market strategy americas the ins and outs of the labor market

7/31/2019 Market Strategy Americas the Ins and Outs of the Labor Market

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Barclays | Market Strategy Americas

10 May 2012 2

FORECASTS

2011 2012 2013 Calendar year average

% change q/q saar Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2011 2012 2013

Real GDP 0.4 1.3 1.8 3.0 2.2 2.5 3.0 3.0 2.0 2.5 2.5 3.0 1.7 2.4 2.5

Private consumption 2.1 0.7 1.7 2.1 2.9 2.5 3.0 3.0 2.0 2.5 2.5 3.0 2.2 2.4 2.6

Public consump and invest. -5.9 -0.9 -0.1 -4.2 -3.0 -3.0 -3.0 -3.0 -2.0 -2.0 -1.5 -1.5 -2.1 -2.7 -2.3

Residential investment -2.4 4.2 1.3 11.6 19.1 8.0 10.0 10.0 8.0 10.0 12.0 12.0 -1.3 10.6 9.8

Equip. & software investment 8.7 6.2 16.2 7.5 1.7 10.0 12.0 12.0 9.0 12.0 12.0 12.0 10.4 8.3 11.1

Structures investment -14.3 22.6 14.4 -0.9 -12.0 10.0 10.0 10.0 8.0 10.0 10.0 10.0 4.6 3.2 9.5

Net exports ($ bn, real) -424 -416 -403 -411 -410 -407 -408 -409 -408 -414 -424 -434 -414 -408 -420

Net exports (contr to GDP, pp) -0.3 0.2 0.4 -0.3 0.0 0.1 -0.1 -0.1 0.0 -0.3 -0.4 -0.4 0.0 0.0 -0.1

Final sales 0.0 1.6 3.2 1.1 1.6 2.5 2.9 2.9 2.1 2.6 2.7 3.0 1.9 2.2 2.5

Ch. inventories ($ bn, real) 49.1 39.1 -2.0 52.2 69.5 69.5 71.5 73.5 77.5 82.5 86.5 90.5 34.6 71.0 84.3

Ch. inventories (contr to GDP, pp) 0.3 -0.3 -1.4 1.8 0.6 0.0 0.1 0.1 0.1 0.2 0.1 0.1 -0.2 0.3 0.2

GDP price index 2.5 2.5 2.6 0.9 1.5 2.6 2.7 2.7 2.7 2.7 2.8 2.9 2.1 2.0 2.7

Nominal GDP 3.1 4.0 4.4 3.8 3.8 5.1 5.7 5.8 4.7 5.2 5.3 6.0 3.9 4.5 5.3

Industrial output 4.4 1.2 5.6 5.0 5.4 4.0 5.0 5.0 4.0 4.5 4.5 5.0 4.1 4.7 4.5

Employment (avg mthly chg, K) 192 130 128 164 229 172 200 230 170 200 220 230 153 208 205

Unemployment rate (%) 9.0 9.1 9.1 8.7 8.2 8.1 7.9 7.7 7.6 7.4 7.2 7.0 8.9 8.0 7.3

CPI inflation (% y/y) 2.1 3.4 3.8 3.3 2.8 1.9 1.8 2.1 2.1 2.2 2.6 2.7 3.2 2.2 2.4

Core CPI (% y/y) 1.1 1.5 1.9 2.2 2.2 2.2 2.2 2.4 2.6 2.6 2.7 2.8 1.7 2.3 2.7

Core PCE price index (% y/y) 1.1 1.3 1.6 1.8 1.9 1.9 2.0 2.2 2.3 2.3 2.4 2.5 1.4 2.0 2.3

Current account (% GDP) -3.2 -3.3 -2.8 -3.2 -2.9 -2.9 -2.9 -2.8 -2.8 -2.8 -2.8 -2.8 -3.1 -2.9 -2.8

Federal budget bal. (% GDP) -8.7 -7.1 -5.5

Federal funds rate (%) 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25

Note: All numbers expressed in q/q saar % unless otherwise specified. The budget balance is fiscal year.Source: BEA, BLS, Federal Reserve, US Treasury, Barclays ResearchSUMMARY OF VIEWS

Direction Fiscal and European uncertainty likely to keep yields at current levels. Remain neutral on duration.

Curve/

Curvature

Term premium in the front end is low, given the uncertainty about the economic outlook. Maintain vol-weighted 2s3ssteepeners.

Maintain 10s30s Treasury curve steepeners. Recommend hedging the mark-to-market risk by being short 10y TIPS. Remain neutral on the long 5s10s30s fly. Short the 5s7s10s fly, as the 7y sector look rich ahead of intermediate supply.

Swap spreads Mar 13 FRA-OIS spread as a protection trade. 30y spread tighteners for asymmetric tightening risk. TY invoice spread tighteners hedged with 1y1y Libor-OIS for swapped issuance.

Other spreadsectors

Front-end agencies have continued to outperform Treasuries; we recommend moving out to the 5-7y sector or owningfront-end MTNs. Short-dated Bermudan callables offer an opportunity to fade the sell-off in rates and spike in vol.

We remain constructive on Canadian covered bonds, given their relative isolation from Europe and continuedsignificant spread pickup to agencies.

Inflation Neutral on breakevens outside the very front end; overweight on 30y breakevens versus 10s. Long Apr13s covered BE hedged with energy. Long 10y relative TIPS ASWs, as the sector looks cheap. Long Apr17s versus Jan17s, as the floor premium on new 5s could rise with risk aversion.

Volatility Neutral 3m*10y, as there is little catalyst to push rates higher, but levels are already low. Short 2y*10y as low rate expectations push further out. 2y*10y is at 20%+ premium to 3m*10y.

Source: Barclays Research


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10 May 2012 3

OUTLOOK

The ins and outs of the labor market

Flows out of employment into unemployment have fallen sharply since the end of therecession; jobless claims and layoffs are close to pre-recession levels.

However, flows out of unemployment into employment have not risen materially,despite a pickup in job openings.

We expect job growth to average about 200k per month, weak compared with previousrecoveries from deep recessions but sufficient to push the unemployment rate lower.

Go with the flow

Data on labor market flows (ie, the movement of workers between employment and

unemployment and in and out of the labor force) can help illuminate shifts in payroll growth

and the unemployment rate. For example, flows out of employment into unemployment have

fallen consistently since the end of the recession, in line with the decline in initial jobless claims,

which have reversed most of the increase during the recession (Figure 1). An alternativemeasure of job losses layoffs and discharges as measured in the JOLTS report paint a similar

picture. Indeed, layoffs fell below pre-recession levels during 2011. In other words, the job loss

side of the ledger looks much like one would expect for an economy three years into a recovery.

However, the hiring side of the ledger remains very weak. In particular, the flow of workers from

unemployment to employment, having stabilized in mid-2009, has barely risen since. Strikingly,

this remains the case despite a significant pickup in job openings. The JOLTS measure of hiring

tells a similar story (Figure 2). As we have written previously (see US Outlook: A not so

refreshing Beveridge, 30 March 2012), we believe this in part reflects a mismatch between the

supply of available labor (the unemployed) and the demand for labor (job openings).

It also helps explain why long-term unemployment (defined as those out of work for six

months or longer) has persisted at unprecedented high levels. This is particularly striking

compared with the expansions that followed the deep recessions in the 1970s and 1980s

(Figure 3) and is likely explained by the relatively weak pace of hiring in the current cycle.

Taken together, the mismatch of available jobs and available workers and the persistence of

Peter Newland

+1 212 526 [email protected]

Job losses have eased

considerably

Figure 1: Flow from employment to unemployment falling Figure 2: Flow into employment yet to pick up significantly

1.0

1.2

1.4

1.6

1.8

2.0

2.2

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

250

300

350

400

450

500

550

600

650

700Inflow rate, employed to

unemployed (lhs)

Initial j obless claims (rhs)

000sratio, 3mma

14

18

22

26

30

34


0.55

0.65

0.75

0.85

0.95

Outflow rate, unemployed to

employed (lhs)

Ratio of openings to hires (rhs)

ratio, 3mmaratio, 3mma

Source: BLS, Labor dept, Barclays Research Source: BLS, Barclays Research

but hiring remains weak

and long-term

unemployment very high
https://live.barcap.com/go/publications/content?contentPubID=FC1806655https://live.barcap.com/go/publications/content?contentPubID=FC1806655https://live.barcap.com/go/publications/content?contentPubID=FC1806655https://live.barcap.com/go/publications/content?contentPubID=FC1806655


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10 May 2012 4

long-term unemployment suggest that the increase in unemployment during the downturn

will prove partly structural, in our view.

Job flow data can also shed light on movements in and out of the labor force. The outward

flow, reflected in the decline in the labor force participation rate, has been notable in recent

years. As we detailed in Dispelling an urban legend: US labor force participation will not stop

the unemployment rate decline, 1 March 2012, we believe the majority of the decline can beexplained by demographic factors, particularly the increasing retirement rates of the baby

boom generation, and that a sharp rebound in participation (which would stall the

downward trend in the unemployment rate) is very unlikely.

The job flow data provide some supporting evidence: since the end of the recession, those

leaving the labor force have increasingly been from employment (rather than

unemployment). This is also reflected in the JOLTS data on separations, which show that

layoffs and discharges have fallen sharply, while quits and other separations (including

retirement) are now trending higher. On the flip side, those entering the labor market are

increasingly doing so into employment, rather than into unemployment (Figure 4).

