Global Fixed Income Weekly Deutsche Bank Markets Research
Deutsche Bank Markets Research Global Rates Credit Date 10 October 2014 Francis Yared Global Fixed Income Weekly Strategist (+44) 020 754-54017 [email protected] Dominic Konstam Two strong themes have emerged from our tri-annual bottom-up top trade selection: (1) yield curves are excessively flat and the current combination of expected policy normalisation in the US and the UK and depressed inflation expectations cannot be sustained (2) carry remains king in Europe thanks to an ECB which is ultimately determined to do “whatever it takes”. Draghi stepped up the dovish rhetoric, but the risk remains that the market will challenge the ECB first. We recommend being long USD5Y5Y breakeven vs. EUR. We also maintain the EUR10s30s flattener and recommend a EUR3M30Y receiver spread as a hedge against further stresses in risky assets. The current combination of slow progress in some of the leading indicators of wage inflation and pressure on commodity prices is for now giving the Fed more time without invalidating the views of the dovish centre of the committee. We think the market will completely price out the Fed for 2015. Until it does we think risk assets remain on their back foot and the dollar tends to be stronger as part of generalized risk aversion. The markets will return to equilibrium in our view with 5s closer to 1 ¼ percent; stocks maybe another 5-10 percent lower, breakevens slightly lower and 10s having touched 2 percent tending to stabilize back in the current range of 2 ¼ to 2 ½ percent. Near term this favors buying on dips but especially 5s for an eventual and more persistent (bull) steepening. Research Analyst (+1) 212 250-9753 [email protected] Table of contents Bond Market Strategy Page 02 US Overview Page 07 Treasuries Page 18 Spec short positions in Eurodollars have always been vulnerable and no more so than now. Real money credit longs and short duration positions should also be hedged in our view. Derivatives Page 24 Mortgages Page 28 Euroland Strategy Page 46 The good news is that this means the Fed is more likely able to normalize rates as they start later. Risk assets better priced to fundamentals and fundamentals that have more time to improve with less downside tail risk represent a “pause that refreshes”. Investors who disagree tend not to recognize the weakness in the recovery and the risk that a strong dollar poses to inflation. We emphasize that profits, that are growing at best slowly, are “bad” profits and the tail risk suggests they may become “no” profits if inflation falls. A model fitted to a sample since 2007 suggests a swing of 100 bps on goods inflation related to another 4 percent appreciation in the USDTWI. Covered Bond and Agency Update Page 50 UK Strategy Page 52 Japan Strategy Page 55 Dollar Bloc Strategy Page 59 Global Inflation Update Page 62 Inflation Linked Page 65 Contact Page 67 We suspect the FOMC minutes are likely an opening salve in the unfolding of a more dovish (delayed) Fed. Whether they realize it or not, they neither want to raise rates prematurely to reverse later, nor worse still, have to restart QE that is about to end. We suspect taper will be completed but considerable period stays perhaps even into 2015. Either way the market should discount a drop in the dots come December as a means to finding some equilibrium in risk assets and dollar consistent with the bull steepener. If we are wrong on the Fed, risk off may have further to go. ________________________________________________________________________________________________________________ Deutsche Bank AG/London DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014. 10 October 2014 Global Fixed Income Weekly Global Rates Gov. Bonds & Swaps Inflation Rates Volatility Bond Market Strategy Two strong themes have emerged from our tri-annual bottom-up top trade selection: (1) yield curves are excessively flat and the current combination of expected policy normalisation in the US and the UK and depressed inflation expectations cannot be sustained (2) carry remains king in Europe thanks to an ECB which is ultimately determined to do “whatever it takes” Draghi stepped up the dovish rhetoric, but the risk remains that the market will challenge the ECB first. We recommend being long USD5Y5Y breakeven vs. EUR. We also maintain the EUR10s30s flattener and recommend a EUR3M30Y receiver spread as a hedge against further stresses in risky assets The current combination of slow progress in some of the leading indicators of wage inflation and pressure on commodity prices is for now giving the Fed more time without invalidating the views of the dovish centre of the committee Bipolar trading for a bipolar world ECB: taking control over its balance sheet After a mildly hawkish parenthesis at the last ECB meeting, Draghi has again stepped up the dovish rhetoric in his intervention at the Brookings Institute. More specifically, he endorsed expanding the balance sheet towards the 2012 levels as being an estimate of what is necessary for the ECB to achieve its inflation mandate. He also highlighted that the ECB has not been so far in a position to adopt an explicit balance sheet target as it was only passively controlling its size. But it is now gradually shifting towards a more active management of its balance sheet, i.e. it will increasingly rely on asset purchases rather than TLTROs. Francis Yared Strategist (+44) 020 754-54017 [email protected] Jerome Saragoussi Strategist (+33) 1 4495-6408 [email protected] Abhishek Singhania Strategist (+44) 207 547-4458 [email protected] Soniya Sadeesh Strategist (+44) 0 207 547 3091 [email protected] George Saravelos Strategist (+44) 20 754-79118 [email protected] Markus Heider Strategist (+44) 20 754-52167 [email protected] Meeting the EUR1trn target with the existing measures remains a tall order. We remain of the view that the ECB will do “whatever it takes”, but the process to get there may involve first the market challenging the central bank. This is particularly the case as the data in Europe has generally continued to disappoint. We thus maintain the EUR10s30s flattener discussed last week but also enter a long USD5Y5Y breakeven vs. EUR. The latter is discussed in more details in the Global Linkers section. The EUR10s30s flattener should also benefit from rising risk aversion as a decline in equities could increase the pressure on ALM investors and the long end of the curve. Alternatively, one could consider a 3M30Y receiver spread 10bp/40bp for a running premium around 5-6bp hence a 5:1 to 6:1 leverage ratio. We remain constructive on peripheral debt and the assets more directly targeted by the ECB in particular. However, given the positive view on the front-end of the core euro curve, the decline in the ex-post Sharpe ratio at the long-end of the curve, and the risk of the market challenging the ECB in the short-term, we have reduced the risk and rotated the BTP-Bund tightener recommended 4 months ago into an outright long in 5Y BTP. Page 2 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly US: Good domestic growth vs. low inflation and downside risks from Europe The FOMC minutes were more dovish than the corresponding FOMC’s projections and press conference. This has led to a sharp rally in the front-end of the US curve which was favourable to the steepening bias expressed last week. Ultimately the Fed will be data dependent and we evaluate whether the incoming information indicates a material deviation from the FOMC’s expectations on growth and inflation. On the growth front, the domestic data are in line (if not ahead) of the FOMC’s projections. Consensus expectations for Q3 GDP remain around 3% and the hard data so far (as summarized by the Atlanta Fed tracking GDP) seem to be consistent with this expectation. The soft indicators have been more optimistic with the composite ISM for Q3 at a decade high. On the job front, the latest NFP was better than expected and the unemployment rate is already through the year-end Fed forecast. Importantly, the reduction in the pace of fiscal tightening is starting to be reflected in GDP data and should continue to be supportive in the quarters ahead. Thus the risk on the growth front comes primarily from external factors as the data in Europe continues to disappoint. ISM data suggests that the momentum in Q3 remains The reduction in the pace of fiscal tightening is robust supportive of domestic demand 5.0 1.0 ISM Implied Real Gross Domestic Product (SA 4QMA, %Chg) Implied by July ISMs 4.0 0.8 3.0 0.6 2.0 0.4 1.0 0.2 0.0 0.0 -1.0 -0.2 -2.0 -0.4 3 Estimated fiscal impulse from IMF (change in fiscal drag, rhs) 2 1 0 -1 -0.6 -3.0 -2 -0.8 -4.0 -5.0 2004 Contribution of public sector to real GDP growth YoY -1.0 2005 2006 2007 2008 Source: Deutsche Bank, Bloomberg Finance LP 2009 2010 2011 2012 2013 2014 -3 07 08 09 10 11 12 13 14 15 Source: Deutsche Bank, Bloomberg Finance LP On the inflation side, the dynamics are more negative, but not (as yet) threatening the FOMC’s central scenario. Wage inflation remains weak, and indicators of labour market slack (part-time, quits and hires) which are good leading indicators of wage inflation are improving only slowly. Some of these metrics (e.g. quits) are within a touching distance of the levels observed ahead of the start of the last tightening cycle. Others (such as part time) are lagging behind. On the basis of these indicators (and their respective lead in forecasting wage inflation), ECI (private industries) wage inflation should converge to a 2.20-2.35% YoY run rate (0.55-0.60% on a QoQ). For reference, ECI averaged 2.65% in 2004 when the Fed hiked, and reached a trough of 1.4% in 2009. Deutsche Bank AG/London Page 3 10 October 2014 Global Fixed Income Weekly Slow progress in the measures of labour market slack Part Time Hires Quits Avg Q2 03 - Q1 04 3.2 4.2 2.1 Crisis trough 5.9 3.2 1.4 Q4-13 5.1 3.7 2.0 Q1-14 4.7 3.8 2.0 Q2-14 4.8 3.8 2.0 Q3-14 4.7 3.9 2.1 45% 68% 88% Last 4q (quarter averages) % Normalisation done Correlation with ECI Leading ECI by 92% 89% 91% 1 - 2 quarters 3- 4 quarters 2 - 3 quarters Source: Deutsche Bank, Bloomberg Finance LP The decline in commodity prices could push headline inflation to a trough of 1% in March 2015 assuming some stabilization of energy prices until February. It will also generate (with a lag) some downward pressures on core inflation. Given the currently available data, core CPI is likely to slowly increase to slightly more than 2% at the end of 2015. Allowing for the usual core PCE-CPI wedge, this would be consistent with a slightly below 2% core PCE in Q4 2015 (around 1.75%) (see graphs below). This is broadly in line with the September FOMC forecasts on core inflation (headline will be lower at current level of commodity prices). The decline in oil and food prices has been significant, but as long as they reflect supply factors or USD strength rather than demand factors, the negative impact on inflation will be mitigated by the positive impact on growth. The behavior of industrial metals is arguably a better metric on which to evaluate the extent of a negative demand shock. Industrial metal can be explained by the USD and the global output gap. Industrial metal prices seem to be currently in line with these two drivers. Of the ~6% decline in industrial metal prices since the end of July, 75% (~4.5%) can be attributed to the USD strength and 25% (~1.5%) to weaker global growth. Thus, while there is certainly some loss of momentum at the global level, the 15% decline in WTI crude oil prices possibly overstates how much of that is due to lower global demand vs. USD strength and supply factors. Projected headline and core CPI YoY 4.5% Metal prices vs. USD and the global output gap 600 Headline CPI YoY - DB forecasts Metal price (S&P GSCI Industrial Metals) Core CPI YoY - DB forecasts 4.0% 500 3.5% Model (log real metal vs. global output gap and log USDTWI) 400 3.0% 300 2.5% 2.0% 200 1.5% 100 1.0% 0.5% Dec-09 - Dec-10 Source: Deutsche Bank Page 4 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 89 91 93 95 97 99 01 03 05 07 09 11 13 Source: Deutsche Bank, Bloomberg Finance LP Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Overall, while there are downside risks to growth emanating from Europe, inflation remains for now the key binding constraint. The current combination of slow progress in some of the leading indicators of wage inflation and pressure on commodity prices is for now giving the Fed more time without invalidating the views of the dovish centre of the committee. For instance both Dudley and Williams have reiterated that they still see a lift-off mid 2015, while expressing to varying degrees concerns about growth in Europe and the inflation momentum. From a market perspective, given the extreme flatness of the curve and the current pricing in the front-end, we favour a 5s10s steepener hedged with a short position in 2s (beta weighted), discussed in more details in our recent Top Trades publication. Top trades for the end of the year Yesterday we published our Top Trades for the end of the year. In this publication1, each participating DB analyst has identified the best trades in his or her markets, unconstrained by a top-down macro view. Two strong themes have emerged from this bottom-up process: (1) yield curves are excessively flat and the current combination of expected policy normalisation in the US and the UK and depressed inflation expectations cannot be sustained (2) carry remains king in Europe thanks to an ECB which is ultimately determined to do “whatever it takes”. First, on almost any metric, yield curves are too flat in the US, the UK and Australia. The market is pricing both policy tightening in the US and depressed inflation levels. Something will have to give. There are several (non-mutually exclusive) ways the curve could normalise back. First, inflation breakevens could normalise from depressed levels, and we express this with a long USD2Y2Y breakeven. Second, the front-end