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INTEREST RATES RESEARCH Global Rates Strategy | 9 July 2010

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 49

GLOBAL RATES WEEKLY

The road to normalisation?

Risk appetite has stabilised and EGB peripheries have performed. The front end of Europe

remains under pressure as Euro money market conditions continue to normalise. While

confidence remains fragile, we have taken the first steps towards near-term stabilisation.

United States

Treasuries: Demand spreading across the curve 3

The Treasury is scheduled to auction 3y, 10y and 30y bonds next week. Auction

allotment data indicate a strong pickup in demand from domestic investors across the

curve and terming out from foreign investors.

Swaps: Time to dust off bearish spread wideners? 6

Money Markets: Money funds Stiffer competition ahead 9

TIPS: The concession is done, long live the concession 12

Volatility: Vol decline likely to persist 14

Europe

Euro: Near-term outlook and EUR rates trade ideas 17

This week we look at the short and long ends of the EUR curve and review some of our

preferred trade ideas. Despite recent moves, we still like being long the belly on EUR

2s/10s/30s from here.

UK Inflation linked: RIP RPI? No, but hi to CPI 22

The UK government has announced its intention to encourage private pension schemes

to switch indexation from RPI to CPI. We do not see this as the death knell of the RPI

market, but it is likely to hasten the birth of the CPI market.

UK Rates: The irresistible force 25

Covered Bonds: Relative value thoughts on the Nordic covered bond market 28

Scandinavia: Riksbank commences rate-hiking cycle 32

Euro Inflation-Linked: OATi22 cheap ahead of supply 34

Sovereign Spreads:EGB relative value 35Volatility: Protection against higher money-market rates with a 1y cap condor 38

Japan

Correction in progress in the rich futures sector 40

Bond markets have entered a temporary correction phase that looks set to continue for

some time. Last week, we recommended shorting futures (7y) in a 5s7s10s butterfly,

assuming futures would weaken during the market downturn, as is the typical pattern.

Surprisingly, however, the sector strengthened over the past week and is now rich.

Nevertheless, we expect flattening over the medium term and continue to recommend

a short 7y position.

Global Views on a Page

Global Traders Guide

Global Economics Calendar

Global Supply Calendar

Global Bond Yield Forecasts

United States

Ajay Rajadhyaksha

+1 212 412 7669

[email protected]

Michael Pond

+1 212 412 5051

[email protected]

Rajiv Setia

+1 212 412 5507

[email protected]

Europe

Laurent Fransolet

+44 (0)20 7773 8385

[email protected]

Alan James

+44 (0)20 777 32238

[email protected]

Japan

Chotaro Morita

+81 3 4530 1717

[email protected]


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Barclays Capital | Global Rates Weekly

9 July 2010 3

UNITED STATES: TREASURIES

Demand spreading across the curve

The Treasury is scheduled to auction 3y, 10y and 30y next week. Auction allotment data

indicate a strong pickup in demand from domestic investors across the curve andterming out from foreign investors. An increase in net stripping activity in the long end

in June also suggests investors are not yet balking at the low level of yields.

Demand spreading across the curve

The Treasury market sold off marginally in the holiday-shortened week, with the 10y ending

at 3.02%, compared with 2.98% as of last Fridays close. With little economic data to speak

of, the sell-off seems to be driven primarily by a reduction in risk aversion; European

sovereign CDS spreads were generally tighter, LOIS expectations were revised lower along

with lower Libor settings, and the VIX also receded.

The Treasury announced sizes for 3y, 10y and 30y auctions to be held next week (in a

departure from typical cycle, they are scheduled for Monday, Tuesday and Wednesday). Itreduced 3s by $1bn, to $35bn, and kept 10s and 30s unchanged at the previous reopening

sizes of $21bn and $13bn, respectively. The reduction in 3y was $1bn less than expected,

and we believe the Treasury is coming closer to the end of the process of normalizing

auction sizes. As we have highlighted earlier, there is a limit to how much they can be

reduced, due to an acceleration in the amount of coupon debt coming up for maturity over

the next few years. Figure 1 shows that in the fiscal year 2012, ~$1trn of coupon debt will

mature, compared with ~$500bn in the past couple of years, and this number will rise to

$1.4trn by 2014. Hence, even as net borrowing needs decline, there is a limit to possible

cuts in gross coupon issuance. We expect the Treasury to stabilize auction sizes by the end

of this fiscal year.

Demand at auctions: Higher domestic investor participation

Recent auction allotment statistics show domestic participation has picked up across the

curve, and foreign investors seem to be shifting out the curve as well. Figure 2 shows that

domestic investment funds absorbed 22%, 33% and 37% in 3y, 10y and 30y auctions,

Anshul Pradhan

[email protected]

Figure 1: A limit to cuts in auction sizes Figure 2: Domestic investor participation picking up

0

200

400

600800

1,000

1,200

1,400

1,600

FY-

2006

2007 2008 2009 2010 2011 2012 2013 2014 2015

Maturing Coupon Debt,$bn

22%

33%

37%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Oct Nov Dec Jan Feb Mar Apr May Jun

3s 10s 30s

% Auction Alloted to Domestic Investment Funds,

3M Moving Average

Source: Barclays Capital Source: Treasury

The Treasury announced a $1bn

higher-than-expected size forthe upcoming 3y auctions; we

believe it will stabilize auction

sizes by the end of this fiscal year


4/51


9 July 2010 4

respectively, in the second quarter, well above that in the first quarter. At the same time,

foreign investors have been terming out. Figure 3 shows that their participation in the front

end has steadily declined since the beginning of the year and picked up slightly at the long

end. Foreign investors have mostly termed out to the 7y/10y sectors. In addition, in the June

bond auction banks, absorbed 9%, though we suspect this was mostly on asset swap as

their participation did not pickup in other sectors.

While foreign investors continue to dominate the front end and domestic investors the long

end, such a convergence is likely to benefit auctions across the curve. The tails data are

beginning to reflect that, as recent 3y auctions have not come as through as they did in

2009 and bond auctions have not tailed as much either (Figure 4). With the 5s30s/10s30s

curves steepening back to recent highs despite a sharp decline in TIPS breakevens, we

believe there is likely to be decent demand at upcoming long-end auctions. While the

market has rallied quite sharply in the past couple of weeks, a pickup in the stripping activity

in the long end suggests that investors are not yet balking at the low level of yields.

June STRIPS report: A pickup in long end net stripping activity

The Treasury released the June STRIPS monthly report this week. It showed a pickup in net

stripping activity despite a decline in rates, suggesting strong demand for long durationsecurities. Figure 5 shows that the bond STRIPS universe increased $5bn in June, compared

with a monthly run rate of $1.6bn from January to May of this year. More importantly, this

was largely a result of net stripping in the very long end. 25y+ bonds accounted for $6.6bn,

up from a monthly run rate of $2.6bn from January to May.

Interestingly, most of the activity has been in the offthe-run bonds, and not so much in the

May 40s. Since the beginning of the year, the outstanding portion held in STRIPS form in the

25y+ sector has increased $20bn, of which Aug 39, Nov 39 and Feb 40s together have

accounted for $18bn (roughly a third each). While May 40s were only recently issued and

have not aged much, even accounting for the stage of aging, stripping activity in that issue

seems low.

In Figure 6, we plot the outstanding amount of STRIPS in issues in the long end against

months passed from issuance of the underlying. For instance, $6.2bn of Feb 40s was held in

stripped form two months from issuance. In comparison, only $0.86bn of May 40s is held in

stripped form. The average outstanding for issues in Figure 4 was roughly $3bn at this

Demand from domestic investors

picking up across the curve

Figure 3: Foreign investors terming out Figure 4: Tails converging across sectors

0%

10%

20%

30%

40%

50%

60%

Oct Nov Dec Jan Feb Mar Apr May Jun

3s 10s 30s

% Auction Alloted to Foreign Investors,

3M Moving Average

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

3y 10y 30y

Tails, bp, 3M Moving Average

Source: Treasury Source: Barclays Capital

June STRIPS report highlights

that net stripping activity ispicking up in the long end

May 40s stripping activity

low for the stage of aging


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9 July 2010 5

stage. Since activity in bonds just a couple of months shorter has been quite high, this is

not, in our opinion, an indication of a lack of duration demand, but of investors perceiving

May 40s as rich on the curve.