Where next for employment and the unemployment rate?

Payroll growth reflects the net of new hires (those entering employment from unemployment

or from outside the labor force) and job losses (either those entering unemployment due to

layoffs or leaving the labor force due to retirement or for other reasons). With job losses

having subsided, payroll growth will likely be driven by the hiring side of the equation. Hiring

is picking up but has not kept pace with job openings. To the extent that this reflects

structural factors, including the troubles of the long-term unemployed finding work, job

growth is likely to remain modest compared with recoveries from previous deep recessions.

We expect payroll growth of about 200k per month, in line with the recent trend (absent the

likely boost from weather effects in the winter and subsequent payback in March and April).

Meanwhile, flows into unemployment are, absent a shock to the broader economy, likely to

continue to ease job losses have slowed, and we do not believe that a surge into

unemployment from outside of the labor force is very likely. Combining these factors

suggests that a modest pace of employment growth will be sufficient to push the

unemployment rate lower.

Figure 3: Long-term unemployment has barely declined Figure 4: Flows in and out of the labor force

0

10

20

30

40

50

Jan-70 Jan-80 Jan-90 Jan-00 Jan-10

2

4

6

8

10

12Long-term unemployed (lhs)

Unemployment rate (rhs)

% unemployed %

3200

3400

3600

3800

4000

4200

4400

4600


Flow from not in the labor force to employed

Flow from employed to not in the labor force

000s, 3mma

Source: BLS, Barclays Research Source: BLS, Barclays Research

Flow out of the labor force

unlikely to be reversed in full

Layoffs have fallen as

a share of separations

Employment growth likely

to remain modest

but sufficient to push the

unemployment rate lower


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10 May 2012 5

GDP TRACKING

Q1 GDP tracking 1.9%, Q2 tracking 2.5%

A deterioration in the trade balance in March was largely offset by an upward revision to

February. Meanwhile, growth in wholesale inventories was weaker than expected inMarch. The net result was a one-tenth reduction in our Q1 GDP tracking estimate.

The real trade in goods deficit widened more than the BEA had assumed at the time of thefirst Q1 GDP estimate. However, this was largely offset by an upward revision in February,

suggesting that net trade will remain broadly neutral for Q1 GDP growth (Figures 2 and 3).

Wholesale inventories outside of the auto sector rose a softer-than-expected 0.3% inMarch. This subtracted 0.1pp from our tracking estimate (Figure 1), although inventory

accumulation is still likely to have added to growth in Q1.

The April vehicle sales report remains the only hard data released for April. Sales roseto 14.4mn, broadly in line with the average in Q1. Our Q2 GDP tracking estimate

stands at 2.5%.

Peter Newland


Figure 1: GDP tracking*

Release date Indicator Period

Q1

tracking

Q2

tracking

27-Apr GDP Q1-1st 2.2

30-Apr Personal spending March 2.2

1-May Construction spending March 2.2

1-May Vehicle sales April 2.2 2.5

2-May Factory orders March 2.0 2.5

9-May Wholesale inventories March 1.9 2.510-May Trade March 1.9 2.515-May Retail sales April

15-May Business inventories March

16-May Housing starts April


Figure 2: GDP growth contributions Figure 3: Net trade

Q4 3rd estimate Q1 1st estimate

% q/q

(saar)

Cont.

(pp)

% q/q

(saar)

Cont.

(pp)

Real GDP 3.0 2.2

Consumption 2.1 1.5 2.9 2.0

Govt. spending -4.1 -0.8 -3.0 -0.6Res. investment 11.7 0.3 19.0 0.4

E&S investment 7.5 0.6 1.7 0.1

Structures -1.0 0.0 -12.0 -0.3

Net exports, $bn -411 -0.2 -410 0.0

Ch inventories, $bn 52.2 1.7 69.5 0.4 -750

-700

-650

-600

-550

-500

-450

-400

Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Customs values, monthly

NIPA basis, quarterly

$bn (saar)

Source: BEA, Barclays Research Source: BEA, Census Bureau, Barclays Research

Note: *Our GDP tracking estimate is distinct from our published GDP forecast. It reflects the mechanical aggregation of monthly activity data that directly feed into theBEAs GDP calculation.


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10 May 2012 6

DATA REVIEW & PREVIEW

Dean Maki, Michael Gapen, Peter Newland, Cooper Howes

Review of last weeks data releases

Main indicators Period Previous Barclays Actual Comments

Consumer credit, chg, $ bn Mar 9.3 R 8.5 21.4 Continues to be driven by growth in student loansWholesale inventories, % m/m Mar 0.9 0.5 0.3 Small negative for our Q1 GDP tracking estimate

Trade balance, $ bn Mar -45.4 R -49.0 -51.8 Strong rise in non-petroleum goods imports

Import prices, % m/m (y/y) Apr 1.5 (3.6) R 0.0 -0.5 (0.5) Largely reflected drop in petroleum prices

Nonpetroleum import prices, % m/m (y/y) Apr 0.3 (0.7) R 0.1 0.0 (0.3) Sharp decline in prices of industrial supplies

Treasury budget balance, $ bn Apr -40.4 ('11) 60.0 59.1 First monthly budget surplus since 2008

Preview of the next week

Monday 14 May Period Prev 2 Prev 1 Latest Forecast Consensus

Tuesday 15 May Period Prev 2 Prev 1 Latest Forecast Consensus

8:30 Retail sales, % m/m Apr 0.6 1.1 0.8 0.2 0.2

8:30 Retail sales ex autos, % m/m Apr 1.1 1 0.8 0.2 0.2

8:30 Core retail sales, % m/m Apr 1.0 0.5 0.4 0.4 -

8:30 CPI, % m/m (y/y) Apr 0.2 (2.9) 0.4 (2.9) 0.3 (2.7) 0.0 (2.2) 0.1 (2.4)

8:30 Core CPI, % m/m (y/y) Apr 0.2 (2.3) 0.1 (2.2) 0.2 (2.3) 0.2 (2.3) 0.2 (2.3)

8:30 CPI, NSA index Apr 226.665 227.663 229.392 229.9 230.0

8:30 Empire State mfg, index May 19.5 20.2 6.6 11.0 9.0

9:00 Net long-term TIC flows, $ bn Mar 19.1 102.4 10.1 - -

10:00 Business inventories, % m/m Mar 0.6 0.8 0.6 0.4 0.5

10:00 NAHB housing market, index May 28 28 25 27 26

No significant events or releases

Retail sales:We expect retail sales to increase 0.2% m/m in April. Within non-core components, we are looking for a small gainin auto sales (in line with the rise in unit sales reported by the main suppliers) to be largely offset by a decline in gasoline, in line

with the decrease in prices relative to March on a seasonally adjusted basis. Elsewhere, we are also looking for a solid 0.4% gain

in core sales, in line with the increase in March.

CPI: We are looking for a flat m/m reading on the CPI in April, consistent with an NSA CPI index print of 229.9, up from 229.392

in March. Within this, we expect a negative contribution from energy (notably gasoline) prices and a small increase in food prices,

alongside a 0.2% rise in the core CPI. We continue to believe that core price gains will be underpinned by persistent gains in the

heavily weighted core services components, particularly shelter. Core goods prices are likely to be more volatile but we expect

them to, on net, add to the core CPI over the coming months as well.

Empire state mfg: While the Empire State manufacturing index declined in April, the new orders component was little changed

and the employment index experienced a solid increase. Given that, we look for a rebound in the headline index to 11.0 in May.

NAHB housing market: We look for the NAHB housing index to increase to 27 in May from a print of 25 in April. This would keep

the index in line with levels that, until the boost likely caused by warm weather in the first few months of 2012, have not been

seen since 2007.


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10 May 2012 7

Wednesday 16 May Period Prev 2 Prev 1 Latest Forecast Consensus

8:30 Housing starts, thous saar Apr 714 694 654 685 678

8:30 Building permits, thous saar Apr 682 715 764 - 735

9:15 Industrial production, % m/m Apr 0.7 0.0 0.0 0.4 0.5

9:15 Capacity utilization, % Apr 78.7 78.7 78.6 79.0 79.0

12:30 St. Louis Fed President Bullard (FOMC non-voter) speaks in Kentucky14:00 Minutes of FOMC meeting released 24-Apr

Thursday 17 May Period Prev 2 Prev 1 Latest Forecast Consensus

8:30 Initial jobless claims, thous (4wma) May-12 392 (383) 368 (384) 367 (379) 365 (373) -

10:00 Philadelphia Fed mfg, index May 10.2 12.5 8.5 10.5 10.0

10:00 Leading indicators index, % m/m Apr 0.2 0.7 0.3 0.2 0.2

12:35 St. Louis Fed President Bullard (FOMC non-voter) speaks in Kentucky

Philadelphia Fed mfg: We expect the Philadelphia Fed manufacturing index to rise to 10.5 in May, partially offsetting the decline

last month. Like the Empire State, the April Philadelphia Fed manufacturing index experienced only a small decline in the new

orders index and a strong improvement in the employment index despite a headline decrease.