of the US curve could rally as the market prices a delay in the normalisation of monetary policy in the US, and we express this via a USD3M5Y receiver spread. Third, one could be agnostic about what will drive the normalisation and we express this via a GBP5s10s steepener. Fourth, one could hedge the directionality of the curve with frontend rates and trade the excess flatness more directly. We express this view with a USD 5s10s steepener vs. a (beta weighted) short in USD2s. The latter trade happens to also be an efficient way to position for a widening of breakevens. Finally, one can trade the normalisation of the USD curve via other markets and we express this via AUD 6M fwd 1Y vs.3Y steepener which has flattened as 10Y UST yields have rallied over the past few months. Second, the theme in Europe remains very much focused on carry, with a particular emphasis on the impact of the forthcoming ECB intervention. The ECB is unlikely to reach its implicit balance sheet target with the measures announced so far. Its willingness to try and ultimately to do “whatever it takes” (reiterated by Draghi at the IMF meetings), has nonetheless important implications. Given the relative reluctance to cross the public QE Rubicon at this stage, the ECB is likely to be more aggressive in implementing its private asset purchase programmes. This should support the targeted assets, and we recommend being long the weaker covered bonds in Spain and Italy and new issue CMBS focusing on the front pay level, where liquidity is greatest and spreads range from around 90bps Dutch CMBS to around 125bps for Italian CMBS. We also favour being long single-B credit which are the current sweet spot for buy and hold credit investors with an aggregate spread above 600bp. Also, the front-end of the euro curve is only pricing a marginal increase in the overall size of the ECB’s balance sheet. Even if the ECB is unable to increase its balance sheet by the advertised EUR1trn, it should manage to accumulate more than the ~EUR200bn implied by the Eonia market. We thus recommend 1 https://gm.db.com/global_markets/publications/fixed_income_special/specialreport_9oct14.pdf Deutsche Bank AG/London Page 5 10 October 2014 Global Fixed Income Weekly being long June-16 Eonia. Finally, the combination of lower front-end core rates and tighter peripheral covered bonds should together imply lower peripheral bond yields. The latter is also supported by favourable funding dynamics thanks to positive current accounts and the support of the ECB via the TLTRO. We thus recommend being long 5Y BTPs outright. The full list of trades below is discussed in more details in the publication. US: Buy 3m5y -25/-50 receiver spread US: Sell FVH5 puts vs. payer swaptions US: USD5s10s steepeners hedged by paying 20%2s Eurozone: Receive June-16 Eonia Eurozone: Long 1.5% BTPS Aug-19 UK: GBP5s10s Steepener Japan: JGB20Y asset swap wideners Dollar Block: AUD 6M1Y-3Y steepeners Inflation: Long USD2Y2Y breakevens Corporate Credit: Long EUR single-B credit Covered Bonds: Long Multi-Cedulas IMECDI 4% Mar 2021 (A1/-/A-) versus single Cedulas BBVASM 3.5% Oct 2020; Buy Multi-Cedulas AYTCED 4.75% May 2027 (A3/BB/BBB) versus single Cedulas SANTAN 4.625% May 2027 (A1/-/AA); Buy OBG MONTE 2.875% July 2024 (Baa3/-/A) versus OBG UCGIM 3% Jan 2024 (A2/-/AA-); Buy OBG BANCAR 3.875% Oct 2018 (Ba1/-/BBB+) versus UCGIM 1.875% Jan 2019 (A2/AA/AA-) CMBS: Long DECO 2014 GNDL A, MODA 2014-1 A, DECO 2014- TLPX A, WSTSTR CORP Page 6 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly United States Rates Gov. Bonds & Swaps Rates Volatility US Overview Dominic Konstam Research Analyst (+1) 212 250-9753 [email protected] Aleksandar Kocic Research Analyst (+1) 212 250-0376 [email protected] We think the market will completely price out the Fed for 2015. Until it does we think risk assets remain on their back foot and the dollar tends to be stronger as part of generalized risk aversion. Alex Li The markets will return to equilibrium in our view with 5s closer to 1 ¼ percent; stocks maybe another 5-10 percent lower, breakevens slightly lower and 10s having touched 2 percent tending to stabilize back in the current range of 2 ¼ to 2 ½ percent. Near term this favors buying on dips but especially 5s for an eventual and more persistent (bull) steepening. Stuart Sparks Spec short positions in Eurodollars have always been vulnerable and no more so than now. Real money credit longs and short duration positions should also be hedged in our view. The good news is that this means the Fed is more likely able to normalize rates as they start later. Risk assets better priced to fundamentals and fundamentals that have more time to improve with less downside tail risk represent a “pause that refreshes”. Investors who disagree tend not to recognize the weakness in the recovery and the risk that a strong dollar poses to inflation. We emphasize that profits, that are growing at best slowly, are “bad” profits and the tail risk suggests they may become “no” profits if inflation falls. A model fitted to a sample since 2007 suggests a swing of 100 bps on goods inflation related to another 4 percent appreciation in the USDTWI. We suspect the FOMC minutes are likely an opening salve in the unfolding of a more dovish (delayed) Fed. Whether they realize it or not, they neither want to raise rates prematurely to reverse later, nor worse still, have to restart QE that is about to end. We suspect taper will be completed but considerable period stays perhaps even into 2015. Either way the market should discount a drop in the dots come December as a means to finding some equilibrium in risk assets and dollar consistent with the bull steepener. If we are wrong on the Fed, risk off may have further to go. We have updated our forecasts and now expect the 10y Treasury yield to end 2014 at 2.35% and end 2015 at 2.80%. We see scope for the 5y Treasury to fall to as low as 1.25% in the short run, ending 2014 at 1.40% and 2015 at 2.25%. This forecast is consistent with markets pricing the Fed to delay lift-off until 2016 as well as with a lower equilibrium or terminal cyclical rate. We recommend investors buy 3m5y OTM receiver spreads to position for 5y outperformance. Currently 3m5y -25/-50 receiver spread structures offer payoff ratios of 7.5:1. We think it prudent for investors to hedge for wider spreads at higher rates. The idea is that a more hawkish Fed will exacerbate weak profits, undermining spread product valuations. If the market behaves as it did during the Taper Tantrum, spread product hedging flows are likely to push spreads wider. We like selling OTM FVH5 puts versus like-structured swaptions for zero premium for a zero strike spread that is modestly better than the forwards. Deutsche Bank AG/London Research Analyst (+1) 212 250-5483 [email protected] Research Analyst (+1) 212 250-0332 [email protected] Daniel Sorid Research Analyst (+1) 212 250-1407 [email protected] Steven Zeng, CFA Research Analyst (+1) 212 250-9373 [email protected] Page 7 10 October 2014 Global Fixed Income Weekly Putting the Fed to Bed until 2016 We think the market will price the Fed out until 2016. Spec shorts in Eurodollars remains vulnerable to a squeeze. Real money risk asset longs are vulnerable to weaker pricing and wider spreads, compounded by the rate side rallying. Upper left volatility shouldn’t soften as this is part of a transition for all assets to be better aligned with the fundamentals and realized volatility should tend to rise. Breakevens should remain pressured and the dollar strong until the Fed acquiesces to further accommodation. Fed capitulation will allow a partial unwind of dollar strength, some recovery in risk and higher inflation expectations. The curve is likely to be slightly steeper/parallel shifting near term and on Fed capitulation can resteepen bearishly. We suspect 10s can easily trade through 2 ¼ near term with 5s heading towards 1 ¼ percent. Later, 10s can revert to 2 ½ percent. We have freshened up our forecasts to reflect these emerging dynamics accordingly. We interpret the FOMC minutes as an important shift in Fed concern for the recovery. To the extent the minutes were massaged to reflect concerns for global growth and excess dollar strength makes the minutes even more important. However precisely because confusion now reigns as to whether the dots are more important than the minutes means the markets will fumble towards resolution ahead of the 29th October FOMC and possibly until the December meeting with new dots and forecasts. In our view we think the Fed should quickly move to consolidate a more dovish tone if it wants to forestall more dollar strength and risk asset weakness. Equally though if they want more volatility, which we think they have wanted, they could reasonably decide to move more slowly and only be forthright dovish in December. By then risk assets will be cheaper and better aligned to fundamentals. This would include taking DBHYSDM (high yield) back to the 2013 highs of over 500 bps and RTY 2000 down another 10 percent or so for example, to be better aligned with profit growth (and lack of for the past few years). We suspect the Fed will tend to move slowly: probably keeping considerable period through October statement and maintaining concern for global growth but still completing taper and allowing for ambivalence towards the timing of rate hikes (2 to 12 months!?). Come December we suspect the dots will be lower and greater emphasis placed on a likely 2016 start date for normalization. Fundamentally the Fed wants to finish QE. It wants to raise rates towards neutral. It thinks neutral is “high” around 3 3/4 percent. If it has any hope of even getting to 2 ½ percent where the Cleveland Fed Taylor rule model would currently estimate neutral, it has a better chance of starting later. If it starts early not only does it risk having to reverse rate hikes but it might need in desperation to resort to QE again. An early start to tightening could become a spectacular own goal. The problem the Fed faces is two-fold. As we have consistently argued, the recovery is sub par. It is over reliant on labor input at the expense of productivity. We highlighted last week’s payrolls as being problematic because thanks to recent output data, productivity doesn’t appear to be strengthening. Labor input (hours worked) has anyway been softer than payrolls and at around 2 ½ percent, if productivity remains well below 1 percent, there is no guarantee that GDP growth is sustaining a higher pace. In general the constraint of low productivity means that once full employment is reached jobs will slow to underlying potential of around 100k since business will not bid up wages that are not “paid for” by productivity UNLESS they can pass wage rises on into higher prices. The second problem is that pricing power is a little weak and looks like weakening further thanks to a stronger dollar and generalized global disinflation. This represents a fattening “tail risk” to Fed normalization. In terms of profits, currently decent profit levels albeit virtually Page 8 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly stagnant growth, should be characterized as “bad” profits because they are not supported by productivity but instead supported by low wages and constrained by so so pricing. The danger – or tail risk – is that bad profits become falling or “no” profits because pricing weakens and forces business to raise productivity the “wrong” way by firing labor. The Fed if it moves to normalize too quickly emphasizes the tail risk through the stronger dollar whilst also not giving further time to perhaps allow for a recovery in productivity the right way i.e. investment led capital deepening. The charts below tell the story. We also highlight the importance of the 1994 tightening cycle as a checklist of what to watch for as there are both important similarities and differences to the current stage of the cycle. The first point is to highlight the strong link between productivity growth and profit change with the exception of 1994 when profits were equally weak as now despite a rise in productivity. This reflected strong wage growth with pricing power being crimped (Greenspan’s “opportunistic disinflation”). Note the pricing contribution was not very strong – about 8-9 bps to profit change versus the current 5-6 bp, but came on the back off inflation being a fairly high 2 ½+ percent. Wage inflation was thus absorbed by strong productivity to allow a downward drag on inflation as the Fed crimped demand through normalization. This cycle could eventually see the same only if productivity picks up but also with a caveat that inflation is still below target and pricing power is weaker. So the Fed needs anyway to be more tolerant of any rise in wages, especially if it front runs a rise in productivity. Productivity contribution to NIPA profit growth 0.3 0.5 profit change 0.25 profit change prody contribution 0.2 0.15 0.4 price contribution 0.3 0.1 0.2 0.05 0 0.1 -0.05 0 -0.1 -0.15 19611 Pricing contribution to NIPA profits 19761 Source: Haver and Deutsche Bank Deutsche Bank AG/London 19911 20061 -0.1 19611 19761 19911 20061 Source: Haver and Deutsche Bank Page 9 10 October 2014 Global Fixed Income Weekly Core CPI vs. price contribution to profit change Russell 2k yoy change (4 qtr average) vs. Profit yoy 14 0.45 50 0.4 40 Profit change yoy+2 qtrs 12 0.35 30 Russell 2k yoy 4q av 0.3 20 0.25 10 0.2 0 core CPI yoy 10 price contribution rhs 8 6 4 0.15 -10 0.1 -20 2 0.05 -30 0 19611 0 -40 19883 19761 Source: Haver and Deutsche Bank 19911 20061 19943 20003 20063 20123 Source: Haver and Deutsche Bank Additionally the strong dollar is clearly a risk to less pricing power going forward, hence the FOMC minutes. Below we highlight two sub indices of core CPI, “high” volatility components that mainly cover core goods and “low” volatility components that mainly cover services excluding OER. We fit a model based on unit labor costs using a monthly GDP proxy as well as aggregate