Figure 5: A pickup in net stripping activity in June

5.3

6.6

-4

-2

0

2

4

6

8

Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10

Net Monthly Increase in Bond STRIPS of which 25yrs +

$bn

Source: Treasury

Figure 6: Stripping activity in May 40s slow in the cycle

0

2

4

6

8

10

12

14131211109876543210

05/15/39 08/15/39 11/15/39 02/15/40 05/15/40

$bn

Months from issuance

Source: Treasury


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9 July 2010 6

UNITED STATES: SWAPS

Time to dust off bearish spread wideners?

The possibility of convexity paying in a significant sell-off leading to a widening of swap

spreads cannot be ruled out. While this is not our baseline view, in a conditional form,current market levels allow for expressing intermediate sector swap spread widening

views at levels nearly 10bp tighter to spot spreads. We outline such a trade.

With 10y rates trading near 3% and 10y swap spreads in mid-single digits, questions about

whether there could be a swap spread widening similar to the one in May 2009 have begun

to arise. Our baseline view on 10y swap spreads is that they will remain in the single digits

over the near term, driven by a combination of high financial issuance and Treasury supply.

However, there remains the possibility of a convexity selling episode such as the one that

occurred in late May and June 2009. With swaption vols trading cheaper to September

Treasury futures option vols, spread wideners conditional on a rate sell-off can be initiated

for zero cost at spread levels that are nearly 10bp tighter to spot. If the recent decline in

spread rate directionality reverses even because of a minor convexity paying episode, such a

conditional spread widener would offer an attractive risk-reward profile. The risk to the

trade would be a rate sell-off that is driven primarily by deficit concerns, which could

tighten, rather than widen, swap spreads. However, other indicators such as sovereign CDS

spreads indicate that these concerns have faded for now.

May 2009: The similarities and the differences

At face value, there are several similarities between market conditions in May 2009 and

now. These include 10y Treasury rates near 3%, 10y swap spreads in the single digits,

primary mortgage rates near all-time lows and the general perception of a weak economy

that will likely keep rates low. When rates did sell off in May 2009, the move was quite

violent, as Figure 1 shows. 10y rates sold off nearly 80bp between mid-May and mid-June2009, mortgage current coupon rates went from less than 4% to nearly 5%, and 10y swap

spreads widened from 8bp to nearly 43bp at the peak.

Amrut Nashikkar

+1 212 412 [email protected]

Piyush Goyal

+1 212 412 6793

[email protected]

Figure 1: 10y rates, 10y spreads and mortgage rates similarto levels in early May 2009

Figure 2: The Fed holds more negatively convex fixed ratemortgages than the overall fixed rate universe

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10

-10

0

10

20

30

40

5010y rate (%)

Mortgage current coupon (%)

10y swap spread (bp, RHS)

-2.1

-2.0

-1.9

-1.8-1.7

-1.6

-1.5

-1.4

-1.3

Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10

MBS Index MBS Index ex-Fed

Source: Bloomberg, Barclays Capital Source: Barclays Capital


7/51


9 July 2010 7

Is another convexity paying episode likely if rates back up?

This raises the question about whether a similar episode is likely in case of a back-up in rates.

The answer, in our opinion, is probably not to the same extent. There are several reasons.

First, as our Mortgage Strategy team pointed out in last weeks Securitized Products Weekly,

refinancing activity remains lower than would be expected at these mortgage rates. This is

different from the situation in May 2009, when significant refinancing had taken place in thefirst quarter. Primary mortgage rates are still not low enough to induce a refinancing wave,

and tight underwriting standards for agency mortgages make refinancing difficult. As a

result, prepays are expected to be much less sensitive to lower rates, leading to lower

negative convexity (as evidenced by historically high dollar prices on mortgages).

Second, a significant proportion of the mortgage universe is now held by the Fed, which

was not the case in May 2009 because the Fed purchase program was still in its early

stages. Moreover, the Fed holds a disproportionately larger share of the more negatively

convex coupons than the rest of the market (Figure 2). The fact that it does not hedge

duration risk on its mortgage portfolio may be an important factor driving the view that

convexity hedging is now much less significant for swap spreads.

Last but not the least, mortgage hedgers may be set up for a possible sell-off in rates,

considering that rate levels were much higher just three months ago.

Paying may yet occur in a sell-off

That said, the convexity profile of the mortgage universe (ex-Fed) indicates nearly $43bn of

10y equivalents in duration shedding needs in a 50bp sell-off in rates from servicers alone,

and even more so from hedged holders of mortgages such as the GSEs. Our models indicate

that servicer portfolios at these rate levels are skewed more towards paying in a sell-off than

receiving in a rally. Thus, while we do not believe that duration supply because of a

refinancing wave will be a catalyst for a sell-off, if one does occur for fundamental reasons,

there could be paying pressure on swap spreads.

Figure 3: Decline in the beta between swap spreads andswap rates

Figure 4: Swaption implied vols are lower than Treasuryfutures implied vols

-5%

0%

5%

10%

15%

20%

25%

30%

Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10

10y swap-spread rate beta (60d realized)

0.7

0.8

0.9

1.0

1.1

1.2

1.3

Jul -09 Sep-09 Nov-09 Jan-10 Mar-10 May-10

3m*7yr to TY option vol ratio

Source: Barclays Capital Source: Barclays Capital
https://live.barcap.com/go/research/content?contentPubID=FC1611841https://live.barcap.com/go/research/content?contentPubID=FC1611841


8/51


9 July 2010 8

We hesitate to express an outright widening view on 10y spreads

There are two countervailing forces serving to keep 10y swap spreads in single digits. The

first is swapped financial issuance, which since the end of June has shown indications of

picking up again. The second is concerns about the US fiscal picture, which, in addition to

financial issuance, contributed to the tightness of swap spreads when 10y rates were near

4% in late March and early April. Although swapped financial issuance remains a near-term

tightener for swap spreads, fiscal concerns seem to have receded somewhat, with US

sovereign CDS levels back to where they were before the flare-up of the sovereign crisis in

January. Further, economic data have been on the weaker side, which makes a significant

sell-off in rates less likely. Given these counteracting effects, we hesitate to express an

outright widening view on spreads.

However, bearish spread wideners for out-of-the-money strikes are attractive

We believe that a much more attractive way to express the trade is through bearish spread

wideners ie, by selling puts on TYU0 and buying a payer swaption on a swap matched

with the CTD, currently the 4.5 May 2017 note.

There is a reason why the trade is attractive: swaptions are less expensive than Treasuryfutures options. Contributing to this has been a considerable decline in the directionality of

swap spreads and rates (Figure 3). The reason is that recently, swap spreads have been

widening in rate rallies because they have been driven by a flight to Treasuries and

tightening in rate sell-offs, which have been driven primarily by supply concerns. As a result,

swap rates have become less volatile than Treasury rates.

Figure 4 shows a one year history of the ratio of TY futures option implied vol and

comparable 3m*7y swaption vol. Swaptions typically trade at a premium to Treasury

futures options. But recently, they have cheapened considerably and are trading at a large

discount to Treasury futures options. Some of this can be explained by realized vols, but the

implieds seem to have gone a bit too much in pricing swaptions at lower vol. We expect this

to correct, which offers an additional reason for a bear spread widener that involves selling

the Treasury future put and buying the payer swaption.

The current profile of the delivery basket for TYU0 indicates that a switch is unlikely in a

parallel sell-off of 50bp, which ensures that there will be no duration mismatch between the

swaption and the Treasury futures option legs. Further, selling a TYU0 put at a strike of 119

allows for taking in enough option premium to put on a zero cost bearish spread widener

nearly 10bp tighter than spot spreads (Figure 5).

The risk to the trade remains a slow, supply driven selloff in treasuries and not enough

convexity paying from mortgage hedgers to widen swap spreads. Even in such a scenario,

the fact that a zero cost trade can be initiated at spreads tighter to spot offers some

protection against a repeat of the events of March/April 2010, when spreads tightened as

10y rates sold off.

Figure 5: Details of the trade

Trade Option Fwd Strike Spot Expiry Start

Sell put TYU0P 119.0 2.48% 2.91% 2.38% 8/27/2010 9/30/2010

Buy payer Swaption 2.65% 3.01% 2.58% 8/27/2010 9/30/2010

Spread 17.7 bp 10.1 bp 19.8 bp

Source: Barclays Capital


9/51


9 July 2010 9

UNITED STATES: MONEY MARKETS

Money funds: Stiffer competition ahead

Stiff competition isnt limited to the soccer pitch money funds will face pressure from

banks eager to ramp up their holdings of sticky retail deposits ahead of Basel III.