Leading indicators: We look for the Conference Board's index of leading indicators to rise 0.2% in April. We expect interest rate

spreads and building permits to provide solid positive contributions, but these will be largely offset by negative contributions

from initial claims and consumer confidence.

Friday 18 May Period Prev 2 Prev 1 Latest Forecast Consensus

No significant events or releases

Housing starts: We expect housing starts to rise 4.7% m/m in April to 685,000 units. While single-family starts were flat last

month, multi-family starts fell 17% on the month. The strong 26% m/m increase in multi-family permits suggests that this will

be reversed in the coming months, and we look for some of that to be reflected in the April report. A rise to 685,000 units would

return starts to the Q1 average of 687,000 units and well above 2011 levels. It would also provide confirmation that

improvements in homebuilder sentiment, falling inventory, and a robust rental market are translating into better start activity. We

continue to expect residential construction to add to GDP growth in the coming quarters.

IP: We are looking for a 0.4% m/m increase in industrial production and manufacturing output in April. Headline industrial

production growth has been volatile in recent months, largely reflecting swings in the mining and utilities components, likely

partly related to the warmer-than-usual weather over the winter. Excluding these, manufacturing output posted a small decline in

March (-0.2%), following very strong gains in December, January, and February. Our forecast for a rebound in April reflects theincrease in the production component of the ISM survey, as well as small gains in manufacturing employment and hours worked

during the month. We also expect a small positive contribution from auto output, consistent with production schedule data.

FOMC minutes: We read the tone of the April FOMC statement as indicating that the Fed does not expect to conduct further

asset purchases or continue its maturity extension program beyond June. In addition, several participants brought forward the

expected timing of the first rate increase. Therefore, we look for the minutes of the April FOMC meeting to provide additional

insight into why Chairman Bernanke characterized monetary policy as being in the right place and how the committee came to

adjust its forecast in favor of stronger growth (in 2012), higher inflation, and a lower unemployment rate. We also look for the

minutes to provide further context about how the committee views the decline in the unemployment rate and what conditions

would be necessary to begin further purchases of securities. One other aspect to watch will be whether a couple of members

still judged that, in April, additional asset purchases may be warranted, as was the case in March.


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10 May 2012 8

TREASURIES

Another reason to worry

We remain wary of fading the rally, given a modest growth outlook and strengthening

linkages between sovereigns and banks in Europe. We instead recommend shorting 7sversus the wings for normalization of QE expectations and intermediate supply ahead.

Treasury yields gradually drifted lower as economic data weakened somewhat; our

economists tracking estimate of Q1 GDP fell to 1.9% from 2.2% at the beginning of the

month due to lower inventory accumulation, but mainly in response to higher uncertainty in

Europe following the elections in France and Greece. The spread of French government

yields to German yields has remained elevated and that of Italy and Spain has widened over

the week (Figure 1). The latter was likely due to increased concerns about public finances

being used to shore up the banking system.

Given the political uncertainty and even stronger linkages between European banks and

sovereigns following the LTRO led bank demand for government securities, we remain wary

of fading the rally. Figure 2 shows that since the beginning of the year, banks in Italy and

Spain have increased their holdings of government securities by ~30%. In the recent flare

up, spreads of European financials have caught up with sovereign spreads (Figure 3).

Liquidity injected via the LTROs only helped financials outperform temporarily as the

underlying sovereign concerns were not really addressed; CDS spreads on Spanish

government debt are now trading at wider levels than late last year, and those of Italy and

France have reversed 50% and 60% of the move, respectively.

Another reason we are cautious in fading the rally is that expectations of USD L-OIS basis

have more room to widen before they catch up with European financial spreads. Figure 4

shows that over the past few months, 1y fwd L-OIS expectations have been driven mainly

by European bank credit risk. Even though the latter has reversed more than half of the

move tighter, L-OIS expectations have not risen much; they could easily be 10bp higher. Insuch a scenario, US yields are unlikely to be higher (see the swaps piece for a discussion on

how to best position for a flare up).

Anshul Pradhan


European financial spreads have

caught up with sovereign

spreads given strengthening

linkages between sovereigns and

banks

Figure 1: Recent political changes in Europe have done littleto alleviate uncertainty

Figure 2: Linkage between European banks and sovereignare even stronger now

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Jan-1 Jan-22 Feb-12 Mar-4 Mar-25 Apr-15 May-6

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

Spain Italy France, rhs

Spreads of 10y Govt bonds vs Germany, %

150

175

200

225

250

275

300

325

350

Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12

$bn

Italian Banks Spanish Banks

A 28% in holdings of

general government

securities

A 28% increase in

holdings of general

government securit ies

Source: Bloomberg Source: EUDATA, Haver Analytics

USD Libor-OIS expectations have

room to widen, given the level of

European financial spreads


9/47


10 May 2012 9

Finally, recent trends in US economic data do not justify much higher yields. Our

economists Q1 real GDP growth tracking estimate is now 1.9% and real final sales over the

last year have also grown at ~1.9%. While growth is indeed expected to pick up, consensus

forecast is for 2.3% growth in 2012 and 2.5% in 2013; our models suggests that 2-2.5%

growth is consistent with about spot 10y yields of 2%. In addition to the European

sovereign risk, the downside potential from fiscal tightening next year should prevent

investors from extrapolating upside surprises this year (please read Will the bond marketselloff be sustained?March 22, 2012, for a detailed discussion).

Such an outcome should keep the Fed in wait-and-see mode, with the outlook neither weak

nor strong enough to announce any policy changes. Given that the markets expectations of

further stimulus have risen substantially, as evident in the richness of the belly of the curve

and the low level of real yields, we believe investors should position in the near term for a

normalization of such expectations instead of position for much higher yields. At similar

level of yields, the belly was much cheaper earlier this year. We recommend shorting the

5s7s10s fly, which should also benefit from intermediate sector supply.

We also maintain our 10s30s steepener view as fundamentally the curve looks too flat given

current expectations of monetary policy and the levels of long term inflation expectations,

though investors should consider hedging it by shorting real yields to benefit from an

unwind of QE expectations. While long-end supply being behind us argues for a near-term

flattening as the concession is unwound, the setup that happened mainly in the morning

heading into the auction has already been unwound, in our view. 30y yields rose 7bp until

1pm on Thursday but ended the day almost unchanged as the auction came through by

2.5bp. Similarly, the 10s30s curve steepened ~2bp until 1pm but ended the day slightly

flatter. Hence, the risk of a flattening from a further unwind of the concession seems low.

RV opportunity in shorter maturity HC securities

With ongoing Fed sales in the front end but stable short-term yields, relative value

opportunities in the high coupon space have gone unnoticed. We recommend switching

from the rich high coupon issues, 9.875% Nov 15s, to the cheaper ones , 11.25% Feb 15s,

as the latter have unduly cheapened after becoming eligible for Fed sales under Twist.

Modest economic data in US do

not argue for much higher yields

We recommend shorting the

5s7s10s fly, as excessive

expectations of further stimulus

should normalize and the

auction concession

should build in the belly

We maintain our 10s30s

steepener view, as the setup

ahead of the bond auction

already seems to have been

unwound

Figure 3: European bank spreads are now catching up withEuropean sovereign spreads

Figure 4: Risk aversion, USD Libor-OIS spread, has room torise

0

50

100

150200

250

300

350

400

Jan-10 May-10 Oct-10 Feb-11 Jul-11 Dec-11 Apr-12

Average Sovereign 5y CDS Spreads, bp

European Senior Financial 5y CDS Spreads, bp

125

175

225

275

325

375

May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12

10

20

30

40

50

60

70

80

European financials,5y CDS spreads, LHS, bp

1y fwd 3M LOIS Expectations, bp, RHS

Source: Bloomberg Source: Bloomberg


10/47


10 May 2012 10

One way to judge the relative cheapness is to compare the discount at which P STRIPS from

the high coupon (old 30y) series are trading versus their lower coupon (10y series)

counterparts (Figure 5). There does not seem to be a consistent trend, and there is a fair bit of

variation in how the high coupon issues are asset swapping versus the low coupon issues; Feb

15s/May 16s are ~2bp cheaper, whereas Nov 15s are 6bp richer. This was not always the

case: Figure 6 shows that Feb 15s cheapened quite dramatically in February, when they first

became eligible for sale, and May 16s also cheapened later, even though they are well beyondthe 3y maturity. Nov 15s, on the other hand, have drifted steadily richer.

While some of this variation can be explained by the difference in the available float, Feb 15s

and Nov 15s are still outliers. Figure 7 plots the relative cheapness of high coupon issues

against the available float (outstanding minus the amount held by the Fed). The higher the

float, the cheaper the issue is. For instance, the cheapness of May 16s can be attributed to

the almost $13.2bn available float as compared with a median float of $5.6bn. Still, Feb 15s

look 2bp cheap and Nov 15s are 2bp rich. Even though Aug 15s float is $1bn lower and Feb

16s is only $0.2bn higher, they are ~3bp cheaper to Nov 15s.

The cheapening of Feb 15s since the beginning of the year is only partly justified by sales

under Operation Twist. The Fed has sold ~$2.2bn since February, increasing the float

outstanding to $8bn. The Fed currently holds $2.5bn but with the recent declining trend of

the amount sold and only two operations left, it is unlikely that the float will increase

materially (Figure 8). It therefore seems odd that Feb 15s are trading at similarly cheap

levels of May 16s.