hours in the goods and service sector. In the case of goods the fit is good but note that unit labor costs are actually negatively correlated along with the dollar. So far from pricing being a mark up on cost, higher costs have been associated with less inflation presumably because the strength of the dollar in the tradable goods sector dominates. In the case of the service sector unit labor costs alone drive most of the correlation with prices with higher costs raising prices. We show in the fitted equation for each CPI a trajectory for the ongoing trend in costs but also a further strengthening in the dollar TWI by another 4 percent. The lags on the dollar are only to 6 months and the model suggests that high vol (goods) inflation could drop to – ½ percent year over year or by around 100 bps all else equal. There are the usual warnings around reading too much into this in that the model fits well only over the past 7 years. Before the crisis it is much weaker and the lags longer. That said also note that as we have shown earlier, inflation is more global post crisis (the first two components in a PCA analysis account for over 90 percent of global inflation correlation versus 70 percent or less pre crisis. This suggests greater globalization and the transfer of (dis)inflation via currency adjustments taking on more prominence. Page 10 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Goods cpi (hi vol) vs. fitted High vol CPI vs. unit labor cost proxy and USDTWI 4.0 10 4.75 5 4.70 - 4.65 (5) 4.60 (10) 4.55 3.5 3.0 2.5 2.0 1.5 1.0 0.5 high vol cpi (0.5) (1.0) 2007-Mar 2010-Mar fitted 2013-Mar Source: Haver and Deutsche Bank (20) 2007-Mar 4.45 2013-Mar Low vol CPI yoy vs. service ulc proxy 7 4 fitted low vol inflation 6 5 4 service unit labor cost proxy-12m 3.5 low vol inflation 3 4 3 2.5 2 3 2.5 2 2 1 1.5 0 1 -1 1.5 1 2008-Mar 2010-Mar 4.50 Source: Haver and Deutsche Bank Service sector (ex OER) CPI “Low volatility” vs. fitted 3.5 high vol cpi goods ULC proxy log USDTWI rhs (15) 2011-Mar Source: Haver and Deutsche Bank 2014-Mar -2 0.5 -3 2008-Mar 0 2011-Mar 2014-Mar Source: Haver and Deutsche Bank So far we have made the case that the rate normalization process is hamstrung by the nature of the profit cycle and dollar led disinflation tendencies. We can now emphasize this point in the context of traditional “late cycle” dynamics. About a year ago we suggested that the US economy was exhibiting late cycle tendencies in that productivity was very weak and labor input very strong versus potential. Tongue-in-cheek we suggested that if the Fed wanted to raise rates it better do so quickly because it was going to have to cut rates before too long as it was. The empirical evidence is quite persuasive. If we consider years where labor input is stronger than productivity relative to potential, on average the subsequent two years sees labor input falling by around 1 percent. Of course this more often than not is because the Fed is raising rates as labor markets are tightening and rising unit labor costs are tending to raise inflation. The chart below highlights again the early 1990s where there is an exception: the labor input-productivity “gap” was persistently negative into the tightening as productivity was initially slow to rise during the recovery but then as it rose labor input was still slow to fall, despite Fed tightening, because productivity was rising for the right reasons i.e. investment led growth. This allowed labor input to stay stronger for longer. The Fed in the 1994 tightening cycle can be Deutsche Bank AG/London Page 11 10 October 2014 Global Fixed Income Weekly viewed as being almost supportive to the recovery – it allowed the recovery to be extended by encouraging capital labor substitution through disinflation rather than bringing it to an end. Of course part of the explanation is that investment needed to be done thanks to the technology revolution. Business needed to invest to apply new TMT and TMT itself was going through major development. The Fed may have been an enabler by forcing business to adopt new technology to boost productivity and to sustain profit growth. It is possible the same could occur this time with robotics or perhaps 3D printing. However if the “secular stagnationists” have their way and say technology change isn’t quite what it has been, then the cycle may still be doomed to end. Labor input falls from 2015. The risk is of course still larger if profits are squeezed further so if there is any hope of a 1995/6 repeat the Fed again is best to be silent for longer and buy more time for investment led productivity growth. Note expectations for investment spending remain robust (Philadelphia Fed index) and general corporate optimism is high (NFIB). This is a recovery that seems extendable despite the raw empiricism. Hence Fed delay is more about a pause that refreshes rather than a reflection of worst to come. A reason to buy stocks for a recovery trade rather than deeply wedded to ongoing risk off. The tail risk of an overzealous Fed however is clear – the risk being a recession wouldn’t be hard to engineer and could easily see yields much lower. Similarly it is a warning to the ECB that there is no solution via a collapsing euro. Capital flight from Europe might be good for a weaker euro and global bond yields but it won’t do risk assets any good whatsoever. Labor input-Productivity “gap” vs. future labor input 15 Labor input vs. productivity relative to potential gap rhs labor input 2 yr forward 10 8 5 3 0 -2 -5 -7 -10 6 4 4 3 2 2 0 1 -2 0 -4 -1 -6 -2 labor input vs. potential -8 -15 -12 1961 1973 Source: Haver and Deutsche Bank 1985 1997 2009 -3 productivity vs. potential rhs -10 1961 1973 1985 1997 -4 2009 Source: Haver and Deutsche Bank Rally in rates has been consistent with past QE experience The recent market rally is consistent with past QE experience. Contrary to conventional wisdom that rates could rise following the Fed exit, the market rallied towards the end of QE1 and QE2, which were October 2009 and June 2011, respectively. Note that the Fed ended Treasury purchases in QE1 at the end of October 2009, while it continued MBS purchases a few months afterwards. During the three-month period prior to the end of QE1, the ten-year yield dropped about 10bp, and the 5s-30s curve steepened. TIPS breakevens widened along with higher equity prices. The rates and curve movements towards the end of QE2 were more significant than those at the end QE1. 10s rallied 28bp during the three-month period leading to the end of QE2, and the 5s-30s curve steepened about 30bp. The Page 12 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly curve bull steepened from 5s to 30s probably because the market was concerned about the economic recovery after QE2. In the current market, 5s remain cheap on the curve. 5s-10s are too flat by more than two standard deviations on our fair value model that incorporates funds rate, 2s-funds and inflation expectations. The recent market rally is consistent with past QE experience; 10yr Treasury yield dropped towards the end of QE1 and QE2 QE1 End QE2 End 4.25 Twist End QE3 End 3.75 3.25 2.75 2.25 1.75 1.25 7/1/2009 7/1/2010 7/1/2011 7/1/2012 7/1/2013 7/1/2014 Source: Bloomberg and Deutsche Bank Ten-year yield around the end of prior QEs 100 10Y Treasury yield Yield change in bp 50 0 -50 QE1 -100 QE2 Twist 125 115 95 105 85 75 65 55 45 35 25 5 15 -5 -15 -25 -35 -45 -55 -65 -75 -85 -95 -105 -115 -125 -150 Trading days relative to end of each operation Source: Bloomberg and Deutsche Bank Change in rates, equities and FX during the three month period prior to the end of QEs Yield Curve TIPS BE Equities FX 10s 5s-30s 10Y SPX DXY Change in yield(%) or indices (%) QE1 QE2 Twist QE3 -0.10% -0.28% 0.07% -0.16% 0.13% 0.31% -0.04% 0.08% 0.24% -0.07% 0.02% 0.02% 4.9% -0.6% -2.7% -2.5% -2.6% -2.4% -0.3% -0.1% For QE3, the changes are for the period from September 29, 2014 to October 9, 2014. Source: Bloomberg and Deutsche Bank Deutsche Bank AG/London Page 13 10 October 2014 Global Fixed Income Weekly Actual and model predicted 5s10s slope 1.60 1.40 Percent 1.20 Regression residual 5s-10s actual 40 Fitted to Fed funds, 2s-Funds, and Michigan 5y infln 30 1.00 0.80 0.60 0.40 0.20 (0.20) (0.40) Sep-90 Sep-93 Sep-96 Sep-99 Sep-02 Sep-05 Sep-08 Sep-11 Sep-14 Source: Deutsche Bank bp Model residual +2 standard errors 20 10 0 (10) (20) (30) -2 standard errors (40) (50) Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Source: Deutsche Bank Credit: Hard to say goodbye Quantitative easing has been in the backdrop of credit markets for so long that its looming end will undoubtedly raise some uncomfortable questions: Does the final stretch of QE herald the end of ‘reach for yield’ buying of credit? Will Treasury yields spike causing mutual fund outflows? We look below at the period leading up to the end of four asset purchase programs to see if there is a pattern in market performance as QE ends approach, using our DB credit indices as proxies. First, as noted above, Treasury yields do not actually tend to jump as Treasury purchase programs come to a close. This should help to calm those concerned about a sudden spike in yields. Second, there is no clear pattern to spread performance in the final stretches of earlier asset purchase programs, although perhaps QE2 is the most apt comparison to current circumstances -- given that it ended amid expectations that the Fed was all finished. And spreads did indeed widen as QE2 ended, as we discuss more fully below. Our US Credit Strategy team remains constructive on credit markets, but we still find it reasonable to assign at least some of the blame for recent credit market weakness to the budding anxiety over the end of QE. Investors may be fretting – as they did last May – that a world in which the Fed is not buying billions of Treasuries at a clip, forcing investors out the credit spectrum, is one in which demand for risky assets will decline. Yet one should not so easily conclude that the Fed is leaving the picture entirely. It will continue to reinvest in order to maintain a $4.2 billion portfolio of securities, and remains a “considerable” period away from raising rates. A more apt comparison, and one described in our Credit Strategy publication in March, considers spreads in the context of the 1994 and 2004 hiking cycles. And corporate bond spreads performed well in the lead-up to the first hike in rates, and continue to tighten, though more modestly, into the new regime as rates begin to rise. And as Fed officials begin to emphasize the gradual nature of future rate hikes, and their plans to continue reinvestments to maintain $4 trillion in securities holdings, we would highlight that gradual increases in Treasury yields are actually associated with spread tightening. That said, the “QE is ending!” narrative is one worth considering, and in the analysis below we use a) the three months leading up to the end of each of the below asset purchase programs and b) spreads in the period between asset purchase programs (when markets did not anticipate a further round of easing). We focus below on pure Treasury purchases, and provide a quick review of what is now well-known history: Page 14 Changes in OAS in 3m prior to end of asset purchase program 3 months ended Oct 2009 June 2011 Dec Sep 302012 Oct 9 2014 QE1 QE2 Twist IG -53 +17 -13 +1 HY -152 +53 -33 +13 IG Fins -84 +20 -18 0 IG Nonfins -36 +5 -10 +1 AAs -34 +13 -6 -1 As -49 +12 -16 +0 BBBs -77 +10 -21 +2 BBs -89 +48 -35 +9 Bs -137 +85 -43 +15 CCCs -235 +70 -82 +26 +4.9% -0.6% -2.7% -2.5% SPX QE3 Source: Deutsche Bank; all units in bps for bonds and % change for SPX Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly QE1: Crisis-era purchases of $300 bn in Treasuries that began in March that lasted through October 2009. (MBS purchases continued into 2010.) QE2: Amid a decline in inflation expectations, the Fed announced a second-round of $600 bn in asset purchases that began in November 2010 and ended in June 2011. QE Interregnum: The period between QE2 and Operation Twist lasted from the end of June to the end of August 2011. Operation Twist: Maturity-extension program announced in September 2011 that ended December 2012. QE3: Third round of unsterilized asset purchases announced in September 2012 and the last asset purchases would be set to wrap up in December. We analyze at the period from Sept 30 to Oct 9. As noted above, Treasury yields have tended – perhaps counter to supplydemand logic -- to decline in the lead-up to the end of asset purchases. In the three months before the end of Treasury purchases in QE1 and QE2, yields on 10-year Treasury notes fell 10 bps and 28 bps, respectively. As QE3 ends, yields are also 16 bps lower. In credit, the story is more mixed. Spreads tightened in the lead-up to the end of QE1 and at the end of Twist, but widened as the end of QE2 approached. Which is a better comparison? Each QE program began and ended under different circumstances. QE1 is probably a poor comparison, because its completion coincided with the restoration of relative normalcy in financial markets. Financial IG corporate spreads tightened 84 bps leading up to the end of QE1, while non-financials tightened 36 bps. QE2 may be a more apt comparison, if only because the program ended cleanly and no other asset purchase program was expected to begin. (When Operation Twist ended, QE3 asset purchases were starting up.) In the lead-up to the end of QE2, spreads widened 17 bps and 53 bps, respectively, in IG and HY. The widening was much more pronounced in financials, suggesting that the underperformance could be attributed more to other coincident events – such as stress in the Eurozone periphery. OAS changes over periods between asset purchase programs 3/31-10/29/10 6/30-9/30/11 Between QE1* & QE2 Between QE2 and Twist IG +20 +92 HY +10 +233 IG Fins +16 +150 IG Nonfins +11 +60 AAs +13 +70 As +14 +98 BBBs +18 +101 BBs +10 +204 Bs +26 +249 CCCs +73 +559 Source: Deutsche Bank; QE1 Treasury purchases