Years before Basel III goes into effect and in advance of net stable funding guidelines, UScommercial banks have already begun boosting their retail deposit base.

Money fund rates are 70bp below bank savings rates. To attract additional retaildeposits and pull more funds out of money market accounts, banks may need to widen

this spread further.

Likewise, banks may need to compete more aggressively in the certificate of depositmarket. CDs, however, are an expensive source of funding.

SEC limits on money market funds and their ability to buy higher-yielding term and credit

paper, along with stiff bank competition, will likely put further pressure on the industry to

shrink. In the absence of a significant foray into floating NAV funds, money funds couldcontract by more than $500bn, or 20%.

Net stable funding

One of the key requirements for banks to meet the Basel III guidelines is a net stable

funding ratio of 1 or higher. This ratio compares all the sources of bank funding to a pre-

set schedule of assets and separates those liabilities that are considered flight prone

that is, those that would leave quickly in the event of a financial or funding crisis. Under

Basel III, repo, fed funds, and commercial paper are all considered unstable sources of

bank asset funding. By contrast, long-term debt (with a maturity of longer than 1y),

equity capital and retail deposits are the most stable sources of funding. In examining US

commercial bank balance sheets, we found a gap of approximately $1.7trn between the

available level of net stable funding and what would be required under Basel III. 1

Assuming there is no relief on the stable funding ratio, US institutions might need to raise

1 Please see, Liquidity Regulation: (Un)Intended Consequences?, R. Setia, A. Pradhan, and A. Nashikkar, BarclaysCapital, June 18, 2010

Joseph Abate


Figure 1: Non-large time bank deposits (% bank liabilities) Figure 2: Savings and small time deposits ($ bn)

45

47

49

51

53

55

57

59

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

3000

3200

3400

3600

3800

4000

4200

4400

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

700

750

800

850

900

950

1000

1050

1100Small time, rhs

Savings deposits, lhs

Source: Federal Reserve Source: Federal Reserve

Long-term debt, equity

capital and retail deposits

are all stable funding sources


10/51


9 July 2010 10

$500-750bn in retail deposits. The balance of their stable funding gap could be met

through debt issuance and asset run-offs.

The return of pass-book savings

Years of disintermediation and access to cheaper sources of wholesale funding have reduced

bank reliance on traditional retail deposits. Just before the height of the financial crisis, non-

large time bank deposits accounted for 48% of all commercial bank liabilities (Figure 1). The

flightiness of wholesale funding particularly repo at the height of the financial crisis caused

banks to move aggressively to shift their funding mix. A recent BIS paper notes the global shift

to more retail deposit funding, alongside a move away from centralized funding models. 2

Importantly, the authors conclude that the entire shift from wholesale funding reflects market

pressures, rather than the consequences of regulatory efforts.

Digging deeper, we find that the increase in deposits at commercial banks is curiously

concentrated. Indeed, all of it has been in passbook-type savings accounts a savings

vehicle normally associated with Christmas Clubs, toasters, and ornate branch lobbies.

Balances held in certificates of deposit (with balances under $100,000 and geared to retail

depositors) have declined (Figure 2). Since January 2009, passbook savings deposits have

increased nearly $850bn (or almost 25%), while small time deposits have contracted more

than $315bn (or nearly 30%). While some of the increase in passbook savings was driven

by household asset reallocation in the wake of the financial crisis, inflows since January

2010 and since the stabilization in financial markets have also been strong. Both the

increase in passbook balances and the decline in small time accounts have continued this

year, although at a somewhat slower pace. At the same time, balances held in retail money

market accounts have declined (Figure 3). Since the start of the year, retail deposits in both

government-only and prime funds have fallen $175bn, or nearly 13%. Looking at the rate

differential between these accounts, it is not hard to see why.

A question of rate

Bank Rate Monitor publishes monthly deposit rates for bank money market and certificateof deposit accounts.3 These figures are based on regional surveys and are the most

2 See Funding Patterns and Liquidity Management of Internationally Active Banks, Committee on t he Global FinancialSystem, Bank for International Settlements, May 2010.3 See, http://www.bankrate.com/funnel/graph/

Figure 3: Retail money fund balances ($ bn) Figure 4: Bank and money market rates (%)

1000

1100

1200

1300

1400

1500

1600

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10

MMF

Bank Rate Monitor

Source: imoney.net Note: The bank rate is the rate paid on money market accounts held at bankswhich are similar to money market funds. Source: bankrate.com and imoney.net

Deposit funding has

picked up since 2008

entirely in passbook accounts

as the bank and moneyfund spread has widened


11/51


9 July 2010 11

frequently referenced deposit rate source in academic studies. However, the results reflect

the lowest offered rate, notthe most commonly offered rate; as a result, they tend to have a

downward bias.4 Nevertheless, beginning in mid-2008, the spread between bank and

money fund rates has widened (Figure 4). Backing out the implied rate on savings deposits

from the Feds M2 own series also reveals a sharp widening in the bank-to-money fund

rates spread.5

Money fund competitive disadvantage

Retail investors in money funds and bank passbook deposits are similarly concerned with

safety and liquidity, but they are not indifferent to yield. The wider the spread between bank

and money fund rates, the more likely it is retail investors will shift their balances back into

passbook savings accounts. We expect depositors to continue to shun small time deposits

in favor of the greater liquidity in savings accounts. Thus, to raise the estimated $500-

750bn in retail deposits that we estimate banks need to get compliant with the Basel III net

stable funding requirements, bank rates will need to increase.

However, estimating the rate sensitivity of retail depositors is tricky. The permanent increase

in deposit insurance guarantees (to $250,000) makes bank deposits more attractive than

money fund accounts for the extremely risk averse. But even discounting the effect of

deposit insurance, money funds are not competing on a level playing field. The revised 2a7

rules severely crimp their ability to pick up extra yield from investing in term or credit

product. Just to get compliant with their 30% 7-day liquidity requirement forced prime

funds to reduce sharply their holdings of commercial paper and ramp up their low yielding

repo balances. Thus, banks may only need to increase the bank deposit-MMF rate spread by

perhaps 25bp or so in order to attract the extra $500-750bn. To lock in deposits for longer

say, in 1y small time deposits would require a bigger rate incentive. Even with 1y CD rates

exceeding 1.15% and over 100bp above money market fund rates, banks continue to lose

these deposits. Assuming no change in money fund rate-setting behavior, the higher yield

offerings at banks could easily pull $500bn out of retail money funds, shrinking aggregate

balances 20%.

However, money funds are not likely to go gently into that good night. Instead, to level the

playing field a bit, we expect them to begin offering floating net asset value funds

(essentially, very short duration bond funds) in addition to their existing array of stable NAV

funds. Without the flexibility of purchasing higher yielding assets, stable net asset funds will

quickly become less attractive options for retail savers and the only way to prevent

significant outflows is to forsake their stable NAV charter.

Ironically, the same 2a7 fund rules that put the money funds at a competitive rate

disadvantage also make the process of offering floating NAV a bit easier, since the funds are

required to update their back office operations to handle movements in asset prices that

might cause the funds net asset value to move above or below $1/share. So far, however,

the development of floating NAV funds has been slow, with just a handful of offerings. Butwith banks required to meet net stable funding requirements in short order, money funds

could soon face substantially stiffer competition in the super-safe retail money market.

4 See Bank Imputed Interest Rates: Unbiased Estimates of Offered Rates?, E. Ors and T. Rice, Federal Reserve Bank ofChicago, November 20065 M2-own is the weighted average of the rates received on the interest-bearing assets included in M2 (savings, smalltime deposits, and retail money funds).

Banks may need to raise

deposit rates further

SEC 2a7 rules put money funds

at a competitive disadvantage


12/51


9 July 2010 12

UNITED STATES: INFLATION-LINKED MARKETS

The concession is done, long live the concession

After a solid auction, we expect the 10y supply concession to be reversed in the coming

weeks. On the other hand, the market may begin an early set-up for the 30y reopeningin August. In line with this view, we recommend putting on 10s30s breakeven flatteners.

Solid auction

Last week, we described our view that the 10y would have to cheapen significantly for a solid

auction. Since then, the market cheapened significantly and the auction was solid. We were

most concerned about rich real yields, but as 10y real yields backed up about 18bp from the

announcement, that factor became less of a concern. The auction stopped about 2bp through

the 1pm level on the WI, and indirect bidders took down 51% of the auction, a high since

October 2006. While there was likely broad domestic demand, we expect the auction

allotment data to be released on July 22 to show another sizable take-down by foreign

investors an indication of continued structural allocations from foreign central banks.