We therefore recommend investors switch from 9.875% Nov 15s to 11.25% Feb 15s (in

whole bond or STRIPS space); we expect the yield spread of P STRIPS to compress by 4bp.

High coupon Feb 15s and May

16s are trading cheap and HC

Nov 15s are trading rich

Figure 5: No consistent trend in the relative pricing of highcoupon Issues

Figure 6: HC Feb 15s cheapened recently as they becameeligible for Fed sales; spread versus LC counterpart

-38

-36

-34

-32

-30-28

-26

-24

-22

-20

Feb-15 Nov-15 May-16 May-17 May-18

Ps ASW - 30y series Ps ASW - 10y series

-8

-6

-4

-2

0

2

4

Jan-12 Feb-12 Mar-12 Apr-12 May-12

Feb 15s Nov 15s May 16s

Source: Barclays Research Source: Barclays Research

Feb 15s appear cheap and Nov

15s rich, even after controlling

for the level of available float

We recommend switching from

HC Nov 15s to HC Feb 15s


11/47


10 May 2012 11

Figure 7: Feb 15s look cheap and Nov 15s rich, even afteraccounting for the differences in available float

Figure 8: Fed sales of HC Feb 15s have declined quitesharply; not much of a risk to a long view

y = 0.55x - 4.95

R2

= 0.64-6

-5

-4

-3

-2

-1

0

1

2

3

0 2 4 6 8 10 12 14

Feb 15s

May 16s

Nov 15s

Available Float, $bn

Discount of 30y P STRIPS to 10y P STRIPS

y = 0.55x - 4.95

R2

= 0.64-6

-5

-4

-3

-2

-1

0

1

2

3

0 2 4 6 8 10 12 14

Feb 15s

May 16s

Nov 15s

Available Float, $bn

Discount of 30y P STRIPS to 10y P STRIPS

1.444

0.661

0.11

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

2/23/12 3/29/12 4/27/12 5/29/12 June

Amount Sold of 11.25% Feb 15s

$bn

Source: Barclays Research Source: New York Fed, Barclays Research


12/47


10 May 2012 12

INFLATION-LINKED MARKETS

A glance at foreign holdings

Foreign investors have become an important demand base in the TIPS market. The

update to the annual TIC holdings report has finally provided some detail. These datashow that foreign accounts owned $206bn TIPS as of June 2011, a figure we expect to

continue to grow.

Finally, some outside data

In early 2009, when the 10y breakeven got near zero, foreign investors came in to buy. This

in itself was not an oddity because there had been tactical trading from that demand base

before and we also viewed breakevens as cheap to fundamentals. The surprise was that

even once breakevens recovered, not only did those positions not get unwound, but buying

continued. Whereas before 2009 there were few foreign official institutions with structural

allocations to the TIPS market, they seemed to have been drawn in by relative value, but

became structural buyers because of diversification and concerns about the potential for a

declining USD. Others also realized that a neutral weight to TIPS was at least some levelabove zero, given that TIPS make up about 7.5% of outstanding Treasuries.

While we have discussed this changing demand base, there has been little official data as

evidence to which we could point. Finally, the Treasury has included a breakout of TIPS in its

update of its annual TIC holdings survey of foreign investors, and it shows some interesting

results. As of June 30, 2011, the data show that foreign accounts owned $206bn in TIPS, of

which $136bn was held by foreign official institutions. This means that whereas foreign

accounts own about 50% of all US Treasuries, they owned only about 27% of the TIPS

market. Foreign official accounts, which owned about 18% of the TIPS market, had a lower

relative holding: they accounted for about 75% of total foreign-owned Treasuries, whereas

they only accounted for about 66% of foreign-owned TIPS holdings.

Figure 1: Foreign holdings of Treasuries as of June 30, 2011 Top 10 holders of TIPS

Treasury long-term debt (1)

Countries and Regions Total Total

of which:

Nominal

of which:

TIPS

Treasury

short-term

debt

TIPS as %

of Total

TIPS as a

% of LT

China, mainland 1,307 1,302 1,266 37 5 2.8% 2.8%

Middle East oil-exporters 189 117 97 20 72 10.6% 17.2%

Taiwan 147 144 125 20 2 13.3% 13.6%

Singapore 64 58 40 18 7 28.3% 31.5%

Japan 882 818 805 13 64 1.5% 1.6%

Cayman Islands 111 47 36 11 64 9.9% 23.5%

Brazil 216 212 201 11 4 4.9% 5.0%

United Kingdom 130 118 108 10 13 7.5% 8.3%

Switzerland 118 106 97 10 12 8.2% 9.1%

Luxembourg 124 88 81 7 36 5.3% 7.5%

Australia 21 17 11 6 5 27.2% 35.0%

Note: (1) Long Term (LT) denotes original maturity of over one year. Source: US Treasury

Michael Pond


Chirag Mirani

+1 212 412 6819

[email protected]

As of June 30, 2011, the TIC data

show that foreign accounts

owned $206bn in TIPS


13/47


10 May 2012 13

A few data highlights stick out. China is reported to have owned the most TIPS among

foreign accounts at $37bn, though this is only 2.8% of Treasury holdings, whereas TIPS

accounted for about 4% of total foreign ownership of Treasuries (Figure 1). Middle East oil

exporters, Taiwan, and Singapore come in a close second, third and fourth with about

$20bn each in TIPS holdings. Singapore, Australia and Malaysia have over 30% of long-term

Treasury holdings in TIPS, and Denmark is not far behind with a 26% allocation. Of its

$151bn in Treasury holdings, Russia owns just $21mn in TIPS.

The regional breakout (Figure 2) shows that Asia owned the most TIPS at $117bn; we

believe this largely represents foreign official holdings. Europe and the Caribbean owned

$44bn and $15bn, and we believe this is held mostly by money managers and hedge funds.

If foreign accounts were to move to a market neutral weight, which would be about 7.5% of

total Treasuries, this would mean holding about $350bn, or about $147bn more than June

2011 levels. We would argue that foreign accounts should actually hold greater than a

market weight allocation to TIPS because they offer a de facto currency hedge relative to

nominal Treasuries. Therefore, while structural buying has been strong and the Treasury

has responded to additional demand through increased issuance, we believe structural

foreign demand will continue to grow with the market. We hope more detail will follow on

the history on foreign ownership of TIPS, but are happy to have gotten some hard data.

Figure 2: Foreign holdings of Treasuries as of June 30, 2011 regional breakdown

Treasury long-term debt (1)

Countries and Regions Total Total

of which:

Nominal

of which:

TIPS

Treasury short-

term debt

TIPS as %

of Total

TIPS as a

% of LT

Total 4,708 4,049 3,843 206 658 4% 5%

of which: Holdings of foreign officialinstitutions 3,518 3,103 2,968 136 414 4% 4%

Total Africa 36 24 24 0 12 0% 0%

Total Asia 2,962 2,658 2,540 117 304 4% 4%

Total Caribbean 212 111 96 15 101 7% 14%

Total Europe 1,041 851 807 44 190 4% 5%

Total Latin America 318 288 273 15 30 5% 5%

Canada 45 36 31 4 9 9% 12%

Total Other Countries 25 19 13 6 6 24% 32%

Country Unknown 0 0 0 0 0 16% 19%

International and Regional Organizations 68 63 59 4 6 6% 7%

Note: (1) Long Term (LT) denotes original maturity of over one year. Source: US Treasury

Buying at auction accounts for less than half of holdings

Also providing evidence of increased foreign involvement in the TIPS market are the

Treasurys auction allotment data. Since 2009, foreign accounts have bought an average of

$1.27bn at 5y TIPS offerings, compared with about $730mn before 2009 (Figure 3).

Similarly, the average 10y auction takedown by foreign and international accounts has been

$1.5bn, whereas before 2009 it had been $668mn (Figure 4). However, the sum of all TIPS

bought by foreign and international accounts since 2000 is about $70bn. The total holdings

data of $206bn as of June 2011 indicate that this was only a small part of the demand

coming from abroad.

The regional breakout (Figure 2)

shows that Asia owned the most

TIPS, at $117bn


14/47


10 May 2012 14

Figure 3: 5y TIPS auction allotment to foreign accounts($mn)

Figure 4: 10y TIPS auction allotment to foreign accounts($mn)

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

Oct-05 Apr-07 Oct-08 Apr-10 Aug-11

Foreign and international

0

500

1,000

1,500

2,000

2,500

3,000

Apr-06 Jul-07 Oct-08 Jan-10 Jan-11 Nov-11

Foreign and international

Source: US Treasury Source: US Treasury


15/47


10 May 2012 15

AGENCIES

Back in black

With foreign interest in agency bellwethers returning, we examine the first Fannie Mae

quarterly profit to taxpayers since conservatorship. While both GSEs could stay roughlyprofitable near term, a dividend-rate redefinition would remove significant uncertainty.

Foreign participation remains robust; opportunities remain

Well above average foreign participation in recent 5y bellwether issuance, in our view,

reflects market participants comfort with GSE credit, which Fannie Maes (FNM) 1Q12

results should boost. At +27bp to matched-date Treasuries, we believe the 5y sector still has

tightening potential, as does the 7y point at T+33bp (Figure 1).