only One comparable period worth considering would be the period between QE2 and Twist, when no asset purchases occurred. In this period, credit badly underperformed, widening 92 bps in IG and 233 bps in HY, although again, events unfolding in Europe at the time are likely more directly related to these moves. Yet the absence of Fed asset purchases may have increased the fragility of credit markets when shocks did occur. Forecast update The market rally following last week's release of the September Fed minutes was the first of what we think will be substantial 5y outperformance going forward. Interestingly, last week's rally saw greens/blues steepen. This is suggestive of a delay in the first hike, but with blues stickier at high levels due to the language of optimal control. That is, the market continues to reflect expectations of an ultimate Fed catch up to a relatively high terminal rate. A market revision of that terminal rate lower could allow more significant 5y richening on the curve and would likely see greens/blues flatten as both rates fall. We have revised our official forecasts to reflect this dynamic. We have lowered our 10y forecast to 2.35% for year-end 2014 and to 2.80% for yearend 2015. We now forecast the 5y yield to end the year at 1.40%, with scope to trade as low as 1.25% in the near term. Deutsche Bank AG/London Page 15 10 October 2014 Global Fixed Income Weekly Treasury yield forecasts 10s30s 2s5s10s * 2Y 5Y 10Y 30Y 5s10s Current 0.43 1.54 2.29 3.02 75.1 73.0 18.0 2014 H2 0.50 1.40 2.35 3.05 95 70 -2.5 2015 H1 0.95 1.70 2.60 3.25 90 65 -7.5 2015 H2 1.55 2.25 2.80 3.30 55 50 7.5 * 5y -0.5*(2y+10y) Source: Deutsche Bank The key near term dynamic in our forecast is 5y outperformance on the curve. This would be consistent with markets pricing for a delay of Fed lift-off until 2016, a lower implicit terminal cyclical rate, or some of both. The steepening of the curve keeps the 5y5y forward rate anchored in a 3.25%-3.75% range. The relatively low level of yields in our forecasts is driven by our estimate of a 2.75% equilibrium Fed Funds rate and a Fed that is unable to normalize to normalize rates even to this level rapidly, or even mechanistically. This in turn is driven by our view that profits are vulnerable given low pricing power and low productivity growth, and that risk markets are not yet ready for higher real yields. As a result, we reckon that Fed rate hikes will have to be gradual and smaller in magnitude than in past cycles, with longer pauses to refresh and ascertain the effect of tightening policy on risk assets. Trades Buy 3m5y OTM receiver spreads Investors can achieve 7.5:1 payout ratios by buying 3m OTM receiver spreads on 5y tails. Both the 2y1y and 3y1 rate look cheap on the curve from the perspective of a DV01 and curve neutral butterfly with risk weights derived from 10y of history. Buy 3m5y -25/-50 receiver spread for 16 bp up front. Given the strike spread and premium the payout ratio is 7.5:1. The maximum loss is the premium outlay. The maximum profit is the strike spread (adjusted to up front terms) less the premium outlay. Cheapness in the 5y sector: curve neutral 2y/2y2y/4y2y butterfly 80 60 Curve neutral fly 40 BP 20 0 -20 -40 -60 -80 Source: Deutsche Bank If we are right that risk asset valuations aren’t yet “ready” for tighter policy – for example the coefficient of (log) S&P500 prices on real yields from a regression versus breakevens, real yields, and DXY has turned negative and Page 16 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly increasingly so post crisis – then the Fed will at best be forced to hike haltingly and at worst will be prevented from “normalizing” fully even to our 2.75% estimate of equilibrium funds. This would lead the market to re-price the terminal rate lower and would favor the 5y sector of the curve, in our view. Sell FVH5 puts versus payers swaptions A more aggressive Fed might carry on with what we perceive as attempts to increase risk premia and raise volatility to smooth the impact of prospective rate hikes. If risk assets are not able to withstand higher rates, then the reaction could be a wobble in valuations akin to that of late spring/early summer 2013. . During the Taper Tantrum of 2013 investors hedging spread product used swap spreads as a hedging vehicle, and given the lower volatility of swap spreads relative to corporate spreads, were obliged to over-hedge from the perspective of notional principal versus the underlyincg asset being hedged. The result could be a sharp and (bearish) directional widening of spreads much like that experienced during the Taper Tantrum. Such a market dynamic would be conducive to conditional spread wideners such as selling FV puts and buying the analogous swaption with maturity matched underlying rate. : Correlation of swap spreads and IG OAS during Taper Tantrum 160 USD IG OAS, bp 150 IG USD OAS USSP5 25 20 140 130 120 15 10 110 100 5y swap spread, bp 170 5 90 80 0 Source: Deutsche Bank Sell 1,000 FVH5 117 puts versus buy $117mm 2.155% payers expiring February 20, 2015 into swap commencing April 6, 2015 and maturing May 31, 2019 for zero premium. At the time of writing the FVH5 strike was just over 23 bp OTM. Due to the vol premium of FV over swaptions, the zero premium strike spread of 10.8bp is 1.75bp better than the invoice spread, which was 12.6 bp. The risk to the trade is that spreads tighten in a sell off. The maximum loss and maximum gain are in theory unlimited provided strikes are crossed. If strikes are not crossed, i.e. the market rallies, then both options expire worthless. We recommend observing a stop level of 8bp in terms of the underlying invoice spread targeting 10 bp of spread widening. Deutsche Bank AG/London Page 17 10 October 2014 Global Fixed Income Weekly United States Rates Gov. Bonds & Swaps Alex Li Steven Zeng, CFA Research Analyst Research Analyst (+1) 212 250-5483 (+1) 212 250-9373 [email protected] [email protected] Treasuries The recent market rally is consistent with past QE experience. Contrary to conventional wisdom that rates would rise following the Fed exit, the market rallied towards the end of QE1 and QE2. In the current market, 5s remain cheap on the curve. There is a lot of carry and roll in 5s. 5s-10s are too flat by more than two standard deviations on our fair value model that incorporates funds rate, 2s-funds and inflation expectations. In the latest COT data, specs added net long positions in the ultra, while cutting net short positions in TU. Consistent behavior The recent market rally is consistent with past QE experience. Contrary to conventional wisdom that rates could rise following the Fed exit, the market rallied towards the end of QE1 and QE2, which were October 2009 and June 2011, respectively. Note that the Fed ended Treasury purchases in QE1 at the end of October 2009, while it continued MBS purchases a few months afterwards. During the three-month period prior to the end of QE1, the ten-year yield dropped about 10bp, and the 5s-30s curve steepened. TIPS breakevens widened along with higher equity prices. Ten-year yield around the end of prior QEs 100 5s-30s curve around the end of prior QEs 60 10Y Treasury yield 0 -50 QE1 -100 QE2 Yield change in bp 50 Yield change in bp 5s-30s Treasury spread 40 20 0 -20 -40 Twist QE1 -60 Trading days relative to end of each operation Source: Bloomberg Finance LP and Deutsche Bank Twist -80 -125 -115 -105 -95 -85 -75 -65 -55 -45 -35 -25 -15 -5 5 15 25 35 45 55 65 75 85 95 105 115 125 -125 -115 -105 -95 -85 -75 -65 -55 -45 -35 -25 -15 -5 5 15 25 35 45 55 65 75 85 95 105 115 125 -150 QE2 Trading days relative to end of each operation Source: Bloomberg Finance LP and Deutsche Bank The rates and curve movements towards the end of QE2 were more significant than those at the end QE1. 10s rallied 28bp during the three-month period leading to the end of QE2, and the 5s-30s curve steepened about 30bp. The curve bull steepened from 5s to 30s probably because the market was concerned about the economic recovery after QE2. Page 18 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly In the current market, 5s remain cheap on the curve. 5s-10s are too flat by more than two standard deviations on our fair value model that incorporates funds rate, 2s-funds and inflation expectations. 5s remain cheap on the curve 0.8 First rate hike in the 2004-2006 tightening 0.6 0.4 0.2 0.0 -0.2 Avg = -6.5bp -0.4 -0.6 2s-5s-10s -0.8 -1.0 7/1/03 7/1/05 7/1/07 7/1/09 7/1/11 7/1/13 Source: Bloomberg Finance LPand Deutsche Bank In the latest COT data, specs added net long positions in the ultra (now at +27,571 contracts), while cutting net short positions in TU (-79K contracts). Specs are net long the ultra long bond futures Specs have cut net short in TU 300,000 40,000 Net spec in TU Net spec in WN 30,000 200,000 20,000 100,000 10,000 0 0 -10,000 -100,000 -20,000 -200,000 -30,000 -40,000 7/1/12 1/1/13 7/1/13 1/1/14 Source: Bloomberg Finance LP and Deutsche Bank 7/1/14 -300,000 1/1/04 1/1/06 1/1/08 1/1/10 1/1/12 1/1/14 Source: Bloomberg Finance LP and Deutsche Bank Auction update: 3s, 10s, and 30s The market supply included $61 billion of notional through three- and ten-year notes and 30-year bond auctions this week. The ten-year note auction had a tail, but the 3s and 30s witnessed good customer participations. The indirect bidders took down 40.9% of the combined notional supply as compared to their prior-year average of 39.6%. The direct bidder participation however fell below the average 17.9% to 14.6% from 18.2% in previous month. The combined buyside takedown was also down to 55.4% from 60.8% in September and compares with its trailing twelve month average 57.5%. 3-year note Deutsche Bank AG/London Page 19 10 October 2014 Global Fixed Income Weekly The indirect participation increased from 33.1% to 35.5% and remained above the prior-year average 32.9% for the fourth straight month. The direct bidder takedown however dropped below the average 18.8% to 17.4% from 20.3% in September. The combined buyside takedown declined a touch to 53% and compares with its prior-year average 51.8%. The bid-to-cover ratio jumped past the average 3.31 to 3.42, the highest since February, from 3.17 in the previous month. And the auction stopped through by 0.3 basis points. 3-year note auction statistics Size ($bn) 1yr Avg $29.0 Primary Dealers Direct Bidders 48.2% Indirect Bidders 18.8% 32.9% Cover Ratio Stop-out 1PM WI Yield Bid BP Tail 3.31 -0.1 Oct-14 $ 27.0 47.0% 17.4% 35.5% 3.42 0.994 0.997 -0.3 Sep-14 $ 27.0 46.6% 20.3% 33.1% 3.17 1.066 1.064 0.2 Aug-14 $ 27.0 44.8% 19.0% 36.2% 3.03 0.924 0.925 -0.1 Jul-14 $ 27.0 49.1% 12.7% 38.2% 3.38 0.992 0.998 -0.6 Jun-14 $ 28.0 54.1% 19.4% 26.5% 3.41 0.930 0.928 0.2 May-14 $ 29.0 47.3% 24.5% 28.1% 3.40 0.928 0.926 0.2 0.1 Apr-14 $ 30.0 48.8% 24.0% 27.3% 3.36 0.895 0.894 Mar-14 $ 30.0 54.6% 15.5% 29.9% 3.25 0.802 0.800 0.2 Feb-14 $ 30.0 41.3% 16.6% 42.0% 3.42 0.715 0.718 -0.3 Jan-14 $ 30.0 49.4% 22.6% 28.0% 3.25 0.799 0.796 0.3 Dec-13 $ 30.0 49.6% 12.0% 38.4% 3.55 0.631 0.637 -0.6 Nov-13 $ 30.0 47.3% 19.4% 33.3% 3.46 0.644 0.645 -0.1 Source: US Treasury and Deutsche Bank 10-year note, re-opening The ten-year note auction had a tail. The combined customer participation dropped to 51%, the lowest since May 2013, from 66.5% in September and compares with its prior-year average 62.6%. The direct bidder takedown hit the lowest level of 6.6% since August 2012 and compares with its trailing twelvemonth average of 17.2%. The indirect bidder participation also fell a full percentage point below the average to 44.4% from 53% in September. The bid-to-cover ratio of 2.52 was the lowest since August last year and compares with the about average 2.71 level in previous auction. 10-year note auction statistics Size ($bn) 1yr Avg $ 22.0 Primary Dealers Direct Bidders Indirect Bidders Cover Ratio 37.4% 17.2% 45.4% 2.70 Stop-out 1PM WI Yield Bid BP Tail 0.1 Oct-14 $ 21.0 49.0% 6.6% 44.4% 2.52 2.381 2.366 1.5 Sep-14 $ 21.0 33.5% 13.5% 53.0% 2.71 2.535 2.532 0.3 Aug-14 $ 24.0 37.9% 15.1% 47.0% 2.83 2.439 2.437 0.2 Jul-14 $ 21.0 46.5% 13.9% 39.6% 2.57 2.597 2.585 1.2 Jun-14 $ 21.0 44.5% 19.4% 36.1% 2.88 2.648 2.639 0.9 May-14 $ 24.0 29.1% 21.6% 49.3% 2.63 2.612 2.615 -0.3 Apr-14 $ 21.0 40.1% 15.2% 44.7% 2.76 2.720 2.71 1.0 Mar-14 $ 21.0 29.1% 27.5% 43.4% 2.92 2.729 2.742 -1.3 Feb-14 $ 24.0 34.1% 16.2% 49.7% 2.54 2.795 2.801 -0.6 Jan-14 $ 21.0 39.8% 13.6% 46.6% 2.68 3.009 3.008 0.1 Dec-13 $ 21.0 40.4% 10.6% 48.9% 2.61 2.824 2.815 0.9 Nov-13 $ 24.0 33.8% 18.6% 47.7% 2.70 2.750 2.755 -0.5 Source: US Treasury and Deutsche Bank Page 20 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly 30-year bond, re-opening Both the direct and indirect bidders were strong for the third consecutive month and the combined customer participation went up a touch to 67.8% (avg. 61.2%). The indirect bidders increased their takedown from 45.5% in September to 46.2% (avg. 44.3%) whereas the direct bidder participation declined slightly to 21.5% (avg. 16.9%). The bid-to-cover ratio however dropped from 2.67 to 2.40 and compares with its prior-year average of 2.44. The auction generated a small tail of 0.3 bp. 30-year bond auction statistics Size ($bn) Primary Dealers Direct Bidders Indirect Bidders Cover Ratio 1yr Avg $14.0 Oct-14 $ 13.0 Sep-14 Stop-out 1PM WI Yield Bid BP Tail 38.8% 16.9% 44.3% 2.44 32.2% 21.5% 46.2% 2.40 3.074 3.071 0.3 $ 13.0 32.8% 21.8% 45.5% 2.67 3.240 3.261 -2.1 Aug-14 $ 16.0 29.8% 24.4% 45.9% 2.60 3.224 3.245 -2.1 Jul-14 $ 13.0 35.7% 11.1% 53.2% 2.40 3.369 3.361 0.8 -0.1 Jun-14 $ 13.0 26.5% 21.8% 51.8% 2.69 3.444 3.468 -2.4 May-14 $ 16.0 51.2% 8.4% 40.4% 2.09 3.440 3.404 3.6 Apr-14 $ 13.0 38.8% 17.9% 43.3% 2.52 3.525 3.524 0.1 Mar-14 $ 13.0 48.6% 12.6% 38.8% 2.35 3.630 3.615 1.5 Feb-14 $ 16.0 40.8% 13.9% 45.3% 2.27 3.690 3.696 -0.6 Jan-14 $ 13.0 38.1% 17.5% 44.4% 2.57 3.899 3.905 -0.6 Dec-13 $ 13.0 41.4% 12.5% 46.0% 2.35 3.900 3.892 0.8 Nov-13 $ 16.0 46.5% 18.3% 35.3% 2.16 3.810 3.794 1.6 Source: US Treasury and Deutsche Bank Allotments update Treasury released the allotments data for the September two-, five- and sevenyear notes and the two-year floating rate note (FRN) auctions this week. Investment funds were allotted 37% of the combined fixed coupon supply versus their 40% share in August but slightly above their average 35% allotment share of 35.4%. The allotment share to the foreign and international investor remained above its average 14.7% level for the fourth consecutive month at 16.9% although it declined from 18% in the previous month. The combined share allotted to the two investor classes was down from 57.6% in August to 54%, but it was still strong as compared to its average of 50%. 