As the market breathes a sigh of relief now that supply has been absorbed, we expect the

concession to be reversed over the next few weeks and 10y breakevens to move back closer

to 2.00%. The new 10y has generally performed well post-auction (Figure 1). However, the

market may begin to build in a concession for the end-of-August 30y reopening well ahead of

time because of increased sensitivity to real yield levels and a lack of historical demand from

foreign investors. To position for these moves, we recommend a 10s30s BE curve flattener.

Figure 1: On average, the newly issued 10y richens as much as 10bp after the auction

10y Avg (AuctionDateYield - GivenDatesYield), 16 New 10y TIPS Auctions

-4

-2

0

2

4

6

8

10

-10 -5 0 5 10 15 20 25 30 35 40

Days before/after auction

New Issue RicheningOff-the-run

cheapening

Note: Using the past 16 TIPS auctions data. Source: Barclays Capital

Trade idea: Long TIIJan18-Feb40 BE flattener ahead of 30y TIPS reopening

in August

At the November 2009 refunding announcement, the Treasury announced a switch from a

20y TIPS offering to 30y TIPS (issued on a semi-annual basis, initial offering in February,

followed by a reopening in August). 30y TIPS issuance had been absent in the market since

October 2001. There was considerable uncertainty regarding fair value for this point on the

curve because it was 8y beyond the nearest maturing bond (Apr 32s). In the process, the

bond sector of the TIPS curve cheapened significantly going into the auction (Figure 2). The

Michael Pond


Chirag Mirani

+1 212 412 6819

[email protected]


13/51


9 July 2010 13

30y auction on February 22 tailed by 6-7bp, but the market did retract afterwards. While we

believe there is a large potential domestic demand base at the 30y point, this is still

unproven and may not be significant at real yields below 2%. In our view, the TIIFeb40s

issue will likely cheapen ahead of its reopening auction on August 23, perhaps well before

the auction process.

We believe the best way to take advantage of potential cheapening in the 20-30y sector isvia a relative position versus the 10y sector. Given that the 10y sector had cheapened going

into the auction and the auction went well, we expect the historical post-auction richening

pattern to hold again (Figure 1).

Why a 10s30s breakeven flattener and not a 10s30s real curve steepener?

The reason we favor BE flatteners over real curve steepeners is that the 10s30s nominal

curve is at a fairly steep level. The 10s30s nominal curve is close to the top of its range over

the past year and a half (Figure 3) and may flatten after next weeks auctions. In this

scenario, the real curve is also likely to flatten, albeit at a lower beta. So from a relative value

perspective, we expect 30y TIPS to underperform the 10y sector; we believe this view is

better expressed in breakeven form to eliminate some of the macro curve exposure.

Which 10y point will make for the best 10s30 breakeven flattener trade?

Our forward 1y breakeven reportshows that in the 10y sector, Jan17-Jan18 forward 1y BEIs

are trading at 162bp (a fairly low level), implying that Jan18 BEIs are cheap. This is also

confirmed by Jan18s 3m z-score of +0.9 versus the real spline curve. Thus, we recommend

that investors put on Jan18-Feb40s BEI flatteners, as this is the best way to position for the

above view. Currently, the Jan18-Feb40 breakeven spread is trading at 60bp; we expect it to

revert to 45bp with a stop-loss at 70bp. The trade has -1bp of carry over a 3m period.

Figure 2: 20y sector cheapened 10-15bp relative to 10ygoing into the new 30y auction in February, but richenedthereafter. It is at a favorable entry point now.

Figure 3: 10s30s nominal yield curve is at its peak over thepast 1.5 years.

30

35

40

45

50

55

60

65

Nov-09 Jan-10 Mar-10 May-10 Jul-10

10

15

20

25

30

35

40

45

50

55

Feb40-Jan18 BEI Spread (LHS, bp)Apr32-Jan18s BEI Spread (RHS, bp)

0

20

40

60

80

100

120

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

10s30s Nominal Curve



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9 July 2010 14

UNITED STATES: VOLATILITY

Vol decline likely to persist

The option market received more supply from callable notes in June than in previous

months. Moreover, the hedging community, including mortgage asset managers andinsurance companies, remains on the sidelines. This dynamic seems unlikely to change in

the foreseeable future.

Option supply picks up

Callable zero-coupon notes

About $1.35bn initial notional of callable zeroes were issued last month, exceeding the

levels of the preceding two months but in line with the broader declining pattern (Figure 1).

Most of the callable notes mature in 30 years and are callable after the first year.

Accordingly, the option supply is ~ $20mn log vega. This is higher than in the previous two

months but in line with supply during the first quarter of 2010.

We expect issuance to remain tepid: about $2-3bn every quarter. Accordingly, option supply

should be smaller than the market is used to.

Agency callable notes

There was a notable pickup in new issuance of agency callable notes last month. About

$77bn was issued 25% higher than in May. But only $14bn of the issuance was from the

Federal Home Loan bank (FHLB) system. More long-term securities are being issued; thus,

despite the drop in issuance, option supply was roughly $6mn, about the same as in the

past few months.

We expect issuance and related option supply from agency callable notes to remain robust

as there are few alternatives for investors looking for higher yield.

Piyush Goyal

+1 (212) 412 [email protected]

Figure 1: Callable Zero note issuance is on a decline Figure 2: FHLB issuance is also on a decline

-

1

2

3

4

5

6

7

Q1 06 Q1 07 Q1 08 Q1 09 Q1 10

0

50

100

150

200

250

300

Issuance ($bn,L) 2-10 curve (bp,R)

0

10

20

30

40

50

60

70

80

90

Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10

FHLB Gross Issuance ($bn) Other

Source: Bloomberg Source: Barclays Capital


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9 July 2010 15

Total supply

To sum up, the option market received about $26mn in vega supply during June. This is

higher than the past two months. We expect supply to decline over the next few months as

callable zero note issuance decreases.

Smaller demand from hedgersThe declining supply would have been a bigger deal had it been accompanied by rising

demand from hedgers, a scenario we consider unlikely.

Mortgage hedgers

The SEC filings of Fannie Mae and Freddie Mac show that option portfolios at the two

entities declined by about $40bn in notional during the first quarter of 2010 (see Supply: A

smaller deal, Market Strategy Americas, June 4, 2010).

The vega exposure embedded in the GSE mortgage portfolio has declined in the past few

quarters, so the lukewarm interest in options is not surprising. Unless rates rise sharply, and

fast, asset managers are unlikely to need much in the way of vega hedges.

In our base case, we do not expect rates to rise by as much as required to bring asset

managers into action. Thus, we expect their demand for options to remain non-existent for

several months.

Insurance companies

We also expect demand from insurance companies to remain small as a result of

insignificant growth in variable annuity sales (Figure 3). Annuities matter because insurance

companies that have sold these policies need to buy long-dated options to hedge the risk

embedded in their policies.

Annuity sales look unlikely to pick up, so hedgers could remain on the sidelines for sometime yet (Figure 4).

Figure 3: Variable annuity sales have reached a plateau Figure 4: so hedgers are not buying options

25.0

30.0

35.0

40.0

45.0

50.0

Q1 05 Q1 06 Q1 07 Q1 08 Q1 09 Q1 10

800

900

1000

1100

1200

1300

1400

1500

1600

VA Sales S&P

Floors Outstanding (notional, $bn)

-

10

20

3040

50

60

70

80

Q4 05 Q4 06 Q4 07 Q4 08 Q4 09

Metlife AXA

Source: LIMRA quarterly and annual reports Source: SEC 10-Q filing
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9 July 2010 16

Dealer hedging of existing callable zeroes

As discussed in our Primer on Callable Zeroes and Vol (May 21, 2010), dealers hedging the

option supply from callable zeroes become short vol as rates fall, and vice-versa.

Given how low we already are on the level of rates, and dealers hedging experience during

May (rates fell, they become short vol and have to buy at expensive levels), the hedging risk

is more towards vol selling. So if rates rise, there may be option selling from the dealercommunity. But if rates fall, there may not be much of an impact.

Total demand

Option demand from hedgers, including mortgage asset managers, insurance companies

and the dealer community hedging the callable zeroes, is likely to remain low for the next

several months.