We concur in our base-case view that the remaining $125bn/$150bn in post-2012 capital

support will more than suffice to support the GSEs over the next few years, as the high

credit quality, post-conservatorship vintages have become a 55%-and-growing share of the

guarantee books (Figure 2). This should allow enough time for Congress to hammer out

housing finance reform. Furthermore, the Treasury can unilaterally increase the margin of

safety, and time, by modifying the senior preferred dividend rate.

Fannie Mae 1Q12 financials: The beginning of the end (of provisions)

Fannie Mae posted net income of $2.7bn in 1Q12 after a $2.4bn loss in 4Q11, the first

positive quarter since 4Q10, before paying $2.8bn in senior preferred dividends to the

Treasury. Owing to a mark-up in AOCI, FNM did not make a request for more capital during

the period, the first such quarter since the conservatorship. Factors in the improvement

occurred across the board: a reduction in credit loss provisions, increase in net interest

income, and modest MTM gains on derivatives all contributed.

Credit provisioning reduces sharply; reserves expected to sufficeFNM provisioned just $2.0bn for credit losses in 1Q12 after $5.5bn in 4Q10, as single-family

loss severities decreased to 33% after reaching 37% in late 2011. In our view, this seems in

line with the sharp recent reduction in serious delinquency rates at FNM. Notably, FNM

James Ma


Rajiv Setia

+1 212 412 5507

[email protected]

We expect remaining PSPA

capacity post-YE12 to more than

suffice

Figure 1: Agency-Treasury spread curve stays steep Figure 2: Guarantee book quality varies sharply by vintage

0

10

20

30

40

50

0 2 4 6 8 10

Maturity, y

A-T Spd, bp

FNM FRE FHLB

660

680

700

720

740

760

780


16/47


10 May 2012 16

estimates that with the $2.0bn in credit provisioning it recognized this quarter, its balance of

loan loss reserves would be sufficient to cover future losses on the legacy guarantee book.

With this balance at $75bn, the $85bn in cumulative charge-offs since 2008 imply total legacy

guarantee losses of $160bn; this is roughly in line with our own estimates. 1 This dovetails with

FNMs expectation that credit-related expenses will be less in 2012 than 2011 (which were

$26bn). The same calculation at FRE gives $83bn in guarantee losses from $38bn in reserve

balances and $45bn in charge-offs (also close to our estimates, Figure 3).

Recall that our estimates were based on cumulative NPA reaching $550bn at both GSEs with a

45% severity rate, for combined credit losses of $250bn. Our view was partly predicated on

lower recovery from the MIs, to which FNM/FRE have $90bn and $40bn of exposure,

respectively. As of Q1, the GSEs have recognized $464bn (Figure 4). If housing rebounds

strongly, it is possible our default and severity estimates may prove high. The fact that the

GSEs provisioning has been in line with our more punitive estimates indicates that FNM/FREhave been conservative in provisioning for losses on their legacy book of business.

Net interest income stays stable; MTM items swing to gains

Net interest income improved in 1Q12 at FNM to $5.2bn, after totalling $4.5bn the previous

quarter, as funding costs fell. Along with slow prepayments, this has made the portfolios a

profitable revenue stream for the GSEs (Figure 5), a pattern likely to continue over the next

few years. However, in the medium term, mandatory portfolio shrinkage (at least 10% per

year), increasing NPA, and rising funding costs could all erode net interest income.

Derivatives positions led to a MTM $280mn gain at FNM in Q1, up from the $800mn loss in

4Q11 (note that FRE booked a $1bn loss in Q1). The level of rates should remain a large

source of volatility in GSE earnings: for instance, the 5y swap rate has rallied 20bp quarter-to-date, a move that would likely lead to a FAS 133-related charge in Q2.

OTTI has remained minimal at $60mn recognized in income. Also, AOCI in owners equity was

marked up $400mn, leading to the zero draw in Q1. We are less sanguine about such mark-

ups to offset taxpayer lossesat currently high dollar prices/low durations, the retained

portfolios higher-coupon MBS have more limited scope for price appreciation.

1 US Agencies Outlook 2012 Achtung baby, 13 December 2011

Figure 3: Provisions approach our estimated total needs Figure 4: NPA balances increase, but more slowly

79

160

0

20

40

60

80100

120

140

160

180

FHLMC FNMA

$bn

Loss provision Barclays' estimated credit loss

85

165

in 000 loans FNM FRE Total

90d+ Delinquencies, as of 1Q12 651 401 1,052

REO on Balance Sheet, 1Q12 114 59 173

Cum REO Liquidations, 3Q08-1Q12 629 314 943

Cum Short Sales/DIL, 3Q08-112 219 123 342

Total NPA Loans, as of 1Q12 1,613 897 2,510

Total Loans Serviced 17,738 11,425 29,163

As a % of Guarantees 9.10% 7.90% 8.60%

Total NPA Loans, in $bn 298 166 464

As a % of Guarantees in $bn 10.70% 9.50% 10.30%


Balance of loss reserves and

cumulative charge-offs in line

with our projections

Net interest income improves,

but we see reasons for portfolio

revenues to erode


17/47


10 May 2012 17

A pause in draws bolsters our views on GSE credit

By making no draw this period, FNM has kept its balance of senior preferreds outstanding at

$117bn through 1Q12 (FRE has also stayed stable at $72bn). We would not be surprised to

see FNM stay just at the cusp of profitability for the balance of 2012, but would anticipate

sustainable profits once loss provisioning for legacy guarantee losses ceases in 2013.

Consider the below stylized GSE income statement (Figure 5):

We assume the guarantee books stay stable at $4.7trn combined (ie, the GSEs maintainmarket share) and fee rates stay at 25bp the Treasury has diverted revenues from the

last fee hike (10bp) to fund the payroll tax cut extension, and we expect any future fee

hikes to be similarly siphoned. This leaves $11.75bn/year in revenues, assuming

minimal prospective credit losses.

At a 180bp NIM and $1.3trn size, the retained portfolio throws off $23bn in net interestincome in 2012; however, as the portfolio is mandated to shrink 10%/year, this revenue

stream decreases, for instance to $20.7bn in 2013.

With credit provisioning finished in 2012, the main source of expenses will be the seniorpreferred dividend payments, which at 10%/year is near $20bn combined.

This simplistic exercise implies that the GSEs could become profitable for a period in the

medium term in our base case, even assuming a 10% preferred dividend. However, draws

would continue if: a) NIM compresses, b) the portfolios shrink, or c) both occur. Thus, to

increase the margin of safety in case of a double dip in the economy, we recommend the

Treasury redefine the senior preferred dividend to the lesser of 10% or all the net income in

a period. Note that no congressional approval would be needed for this; pending the

outcome of the elections, this may occur as early as December.

Stress case scenario and implications for the future of housing finance

In this vein, we have received increasing inquiries on how long the remaining capital

($125bn at the larger FNM) would last after YE12 in a stress case. Using a stylized example:

The $125bn in capital remaining post-YE12 supports a mortgage portfolio of about$2.8trnthis would be exhausted with roughly 5% losses on the post-conservatorship

book. Assuming severity rates near the current 40%, the implied default rate is 12.5%.

We expect GSE profitability to be

ultimately temporary, requiring

Treasury action

Figure 5: Stylized GSE income statement Figure 6: GSEs continue to short fund

Projections, $mn 2012 2013

Guarantee income (25bp on $4.7trn) 11,750 11,750

Net interest income (1.8% on $1.3->$1.15trn) 23,400 20,700

Expenses ($0.5bn/quarter each) -4,000 -4,000

Credit provisioning (est) -14,000 0

Net income before senior pfd dividend 17,150 28,450

Senior preferred dividend -19,400 -19,625

Net income to the taxpayer -2,250 8,825 0%

10%

20%

30%

40%

50%

60%

70%


Short-term Bullet Callable



18/47


10 May 2012 18

Per our colleagues in residential credit strategy, this is consistent with another 20% HPIdecline and/or a spike in unemployment to 13-14%; as the underlying mortgages are

higher-quality origination, the latter would be more significant.

We think a stress scenario such as the one above is not particularly useful. The fact remains

that in the event that market shocks tighten financial conditions and lead investors to

conclude that another double-dip in housing is likely, a lack of capital support at the GSEswill trigger market instability even before credit losses materialize. The simple fact is that the

GSEs funding is still extremely reliant on continued market access. Consider that about

40% of the GSEs funding is either discount notes or callable debt (Figure 6); FNM/FRE

would face refunding difficulties well in advance of their capital being drawn down.

We also believe the entrenched interests in FNM/FRE, including Fed ownership of $950bn in

their debt and MBS, are too great for the government not to act to prevent any adverse

outcome such as the above. Further, in the near term, given that there are no viable

alternatives to the GSEs for housing finance, any market shock would have severe ripple

effects on global capital markets.

For instance, foreign capital would likely flee the mortgage market. By our measures,

foreigners hold about $1trn in agency MBS and debt combined. Moreover, in this macro

environment, banking sector losses would also be substantial and require government

support. Given the numerous steps taken by policymakers to support housing thus far, the

scenario above is far-fetched.