2-year floating rate note (FRN) The foreign and international investor allotment share subsided to 30.6% from the record 42.6% in the previous month. The allotment share to investment funds fell further to a paltry 0.6% from 3.5% and compares with 13.2%, the average in the all actions so far. And the combined share allotted to the two investor classes dropped to 31.2% (avg. 37.9%), the lowest in last five months, from the record 46% in previous auction. Notably, 23% of the supply was awarded to investors classified as “other”. 2-year note The allotment share to foreign and international investors increased from 18.6% in August to 24.7% (avg. 14.8%), the highest in about three years. The share allotted to investment funds however fell from 28.4% to 26.7% and compares with its one-year average of 27.1%. The combined allotment share of the two classes of the investors rose from 47% in August to the six month high of 51.3% and compares with the average 41.9%. Deutsche Bank AG/London Page 21 10 October 2014 Global Fixed Income Weekly 5-year note The investment funds were allotted 41.3%, up from 40.7% in August, of the supply versus their average allotment share of 37.4%. The allotment share to foreign and international investors dropped to 14.1%% from 18.6% in the previous month, but was in line to its average. The combined 55.4% allotment share to the two investor classes was above its average 51.6% for the third straight month, though it declined from 59.4% in August. 7-year note The allotment share to investment funds fell from 49.3% in August to 42.2% but remained slightly above its average of 41.6%. The foreign and international investors were allotted 12.4% (avg. 15.4%) of the supply, which compares with their 16.7% share in previous month. And the combined allotment share to the two investor classes dropped below the average 57% to 54.7% from 66% in August. Fed buyback The Fed plans to remove about $2.2 billion of notional Treasuries worth $3 billion in ten-year equivalents from the markets through three buyback operations next week. Tuesday’s purchases are targeted at the long-end of the curve whereas the 4 to 4.75 and 10 to 17 year maturity sectors, respectively, will be in focus over the next two days. Recent three buybacks operations in 10-17 year sector had strong bid-to-cover ratios; the latest operation on September 18 had a coverage ratio of 14.24. Fed buyback schedule for October 13-17 Date Operation type 14-Oct 15-Oct 16-Oct Treasury Treasury Treasury Expected Avg. par ($bn) Duration Maturity range 2/15/2036 10/31/2018 11/15/2024 8/15/2044 6/30/2019 2/15/2031 Total 0.95 1.05 0.2 17.0 4.1 9.5 2.20 10.18 Avg. DV01 19.75 4.30 13.46 11.81 10yr Equiv Sub/cover ($bn) (Last 4 avg) 2.14 0.51 0.31 4.87 5.25 11.23 2.96 Source: Deutsche Bank, New York Fed. Two-year floating rate note (FRN) auction allotments Settle Date 1 Yr Avg 9/26/2014 8/29/2014 7/31/2014 6/27/2014 5/30/2014 4/30/2014 3/28/2014 2/28/2014 Total (less Fed) $bn 14 13 13 15 13 13 15 13 13 Federal Reserve $bn %* 0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0% 0% 0% 0% 0% 0% 0% 0% 0% Dealers and Brokers $bn % 7.9 5.9 6.9 8.6 7.8 7.6 9.8 8.7 7.8 58% 46% 53% 57% 60% 58% 65% 67% 60% Investment Funds $bn Foreign and International $bn $bn %* $bn 1.8 0.1 0.4 0.9 1.2 1.5 2.5 2.9 4.0 3.4 4.0 5.5 5.0 4.0 3.6 2.2 1.3 1.0 0.5 3.0 0.1 0.5 0.1 0.3 0.5 0.0 0.2 4.0% 23.2% 0.6% 3.4% 0.5% 2.3% 3.5% 0.1% 1.3% 13.2% 0.6% 3.5% 6.1% 8.9% 11.5% 16.5% 22.7% 30.8% Other 24.8% 30.6% 42.6% 33.4% 30.8% 28.0% 14.5% 10.0% 7.7% * Percentage as of total less Fed SOMA Source: US Treasury and Deutsche Bank Page 22 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Two-year note auction allotments Settle Date 1 Yr Avg 9/30/2014 9/2/2014 7/31/2014 6/30/2014 6/2/2014 4/30/2014 3/31/2014 2/28/2014 1/31/2014 12/31/2013 12/2/2013 10/31/2013 Total (less Fed) $bn 31 29 29 29 30 31 32 32 32 32 32 32 32 Federal Reserve $bn %* 0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Dealers and Brokers $bn % 17.7 13.8 15.0 18.5 18.1 19.5 20.4 13.6 16.9 18.6 18.6 20.4 18.6 57% 48% 52% 64% 60% 63% 64% 43% 53% 58% 58% 64% 58% Investment Funds $bn Foreign and International $bn $bn %* $bn 8.4 7.7 8.2 6.8 6.2 7.6 7.9 13.0 9.9 6.2 11.7 8.8 6.8 4.6 7.2 5.4 3.3 5.5 3.4 3.5 4.8 4.4 6.8 1.6 2.6 6.3 0.4 0.3 0.3 0.4 0.2 0.5 0.2 0.6 0.8 0.3 0.1 0.3 0.3 1.1% 1.0% 1.2% 1.3% 0.6% 1.6% 0.5% 1.8% 2.6% 1.0% 0.4% 0.8% 0.9% 27.1% 26.7% 28.4% 23.6% 20.6% 24.5% 24.8% 40.6% 30.9% 19.4% 36.6% 27.5% 21.4% 14.8% 24.7% 18.6% 11.3% 18.5% 11.1% 10.9% 15.0% 13.7% 21.4% 5.0% 8.0% 19.7% Other * Percentage as of total less Fed SOMA Source: US Treasury and Deutsche Bank Five-year note auction allotments Settle Date 1 Yr Avg 9/30/2014 9/2/2014 7/31/2014 6/30/2014 6/2/2014 4/30/2014 3/31/2014 2/28/2014 1/31/2014 12/31/2013 12/2/2013 10/31/2013 Total (less Fed) $bn 35 35 35 35 35 35 35 35 35 35 35 35 35 Federal Reserve $bn %* 0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Dealers and Brokers $bn % 15.4 15.4 14.0 10.2 14.7 15.3 14.1 10.4 15.4 17.7 24.2 15.9 17.4 44% 44% 40% 29% 42% 44% 40% 30% 44% 51% 69% 45% 50% Investment Funds $bn % Foreign and International $bn % $bn % 13.1 14.5 14.3 13.1 13.7 14.1 12.6 14.0 14.5 12.4 6.0 14.5 13.6 5.0 4.9 6.5 6.1 3.7 5.3 5.0 5.5 4.9 4.6 4.7 4.5 3.7 1.6 0.2 0.2 5.6 2.8 0.3 3.3 5.1 0.2 0.2 0.1 0.2 0.3 4.4% 0.6% 0.6% 16.0% 8.1% 0.9% 9.4% 14.6% 0.6% 0.6% 0.4% 0.5% 0.9% 37.4% 41.3% 40.7% 37.3% 39.3% 40.2% 36.0% 40.0% 41.5% 35.6% 17.1% 41.3% 38.9% 14.2% 14.1% 18.6% 17.6% 10.7% 15.2% 14.3% 15.7% 13.9% 13.3% 13.3% 12.8% 10.5% Other * Percentage as of total less Fed SOMA Source: US Treasury and Deutsche Bank Seven-year note auction allotments Settle Date 1 Yr Avg 9/30/2014 9/2/2014 7/31/2014 6/30/2014 6/2/2014 4/30/2014 3/31/2014 2/28/2014 1/31/2014 12/31/2013 12/2/2013 10/31/2013 Total (less Fed) $bn 29 29 29 29 29 29 29 29 29 29 29 29 29 Federal Reserve $bn %* 0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Dealers and Brokers $bn % 11.9 13.0 9.7 11.6 13.5 11.6 10.0 8.4 11.0 10.9 14.6 16.7 12.0 41% 45% 33% 40% 47% 40% 34% 29% 38% 38% 50% 58% 41% Investment Funds $bn Foreign and International $bn $bn %* $bn 12.1 12.2 14.3 12.3 10.3 13.8 11.9 11.4 12.6 14.4 9.7 9.1 12.6 4.5 3.6 4.8 4.9 4.8 3.5 7.0 4.5 5.2 3.6 4.5 3.0 4.1 0.6 0.2 0.2 0.2 0.4 0.2 0.2 4.6 0.2 0.1 0.2 0.2 0.2 1.9% 0.6% 0.6% 0.6% 1.2% 0.6% 0.6% 15.9% 0.8% 0.4% 0.5% 0.6% 0.8% 41.6% 42.2% 49.3% 42.4% 35.6% 47.6% 41.1% 39.4% 43.3% 49.7% 33.4% 31.5% 43.5% 15.4% 12.4% 16.7% 17.0% 16.5% 12.0% 24.0% 15.6% 18.0% 12.3% 15.5% 10.2% 14.2% Other * Percentage as of total less Fed SOMA Source: US Treasury and Deutsche Bank Deutsche Bank AG/London Page 23 10 October 2014 Global Fixed Income Weekly United States Rates Gov. Bonds & Swaps Rates Volatility Aleksandar Kocic Research Analyst (+1) 212 250-0376 [email protected] Derivatives Bull steepeners are fully awake after a while. Reaction of the surface to the Fed minutes was somewhat out of character, with intermediate expiries experiencing the sharpest decline (led by the short tenors), while short covering of the risk reversals was supportive for gamma. In the context of several years of accommodation with excessive transparency, low volatility and complacency, the Fed is facing a high level of addiction liability in the face of possible policy unwind. This could become a sensitive issue when risky assets are concerned, as possible unwind of positions could disrupt the Fed’s exit and in general restrict its maneuvering space if market conditions improve significantly. Thus, return of volatility to the market is an essential step in unwinding monetary policy. It feels like the Fed wants to shake things up, but is afraid of shaking them up too much (as happened in 2013). If, after all is said and done, rates reprice delayed hikes and vol moves higher in the short-run, this can be interpreted as a successful maneuver by the Fed. We would position to benefit from a limited rally in the belly of the curve. Most significant repricing in gamma should be at the front end, led by the green and blue sectors, while 10Y and longer would be less affected. Once the market calms down and positioning is squared, vol would resume its directionality. It is likely to see some compression of the risk premia along the curve while gamma remains supported. This would bring curve closer in line with vol. In that context, continued decline in vol since the mid-2013 would be justified ex-post as a correct view. We are buyers of 1X2 receiver spreads and 1X2 curve caps spreads. We recommend: Buy $100mn 3M10Y ATMF vs sell $200mn 3M10Y 17bp OTM receivers at zero net costs Buy $1bn 3M 5s/10s ATMF vs. sell $2bn 3M 5s/10s 7.5bp OTM curve caps at zero net cost Vol was right all along Rates are down for the week with 5s leading the way in a steepening rally and most of the repricing coming from the green and blue sectors. After 9M of practically uninterrupted flattening, led by the long end and supported by resilience of the belly, the market could be on the verge of revising its view of rate hikes. If the strong USD (vs. EUR) story is experiencing a setback, this could further undermine the viability of the US shorts in the belly. Bull steepeners are fully awake after a while, a mode familiar in the context of economic slowdown and dovish Fed. Reaction of the surface was somewhat out of character, with intermediate expiries experiencing the sharpest decline (led by the short tenors), while covering of duration shorts initiated through risk reversals was supportive for gamma. Page 24 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Figure 1: Repricing of forwards: changes since Oct-1 Figure 2: Repricing of vol: changes since Oct-1 0 5 4 -4 3 -6 Vol change (bp) Rate change (bp) -2 -8 -10 1Y -12 5Y -14 10Y -16 30Y -18 0 1 2 3 4 5 Fwd (y) Source: Deutsche Bank 6 7 8 9 10 2 1 0 1Y -1 -2 5Y 10Y -3 -4 30Y -5 0 1 2 3 4 5 Expiry (y) 6 7 8 9 10 Source: Deutsche Bank We find the expression of disappointment with the Fed after the minutes somewhat puzzling. The post FOMC impression of a hawkish Fed was based primarily on the interpretations derived from higher median dots, which seem to have been one of the main points of confusion since the market started following them. There are several points that we want to clarify in this context. Dots are individual forecasts of the short rate collected from the Fed members. When a dots chart is rotated by 90 degrees, it represents a histogram of the forecasts. There seems to be an underlying tendency to think of these histograms as a pricing distribution and construct some kind of “pricing” framework along the lines of “yield = median dots”. We see no basis for this type of thinking – there is nothing that should force actual yields to track any of the dots or their mean or median. Therefore, shifting of the median up or down should have little bearing on actual yield levels. Reshuffling these points higher or lower does not change much as it does not represent formation of consensus. It is a stretch to interpret shifts in the median as hawkish or dovish. At this point, the main information contained in the dots is their dispersion. As an indication of sentiment within the Fed, a median cannot be representative, at least not yet, because practically no one agrees on where the short rates would be. The dominant pattern that the dots convey is an extremely wide dispersion -- 17 members have 8 different views regarding the level of short rate in 2015 and 12 different views for 2016. Such a broad dispersion of views and the absence of consensus suggest an absence of any radical decision on the horizon. It would be very odd if there were a single voice in the Fed that bullies the rest to agree to any particular plan of action if the majority is against it -- if that were the case, dots would make even less sense. The bottom line is that, as long as there is such a wide dispersion, the likelihood of seeing a significant shift in monetary policy is relatively low, irrespective of where the mean or median resides. Formation of consensus is the first indication that we are approaching a decision time. Only then would median become relevant. In the context of several years of accommodation with excessive transparency, low volatility and complacency, the Fed is facing a high level of addiction liability in the face of possible policy unwind. This could become a sensitive issue when risky assets are concerned, as possible unwind of positions could disrupt the Fed’s exit and in general restrict its maneuvering space if market conditions improve significantly. Thus, return of volatility to the market is an essential step in unwinding monetary policy. It feels like the Fed wants to shake things up, but is afraid of shaking them up too much, along the lines what happened in 2013, so they had to take it back. Deutsche Bank AG/London Page 25 10 October 2014 Global Fixed Income Weekly If, after all is said and done, rates reprice delayed hikes and vol moves higher in the short run, this can be interpreted as a successful maneuver by the Fed. In that context, we would position to benefit from a limited rally in the belly of the curve. Most significant repricing in gamma should be at the front end, led by the green and blue sectors, while 10Y and longer would be less affected. Once the market calms down and positioning is squared, vol would resume its directionality. It is likely to see some compression of the risk premia along the curve while gamma remains supported. This would bring curve closer in line with vol. In that context, continued decline in vol since mid-2013 would be justified ex-post as a correct view. Trades Going into last week, our trades were centered on bull steepening of the curve. As addition to that, we are buyers of short-term 1X2 receivers with preference to 10Y sector and 5s/10s curve caps. 1X2 receiver spreads: Buy $100mn 3M10Y ATMF vs sell $200mn 3M10Y 17bp OTM receivers at zero net costs With fwd at 2.54% and spot at 2.45%, the max payout is 9bp below the current spot. Breakeven is at 33bp below the forward, i.e. at around 2.20% on swaps corresponding to roughly 2.05% on 10Y UST yield. Ageing and P&L profile are shown in Fig 3. The trade has a positive carry and is vulnerable to rally below breakeven with theoretically unlimited downside. Figure 3: Ageing and P&L profile for 1X2 3M10Y receiver spreads 1.50 1.00 0.50 0.00 Today in 1m -0.50 in 2m -1.00 -0.40% near Mat. -0.30% -0.20% -0.10% 0.00% 0.10% 0.20% 0.30% IR curve parallel shift (curve rolls to Spot) Source: Deutsche Bank An alternative trade is a 1X2 3M5Y ATMF/16 costless, and 3M3Y ATMF/13 costless. As we go to shorter tenors, steep forwards imply that rates need to sell off in order to realize maximum profits. For example, for 3M3Y, forward is at 1.31% and spot at 1.14%. Maximum upside is at 13bp below forwards which means at 1.18%, i.e. 4bp above the spot. Also, breakevens at 26bp below the forwards is at 1.05%, i.e. only 10bp below the spot. While shorttenor 1X2 receiver spreads are attractive from a terminal point of view, their mark-to-market could be more problematic as all of them are short gamma. If repricing of the Fed is indeed in the pipeline, this means potentially short covering and even capitulation on the shorts on the Eurodollar strip, which Page 26 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly could be a very volatile event. 