Min -12 -50 -9 -9 -9 -44 -38Max 96 68 47 11 7 -4 -16Av erage 29 -11 25 0 1 -23 -22

10Y UK - 10Y US yield spread

Adjusted 10Y UK - 10Y US yield spread*

* Residual from regressing 10Y par gilt spread -10Y UST spread vs. 0.75*(2Yx1Y GBP OIS – 2Yx1Y USD OIS) from Nov07 – Nov16. R-squ: 75%, std. error: 21bp

10Y gilt -10Y UST spread in outright terms and adjusted for relative money market rates as a measure of risk premia

In periods of increased political risk and uncertainty, particularly in the run-up to the 2010 UK general election, the level of both the outright and adjusted 10Y UK - 10Y US spread has been wider on average than seen currently

15-20bp of relative widening in the adjusted 10Y gilt-10Y UST spread would reflect a reasonable amount of UK specific risk premia

However, we don’t expect the adjusted 10Y gilt - 10Y UST spread to move all the way back to levels seen around the 2010 general election, given we expect US money market yields to rise faster than GBP money market yields

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1Yx1Y/15Y GBP steepeners as 2s/10s proxy

* 3M carry and slide for curve steepeners

Curv e*

(leg1/leg2) Leg 1 Leg 2 Beta R-squ Outright Beta-adj

10Y - 100% 1.0 100% -5.9 -5.9

8s/12s 78% 100% 0.2 83% 0.8 4.1

20s/30s 72% 100% 0.2 93% 0.9 3.5

15s/30s 62% 100% 0.4 94% 1.0 2.7

9s/15s 68% 100% 0.4 92% 1.0 2.6

10s/30s 46% 100% 0.6 94% 1.3 2.4

10s/15s 75% 100% 0.3 90% 0.6 2.1

10s/20s 63% 100% 0.4 93% 0.6 1.5

8s/15s 59% 100% 0.5 96% 0.3 0.6

15s/20s 84% 100% 0.2 95% 0.1 0.5

5s/30s 23% 100% 0.8 97% -0.3 -0.3

12s/20s 64% 100% 0.5 90% -0.2 -0.4

7s/20s 45% 100% 0.6 97% -0.6 -1.0

Risk w eight v s. 10Y y ield** 3M C+S***

Cash-neutral curve steepeners are a carry-efficient way to express a short 10Y duration view Selected cash-neutral gilt curves, statistics from regressing against 10Y yields and outright and beta-adjusted carry and slide; sorted by beta-adjusted carry and slide; bp

We recommend expressing a 2s/10s steepening view via 1Yx1Y/15Y swap curve steepeners given slightly more attractive carry and slide characteristics Statistics from regressing selected swap curves vs. 2s/10s over the past 6M and outright and beta-adjusted 3M carry and slide for steepeners.

* Bonds used: 2Y - 1Q18, 3Y - 3T19, 4Y – 3T20, 5Y – 3T21, 6Y – 1T22, 7Y – 2Q23, 8Y – 2T24, 9Y – 2s25, 10Y - 1H26, 12Y - 4Q27, 15Y - 4Q32, 20Y - 4Q36, 25Y - 4Q42, 30Y - 4Q46. ** Regression over the past 6M. *** 3M outright and beta-adjusted carry and slide for steepener

Weight short leg

Weight long leg

Beta R-squ 3M C+S*Beta Adj

C+S1s/5s -100% 100% 0.95 97% -2 -2

2s/5s -100% 100% 0.64 98% -1 -1

2s/10s -100% 100% 1.00 100% 0 0

3s/10s -100% 100% 0.74 99% 1 1

3s/15s -100% 100% 0.80 98% 2 3

3s/20s -100% 100% 0.80 97% 3 4

3s/30s -100% 100% 0.75 93% 4 5

1Yx 1Y/10Y -100% 100% 0.69 98% 1 2

2Yx 1Y/10Y -100% 100% 0.20 57% 2 10

1Yx 1Y/15Y -100% 100% 0.75 97% 2 3

2Yx 1Y/15Y -100% 100% 0.27 59% 3 13

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Hold 10s/30s gilt curve steepeners into heavy 1Q17 supply

Upcoming conventional gilt supply is heavy and skewed to the long end of the curve Conventional gilt issuance expressed in 10Y equivalent terms, quarterly data, dashed line is forecast; £bn

We expect the limited directionality of the 10s/30s GBP curve with the level of yields to continue R-squared from regressing 10s/30s par gilt curve and 10s/30s GBP swap curve vs. different drivers in single factor regressions over the past 6M and past 12M; %

8%

19%

43%

5%2%

12%

2%

13% 13%

6%

12%

26%

0%

10%

20%

30%

40%

50%

vs 10Y vs. 30Y vs. 10s/30sUS

vs. 10Y vs. 30Y vs. 10s/30sUS

Past 12M

Past 6M

10s/30s par gilt 10s/30s GBP swap

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60

1Q12 1Q13 1Q14 1Q15 1Q16 1Q17

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Inflation - short 10Y UK RPI vs. 10Y US CPI