Conclusion

Long-dated options are likely to trade with a bearish bias for the next several months as the

supply from callable notes persists and demand from hedgers remains tepid. We suggestselling long-dated option structures, such as 5y*5y, 3y*10y, etc.
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9 July 2010 17

EURO AREA: RATES STRATEGY

Near-term outlook and EUR rates trade ideas

This week we look at the short and long ends of the EUR curve and review some of our

preferred trade ideas. Despite recent moves, we still like being long the belly on EUR2s/10s/30s from here. We also enter into EUR 2s/10s 1y fwd flattener vs 1y1y fwd vs 2y1y

fwd steepener and see room for more tactical Schatz ASW tightening in the near term.

This week has generally been good for risky assets. Developed economy stock markets have

bounced about 5%, and euro area government bond spreads, particularly in peripheral

space, have re-tightened. The 45bn-less roll in the ECBs weekly MRO, successful

placement of a new 10y Spanish benchmark, news that the European banking system stress

tests are going to be more detailed than expected, slightly positive tone from the ECB press

conference and relatively reasonable start to the Q2 earning season have all supported the

bounce in risky assets. Apart from these, some other technical factors had already reached

interesting levels to support this weeks moves as well. For instance, the US data surprise

index (developed by our FX colleagues) has already reached very low levels once again(Figure 1). Moreover, the Bull/Bear ratio from the AAIIs equity sentiment indices has also

fallen recently to about early 2009 levels. We think there is more room for this risky asset

rally to continue in the near term and offer some of trade ideas that we like currently.

Figure 1: US data surprise index vs change in 10y Treasury yields Figure 2: AAIIs Bull/(Bull + Bear) ratio vs S&P

-200

-150

-100-50

0

50

100

150

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

-2.0

-1.5

-1.0-0.5

0.0

0.5

1.0

1.5

USGG10YR Index

1-mth rolling average of activity data

surprise z-score (right axis)

600

800

1000

1200

1400

1600

Jan-01 Jul-02 Ja n-04 Jul-05 Jan-07 Jul-08 Jan-10

0.0

0.2

0.4

0.6

0.8

1.0

S&P Index

Equity Investor sentiment, Bull / (Bull + Bear) ratio (RHS)


We still like the variations of EUR curve flattening risks

Keep long the belly on EUR 2s/10s/30s

We recommended going long the belly on EUR 2s/10s/30s to position for a strategic

flattening of the EUR 2s/10s curve on 16 April (EUR rates trade ideas, Global Rates

Weekly). Since then, the EUR 2s/10s curve flattened 35bp and the belly on EUR 2s/10s/30s

has richened 30bp. We still like the flattening risk after recent developments concerning

liquidity issues at the front end of the EUR curve. The notable drop in the liquidity surplus of

the EUR system following the recent rolls of the LTRO and MRO has already led to a notable

sell-off in EONIA. Overall, we still see the risks biased towards further flattening in 2s/10s in

Cagdas Aksu

+44 (0) 20 7773 [email protected]

Giuseppe Maraffino

+44 (0) 20 3134 9938

[email protected]

Being long the belly on EUR

2s/10s/30s barbell still great way

to be short the front end of the

curve and have curve flattening

exposure with positive carry
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9 July 2010 18

bear and bull market scenarios on a medium-to-long term basis (we think the curve can

even bull flatten in a double-dip scenario, although this is not our base case). Our model for

EUR 2s/10s with the current and expectations component of the IFO index still points to

flatter levels (Figure 3). Given its correlation with 2s/10s, we still prefer to position via

2s/10s/30s barbell because it is much more advantageous to hold from a carry perspective

(2s/10s/30s has 12bp positive carry over a year, versus 10bp negative carry for 2s/10s).

Overall, we believe being long the belly on EUR 2s/10s/30s barbell is a great way to be shortthe front end of the curve and have curve flattening exposure while capturing positive carry

(unlike the latter two trade ideas) and not suffering in further rates rallies.

Figure 3: EUR 2s/10s curve vs our models Figure 4: EUR 2s/10s/30s vs EUR 2s/10s

-50

0

50

100

150

200

250

Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10

EUR 2s/10s Predicted EUR 2s/10s

-120

-60

0

60

120

180

240

Jun 05 Jun 06 Jun 07 Jun 08 Jun 09 Jun 10

-130

-30

70

170

270

EUR 2s/10s/30s EUR 2s/10s (RHS)


Also enter EUR 2s/10s 1y fwd flattener vs 1y1y fwd/2y1yfwd steepener

As we have highlighted in our previous publications, the back end of the money marketcurve (reds/greens) is correlated with the 2s/10s part of the curve. In the notable curve

flattening since mid-April, reds/greens has actually flattened much more than the 2s/10s

part of the curve, creating a notable dislocation between the two.

For investors uncomfortable with outright flattening risk after the recent curve moves, we

think positioning for the dislocation is a good trade idea. Looking at the regression between

EUR 2s/10s 1y fwd and 1y1y fwd/2y1y fwd, every 1bp move in the latter results in a

roughly 2.8bp move in the former. Thus, for every 50k per bp risk in 2s/10s 1y fwd flattener,

one should have 140k per bp risk on 1y1y fwd/2y1y fwd steepener. Therefore, the whole

structure nets a three leg trade with the following notionals with the aforementioned risks:

Long/Short/Long: 1y1y fwd/2y1y fwd/10y1y fwd: 1445mn/985mn/60mn

We think the dislocation is worth about 40bp on 2s/10s (meaning 2mn profit with the

nominals mentioned above). All the risk and nominal measures here is for illustration

purposes; investors can adjust the risk according to their risk appetite.


19/51


9 July 2010 19

Figure 5: Evolution of 1y carry from being long the belly on

EUR 2s/10s/30s 1y fwd

Figure 6: EUR 2s/10s versus reds/greens

-50

-30

-10

10

30

50

Jul 05 Jul 06 Jul 07 Jul 08 Jul 09

1yr carry from being long EUR 2s/10s/30s

-100

-50

0

50

100

150

200

Jan 06 Jan 07 Jan 08 Jan 09 Jan 10

-40

-20

0

20

40

60

EUR 2s/10s 1y fwd

EUr 1y1y fwd vs 2y 1y fwd (RHS)


Close FRA EONIA forwards wideners for now, enter Schatz ASWtactical tightener

Following recent developments in the short end, the 3m spot Libor-EONIA basis has

tightened 8bp on the week in the EONIA spike with the spot basis as low as 20bp on

Thursday. At the same time, tightening in 2011 and 2012 forward basis has been much

more limited than front-month tightening (c.2bp). While we still believe that in the medium

to long term, the markets own liquidity normalisation is likely to widen the liquidity

premium of the Libor-EONIA basis; in terms of positioning, it might not be the best time to

hold it in the near term. If it takes more time for the Libor to respond to new liquidity

conditions by starting to rise in a more notable way and spot 3m Libor-EONIA sustains early

20bp levels, then we see near-term risk of further temporary tightening in forward Libor-EONIA basis. Therefore, we close our forward (2011 and 2012 maturity) Libor-EONIA basis

widener and look for better levels to enter this trade again later.

Figure 7: Schatz ASW decomposition into its components Figure 8: Fundamental model

-40

20

80

140

Jan 07 Oct 07 Jul 08 Apr 09 Jan 10

Schatz ASW Schatz FRA - EONIA

Schatz EONIA - Ger

-30

-10

10

30

50

Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10

Schatz EONIA - Ger

Predicted with 3m GC & EUR 1yr ahead German deficit



20/51


9 July 2010 20

We have also been highlighting the richness of the EONIA-Germany component of the

Schatz ASW for a long while but always positioned our tactical tightening views in Bobl and

Bund ASW. Apart from other structural factors, we believe one of the reasons that kept the

EONIA-Germany component of Schatz ASW rich was the belief the FRA-EONIA basis had

bottomed out and would widen significantly. While we maintain our Bobl ASW tightener

versus EONIA that we entered on 4 June (Tactical short in Sep Bobl ASW vs EONIA, Global

Rates Weekly), we think there is tactical value in selling Schatz ASW versus Libor to positionfor temporary near-term Libor-EONIA tightening, as well as a correction in rich EONIA-

Germany tightening on better tone from risky assets. We target mid-50bp levels.