10s, on the other hand, have already rallied and are likely to experience less turbulence either way. In that sense, we see them as a better choice from an MTM perspective. 5s/10s curve caps Buy $1bn 3M 5s/10s ATMF at 6.5bp With forward at 65.5bp and spot at 70.7bp, breakeven is at 72bp, a 1.3bp above the spot. The trade has a limited downside with maximum loss equal to the options premium. Alternatively, a limited steepening view could be expressed through1X2 curve cap spreads Buy $1bn 3M 5s/10s ATMF vs. sell $2bn 3M 5s/10s 7.5bp OTM curve caps at zero net cost This is almost a perfect carry trade. Maximum profit is at 73bp, only 2bp away from the spot. So, roll to spot is an optimal outcome. The breakevens are at 81bp which is roughly the summer levels of the 5s/10s. Beyond this level, the trade becomes vulnerable with theoretically unlimited downside. Deutsche Bank AG/London Page 27 10 October 2014 Global Fixed Income Weekly United States Credit Securitization Steve Abrahams Research Analyst (+1) 212 250-3125 [email protected] Mortgages Originally published on October 8 in The Outlook in MBS and Securitized Products. Pitching the curve Among the assets that sit in any US fixed income portfolio as a pool of liquidity—cash, Treasuries or MBS—relative value has depended significantly in the last year on the shape of the yield curve. A steep curve in the second half of 2013 made it almost impossible for MBS to compete against the return that intermediate Treasury debt picked up simply by repricing day-by-day closer to maturity. But as the curve has flattened and looks set to flatten more, relative value keeps shifting to MBS. Steven Abrahams Research Analyst (+1) 212 250-3125 [email protected] Christopher Helwig Research Analyst (+1) 212 250-3033 [email protected] MBS now looks likely to outperform the Treasury curve under most plausible simple rate scenarios over the next year. In particular: If Treasury yields follow implied forward rates—a plausible and probably the most likely path—then the combination of roughly 107 bp of extra yield in the MBS and the poor price performance of Treasuries on the flatter curve put 30-year Fannie Mae 3.0%s ahead by a projected 62 bp and 3.5%s by a projected 91 bp If rates stay constant over the next year and Treasuries benefit from rolling down the curve, better yield is still enough to push projected MBS performance ahead in 3.0%s by 16 bp and in 3.5%s by 30 bp And against parallel shifts in today’s yields where rolling down the curve helps Treasuries and negative convexity hurts MBS, MBS still has better projected returns, depending on coupon, against shifts of 25 bp to 35 bp lower in yields and 50 bp higher Ian Carow Research Analyst (+1) 212 250-9370 [email protected] Jeff Ryu Research Analyst (+1) 212 250-3984 [email protected] Figure 1: Projected hedged returns in near-par 30-year MBS 1-Year Scenario Returns (%) Security $Amt Price Mkt Val OAS OAD -100 -50 Unch Fwd 50 100 FNCL 3.0 100 99.27 99.3 9 6.8 7.67 5.88 3.12 0.8 -0.01 -3.25 5Y Tsy -47 100.27 -47.1 -18 4.8 6.54 4.6 2.68 0.06 0.78 -1.09 10Y Tsy -52 99.57 -52.2 -15 8.7 11.21 7.13 3.17 0.29 -0.7 -4.48 0 -1.37 -0.08 0.16 0.62 -0.01 -0.37 FNCL 3.5 100 102.79 102.8 1 5.6 5.24 4.69 3.01 1.01 0.48 -2.42 5Y Tsy -81 100.27 -81.3 -18 4.8 6.54 4.6 2.68 0.06 0.78 -1.09 10Y Tsy -22 99.57 -21.5 -15 8.7 11.21 7.13 3.17 0.29 -0.7 -4.48 0.2 -2.08 -0.3 0.3 0.91 0.02 -0.67 Total 0 Total 0 Note: Projected returns assume a linear rate move over 1-year, reinvestment at 1-month LIBOR and repricing at the horizon at a constant OAS. All market levels as of 06 Oct 2014 close. Source: Deutsche Bank The world is never simple, of course, so other factors weigh in the balance: Supply and demand, which have proven very difficult to judge this year but nevertheless seem to favor MBS for now with low net supply—likely lower Page 28 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly in the winter—and marginal demand from banks and, increasingly, money managers starting to rebalance asset allocation from underweight MBS to neutral Financing, where the lingering impact of Fed buying stands to keep the dollar roll at least modestly special into 2015, adding to the returns projected for any simple scenario Volatility, which should reach its lows at the end of QE and poses a modest risk to MBS performance At this point, MBS looks compelling against most liquid US fixed income alternatives. Portfolios can disagree about the amount of liquidity needed, of course. Investment grade corporate debt trades at spreads only 19 bp tighter than MBS and rolls down its own yield curve even better than Treasury debt. But while Treasury debt, excluding TIPS, traded $479 billion on an average day in the week ending September 24 and MBS traded $193 billion, investment grade corporate debt, excluding commercial paper, traded only $14 billion. It’s a different game with different risks. To the extent portfolio want liquidity, MBS looks like it’s right where it wants to be in October. *** Housing: more room to run for prices Rising US home prices over the next few years should keep lifting both the mortgage-backed securities markets and the broader economy, although the pace of appreciation is set to slow. Nevertheless, the impact should show up in both credit and prepayments. The average US home should appreciate in 2014 by 9.3% and in 2015 by 6.9%, according to Deutsche Bank’s latest forecasts published here as a special report, US housing: steady appreciation. But the pace slows after 2015 as housing glides back towards normal after the 2008 financial crisis. For the broader economy, rising home prices should continue rebuilding household wealth and encouraging consumer spending. They also should eventually encourage normal rates of new home building, although that still looks several years away. While the current and prospective pipeline of mortgage delinquencies works its way through the legal system, homebuilders still face competition from properties rolling out of foreclosure. For the next few years, housing should have its most powerful effect on GDP indirectly through consumer spending rather than directly through new residential investment. For the mortgage-backed securities markets, the price rebound should keep reducing loan defaults and losses. It also should lift borrower equity, allowing all borrowers to either move or, if rates allow it, refinance more easily. This issue’s special report offers an updated outlook for US housing and lays out details in a few key areas: The path of average US home prices in the next few years, and the dispersion across local markets The forecasting performance of the model The forecast for serious delinquencies over the next five years One way to optimize portfolios of residential real estate, and The ways that local house prices move together over time, or not *** Deutsche Bank AG/London Page 29 10 October 2014 Global Fixed Income Weekly The view in rates It seems increasingly likely that the US will end up with a relatively flat yield curve over the next 3- to 5-years with rates in the neighborhood of 3.0% to 3.5%. Both US growth and inflation seem muted. Inflation expectations in the US, at least those embedded in the spread between 10-year TIPS and notes, started September at 215 bp and now stand around 192 bp. The unemployment rate has fallen to 5.9%, but wage inflation is nowhere to be found. Core CPI has recently fallen from 2.0% to 1.7%. Core PCE stands at 1.47%. In Europe, deflation has become a greater concern than inflation, and deflation is emerging as a concern in China Although the Fed keeps reading from a script that has Fed funds rising in mid2015, it’s plausible that liftoff will come later. It’s hard to see exactly where the next increment of US growth will come from. It could come from consumers as rising home prices and rallying financial assets encourage spending. That, in turn, could encourage more business fixed investment. But without clear signs of steady growth and with few signs of inflation, the Fed may choose to wait. The view in spread markets Our themes in MBS remain seasonally declining net supply, extended Fed reinvestment, a generally special dollar roll and the possibility of a flatter curve all supporting a moderate overweight in MBS. That and other core positions: Overweight the MBS-Treasury basis Overweight 30-year 3.5%s and higher, underweight 3.0%s Overweight 15-year pass-throughs against 30-year Underweight Ginnie Mae against conventional MBS Overweight LLB 3.0%s and 3.5%s The view in mortgage credit US housing stands to finish 2014 with a mark-to-market gain of 9.3% and finish 2015 with a gain of 6.9%. Markets in the West should do better than markets in the East as serious delinquencies tumble. And investors putting together portfolios of residential real estate may want to look in some unusual places to optimize their holdings. These and other topics get covered in today’s special report US housing: steady appreciation. Sizing up CMO in September CMO issuance in the month of September continued to be dominated by banks’ need to satisfy regulatory mandates as well as GSE portfolio issuance. We look at the current shape of CMO new issue with implications for relative value in both structure and underlying collateral, namely: Seasoned conventional 3.0%s remain popular with dealers and the GSEs— likely reflecting demand for 3.0% coupon sequential as a 15-year 3.0% surrogate. We highlight FNR 14-74 AE against FNCI 3.0%s below Otherwise, conventional deals were largely backed by generic or nondeliverable collateral—a trend that also looks likely to continue Freddie issuance continues to run well ahead of Fannie and Ginnie, but around 50% was driven by Freddie portfolio deals Sequentials lead front end issuance in conventional space, PACs in Ginnie—we illustrate relative value between GN sequential and GN PAC below Page 30 Ian Carow Research Analyst (+1) 212 250-9370 [email protected] Christopher Helwig Research Analyst (+1) 212 250-3033 [email protected] Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Finally, although IO execution appears to have been more popular than floater/IIO for stripping coupon, IIO creation remains surprisingly robust in the face of a potential Fed driven bear flattener in 2015 Below we break down September’s CMO issuance by each issuer across collateral types and structures. A look at CMO collateral composition in September CMO collateral composition in September could be broadly characterized as generic. Conventional seasoned 30-year 3.0% pools made up the largest share of issuance, followed by Fannie 4.0% CK jumbos and a smattering of other non-deliverable stories in CK and high-LTV (Figure 2, Figure 3 and Figure 4). Traditional pay-up stories like loan balance and low FICO made up less than 25% of total issuance. In spite of lower rates, prepayments and volatility remain muted and spreads tight—likely driving demand away from those higher pay-up stories. Figure 3: FH collateral composition 20% 15% 10% 5% 0% 25% 20% 15% 10% 5% % Port % Street Source: Deutsche Bank, Fannie Mae FGLMC 3 FGLMC 4 HLB FGLMC 4 FGLMC 4.5 FGJMT6 4 FGMDMA 4 FICO FGLMC4.5 HLB FGLMC 5 FGMDM 3.5 FICO FGLMC 7 FICO MLB FGCI 4 SHLB FGJMT6 3.5 FGMDMA 5 FICO FGCI 4.5 HLB FGLMC 5.5 HLB FGHLU6 4 FGCI 2.5 HLB FGHLU3.5 FGLMC2.5 FHARM2.4 FGJMT2.5 FNJMCK 4 FNCL 3 FNHLCQ 3.5 FNCL 4 FNJMCK 3.5 FNHLCQ 3 FNCT 3.5 FNAS 2.3 FNCL 4 FICO FNCL 4.5 FNRE 3.5 FNCT 3 FNCL 5 FNCL 5.5 HLB FNRE 4 FNCL 6.5 LLB FNGL 3.5 FICO SHLB FNCL 4.4 FNHLCQ 4 FNCI 2.5 FNCI 2.5 HLB 0% % Port % Street Source: Deutsche Bank, Freddie Mac 15% 10% 5% 0% G2SF 4 G2SF 5 G2JM 4 G2SF 3.5 G2JM 3.5 GNSF 4 G2SF 4 MLB G2JO 3.5 G2SF 5.5 GNSF 5 G2SF 3 GNSF 5.5 G2JO 3.5 SHLB GNSF 3.5 G2SF 4.5 G2AR 1.9 GNJO 3 G2SF 6.5 G2AR 3.8 G2JM 4.0 G2SF 7 25% 20% Figure 4: GN collateral composition % GNR Total Iss 25% % FHR Tot Iss % FNR Tot Iss Figure 2: FN collateral composition Source: Deutsche Bank, Ginnie Mae One thing that jumps out immediately is the percentage of Fannie Mae jumbo issuance relative to Golds. The 