Despite our base case view that the GSEs will become profitable before preferred dividends

by next year, we continue to recommend that the Treasury adjust the preferred coupon,

preferably to the lower of 10% or all net income in any given quarter. In our view, this would

increase the margin of safety available to debt/MBS investors, and ensure that:

Future dividends are not paid with still more draws, a problem in past quarters. The credit and capital situation at FNM/FRE cannot become a cause of financial

instability and investor concern.

Windfall gains are not given to junior preferred and common equity holders.In our view, such a course of action would buy sufficient time for true housing finance

reform, both for Congress to agree on replacements and for household and bank balance

sheets to heal enough to accommodate a new system.

While the 1Q12 FNM result is a positive and squares well with our loss estimates, the GSE

business model is not sustainable in the long run. Therefore, we expect the government to

act sooner rather than later to address some of these concerns and prevent undue

turbulence in global markets. We believe it would be prudent to do so before YE12, when

the PSPA limits return.

A stress case scenario may not

need to occur for GSE funding to

be disrupted

We continue believe the simplest

way to increase the margin of

safety is a dividend redefinition


19/47


10 May 2012 19

SWAPS

May 2010 all over again?

Given the return of European concerns, we believe that near-dated FRA-OIS wideners

have attractive risk-reward profiles. They should benefit even if Libor rises for a few daysin a row, and the downside is limited, in our view, given Libors recent stability.

Greek and French election results last week sparked renewed concerns about a crisis in

Europe, sparking a flight to quality and a widening of front-end swap spreads. Libor registered

its first increase in two weeks, even though it was a tenth of a basis point and driven by the

Libor setting of only one bank. Given the extreme degree of uncertainty until the middle of

June, when Greece has payments due, we still recommend buying protection in the form of

Libor-OIS spread wideners.

The optimal point for buying protection is now at the very front end

In Simmers of Discontent, published on April 12, we introduced two metrics to determine

the optimal forward starting point for buying Libor protection:

The ratio of the upside to the 1y range in putting on a widener, assuming a move inFRA-OIS comparable with that of September last year over the next three months, after

accounting for roll-down. A higher ratio means that the point is further away from the

high of last year and closer to the lower end of the range.

The risk in the trade, represented by the volatility of the particular forward Libor-OISspread over the past year.

Based on these metrics, we recommended Libor-OIS wideners with 2y forward starting dates.

However, over the past four weeks, there has been a widening of this spread, and from a roll-

down point of view, the trade is no longer as attractive (Figure 1). In fact, long-dated forward

Libor-OIS spreads are now wider than at the peak of last year.

Figure 1 suggests that the risk reward of buying FRA-OIS protection at the very front end,

has improved significantly. The market is pricing in only a 1bp widening in spot Libor-OIS

Amrut Nashikkar


The resurgence of European

sovereign risk has led protection

trades to perform well

Figure 1: 3m3m Libor-OIS wideners now offer a better riskreward profile than spreads further out

Figure 2: The average European bank has higher Libor setsthan the average non-European bank

40%

45%

50%

55%

60%

65%

70%

75%

1m3m 3m3m 6m3m 1y3m 2y3m

Upside/1y

range

9-May-12

40

42

44

46

48

50

52

54

56

58

60

Feb-12 Mar-12 Apr-12 May-12

Avg US bank setting Avg UK bank setting

Avg EUR bank setting



20/47


10 May 2012 20

spreads over the next month. A short-term widener would benefit from any risk flare but

should not lose too much otherwise, considering that Libor has been stable at its current

levels and the European crisis is likely to continue. Furthermore, given the momentum the

market prices in the forward spread curve once Libor begins to widen, a 1m or a 3m

forward starting widener should do well even if Libor merely rises for three or four days in a

row. We believe that the chances of that happening are high, and the trade can be re-

evaluated at that stage. The question is whether a near-term increase in Libor that wouldmake these trades perform is possible.

The link between Libor-OIS and sovereign risk

Since the beginning of the financial crisis in 2007, the Libor settings of European banks have

generally been higher than those of US banks. This can be seen in Figure 2 while the Libor

sets of US and UK banks declined significantly over the past three months, those of

European banks have lagged. This is because of a dollar asset-liability mismatch in Europe

and because Europe has experienced the sovereign and the associated banking crisis.

This can be seen in Figure 3, which shows that the average USD Libor setting of banks

belonging to a particular country is higher if the sovereign CDS of the country trades at a

higher level. This relationship is as true today as it was three months ago. For instance, whileFrench sovereign CDS has deteriorated, the average French bank 3m Libor setting has not

risen. This, in itself, suggests that a rise in Libor is possible.

Furthermore, the recent increase in European banks CDS has yet to be reflected in their

Libor settings. This can be seen from Figure 4, which shows a plot of spot 3m Libor-OIS

spreads against European financial CDS spreads. Since 2009, an increase in CDS spreads has

usually preceded a rise in Libor, and a decrease in CDS has preceded a fall in Libor. When

viewed in this light, a rise in Libor back to the levels of January 2012 does not appear far-

fetched. With a one-month lag, a monthly increase of 40bp in European bank CDS spreads

should lead to a 1m rise in Libor of 5bp. Considering that this is comparable with the

increase in bank CDS spreads over the past month, it would be consistent with the historical

pattern if Libor rose by 5bp.

However, it might now

make sense to initiate near-

dated FRA-OIS wideners rather

than long-dated ones

The increase in sovereign and

bank CDS spreads over the past

month suggests that a near-

term rise in Libor is possible

Figure 3: Libor settings of banks are strongly related to thehealth of their sovereigns

Figure 4: Changes in the European financial CDS indexprecede changes in 3m Libor-OIS by about a month

Swiss

US

UK

Germany

Japan

France

35

40

45

5055

60

65

25 75 125 175 225

Sov. CDS (bp)

Avg Libor

set (bp)

Current

3 months ago

-30

-20

-10

0

10

20

30

-100 -50 0 50 100

Itraxx- SNRFIN 5y (MoM 1m lagged)

3mLOIS

MoM



21/47


10 May 2012 21

FUTURES

TU too rich

The front TU contract appears rich, driven by positioning; we recommend purchasing

the two potential CTD securities basis heading into the roll month. In tandem, sellingATM straddles can be used to establish a position that performs well across scenarios.

As the front TU front contract enters the M2-U2 roll month, it appears rich, as evidenced by

a negative net CTD basis (Figure 1) and high implied repo rates. One possible reason is the

recent increase in long positions by asset managers and other reportable investors, because

these tend to be less price sensitive categories. The two classes of investors have increased

their net long positions, as a percentage of open interest, by 30pp and 5pp, respectively,

since the end of March (Figure 2).

Trade outline and rationale

Given the richness of the TU contract, we think going long the basis of either of TUM2s

close CTDs. The risk-return profile is even better if we combine basis positions in the twoclose CTDs. Assuming a notional of $10mn, we recommend buying $10mn par of 1.75%

Mar14s, buying 10mn par of 1.25% Mar14s and selling 93 TUM2 ($200k notional)

contracts against the cash securities. Since basis positions are effectively options on the

yield curve and slope, the combined position is effectively a long straddle position, while

taking advantage of the current richness of the contract. The position benefits from the net

basis increasing to zero at expiration. Further, considering the recent long build-up by asset

managers and other traders, there could be cheapening pressure on TUM2 during the roll,

so this is a good time to establish the position, in our view.

Since the combined basis position has a payoff at expiry similar to that of an option straddle,

we can monetise it by selling straddles with an offsetting payoff. Specifically, against the

basis positions highlighted earlier, we recommend selling five TUN2 call options struck at110.25 (ATM) and five TUN2 put options struck at 110.25 (ATM).

Amrut Nashikkar


Vivek Shukla

+1 212 412 2532

[email protected]

Figure 1: TUM2 net basis for the two potential CTDs appearsrich (32nd)

Figure 2: CFTC reports shows that asset managers and otherreportables have increased their net longs in the TU contract

-1.4

(2.5)

(2.0)

(1.5)

(1.0)

(0.5)

-

0.5

1.0

1.5

2.0

05-Apr 12-Apr 19-Apr 26-Apr 03-May

1.75% Mar14s Net Basis 1.25% Mar14s Net Basis

-30%

-20%

-10%

0%

10%

20%

13-Mar 22-Mar 31-Mar 09-Apr 18-Apr 27-Apr

Dealer Net Long

Asset Manager Net Long

Leveraged Money Net Long

Other Reportables Net Long

As % of open interest

Source: Barclays Research Source: CFTC, Barclays Research

Implied repo rates and the net

bases of the two CTD contenders

suggest that TUM2 is rich


22/47


10 May 2012 22

CTD switch under different yield curve and slope scenarios

Two securities can be the CTD at the time of last delivery date for the TUM2 contract:

1.75% Mar14s (current implied repo of 40bp) and 1.25% Mar14s (current implied repo of

41bp). Under scenarios of an increase in 2y rates or a 2s3s curve steepening, the former is

more likely to be the CTD, given that it has slightly higher modified duration, while the

opposite is true for the latter.

Based on the historical relationship between 2y yields and the 2s3s curve, where the curve

steepens 0.7bp for every 1bp sell-off, and vice versa, we have considered scenarios of 2y

yields declining 25bp or increasing to 55bp in increments of 5bp, and 2s3s curve steepening

8-30bp correspondingly. We use these scenarios to judge the performance of the proposed

trade in Trade Details below.