ECB and liquidity update

Short-term rates continued to increase this week: the results of last Tuesdays MRO

(EUR45bn of the expiring EUR276bn was not rolled) has pushed the liquidity surplus down

(to about EUR120bn). Furthermore, at the ECB meeting, Trichet did not seem worried about

the latest movements of short rates; in the Q&A session, he stated that banks decided to not

roll part of the expiring liquidity at the 12M and the MRO and that the increase in EONIA

rates is just a demand-driven phenomena. This has reinforced expectations that restoring

the exit strategy is in the pipeline. At present, the forward curve sees the EONIA for

December at 0.75% (signalling further reduction in the liquidity surplus/average maturity of

OMOs) and moving above 1% in September 2011 (normalization) a sharp contrast to

some weeks ago when the market was not expecting EONIA to be 1% before the end of

2011. Indeed, spot 1y OIS rate and Libor rate are at the highest this year: on the forward

curve, the 1y1y OIS is 1.09%, up sharply from the 0.88% at the beginning of May (the u-

turn of the ECB due to the worsening of the Greek crisis). The 1y Libor rate has moved up as

well, in spot and 1y forward, with the former returning above 1% after moving at 0.80-

1.00% since the beginning of the year (Figure 9).

Figure 9: Rising trend Figure 10: Excess reserves (bn) vs Eonia/refi (bp), 1wk MA

0.25

0.50

0.75

1.00

1.25

Jan-10 Apr-10 Jul-10

Libor 1y OIS 1y

-100

-50

0

50

100

150

200

Jan-08 Oct-08 Aug-09 Jun-10-100

-80

-60

-40

-20

0

20

40Excess reserves

Eonia-Refi (RHS)


As we stressed in the 2 July Global Rates Weekly, in a context of low liquidity surplus (ie,

c.100bn) and short average duration of the outstanding refinancing operation, the

relationship between the liquidity surplus dynamics and EONIA should be stronger as well

as sensitive to the evolution of the excess reserve during the maintenance period. In this

respect, it is important to stress that next week EUR229bn will mature at the weekly MRO

The market has started

pricing less accommodative

liquidity conditions

Next week: the start of the new

maintenance period and the roll

of the 1M STRO
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9 July 2010 21

and EUR31bn at the 1M STRO. Based on the recent bank behaviour, it is likely that part of

the STRO will not be rolled and that the roll is concentrated in the MRO. This would further

reduce the liquidity surplus as well as the average duration. Furthermore, the new

maintenance period starts on 14 July: excess reserve should return to positive territory with

the consequent decrease in deposit facility. These two factors should create the potential

for a further increase in the EONIA, likely to move up to 0.50-0.60% (as the movement from

January-June 2009 in Figure 10 suggests). Note that, at present, the July forward EONIAprices in a fixing at 0.52%, which suggests that some spikes of the EONIA beyond 0.60%

are already priced in.


22/51


9 July 2010 22

UNITED KINGDOM: INFLATION-LINKED MARKETS

RIP RPI? No, but hi to CPI

The UK government has announced its intention to encourage private pension schemes

to switch indexation from RPI to CPI. We do not see this as the death knell of the RPImarket, but it is likely to hasten the birth of the CPI market.

On Thursday 8 July, Pension Minister Steve Webb made a written statement to the House of

Commons that could have a profound effect on the UK pensions industry. The statement

read as follows:

The Chancellor of the Exchequer announced in the Budget statement on 22 June that, with

some exceptions, consumer prices rather than retail prices will be the basis for uprating

most benefits and public sector pensions.

The Government believe the CPI provides a more appropriate measure of pension recipients

inflation experiences and is also consistent with the measure of inflation used by the Bank of

England. We believe, therefore, it is right to use the same index in determining increases for

all occupational pensions and payments made by the Pension Protection Fund (PPF) and

Financial Assistance Scheme (FAS).

Consequently we intend to use the CPI as the basis for determining the percentage increase

in the general level of prices for the 12 months ending 30 September 2010 when preparing

the order required under paragraph 2(1) of schedule 3 to the Pension Schemes Act 1993 in

relation to revaluation and indexation of pension rights in defined benefit pension schemes,

and the order made under section 109 of that Act in relation to increases in guaranteed

minimum pensions paid by contracted-out defined benefit schemes in respect of

pensionable service between 1988 and 1997; and amend legislation to enable CPI to be

used for relevant increases in respect of the PPF and FAS.

Using CPI will mean making some small changes to primary legislation to ensure we can apply itfully in every circumstance. We will bring these before Parliament at the earliest opportunity.

The intent of this statement is clear: to switch, as much as possible, from RPI inflation as the

basis for indexation of pensions to CPI inflation. On average, since 1997 (the first year for

which we have a full breakdown of data), RPI inflation has been 0.85% higher than CPI

inflation; since 1988 the difference has been 0.68%, so such a change would tend to reduce

expected future pension liabilities significantly. However, the ability of the government to

adjust accrual of existing private pension liabilities is somewhat limited. The Pension

Schemes Act 1993 set out only the minimum indexation that schemes could henceforth

provide. This minimum was flexibly defined, making it straightforward for the government

to adjust. Each year it is the lower of 5% or the percentage which appears to [the Secretary

of State] to be the percentage increase in the general level of prices in Great Britain...

If pension schemes refer to the indexation in the 1993 Act, then their liabilities will adjust

with respect to CPI once the change is enacted (accruing from the start of 2010 or 2011,

depending on whether the change is made by the start of October 2010). However, for

schemes not explicitly referencing the indexation in the Act, existing liabilities should not be

affected unless more exhaustive legislation is brought in. Schemes indexed directly to RPI

inflation should not be affected, nor should those with Limited Price Indexation (LPI).

Although LPI (0,5%) is currently similar to the Act, it is not explicitly flexible or, indeed, the

same, given that the legislation does not define a floor. It is our understanding that most of

Alan James


Government can easily change

indexation for schemes that

reference 1993 legislation

Most large private sector

schemes do not refer to the 1993

Act, but many smaller ones do


23/51


9 July 2010 23

the largest UK private sector schemes are linked to RPI or LPI rather than referring to the

linkage in the legislative framework. However, there will be a significant number of schemes

that do reference the legislation and, since the announcement, trustees and finance

directors are likely to be examining the detail of their contracts.

The current proposal means that some firms will receive a windfall in terms of a much

healthier pension funding status than currently, with the scheme members having theirfuture benefits cut. It is possible that the government will bring more far-reaching legislation

to directly affect more private pension schemes. We expect that the governments action

will also prompt some of the few remaining open pension schemes to redefine their

accruals for new liabilities on a CPI basis. Until there is greater clarity as to the governments

strategy, we would expect the announcement to influence the behaviour of many funds

that are not directly affected by the change as currently indicated, with LDI activity in

general curtailed. Almost all firms with defined benefit schemes will also be affected

indirectly by the change in the basis of assessment for the Pension Protection Fund if, in

future, payouts to members transferred to it will also be linked to CPI rather than RPI.

Conceptually, the change in discount rate for PPF assessment should lead to a significantly

better funded pension sector on the s179 basis. The PPF has estimated that every 10bp

change in the inflation assumption affects the aggregate PPF 7800 sample by 9bn.

We have very little doubt that, on average, CPI inflation over the long term will be lower than

RPI inflation, but the basis in the short term is relatively volatile, so hedging CPI-linked

liabilities with RPI inflation is far from ideal. Since 1997, the difference between annual RPI

versus CPI inflation has been as high as 2.6% and as low as -3.4%. Most of the big swings in

the differential come from housing, with the sharpest changes stemming from mortgage

interest payments, where this years change in methodology should reduce basis volatility.

The stated intention to try to include house prices in CPI if implemented may further reduce

this basis spread and volatility. However, RPI inflation ex-housing over this period has

swung between +1.2% and -0.7% versus CPI. Although CPI inflation swaps have

occasionally traded in the UK, it is likely to take some time before the curve is well enough

defined to provide an effective discount function for measuring the value of CPI-linkedliabilities. Until there is significant CPI supply forthcoming, the basis is likely to be

conservatively priced.

We see the government announcement as hastening the start of an active market in CPI-

linked products. We expect that in addition to the potential private pension liabilities already

discussed, there will also be significant indexation of funded public sector pension schemes

to CPI (at least on an ongoing basis and potentially for future accrual of existing liabilities).

To encourage this market to develop we would expect the DMO to issue CPI-linked bonds

by next fiscal year, in addition to continued issuance of RPI linkers. It seems highly likely that

future long-term indexation will also become CPI-based. The most important new example

of this is likely to be nuclear decommissioning liabilities for the proposed new generation of

power plants. We would not be surprised to see a switch of indexation for regulated utilitiesthe next time sectors come up for regulatory review.