3.5% and 4.0% cohorts comprised nearly 25% of Fannie’s total monthly supply, while jumbos made up less than 5% of Gold issuance. This is likely just a reflection of greater jumbo issuance in Fannies coupled with a strong bid for supports backed by jumbo collateral. Another clear difference is the percentage of issuance coming from Freddie’s portfolio at around 50%. Portfolio contributions as a percentage of overall Fannie issuance were far less significant. In Ginnie space, there was predominant issuance in G2SF 4.0%s, which presumably were stripped down for banks with LCR needs. Finally there is the bias in issuance in conventional space towards seasoned 30-year 3.0% pools. Limited extension coupled with shorter average life from seasoning make these pools an attractive option for structuring sequential deals. Shaping up CMO structure In terms of structure, issuance for both Fannie and Freddie was dominated by front sequentials and then PACs (Figure 5, Figure 6 and Figure 7). In contrast, front PACs ran ahead of sequential issuance in Ginnie, although only narrowly. Deutsche Bank AG/London Page 31 10 October 2014 Global Fixed Income Weekly Figure 6: FH structure summary 35% 25% % FHR Tot Iss % FNR Tot Iss 30% 20% 15% 10% Figure 7: GN structure summary 25% 30% 20% 25% % GNR total iss Figure 5: FN structure summary 15% 10% 5% 5% % Port Source: Deutsche Bank, Fannie Mae 15% 10% 5% NAS AS PAC2 Front TAC Other Inv Supp Front VADM LCF SEQ Long VADM LCF PAC SUPP % Port 15Y Strip PT Z PO IO IIO % Street Floater Front SEQ 0% Front PAC 0% 20% 0% % Street Source: Deutsche Bank, Freddie Mac Source: Deutsche Bank, Ginnie Mae One possible interpretation of that differential is that LCR gets calculated on a market value basis, and well structured PACs should hold their value better than sequentials in a rising rate scenario. The composition of IO relative to floaters and inverse IO is also worth highlighting against the backdrop of a potential bear flattener scenario in 2015. That would favor IO over inverse IO—and while IO was a greater percentage of issuance than inverse IO, the difference was not as substantial as one might expect. A trend worth following in October. Relative value implications Given the shape of CMO issuance in terms of collateral and structural composition observed above, we consider several relative value propositions. Front sequential 3.0%s backed by 30-year 3.0% collateral look likely to remain an attractive alternative to fully valued 15-year 3.0% pass-throughs as net supply continues to shrink in that sector: The seasoning curve in conventional 30-year 3.0%s should persist Front sequentials like FNR 14-74 AE in Figure 8 below can offer increased spread and yield at similar average life Figure 8: Comparison of 3x3 front SEQ FNR 14-74 AE as surrogate to FNCI 3.0%s Issue Type Collat Cpn WAL +300 I Sprd PSA Px Yld OAS OAD OAC FNR 14-74 AE Front SEQ FNCL 3.0 3.00 5.0 6.6 75 130PSA 102-21 2.39 -9.1 4.8 -1.1 FNCI 3.0 TBA FNCI 3.0 3.00 5.2 6.3 55 184PSA 103-19 2.22 -8.7 4.2 -1.4 Note: All levels indicative, as of COB: 10/3/14. Source: Deutsche Bank, YieldBook, Bloomberg Finance LP On the front end of the structure curve in Ginnie space, demand competition between sequential and PAC structures should continue as well—as banks weigh the relative tradeoffs between spread and average life stability (Figure 9). Figure 9: Comparison of Ginnie front PAC and front sequential Issue Type Collat Cpn WAL 300 Px Yld GNR 14-158 DC Front SEQ G2SF 3.5 2.50 3.9 6.5 I Sprd PSA 84 207 101-11+ 2.10 GNR 14-60 GC Front PAC G2SF 4.5 2.50 4.3 7.0 67 295 101-21 2.06 Source: Deutsche Bank Finally, while front end structures are the bulk of issuance, last cash flows look somewhat undervalued on OAS terms—at least within the context of the rest of the structure. For accounts that are willing to add longer duration, last cash flows like FHR 4103 NW—a 3.0% coupon LCF PAC backed by FGLMC 4.0%s— can be a way to reduce front-end key rate exposure relative to collateral, while maintaining MBS exposure (Figure 10). Page 32 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Figure 10: LCF FHR 4103 NW focuses key rate exposure away from front end 60% 50% 40% 30% 20% 10% 0% FGLMC 4 KRD30% KRD20% KRD15% KRD10% KRD7% KRD5% KRD3% KRD2% KRD1% -10% FHR 4103 NW Source: Deutsche Bank, YieldBook US housing: steady appreciation Key points from our forecast National home prices should rise in 2014 by 9.3% and in 2015 by 6.9% before moderating in later years. The West should outperform other regions through 2015. Serious delinquencies should return to normal levels by 2018, and, with that, home prices should return to normal rates of appreciation of less than 5%. A review of model performance shows that it continues to capture pricing in major housing markets. Investors looking to optimize their portfolio of residential real estate might find themselves holding property in a surprising set of locations. Overview Rising prices for US homes over the next few years should keep lifting both the broader economy and the mortgage-backed securities markets, although the pace of appreciation is set to slow. The price of the average US home should rise in 2014 by 9.3% and in 2015 by 6.9%, but the pace slows from there as housing glides back towards normal after the 2008 financial crisis. Steven Abrahams Research Analyst (+1) 212 250-3125 [email protected] Richard Mele Research Analyst (+1) 212 250-0031 [email protected] Ying Shen Research Analyst (+1) 212 250-1158 [email protected] Doug Bendt Research Analyst (+1) 212 250-5442 [email protected] For the broader economy, rising home prices should continue rebuilding household wealth and encouraging consumer spending. They also should eventually encourage normal rates of new home building, although that still looks several years away. While the current and prospective pipeline of mortgage delinquencies works its way through the legal system, homebuilders still face competition from properties rolling out of foreclosure. For the next few years, housing should have its most powerful effect on GDP indirectly through consumer spending rather than directly through new residential investment. For the mortgage-backed securities markets, the price rebound should keep reducing loan defaults and losses. It also should lift borrower equity, allowing all borrowers to either move or, if rates allow it, refinance more easily. Deutsche Bank AG/London Page 33 10 October 2014 Global Fixed Income Weekly The rate of house price appreciation should eventually slow to an annual pace of less than 4% or lower as the supply of distressed property falls to equilibrium levels. Since the supply of these properties varies dramatically across local markets, the prospects for housing across these markets should vary, too. Nevertheless, at equilibrium, if broad terms of financing remain stable, the price of the average home should rise in line with inflation. This updated outlook for US housing lays out details in a few key areas: The path of average US home prices in the next few years, and the dispersion across local markets The forecasting performance of the model The forecast for serious delinquencies over the next five years One way to optimize portfolios of residential real estate The ways that local house prices move together over time, or not Forecasts Following a gain of 11.2% for 2013 and 5.7% for the first half of 2014 on the CoreLogic US home price index, home prices should rise 9.3% in 2014, 6.9% in 2015, and 5.9% in 2016 (Figure 11). These forecasts follow largely from the expectation that the supply of loans delinquent by 60 days or more will fall from 6.1% of outstanding mortgage principal at the end of 2013 to 3.7% at the end of 2016. Sales of distressed homes, often to investors since 2011, takes supply off of local markets and allows the price of all homes to rise. Rising home prices accelerate the drop in this distressed supply, which, in turn, lifts home prices further in a reinforcing cycle. Figure 11: National historical and projected house price annual returns 20 15 9.3 HPA (%) 10 5 6.9 5.9 4.9 4.4 0 -5 -10 -15 -20 Actual Projected Source: Deutsche Bank, CoreLogic Local outcomes over the next one-to-two years should vary significantly as each area works through varying levels of distressed properties at various speeds. We saw that last year. Among the Top 25 markets, returns in 2013 varied from 25.3% in Las Vegas to only 3.2% in Philadelphia (Figure 12). However, forecast returns three years out are converging toward a 3% to 4% annual pace similar to the national forecast. Page 34 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Figure 12: Local returns (historical and projected) vary widely among the Top 25 markets 30 25 HPA (%) 20 15 10 5 0 2013 Actual 2014 2015 2016 Note: Actual returns are used for the first half of 2014. Source: Deutsche Bank, CoreLogic Areas in the West should outperform over the near term although not all of them because of declining delinquencies (Figure 13): San Francisco should gain 13.0% over the next year and 34.5% over the next three years. This is on top of gaining 56.4% since prices reached their trough in 2012. Prices are already 17.7% above their 2007 peak. Oakland should gain 11.5% over one year and 25.8% over three years. This is on top of gaining 60.4% since prices reached their trough in 2012 although prices still remain 15.4% below their peak in late 2005. San Jose should gain 11.2% over one year and 23.9% over three years. Prices are already up 58.6% since their trough in 2009 and up 7.8% since their peak in 2006. The boom in technology has lifted all of these markets in the San Francisco Bay area. Other markets should lag: Baltimore should gain 1.1% over one year and 10.6% over three years. Prices are up only 11.5% since their trough in 2012 and still remain 17.2% below their peak in 2006. Philadelphia, where prices only declined 16.8% peak to trough, is expected to gain 3.7% over one year and 14.5% over three years. Prices are up 8.6% since their trough in 2012 and still remain 9.6% below their peak in 2006. The recovery has been uneven across local markets. In nominal terms 18% of the 100 largest MSAs have fully recovered their former peak prices. Another 23% of the 100 largest MSAs only have 10% appreciation or less to reach their former peaks. But still 17% of the 100 largest MSAs are 30% or more below their former peak prices. Deutsche Bank AG/London Page 35 10 October 2014 Global Fixed Income Weekly Figure 13: Distressed supply in the West has declined the most and this is expected to continue. Consequently prices in the West are expected to continue to outperform 10 16 9 Serious Delinquencies (%) 18 14 HPA (%) 12 10 8 6 4 2 8 7 6 5 4 3 2 1 0 0 National 2013 Actual West 2014 Midwest 2015 2016 Northeast 2017 South National 2018 West SD now Midwest South Northeast SD forecast in 3 years Source: Deutsche Bank, CoreLogic The differences across markets largely reflect differences in distressed supply. Serious delinquencies in the West, as of June 2014, stand at 4.6% of outstanding mortgage principal compared to 9.1% in the Northeast, and those delinquencies in the West are clearing the market faster than anywhere else (Figure 14). In the West serious delinquencies dropped by 1.8% representing a 28.1% drop in distressed supply. In the Northeast serious delinquencies dropped by 1.2% representing only a 11.7% drop in distressed supply. REO declined slightly in the West and Midwest regions and increased in the South and Northeast regions. Figure 14: Changes in distressed supply by region over the last 12 months 0.20 0.15 -0.5 REO Change Serious Delinquency Change 0.0 -1.0 0.10 0.05 -1.5 0.00 -2.0 -0.05 National West Midwest South Northeast National West Midwest South Northeast Source: Deutsche Bank, CoreLogic The regional difference in distressed supply and the rate at which it clears is reflected in our forecast (Figure 13). In the West distressed supply is expected to drop by 52.6% with serious delinquencies declining 1.8% from 4.6% to 2.2% in three years. In the Northeast distressed supply is expected to drop by 40.7% with serious delinquencies declining 1.2% from 9.1% to 5.4%. Areas in the West are should have significantly higher returns over the next two years while returns in the Northeast areas should be more moderate. Page 36 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Figure 15: HPA forecasts and related data (sorted by balance) Area Los Angeles New York Washington Chicago Atlanta Santa Ana Oakland San Diego Riverside Long Island San Francisco Phoenix San Jose Houston Seattle Baltimore Minneapolis Dallas Philadelphia Denver Sacramento Portland, OR Tampa Miami Las Vegas Balance ($BB) 449 383 297 261 196 190 176 171 163 155 150 142 139 138 137 120 119 116 112 105 97 87 79 74 69 Level 5.1 10.0 4.8 8.1 4.9 3.7 3.8 3.9 6.0 12.5 2.3 3.1 2.9 3.3 5.0 7.2 3.4 3.6 5.5 2.5 4.0 5.2 13.5 19.2 11.7 Serious Delinquency Actual 1Y Resolution Resolution Change Pace Pace (%) -2.2 1.0 19.6 -1.7 1.4 14.2 -0.9 0.4 9.3 -3.0 1.4 17.0 -1.6 0.7 14.7 -1.9 0.7 18.0 -1.9 0.8 21.9 -1.8 0.7 18.5 -2.8 1.1 18.4 -1.4 1.6 12.6 -1.1 0.5 21.0 -1.6 0.3 8.6 -1.5 0.6 21.3 -0.5 0.4 11.7 -2.1 0.9 17.5 -1.0 0.6 8.3 -1.1 0.4 12.4 -0.5 0.4 9.9 -0.6 0.5 8.8 -0.9 0.3 10.4 -2.1 0.8 19.5 -1.2 0.9 16.6 -3.8 1.8 13.6 -7.6 2.3 12.0 -3.9 1.9 16.4 REO Actual 1Y Level Change 0.22 -0.08 0.16 0.06 0.36 0.13 1.29 0.14 0.36 -0.04 0.11 -0.08 0.17 -0.10 0.15 -0.07 0.36 -0.03 0.18 0.07 0.10 -0.08 0.30 -0.05 0.07 -0.05 0.19 -0.01 0.40 -0.01 0.87 0.60 0.58 -0.21 0.18 -0.02 0.46 0.13 0.13 -0.08 0.28 -0.04 0.36 0.15 1.57 0.70 2.44 0.62 0.71 0.32 HPA Actual 1Y 11.5 8.3 4.2 8.2 10.6 7.8 13.5 9.0 16.0 5.1 14.5 6.5 10.3 11.3 9.8 2.5 5.6 7.8 1.1 8.2 10.1 10.0 6.2 10.2 11.4 1Y Projection 3Y Projection 10.7 6.2 4.1 9.2 8.6 11.0 11.5 9.9 11.2 3.7 13.0 7.4 11.2 7.7 9.9 1.1 7.8 7.4 3.7 7.6 10.1 7.6 4.3 7.5 7.5 28.6 20.1 13.0 26.1 22.1 28.7 25.8 22.5 22.6 13.0 34.5 15.8 23.9 18.5 25.5 10.6 22.8 18.3 14.5 17.0 21.4 20.0 18.1 28.8 20.1 Source: Deutsche Bank, CoreLogic