Before we proceed with the analysis of the trade, it is reasonable to ask what range of

changes in the level of 2s and the slope of 2s3s we can expect over the next 50 days (ie,

until the futures delivery date). Over the past year, with the Fed firmly indicating that it

expects to keep target rates at exceptionally low levels, 2y rates have been range-bound

between 55bp and 15bp. Thus, the ranges considered above are reasonable. No other

security, apart from 1.75% Mar14s and 1.25% Mar14s, comes close to being the CTD in anyof the scenarios.

Trade details

Instead of putting on a vanilla long CTD basis position, combining the 1.25% Mar14 and

1.75% Mar14 basis positions makes more sense, in our view. Under scenarios where one of

the two securities happens to be CTD, its net basis is zero. However, the other security will

have a positive net basis, as it is not the CTD. Thus, these two basis positions can be

combined using appropriate weights to produce the desired risk-return profiles.

Simplistically, combining these two basis positions in a 1:1 ratio produces the net basis at

expiration profile outlined in Figure 3. Intuitively, when futures prices are below 110.2 (ie, in

sell-offs and curve steepenings), 1.75% Mar14 becomes the CTD; hence, its net basis at

expiration is 0. In these scenarios, the overall P&L is driven by the richening of the basis of

1.25% Mar14s (in addition to benefiting from the basis of the CTD increasing from the

current -1.3 ticks to zero). The opposite is true for rates rallies or curve flattenings. The

In our view, a combined basis

position in the two CTDs is

attractive across rate scenarios

Figure 3: Net basis at expiration of recommended trade ineach of the considered rate scenarios

Figure 4: Combined payoff of options + futures position

-

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

109.4 109.6 109.8 110.0 110.1 110.3

Basis, 32nd

Futures Price

(2.00)

(1.50)

(1.00)

(0.50)-

0.50

1.00

1.50

2.00

109.4 109.6 109.8 110.0 110.1 110.3

Options position payoff Basis payoff Net

32nd

Futures Price



23/47


10 May 2012 23

trade also earns carry on the long cash note position in both legs. We have assumed that

the positions can be financed at overnight repo rates until expiration at 13bp.

Further, this payoff profile can be monetized using options on TUM2 contracts; hence, the

premium can be collected upfront. For the scenarios considered, Figure 4 outlines the payoff

from selling five ATM (strike 110.25) TUN2 straddles for every 100 long futures positions,

collecting an upfront premium of 0.21 ticks. It also shows the combined payoff at expirationfrom the overall strategy (ie, long two basis positions, short two options). The net payoff

line is close to zero at expiration. In other words, this position does not depend on which of

the assumed scenarios is realized. The total payoff will be the option premium collected,

plus the profits from the net basis increasing to 0 from negative levels.

Given the straddle-like payoff of

the combined basis position, one

can also sell TUM2 straddles to

monetise its positive convexity,in addition to benefiting from the

richness of the futures


24/47


10 May 2012 24

VOLATILITY

Skew blues

The payer skew is higher than can be justified by rates or the delivered rate-vol

relationship. We suggest knock-out payers to those looking for higher rate protection.

The payer skew on 10y tails has richened lately, reflecting market worries about higher rates

(Figure 1). We think some of this is justified, given low rate levels; nonetheless, it may have

gone a bit too far and warrants monetization.

Fundamentally, payer skew is an argument about "lognormal rates." If rates are low, the

possibility of a 10bp decline is not the same as a 10bp rise, so rates are lognormal. This

holds true for front-end rates or for those in Japan. But 10y rates in US, especially in forward

space, while historically low, are not low enough to justify such lognormal expectations.

For example, the 3y forward 10y swap rate is 2.92%, clearly not low enough to suggest a

10bp decline is not as possible as a 10bp rise, or even a +/- 50bp change.

The fair comparison, from a purely rates perspective, is with the EUR market, where 10yrates are quite similar. For example, the 3y10y EUR swap rate is roughly 2.7%, which is

actually lower than the USD rate. Even so, the EUR skew is not as high as the US skew

(Figure 1). To be fair, EUR skew has been richening rapidly, but even so, the USD skew is

now almost as high as it was in H2 09, when there was significant demand for high-rate

positioning. That demand was also manifested as higher vol: 3y*10y was roughly 30bp/y

higher than current levels.

This brings us to the questions whether there should be any skew, and how much. The answer

to the first is easier: the current level for US rates is unambiguously low, and the risk of a large

sell-off (say, 200bp) is more than a large rate rally. So there should be some skew.

To quantify the size of the skew, we looked at delivered skew over the past few years. Figure

2 plots the daily change in 3y*10y normal vol, along with 3y10y swap rate since the

beginning of 2009. We use early 2009 as the start date because the Fed eased to near zero

on fed funds, and even longer rates fell to historical lows. The period since then shares the

generally low rate environment to which skew has been subjected.

Piyush Goyal


Figure 1: USD payer skew has richened, is much higher than EUR where rates are similar

-15

-10

-5

0

5

10

15

20

25

30

Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11

US EUR

3y*10y 100bp HS - 100bp LS skew (bp/y)


US skew is high


25/47


10 May 2012 25

There are two key takeaways.

There is a conspicuous relationship between rate and vol: higher vol has generallyescorted a rise in rates.

Two, even during the past few months (starting September 2011), when a sell-off haseluded rates, there has seen a visible relationship.

So as already argued, some skew is justified. But the regression since September 2011

suggests a 100bp change in rates leads to only a 3bp/y change in vol. So the fair value of a

200bp wide skew is perhaps 6bp/y, much lower than the 19bp/y that it is priced. Even with

the longer history since January 2009, the value for the 200bp wide skew is not justifiable

beyond 14bp/y.

However, the markets pricing in much higher payer skew reflects the presence of flows.

Most likely, there continues to be demand for higher rate protection, with investors

positioning for/hedging the specter of higher rates via out-of-the-money payer swaptions.

Also, 1x2 receiver ladders are in vogue. For example, a 3y*10y 1x2 receiver ladder (2.5 vs.

1.95) costs nothing and does not incur a loss unless the 10y swap rate is lower than 1.4%

three years out. With the Fed fighting deflation, it is not unreasonable to expect 10y swaps toend higher than 1.4%. These ladders also carry well. As investors buy high-strike payers or

sell low-strike receivers via the 1x2 receiver ladders, the skew ends richer than can be

fundamentally justified.

Overall, skew is higher than can be justified by the rate backdrop or the rate/vol correlation.

Therefore, we recommend monetizing the same.

Skewering the skew

Investors looking for higher rate protection should consider knock-out payers. A 3y*10y 3%

payer that knocks out at 5% (so no pay-off if rates are higher than 5% three years later) is

40%+ cheaper than a comparable 3y*10y 3%-5% payer spread (Figure 4). The lower cost

improves the pay-off from the structure. The payer spread has a risk-reward of ~1:4.5, while

the knock-out payer has a risk-reward of more than 1:8.

Figure 2: 100bp rise in rates means ~7bp/y rise in 3y*10y vol Figure 3: More recently, 100bp corresponds to 6.4bp/y

y = 0.070x - 0.008

R2

= 0.178

-8

-6

-4

-20

2

4

6

8

10

-60 -40 -20 0 20 40 60

Daily change in 3y10y rate (bp)

Daily change 3y*10y (bp/y)

y = 0.032x - 0.059

R2

= 0.093

-4

-3

-2

-1

0

1

2

3

4

-40 -30 -20 -10 0 10 20 30

Daily change in 3y10y rate (bp)

Dai ly change 3y*10y (bp/y)

Note: Data period: January 1, 2009-May 10, 2012. The chart shows that dailychanges in normal 3y*10y vol is noticeably correlated with rates. Source:Barclays Research

Data period: September 1, 2011-May 10, 2012. Source: Barclays Research

While some skew should exist,

current levels are higher than

can be justified by the delivered

rate/vol relationship

Investors looking for higher

rate protection should

exploit the skew valuations

with knock-out payers


26/47


10 May 2012 26

Figure 4: Knock-out payer has attractive risk-reward due to high payer skew

3y10y 3% vs. 5% payer spread 3y10y 3% payer KO = 5% 3y10y 3% payer KO = 5%, if payer skew = 0

Spot 10y rate 2.02% 2.02% 2.02%

3y fwd 10y swap rate 2.90% 2.90% 2.90%

Cost (cts) 386 211 343

Cost (bp swap01) 45 25 40Max pay-off 200 200 200

Risk-reward 1:4.5 1:8.1 1:5

Note: Pricing as of May 10, 2012. Source: Barclays Research

Further, this pay-off is attractive only because the payer skew is high. To quantify this effect,

consider this: if the payer skew were flat, ie, high-strike options were priced at the same vol

as low-strike ones, the same knock-out payer would have required 60% more premium

outlay, meaning a much smaller risk-reward of 1:5 (Figure 4).


27/47


10 May 2012 27

BMA

Sell 3y ratios

SIFMA is setting lower than Libor than is priced by front-end ratios. Sell 3y ratios to earn

carry and benefit from a drift higher in Libor. Long-end ratios could come off as municipalyields catch up with sentiment in Treasuries. Sell 15y15y outright or as a 15y-30y flattener.