All in all, we see the government proposals hastening the start of a CPI-linked market but

not the death of the RPI-linked market. Private sector RPI liabilities have barely been

growing in recent years other than through accretion of existing positions, with ever fewer

defined benefit schemes still open to new members, if at all, while many of those remaining

are offering LPI (0,2.5%) accrual, so little RPI exposure. Nonetheless, this is the first time

that there has been a proposal that cuts into existing liabilities. We expect that the

uncertainty that this produces will limit allocations into the long end of the inflation market,

On a PPF basis, pension scheme

liabilities will shrink substantially

Realised RPI-CPI basis is not

stable while the CPI curve is not

yet defined

Other liabilities are also likely to

become CPI based; we expect

the DMO to issue CPI bonds by

next fiscal year

Birth of CPI market should not

mean death of RPI


24/51


9 July 2010 24

which may make long-dated gilt linker supply more challenging to absorb, even though we

do not expect any significant imminent selling as RPI is still a notably better hedge for CPI

than no hedge at all. The impact on swaps may be more even across the curve. The danger

is that there will be some schemes that will be overhedged on inflation after the change

because of the lower discount function and hence will have an incentive to sell, but pinning

down the magnitude of such a position is very difficult without a well defined CPI curve.

From a broader asset allocation perspective, at the margin we see the announcement as

slightly positive for UK financial assets other than RPI linkers. Some companies will gain a

notable windfall as their pension situation swings into an unanticipated surplus. Insurance

companies could gain particular windfalls if they have conducted buyouts for which their

liability is significantly reduced (though in many cases pension scheme terms may have

been locked at this point). In aggregate, we would expect the equities market to benefit

even if it is hard to identify the precise winners at this stage. In the medium term, we see the

move as positive for bonds and potentially less positive for equities, as the improved

funding status may well encourage a de-risking strategy though, this is likely to occur only

once the situation has become clearer and the CPI market better defined.

The IL22 is set to reopen on Thursday 15 July for 1.2bn notional and this auction is likely to

be more challenging than it would otherwise have been given the announcement discussed

above. While not a large auction in duration terms, it is the largest-ever auction in cash

terms, with the potential to raise as much as 1.6bn if post auction options are exercised.

The bond has cheapened on the curve in recent weeks; indeed, we noted in last weeks

edition of Global Rates Weekly that it was already cheap, which we expect to support the

auction. However, the UK linker market typically has more difficulty absorbing large

amounts of cash than large amounts of duration, partly because long auctions produce

index extension bids. The previous (1.1bn) reopening of the IL22 in May is a classic

example: in this case the bond itself rallied into the auction and cleared above mid market,

but linkers cheapened sharply in the afternoon, both outright and in breakeven, even as the

bond held onto its relative outperformance versus its neighbours. We expect a relative value

bid in this auction, too, and the bond is also likely to attract demand in asset swap. Inaddition, we would not be surprised if investors wary of the potential negative impact on

long linkers from the pension reforms shorten duration by selling the long end into the IL22.

The supply shortens over 5y indices by 0.04 years and all linker indices by 0.02 years.

IL22 auction may be well

supported, despite uncertainty

Figure 1: IL22 very cheap on curve Figure 2: IL22 very cheap in outright and relative asset swap

-0.05

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

Nov 09 Jan 10 Mar 10 May 10 Jul 10

IL22 versus IL17+IL32 real yield barbell

IL17+IL32 breakeven barbell versus IL22

-10

0

10

20

30

40

50

60

70

Jul 09 Oct 09 Jan 10 Apr 10

IL22 proceeds asset swap

IL22 relative z-spread asset swap



25/51


9 July 2010 25

UNITED KINGDOM: RATES STRATEGY

The irresistible force

We discuss the recent performance of the 10y sector on the curve and cross market.

While the curve valuation looks stretched, the fundamentals support further cross-market outperformance versus Europe.

In the aftermath of the emergency budget and the 20.2bn downward revision to gilt

issuance for the current fiscal year, we have seen a continuation of the strong bullish price

action in gilts that characterised the post-election aftermath of the election. As can be seen

in Figure 1, having peaked at around 6% in the early part of the year, Gilt 5y5y fwd has now

rallied close to 80bp since mid-April to currently sit at around 5%. The rally has been driven

by four specific factors:

structural short positions after the cessation of the QE asset purchase programmearound issue of fiscal and political risk associated with the election;

a more dovish-than-expected May Inflation Report from the Bank of England essentiallyendorsing a lower for longer term structure of rate expectations in the OIS market;

a more ambitious medium fiscal plan outlined in the emergency Budget on 22 Junewhich is widely viewed as leaving the MPC little alternative but to keep its policy stance

accommodative;

increasing sovereign risk perception in the Eurozone leaving gilts as a safe haven inthe eyes of investors

The degree of short covering from international investors relative to domestic investors can

perhaps best be understood by looking at Figure 2. This shows the rolling 3-month net

change in non-resident holding of gilts which currently stands at just over 35bn, by some

considerable distance a record level for this series (which goes back over 20 years). Havingbeen large sellers of gilts in 2008-09, the international investor base has not only largely

closed its short position that was originally driven by the first factor listed above, but the

latter three factors have driven a more positive outlook for gilts.

Moyeen Islam


Figure 1: Gilt 5y5y fwd hits the lows of the year (%) Figure 2: Overseas purchases of gilts at record levels ( mn)

3.5

4.0

4.5

5.0

5.5

6.0

Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Gilt 5yr 5yr fwd

-20,000

-10,000

0

10,000

20,000

30,000

40,000

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

rolling 3m net change in non-

resident holdings of gilts

Source: Barclays Capital Source: Bank of England, Barclays Capital

The external environment has

been highly supportive for 10y

gilts both on the curve and

cross market

The flow in non-resident gilt

holdings has reached record

levels as shorts have been cut

and gilts have assumed safe-haven status


26/51


9 July 2010 26

The perception of the improved fiscal outlook for the UK can also be seen by looking at the

relative change in 1y ahead budget deficit expectations taken from the mean expectation

from Consensus Economics (Figure 3). The chart essentially shows the relative change in

deficit expectations with a positive change indicating that a UK deficit expectations are

deteriorating more quickly that those for either the US or Germany.

Figure 3: Budget deficit expectations are improving in the UK relative to others

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10

relative change in

1yr ahead budget

deficit (% GDP)

UK vs Germany

UK vs USA

Source: Consensus Economics, Bloomberg, Barclays Capital

As can be seen, there has been a steady improvement in the expectation for the UK as the

nadir of expectations was probably seen in the first half of 2009. Note that the latest survey

data were taken before the emergency Budget. The forecast PSNB for FY 11/12 is 115bn,

some 15bn lower than the Consensus economics figure. However, as can be seen, it is rare

for the relative differential to be any less than -1%. So if anything, we would expect that the

improvement in UK expectations stabilise here and any further progress is likely to be a

function of a worsening in the international leg of the spread. Figure 4 shows the recent

development in the 10yr gilt/bund spread versus the short end of the curve. As can be seen,

there has been a decoupling between the 10y spread and the short end and so the recent

retightening of the gilt-bund spread can be viewed as a catch-up. In contrast, the spread

versus the US has been more orderly (Figure 5).

Figure 4: GBP/Euro 10y spreads vs 1y1y spread (bp) Figure 5: GBP/USD 10y spreads vs 1y1y spread (bp)

-40

-20

0

20

40

60

80

100

120

140

Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10

-50

0

50

100

150

200

10yr Gilt/Bund (bonds)10yr GBP/Euro spread (swaps)GBP/Euro 1yr 1yr fwd spread (RHS)

-40

-20

0

20

40

60

80

100

120

140

Jan-07 Oct-07 Jul-08 Apr-09 Jan-10

0

50

100

150

200

250

10yr Gilt/UST (bonds)10yr GBP/USD spread (swaps)GBP/USD 1yr 1yr fwd spread (RHS)


Deficit expectations and net

issuance dynamics support

continued outperformance

versus Bunds in the 10y sector


27/51


9 July 2010 27

We have previously found that a key driver of the spread in bonds has been the net issuance

profile for gilts. This is illustrated in Figure 6, which shows our forecasts for net issuance for

the remainder of the calendar year based on the DMOs revised remit published alongside

the Budget papers. As can be seen, it suggests that in the medium term there is further

scope for a continuation of the trend of gilt outperformance with a potential move to 50bp

towards the end of the year. If we look at the net balance of issuance between gilts and

bunds (with the bund cash flows converted to sterling at the prevailing spot exchange rate)and as can be seen in Figure 7, the net balance of issuance is not likely to see git issuance

materially outstrip bund issuance. Cumulatively, it is only 8bn higher for the remainder of

this calendar year and it is not out of the question that there might be a further reduction in

issuance later this year at the Pre-Budget Report, although this is also true of Germany but

to a lesser degree.