Despite the recent correction, the 10Y UK RPI - 10Y US CPI spread is at rich levels historically; we recommend shorts in 10Y UK RPI vs. 10Y US CPI given our medium term bearish view on 10Y UK breakevens 10Y UK RPI – 10Y US CPI spread; past 10Y, bp

RPI swaps are modestly rich vs. our 2018 RPI forecast; we are neutral on front end breakevens J.P. Morgan forecasts for average CPI, core CPI and RPI inflation %oya

10Y and 5Yx5Y RPI rich historically and given medium term downside growth risk from Brexit

We see more value in expressing a medium term bearish view on 10Y RPI swaps on a cross market basis vs. 10Y US CPI swaps, to hedge against the global reflation dynamic

3.0

3.4

3.1

3.6

2.5

2.8

3.0

3.3

3.5

3.8

2017 2018

Forecast RPI swap curve

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Euro area: less QE, more reflation and political risk

US: Fed hikes & less easing from DM CBs

UK: Brexit, risk premia and reflation

Japan: challenges to Yield Curve Control

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Executive Summary：challenges to Yield Curve Control

Rates 17-1Q 17-2Q 17-3Q

17-4Q

IOER -0.10% -0.10% -0.10% -0.10%

JGB5y -0.15% -0.10% -0.10% -0.05%

JGB10y 0.00% 0.05% 0.10% 0.10%

JGB20y 0.50% 0.55% 0.65% 0.80%

JGB30y 0.65% 0.70% 0.80% 0.95%

JGB market key points

BoJ introduced “QQE with Yield Curve Control”.

Regime change from “Amount” to “Yield”

YCC has been such a powerful instrument, governing the JGB market so far

Negative yield policy will continue at least 3-4yrs.

Where is the “implicit” target for super-long yield?

Policy direction of the BoJ post-Kuroda

JGB Bearish factors

Uncertainty of BoJ policy

JGB Bullish factors

Extremely expensive USD funding cost

Tight supply-demand

Source J.P. Morgan

Executive Summary

Our Forecast for 2017: We don’t think the BoJ has an

intention to change their target at least until the 2H 2017.

Going into 2H 2017, as Governor Kuroda's term draws to an end, maybe we can expect some more changes in the policy regime leading to a rise in volatility.

Concerns over the BoJ post-Kuroda may prevail

JPM Economist Forecast ： No additional easing in 2017/18

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Looking back at JGB market in 2016

One-man show by BoJ: An eventful year with number of game-changing regimes introduced by the BoJ

January: Introduction of Negative Interest Rate Policy (NIRP)

We started the year with yield of 0.265%, but the balance was soon disrupted after the introduction of Negative Interest Rate Policy (NIRP) in January. 10y yield declined by 20-30bps to negative territory.

July 29th : Announcement of Comprehensive Assessment of QQE

After 10yr yield hovered around 0~-10bps for several months, it further declined to -20~-30bps in June/July with anticipation for further rate cut.

However, the market was surprised once again, when the BoJ announced they will conduct a “Comprehensive Assessment of QQE”, postponing further monetary expansion at the July BoJ meeting.

As a result, 10yr yield rallied back to 0~-10bps. Series of events from the introduction of NIRP to announcement on comprehensive assessment had more impact on the market than QQE1 or QQE2.

September: QQE with Yield Curve Control (YCC)

At the September meeting, the BoJ announced the long waited “Comprehensive Assessment” and its by product, QQE with Yield Curve Control, not a further rate cut. As a result, 10yr yield has been set a target of 0bp, and since then it hasn’t broken out of -10~+10bps range.

10yr and 20yr JGB yield since 2012

Source J.P. Morgan

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1H 2017= the BoJ will probably maintain their current policy, 2H= some actions are expected

Shifting away from excessive monetary expansion

Global

Both “GFSR” by IMF and G20 alarmed us of the risks associated with excessive monetary expansion

U.S.

Under Republican government, it is likely that the Fed will gradually become more hawkish

EU

The possibility of an addition monetary expansion has subsided. Draghi commented on the side effects of NIRP. The ECB may start raising rates earlier than expected.

The ECB decided to reduce purchase amount from €80bn to €60bn/month in Dec 2016.

Japan

As YCC became more effective on higher global rates, the current regime will likely be kept

BoJ’s Financial System report pointed out the risks of deterioration in the banks’ profitability constraining their risk-taking activities and their proactive financial intermediation

Global Economy Outlook

Positives:

Expectation for fiscal expansion in the U.S.

Potential growth rate may rise on the back of monetary expansion

Negatives:

Uncertainties in E.U.

Slowdown in EM economies with the rise of protectionism in the U.S.