Across the curve, BMA ratios have been stuck in a range for many weeks. 2y and 5y ratios

have traded within 60-62bp and 76-78bp, respectively, for the past two months. At the

same time, 30y ratios have drifted marginally higher from 90 to 92 ratios. Clearly, the level

of rates matters, and as rates have been range-bound for multiple months, ratios have failed

to deliver a large change.

Long-end ratios, we believe, could catch up with the shorter-end ratios, leading to a lower

and flatter BMA ratio curve. Therefore, we like a 15y-30y ratio flattener, which also happens

to be at attractive entry levels. Separately, Libor has started drifting higher, and may cause

front-end ratios to take another leg lower. So, we like selling 2y-5y ratios, with 3y ratios

offering the best carry/realized vol ratios. We begin by focusing on the front-end.

Low for long

Selling the front-end BMA ratio has been a clear trade for the past few months. 1y ratios

nosedived in the second half of last year from roughly 90bp to 40bp, before inching higher

and stabilizing at c.50 ratios in the past couple of months. Alongside, 2y and 5y ratios have

been pulled lower (Figure 1). This has been the result of a spike in Libor relative to SIFMA

last year (Figure 2). Essentially, Libor represents the credit risk of the 18 banks in the Libor

panel, more than half of which are European. Whereas, SIFMA is a combination of a pristine

municipal issuer and (mostly American) bank credit risk. Given that the Euro zone is the

epicenter of the sovereign crisis, a low SIFMA set alongside Libor shooting higher is

fathomable, in our view.

Piyush Goyal


James Ma

+1 212 412 2563

[email protected]

Front-end BMA ratios are low in

a historical context as SIFMA is

low relative to libor

Figure 1: Front-end ratios plummeted, then stabilized Figure 2: SIFMA did not participate in the rise of Libor

51

61

77

40

50

60

70

80

90

100

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

1y 2y 5y

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Dec-09 Jun-10 Dec-10 Jun-11 Dec-11

SIFMA 3m Libor 3m OIS

Note: Last data point as of May 9, 2012. Source: Bloomberg Note: Last data point as of May 9, 2012. Source: Barclays Research


28/47


10 May 2012 28

Even if SIFMA continues to set within 20-25bp for many months, at current 50 ratio levels, a

short position in 1y BMA would generate gains, as long as 3m Libor sets higher than 45bp2.

That Libor has already started inching higher suggests to us that even 50 ratios may prove

high for 1y. It is noteworthy the Eurodollar futures market is pricing 49bp on 3m Libor by

mid-June and 53bp+ by September this year. Higher-than-expected Libor sets will only bring

the ratio further lower.

Admittedly, for 1y, levels are already low. Therefore, we like selling 2y-5y ratios. To pick the

best point, we look for the highest 3m carry to realized vol ratio along the curve. The one

with the highest ratio is the most attractive, as it has the highest carry along with the best

probability of making that carry (ie, lowest realized vol). Figure 3 shows the results: 3y ratios

offer the best carry adjusted for realized vol. So we like selling 3y ratios to earn carry as well

as benefit from higher Libor set.

The tide is turning

The long-end ratios, we think, may be peaking out too. Fundamentally, long-end ratios are

driven by the level of rates higher rates imply lower ratios and vice versa. Figure 4 plots the

level of 30y BMA versus 30y Treasuries for the past seven years. There are two key

takeaways from this chart. One, higher rates mean lower ratios and vice versa. Two,recently, for the same level of Treasury yields, ratios have been somewhat lower.

The latter can be explained by the outperformance of municipal yields relative to Treasury

yields in the first quarter of the year. Figure 5 plots the 30y Treasury yield and 30y MMA

yield alongside the ratio of the two. Around mid-2011, municipal yields lagged the decline in

Treasury yields, which is a typical price action in a flight-to-quality-related rally in

Treasuries. However, Treasury yields have stayed range-bound since, and municipal yields

have declined more, reflected as a lower ratio.

2 receive 50% of 45bp vs. pay an average 22.5bp on SIFMA , assuming SIFMA sets within 20-25bp

Front-end ratios could decline

further due to higher Libor sets;

sell 3y

Long-end ratios could come off

too

Figure 3: 3y ratios offer the best carry/realized vol ratio Figure 4: Higher rates mean lower ratios and vice versa

2y 3y 4y 5y

Spot 61.0 67.9 73.6 76.8

3m Fwd 64.5 70.7 75.3 77.9

3m Carry 3.5 2.8 1.7 1.1

60 Realized vol (%/day) 0.44 0.28 0.25 0.24

3m Carry/ realized vol ratio 8.0 9.9 6.8 4.5

y = -12.463x + 138.71

60

70

80

90

100

110

120

2 3 4 5 630y Treasury

30y BMAJan '05 - Dec '12

2012 YTD

Regression

Note: As of May 9, 2012. 3y ratios offer the best carry/realized vol ratio. 3mforward 3y ratio = 70.7, implying 2.8 ratios as three-month carry (= 70.7 67.9).The 60-day realized vol is 0.28 ratios/day, implying that the three-month carry is9.9 times the realized vol. Source: Barclays Research

Note: Data period: January 1, 2005 to May 8, 2012. Source: Barclays Research


29/47


10 May 2012 29

The Treasury yields would likely stay low for a very long time, maybe for all of 2012 and

possibly further out. The collapse in short-dated vol is reflective of such market

expectations. 3m*10y has fallen from 120bpy+ in mid-November last year to about 75bp/y

now, which also happens to be its lowest level since the Lehman crisis in 2008. Incidentally,

very recently, 3m*10y pierced through 85bp/y, a level it had previously bounced off five

times since the crisis. Such low levels of short-dated vol point to the low-for-long

expectations for Treasury/ swap yields.

With such sentiment in Treasuries, we think it is only a matter of time that the municipal

yields catch up with the Treasury yields. We would have thought otherwise, but the supply-

demand dynamic in municipals is positive too as the issuance is quite low and inflows into

the municipal bond funds are still positive (Figure 6). Accordingly, as the ratio of municipal

to Treasury yields come off, a lower BMA ratio is in the offing. Those who are wary of a blow

up in the Eurozone and therefore are not convinced of a short in long-end BMA, can hedge

the short in 30y with a short in 3y ratios, or consider a 15-30y ratio curve flattener, which

also happens to be at good entry levels.

.as the supply-demand

dynamic in municipal bonds is

positive; implying municipal

yields could catch up with the

low-for-long sentiment in

Treasuries

Figure 5: Municipal yields are set to catch up with Treasuries Figure 6: Municpal bonds funds are seeing inflows

2.5

3.0

3.5

4.0

4.5

5.0

5.5

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

80

95

110

125

140

155

170

30y tsy 30y mma 30y mma / tsy ratio

-6

-5

-4

-3

-2

-1

0

1

2

3

May-09 Nov-09 May-10 Nov-10 May-11 Nov-11

Muni fund flows ($bn)

Source: Bloomberg. Barclays Research Source: Haver Analytics


30/47


10 May 2012 30

MONEY MARKETS

Regulatory flanking maneuver

Money funds are at risk of being outflanked by regulators. Unhappy about the progress

of the SECs reform efforts, press reports hint at an alternative regulatory tack thatwould declare money funds to be systemically important financial institutions (SIFIs).3

Section 165 of Dodd-Frank would give the Federal Reserve Board broad anddiscretionary authority to set prudential standards covering capital, liquidity, and

counterparty exposure limits.

A SIFI designation might require significantly higher money fund capital buffers than the1-3% the SEC has advocated.

Money funds would be subject to tighter counterparty credit exposure limits. Unlikecurrent SEC mandates, these limits are insensitive to counterparty credit rating or

collateral type.

It is unclear if an expanded regulatory role for the Federal Reserve might also includeredemption gates or floating NAVs.

We suspect that talk of SIFI designation and Dodd-Frank Sec 165 is primarily meant to bring

the SEC and the industry back to the negotiating table.

Getting nowhere

The SEC was expected to release a follow-up to its May 2010 money market reforms

sometime in the first quarter of 2012. But so far, the SEC has yet to put any official proposal

on the table for addressing destabilizing flight risk from (largely) institutional investors in

money funds. Regulators are interested in requiring money funds to shift to a floating NAV

structure or mandating that stable NAV funds maintain capital buffers (of 1-3%) and

redemptions gates (of perhaps, 3% for 30 days).4

3 See, Regulators Seek Plan B on Money Funds, A. Ackerman and V. McGrane, Wall Street Journal, May 8, 20124 See, Money Market Fund Reform: State of Play, Market Strategy Americas, April 5, 2012

Joseph Abate


Figure 1: Top 10 borrowing banks (% taxable fund balances)

Figure 2: Top 10 complexes (% total industry assets)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

A B C D E F G H I J

0

2

4

6

8

10

12

14

16

18

A B C D E F G H I J

Source: Cranes Data, Barclays Research Source: Federal Reserve, Barclays Research


31/47


10 May 2012 31

Unsurprisingly the industry has consistently expressed its unhappiness with these proposals

for a number of reasons including the prohibitive cost and the potential for investors to

leave the industry all together. At the same time, Congress has entered the fray with two

members of the House Committee on Financial Services expressing concern that the SEC

h

market strategy americas the ins and outs of the labor market

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