So overall, we see little reason to expect a major medium-term correction in the 10y gilt-

bund spread and fundamentally any widening would likely be seen as an opportunity to

reset spread tightening trades. Given the relative cheapness of the long end on the curve

and cross market versus Europe (the GBP/EUR 10/30s box remains close to its historical

highs) and with the proposed changes in the indexation of pension liabilities likely (in the

medium term at least) to leave institutional demand for long dated nominal paper broadlyunchanged, in the medium term we may also see 30y spread also come under tightening

pressure and correct back from its recent wides which remain at historical extremes. Please

see the UK Inflation-linked section for a complete discussion of the proposed changes to the

indexation of pension liabilities.

Deficit expectations and net

issuance dynamics support

continued outperformance

versus Bunds in the 10tyr sector

We look for more medium-term

performance for gilts versus

bunds in the 10y sector .but

the spread in the 30y sector may

well also begin to turn having

reached historical extremes

Figure 6: 10y gilt/bund spread (bp) vs net gilt issuance ( bn)

Figure 7: 10y gilt/bund spread (bp) vs net issuance balance ( bn)

-20

-15

-10

-5

0

5

10

15

20

25

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

0

10

20

30

40

50

60

70

80

90

100

Net supply gi lts (inc BOE APF) 10yr gi lt/bund (RHS)

-40

-30

-20

-10

0

10

20

30

40

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

0

10

20

30

4050

60

70

80

90

100

Gilt vs bund supply (currency adjusted)

10yr gilt/bund (RHS)

Source: Barclays Capital Source: UK Debt Management Office , GFA, Bloomberg, Barclays Capital


28/51


9 July 2010 28

COVERED BONDS

Relative value thoughts on the Nordic coveredbond market

(This is an edited extract from The AAA Investor, published 8 July 2010)

Over the course of previous months, covered bonds from issuers located in the Nordic

countries, ie Denmark, Norway, Finland, and Sweden, have been among the most resilient

against any form of spill-over effects from their respective government bond markets. Instead,

with investors unwilling to abandon their flight-to-quality strategies as of late, swap spreads of

Nordic covered bonds actually tightened and, at the time of writing, traded on tighter levels

than those of comparable French common law covered bonds, a development last observed in

June 2009. This, at first glance, might appear as something of a paradox as, in contrast, to

French papers, covered bonds from the Nordic region (except for issues out of Finland) did not

benefit from the 60bn covered bond purchase programme set up by the Eurosystem.

A closer look at the Nordic market unveils that Finnish covered bonds trade on the relativelytightest levels, which we believe is attributable to the relative scarcity of Finnish covered

bonds. Swedish covered bonds, in contrast, trade slightly dearer than their peers, which, in

our view, is because of a more diverse issuer spectrum and partly also because of the higher

issuance volumes (Figure 1).

Figure 1: Credit term structures on the Nordic covered bond market

0

20

40

60

80

0 2 4 6 8 10 12 14

term-to-maturity (yrs)

Denmark Norway Finland Sweden

OAS swap spread (bp)


With only one issuer active with regards to EUR-denominated benchmark covered bonds,

namely Danske Bank (DANBNK), the analysis of the Danish market is relatively

straightforward. On average, Danish papers trade in between those of Norwegian and

Swedish issuers, which, in our view, is little surprising as the collateral pool backing Danish

EUR-denominated benchmark covered bonds consists of residential property in Norway and

Sweden. Also, Danish covered bonds benefit from a relatively faster swap-spread

adjustment process as a result of the slightly higher liquidity due to a higher amount

outstanding and the fact that the domestic (DKK-denominated) covered bond market is

among the worlds most liquid ones. Thus, we understand the condition of the Danish

Leef Dierks

+49 (0) 69 7161 1781

[email protected]

Fritz Engelhard

+49 69 7161 1725

[email protected]

Michaela Seimen

+44 (0) 20 3134 0134

[email protected]

Denmark


29/51


9 July 2010 29

covered bond market to be attributable both to the sound underlying fundamentals and the

relatively good liquidity endowment.

With merely two active issuers of benchmark EUR-denominated covered bonds at the time

of writing, DnB Nor (DNBNOR) and Sparebanken Boligkredit (SPABOL), the characteristics

of the Norwegian covered bond market can best be compared with the Danish market.

Generally, with largely similar issuance volumes and a comparable asset quality, SPABOLtends to trade slightly dearer than the generally rich DNBNOR. What is more, in light of

virtually no sovereign debt issuance, covered bonds currently appear to be the only

alternative when seeking exposure to AAA-rated, EUR-denominated Norwegian debt.

With only one active issuer (OP Mortgage Bank OPMBK) of benchmark covered bonds

(Sampo Bank (SAMPO) was acquired by DANSKE as per 1 February 2007) at the time of

writing, the Finnish covered bond market still benefits from a degree of scarcity appeal.

This, as illustrated in Figure 1, is reflected in relatively rich swap-spread levels, which

indicate that on average, Finnish covered bonds trade on slightly richer levels than their

peers from other Nordic countries. Whereas we do not expect this situation to materially

change in the near term, we also highlight that apart from liquidity aspects, there is little

reason for the respective covered bonds to trade at a premium (discount) vis--vis its peers.

Figure 2: The Swedish covered bond market

20

30

40

50

60

2 3 4 5 6 7 8

term-to-maturity (yrs)

NBHSS SCBCC SEB SPNTAB LANSBK SHBASS

OAS swap spread (bp)


With regards to the Swedish market, which clearly is the dominating force in terms of

outstanding volume among the other Nordic markets, things appear to be slightly different.

The Swedish covered bond market is less homogeneous, as within the same maturity

bracket, Swedish covered bonds trade nearly 20bp apart (Figure 2). Whereas the 4.250%

NBHSS February 2014 traded at mid-swaps plus 25bp at the time of writing, the 4.125%

SPNTAB June 2014 traded at mid-swaps plus 43bp, a difference we believe is difficult to

justify through liquidity or related issues. Instead, we understand this differentiation to be a

signal for the investors perception of different qualities. In other words, on the Swedish

market, the price of a covered bond appears to be strongly related to the perceived quality

of the collateral pool and an issuers exposure vis--vis potential headline news.

Also, at least partly, the above seems to be reflected in the development of the issuers five-

year senior CDS. Despite having significantly contracted (from 200bp) since summer 2009, the

difference between the five-year senior CDS of Nordea Bank and Swedbank still amounted to

approximately 20bp at the time of writing, ie to precisely the difference we have observed

between the two issuers EUR-denominated benchmark covered bonds (Figure 3).

Norway

Finland

Sweden

CDS mirrors covered bonds

swap spread difference


30/51


9 July 2010 30

Figure 3: Five-year senior CDS of selected Swedish covered bond issuers

0

50

100

150

200

250

300

350

Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10

bp

Nordea SEB Swedbank


What is more, as outlined below, the correlation between an issuers five-year senior CDS

and its covered bonds with a comparable term-to-maturity is rather low except forSwedbank Hypotek (SPNTAB) where the R amounts to 0.92. Generally, however, CDS do

not appear to be a reliable proxy for EUR-denominated covered bonds on the Swedish

market (Figure 4).

Figure 4: 12-months correlation between selected 5-yr Senior CDS and covered bonds

y = 60.393Ln(x) - 233.82

R2 = 0.9235

y = 26.609Ln(x) - 76.008

R2 = 0.0955

y = 84.137Ln(x) - 352.24

R2 = 0.5392

0

25

50

75

100

125

0 50 100 150 200 250 300 350

5-yr Senior CDS (bp)

NORDEA SEB SPNTAB

Covered bond OAS swap spread (bp)


In a subsequent step, we analyse the composition and quality of the Swedish covered bond

issuers respective collateral pools (Figure 5). Whereas we note that, on average, Swedish

covered bond issuers are rather transparent in terms of providing collateral pool-relateddata, we also highlight that the composition of the collateral pools does not justify swap

spread differences of up to 20bp. Instead, in light of broadly homogenous collateral pools

(we do not see any major outliers), we believe that swap spread differences are instead

attributed to potential headline risks. In other words, as in an optimal case, the respective

collateral pools need to be evaluated on an isolated basis, ie

34331824 barclays global rates weekly 20100709

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