Geopolitical risks under President Trump

Potential growth rate may rise on the back of monetary expansion

Economy after breaking away from excessive monetary expansion

BoJ Policy update ：JGB Outlook 2017 Overview

1H: YCC will function well

2H: Volatility may start to rise as people start speculating about Kuroda’s successor (if the current regime were to be kept)

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Bottom-line: 1H 2017 will be relatively quiet, but we will probably observe a rise in volatility from the 2H.

1H 2017: Market will still be dominated by YCC at least in 1H Since the BoJ introduced QQE with Yield Curve Control on 21 September, JGB curve has

only moved in an extremely narrow range. Under the current regime, with short term rate and 10yr JGB yield fixed at -0.1% and 0% respectively, room for other parts of the curve to fluctuate is limited unless the BoJ changes their targets.

We don’t think the BoJ has an intention to change their targets at least in 1H and hence JGB curve to stay in the current position.

2H 2017: Volatility may rise in the view of policy changes by the BoJ after Kuroda’s departure Going into 2H 2017, maybe we can expect some more changes in the policy regime as

Governor Kuroda's term draws to an end. As people start speculating about the BoJ post-Kuroda, this will fuel volatility to the market

regardless of the policy direction: whether it is a further easing or a sign of tapering. At this moment, we believe risk is skewed more to a tapering.

We cannot rule out the additional easing, but odds have decreased. NIRP will likely be kept for at least 3-4years… NIRP is still quite a powerful tool for BoJ and Kuroda prefers a further rate cut… However he

is facing headwind both externally (G20, IMF) and internally (Financial System Report). Our economic team no longer expects an additional rate cut.

We expect a tapering around the end of Kuroda’s term (Apr 2018), but NIRP may be kept even after his departure.

JGB update ：2017 Outlook

2017-1H=Dominated by yield curve control ; 2H=We may see volatility rising

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JGB purchase operation: we expect the BoJ will continue to reduce their purchase amount

Source: J.P. Morgan

Key takeaways:

From beginning of 2016, the BoJ increased the purchase amount to JPY10tn/month reflecting the rise in redemption.

However, after hitting its peak in February, they have been gradually reducing the purchase amount to the current level of JPY9.1tn/month.

With yield curve control, we will not be surprised if the BoJ were to begin a gradual tapering, reducing the net purchase amount to JPY60tn in 2017 from JPY72-74tn in 2016.

Monthly gross JGB purchase amount

BoJ Policy update ： JGB purchase operation in 2017

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Overseas investors: don’t expect rapid growth of JGB holdings by foreigners

Source: J.P. Morgan

The pace of JGB purchase by foreigners slowed down in 2016. Their holdings only increased by JPY 3.5tn YTD as of Sep 2016, compared to JPY 15.4tn and JPY 9.2tn in 2015 and 2014 respectively.

1. As balance sheet cost of funding USD with JPY rises, the USDJPY market is struggling to grow further because burdens on brokers are expanding so much that we are reaching their capacity.

2. Due to a rise in USD funding cost, Japanese investors’ demand for USD does not have any more room to expand.

3. Due to tight demand/supply condition in short duration JGBs, overseas investors have to put the JPY funded into riskier assets like JGBs with 2-5yr maturity.

In 2017, we don’t expect overseas investors’ JGB holdings to grow rapidly and it will likely to remain around the current level.

JGB update ： Overseas Investors

Change in JGB holdings by foreign investors

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10yr yield vs. 20yr yield UST 10yr after FX hedge

Non-yen investment from Japanese insurers

If 10yr yield stays around 0.05%-0.10%, 20yr yield will be 0.5%-0.8%.

UST yields have risen since the presidential election. At this level, insurers will have incentive to invest in foreign assets including US MBS, non-German EU government bonds, and US credits. However, at the same time, they shall continue with their super-long JGB investment agenda, which is JPY300bn/month.

Source J.P. Morgan

JGB update ： Super-long yield Outlook

Super-long yield Outlook

% %

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-30

-20

-10

0

10

20

30

40

50

'06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Trn JPY JGBs

Municipal

Corporate

Loan

Non-yenBonds

Lifers’ portfolio

Lifers’ balance sheet (CY2006=0) Net purchase of super-long JGBs from lifers

0.0

0.3

0.6

0.9

1.2

1.5

'09 '10 '11 '12 '13 '14 '15 '16

Tn JPY

Increase of one-time payment insurance policies

- Decrease for ALM purpose- Shift to Non-yen investment

6m Average

Source: J.P. Morgan

Lifers are not the main player of super-long any more

Lifers increased the purchase of super-long in 2008-2013 for ALM purpose, but decreased after Kuroda.

Some of them stopped the sales of “one-time payment JPY denominated policies” due to ultra low yield.

Even lifers have strong concern for sudden yield spike….

As USD funding cost is surging, they will keep purchasing super-long JGBs to some extent.

JGB update ： Super-long yield Outlook

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Disclosures

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