Figure 16: HPA forecasts and related data (sorted by 3Y projection) Area San Francisco Miami Santa Ana Los Angeles Chicago Oakland Seattle San Jose Minneapolis Riverside San Diego Atlanta Sacramento Las Vegas New York Portland, OR Houston Dallas Tampa Denver Phoenix Philadelphia Long Island Washington Baltimore Balance ($BB) 150 74 190 449 261 176 137 139 119 163 171 196 97 69 383 87 138 116 79 105 142 112 155 297 120 Level 2.3 19.2 3.7 5.1 8.1 3.8 5.0 2.9 3.4 6.0 3.9 4.9 4.0 11.7 10.0 5.2 3.3 3.6 13.5 2.5 3.1 5.5 12.5 4.8 7.2 Serious Delinquency Actual 1Y Resolution Resolution Change Pace Pace (%) -1.1 0.5 21.0 -7.6 2.3 12.0 -1.9 0.7 18.0 -2.2 1.0 19.6 -3.0 1.4 17.0 -1.9 0.8 21.9 -2.1 0.9 17.5 -1.5 0.6 21.3 -1.1 0.4 12.4 -2.8 1.1 18.4 -1.8 0.7 18.5 -1.6 0.7 14.7 -2.1 0.8 19.5 -3.9 1.9 16.4 -1.7 1.4 14.2 -1.2 0.9 16.6 -0.5 0.4 11.7 -0.5 0.4 9.9 -3.8 1.8 13.6 -0.9 0.3 10.4 -1.6 0.3 8.6 -0.6 0.5 8.8 -1.4 1.6 12.6 -0.9 0.4 9.3 -1.0 0.6 8.3 REO Actual 1Y Level Change 0.10 -0.08 2.44 0.62 0.11 -0.08 0.22 -0.08 1.29 0.14 0.17 -0.10 0.40 -0.01 0.07 -0.05 0.58 -0.21 0.36 -0.03 0.15 -0.07 0.36 -0.04 0.28 -0.04 0.71 0.32 0.16 0.06 0.36 0.15 0.19 -0.01 0.18 -0.02 1.57 0.70 0.13 -0.08 0.30 -0.05 0.46 0.13 0.18 0.07 0.36 0.13 0.87 0.60 HPA Actual 1Y 14.5 10.2 7.8 11.5 8.2 13.5 9.8 10.3 5.6 16.0 9.0 10.6 10.1 11.4 8.3 10.0 11.3 7.8 6.2 8.2 6.5 1.1 5.1 4.2 2.5 1Y Projection 3Y Projection 13.0 7.5 11.0 10.7 9.2 11.5 9.9 11.2 7.8 11.2 9.9 8.6 10.1 7.5 6.2 7.6 7.7 7.4 4.3 7.6 7.4 3.7 3.7 4.1 1.1 34.5 28.8 28.7 28.6 26.1 25.8 25.5 23.9 22.8 22.6 22.5 22.1 21.4 20.1 20.1 20.0 18.5 18.3 18.1 17.0 15.8 14.5 13.0 13.0 10.6 Source: Deutsche Bank, CoreLogic Deutsche Bank AG/London Page 37 10 October 2014 Global Fixed Income Weekly Other key influences on home prices show promising trends: Census data shows that median household income fell during 2009 and 2010 but has been rising since then. Unemployment should continue to decline based on forecasts from the Fed and the CBO. Mortgage rates should rise but higher rates should have little influence in light of other factors. Household formation is expected to continue to grow. Detailed forecasts and related data for the top 25 markets are listed in Figure 15 and Figure 16. Actual levels are reported as of the end of June 2014 and projections are from June 2014 onward. Model forecast performance Figure 17 shows the 1-year home price appreciation forecasts published in October 2013 compared to the actual realized returns from CoreLogic (see US housing: A resilient rebound). At the national level we forecasted that house prices would grow by 7.0% from June 2013 to June 2014. This compares well with the actual growth rate of 7.3%. Across the Top 25 markets the differences between actual and forecasted returns are larger. However, the largest market, Los Angeles, with $449 billion in outstanding mortgage balance, was forecasted to grow by 11.5%, which matched the actual growth rate exactly. In another large market, Atlanta, we forecasted 10.9% and the actual return was 10.6%. Figure 18 shows a bubble plot of the actual returns versus the forecasted returns, with the bubble size corresponding to the mortgage balance in each market. The model is calibrated using mortgage balance weighting so we expect to forecast larger areas more accurately than smaller areas. Although the equal weighted R^2 is low, the mortgage balance weighted R^2 of the actual returns versus forecasted returns is 76% for the Top 25 markets. Figure 18: Actual returns versus previously published returns for the Top 25 markets 20 Actual 1Y Return (%) 18 16 14 12 10 Figure 17: Previously published forecast returns and actual returns Area National Los Angeles New York Washington Chicago Atlanta Santa Ana Oakland San Diego Riverside Long Island San Francisco Phoenix San Jose Houston Seattle Baltimore Minneapolis Dallas Philadelphia Denver Sacramento Portland, OR Tampa Miami Las Vegas Balance Forecast Actual 8,573 7.0 7.3 449 11.5 11.5 383 2.8 8.3 297 7.7 4.2 261 1.6 8.2 196 10.9 10.6 190 11.5 7.8 176 10.6 13.5 171 10.4 9.0 163 8.4 16.0 155 -1.6 5.1 150 13.5 14.5 142 13.8 6.5 139 12.7 10.3 138 7.2 11.3 137 8.2 9.8 120 1.6 2.5 119 10.1 6.3 116 9.3 7.8 112 3.1 1.1 105 5.4 8.2 97 15.3 10.1 87 5.6 10.0 79 1.6 6.2 74 3.8 10.2 69 6.1 11.4 Source: Deutsche Bank 8 6 4 2 0 -5 0 5 10 15 20 Forecasted 1Y Return Published October 2013 (%) Source: Deutsche Bank, CoreLogic Page 38 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Serious delinquencies House price returns continue to closely track the change in serious delinquencies (Figure 19). In 2013 serious delinquencies fell 21.7% (from 9.0% to 7.0%) nationally while house prices rose 11.2%. During the first half of 2014 serious delinquencies fell another 12.5% (from 7.0% to 6.1%) while house prices rose another 5.7% Locally serious delinquencies in Oakland fell 33.5% and prices rose 13.5% over the last 12 months. Meanwhile, serious delinquencies in Philadelphia only fell 9.9% and prices only rose 1.1%. Figure 19: HPA tracked serious delinquencies for the Top 25 markets over the last 12 months 18 16 Actual 1Y HPA (%) 14 12 10 8 6 4 2 0 -40 -35 -30 -25 -20 -15 -10 -5 0 Actual 1Y Change in Serious Delinquencies (%) Source: Deutsche Bank, CoreLogic We define serious delinquency as loans that are 60+ days delinquent, in foreclosure, or held as REO (Figure 20). From 2000 to 2006, serious delinquencies were relatively stable around 2% of loan balances. However, during the house price run up just prior to 2006 serious delinquencies were on a slight downtrend. In 2006 the housing market peaked and starting dropping rapidly. At the same time serious delinquencies made a rapid rise reaching a peak of 12.9% in 2010. Since then serious delinquencies have been on a gradual path downward while the trajectory of house prices turned up. Figure 20: Serious delinquencies and sub-components 14 Delinquency (%) 12 10 8 6 4 2 0 DQ60 DQ90 FCL REO Source: Deutsche Bank, CoreLogic Deutsche Bank AG/London Page 39 10 October 2014 Global Fixed Income Weekly We expect serious delinquencies to continue to decline at its current pace, driving our expectation for home prices up for the next few years. We also expect the decline in serious delinquencies to eventually moderate as the stock of distressed properties diminishes (Figure 21). Once serious delinquencies stabilize we expect that income, population growth and other local factors will become the main drivers of house price appreciation. For now serious delinquencies will continue to be important in forecasting HPA. Figure 21: Serious delinquency history and projection Serious Delinquency (%) 14 12 10 8 6 4 2 0 Actual Forecast Note: Actual data used for first half of 2014. Source: Deutsche Bank, CoreLogic Optimizing a real estate portfolio Since 2000, despite the crisis and the slow start of the recovery, house prices have averaged 3.8% annual growth at the national level and had an average volatility of 9.2%. At the state level, Nevada experienced the highest volatility at 17.1% and Iowa experienced the lowest volatility of 2.2%. Projected returns also vary widely from 1.4% in New Mexico to 11.25% in Michigan (Figure 22). Investors usually want to put their money where returns look likely to be highest. But there is a trade off. In general, areas historically delivered higher Figure 22: Projected 1-year returns versus the historical return volatility for the states and the national level 12 MI Projected 1 Year Return (%) 10 MA 8 OH 6 SD NC TN IN TX WI OK KY IA KS MS ND NE AK AR LA AL 4 2 ME IL GA NH MTNY MN UT CO SC MO PA VT WY CA WA US OR DE WV DC NJ CT NV RI ID FL HI AZ VA MD NM 0 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Volatility Source: Deutsche Bank Page 40 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly returns also experienced higher volatility. Recently investors have actively bought properties in California, Florida and Arizona, all of which have relatively high volatility. The projected 1-year price return in California is still a high 10% but the volatility is 13.8%. Investors could buy property in Michigan and earn a higher return with lower risk. Also, using leverage, investors have the opportunity to earn a much higher return on equity for the same level of risk as California. Assuming a funding rate of 4.25% investors could buy property in Ohio using 70.5% debt. The volatility would still be 13.8% but the return on equity climbs to 15.2%. This strategy works best in areas where returns in excess of funding is highest per unit of risk such as South Dakota, Ohio, Colorado, Michigan and Washington. Using diversification investors can further improve the risk to reward ratio. Figure 23 shows a portfolio of properties in Michigan (15.7%), Ohio (59.6%) and Washington (24.7%). The return of the portfolio is a weighted average of the returns of each individual area. However, because diversification lowers the portfolio volatility, the reward per unit of risk is higher than any of the individual areas. Figure 23: Diversification enables investors to attain a higher reward per unit of risk Michigan Ohio Washington Portfolio Financing 4.25 4.25 4.25 4.25 Return 11.3 7.5 10.1 8.7 Volatility Reward / Risk 9.4% 0.75 4.1% 0.80 8.2% 0.71 5.3% 0.84 Holding 15.7% 59.6% 24.7% 100.0% Source: Deutsche Bank Investors can form many different property portfolios that yield the same risk. The portfolio with the highest return for a given level of risk is the most efficient. Figure 24 plots the highest portfolio return attainable for each level of risk that forms the efficient frontier. Furthermore investors can leverage their returns and risk up or down by either borrowing or lending cash. Optimally investors should choose the portfolio Figure 24: The optimal portfolio of properties that has the highest reward per unit of risk can be levered up or down to achieve any desired level of risk 16 Projected 1 Year Return (%) 14 12 MI 10 MA 8 CO OH TX SD TN IN WI MO PA KY OK VT KS MS IA ND NE AK AR LA AL NC 6 4 2 CA WA MEGAIL US MN UT MT NY NH SC OR DE DC NJ WV WY CT NM NV RI ID HI FL AZ VA MD 0 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Volatility 1Y Projected Return Efficient Frontier Optimal Portfolio with borrowing and lending Source: Deutsche Bank Deutsche Bank AG/London Page 41 10 October 2014 Global Fixed Income Weekly with the highest reward per unit of risk, which happens to be the portfolio shown in Figure 23. The dashed line in Figure 24 plots the expected returns if the optimal portfolio is combined with various levels of borrowing or lending. This analysis focused only on the risk and reward of house prices. Investors can also expect to earn higher returns from net rental yield and they also face other risks such as operational risk and funding risk. How local is house price appreciation? Everyone knows that house prices are a local phenomenon. But to some extent they do move together. In the recent crisis most of the large markets experienced peaks around mid-2006 and troughs around 2011 and 2012. Figure 25 shows a correlation of monthly house price returns since 2003. Some markets, such as Los Angeles, Santa Ana, Riverside and Sacramento, are highly correlated with each other with correlations over 90%. Other markets such as Philadelphia and Houston have only a 34% correlation. Baltimore Chicago Dallas Denver Houston Las Vegas Long Island Los Angeles Miami Minneapolis New York Oakland Philadelphia Phoenix Portland OR Riverside Sacramento San Diego San Francisco San Jose Santa Ana Seattle Tampa Washington Atlanta Baltimore Chicago Dallas Denver Houston Las Vegas Long Island Los Angeles Miami Minneapolis New York Oakland Philadelphia Phoenix Portland OR Riverside Sacramento San Diego San Francisco San Jose Santa Ana Seattle Tampa Washington Atlanta Figure 25: Correlation matrix of local house price returns 1.0 0.7 0.9 0.8 0.8 0.7 0.6 0.5 0.7 0.7 0.8 0.5 0.8 0.5 0.6 0.7 0.6 0.7 0.7 0.7 0.8 0.6 0.7 0.7 0.7 0.7 1.0 0.8 0.5 0.5 0.5 0.7 0.8 0.8 0.7 0.8 0.7 0.7 0.7 0.7 0.8 0.7 0.7 0.7 0.6 0.6 0.7 0.8 0.8 0.8 0.9 0.8 1.0 0.6 0.7 0.7 0.6 0.7 0.7 0.6 0.9 0.5 0.7 0.6 0.5 0.7 0.5 0.6 0.6 0.6 0.6 0.6 0.7 0.7 0.7 0.8 0.5 0.6 1.0 0.7 0.8 0.6 0.4 0.6 0.6 0.6 0.3 0.8 0.4 0.5 0.7 0.6 0.6 0.6 0.6 0.7 0.6 0.7 0.6 0.6 0.8 0.5 0.7 0.7 1.0 0.7 0.5 0.4 0.6 0.5 0.7 0.3 0.8 0.4 0.5 0.6 0.5 0.7 0.6 0.7 0.8 0.6 0.6 0.6 0.6 0.7 0.5 0.7 0.8 0.7 1.0 0.5 0.5 0.6 0.6 0.6 0.3 0.7 0.3 0.5 0.6 0.6 0.6 0.6 0.6 0.6 0.5 0.6 0.6 0.6 0.6 0.7 0.6 0.6 0.5 0.5 1.0 0.7 0.9 0.8 0.7 0.7 0.8 0.5 0.8 0.7 0.9 0.9 0.9 0.7 0.7 0.9 0.7 0.8 0.8 0.5 0.8 0.7 0.4 0.4 0.5 0.7 1.0 0.7 0.7 0.7 0.8 0.6 0.6 0.7 0.7 0.7 0.7 0.7 0.5 0.5 0.7 0.6 0.7 0.7 0.7 0.8 0.7 0.6 0.6 0.6 0.9 0.7 1.0 0.8 0.8 0.7 0.9 0.6 0.8 0.8 0.9 0.9 0.9 0.7 0.8 0.9 0.8 0.9 0.9 0.7 0.7 0.6 0.6 0.5 0.6 0.8 0.7 0.8 1.0 0.7 0.7 0.8 0.5 0.8 0.7 0.8 0.8 0.7 0.7 0.7 0.7 0.7 0.9 0.8 0.8 0.8 0.9 0.6 0.7 0.6 0.7 0.7 0.8 0.7 1.0 0.6 0.8 0.5 0.6 0.7 0.7 0.7 0.7 0.6 0.7 0.7 0.7 0.7 0.7 0.5 0.7 0.5 0.3 0.3 0.3 0.7 0.8 0.7 0.7 0.6 1.0 0.6 0.5 0.7 0.6 0.7 0.6 0.6 0.5 0.5 0.6 0.6 0.7 0.6 0.8 0.7 0.7 0.8 0.8 0.7 0.8 0.6 0.9 0.8 0.8 0.6 1.0 0.5 0.8 0.8 0.8 0.9 0.9 0.8 0.9 0.8 0.7 0.8 0.8 0.5 0.7 0.6 0.4 0.4 0.3 0.5 0.6 0.6 0.5 0.5 0.5 0.5 1.0 0.5 0.6 0.4 0.5 0.5 0.4 0.4 0.5 0.5 0.6 0.6 0.6 0.7 0.5 0.5 0.5 0.5 0.8 0.7 0.8 0.8 0.6 0.7 0.8 0.5 1.0 0.7 0.8 0.8 0.7 0.7 0.8 0.7 0.7 0.9 0.8 0.7 0.8 0.7 0.7 0.6 0.6 0.7 0.7 0.8 0.7 0.7 0.6 0.8 0.6 0.7 1.0 0.7 0.7 0.7 0.7 0.7 0.7 0.9 0.8 0.7 0.6 0.7 0.5 0.6 0.5 0.6 0.9 0.7 0.9 0.8 0.7 0.7 0.8 0.4 0.8 0.7 1.0 0.9 0.9 0.7 0.7 0.9 0.6 0.8 0.8 0.7 0.7 0.6 0.6 0.7 0.6 0.9 0.7 0.9 0.8 0.7 0.6 0.9 0.5 0.8 0.7 0.9 1.0 0.9 0.7 0.8 0.9 0.7 0.8 0.8 0.7 0.7 0.6 0.6 0.6 0.6 0.9 0.7 0.9 0.7 0.7 0.6 0.9 0.5 0.7 0.7 0.9 0.9 1.0 0.7 0.8 0.9 0.6 0.7 0.8 0.7 0.6 0.6 0.6 0.7 0.6 0.7 0.5 0.7 0.7 0.6 0.5 0.8 0.4 0.7 0.7 0.7 0.7 0.7 1.0 0.9 0.7 0.8 0.7 0.7 0.8 0.6 0.6 0.7 0.8 0.6 0.7 0.5 0.8 0.7 0.7 0.5 0.9 0.4 0.8 0.7 0.7 0.8 0.8 0.9 1.0 0.7 0.8 0.7 0.8 0.6 0.7 0.6 0.6 0.6 0.5 0.9 0.7 0.9 0.7 0.7 0.6 0.8 0.5 0.7 0.7 0.9 0.9 0.9 0.7 0.7 1.0 0.7 0.8 0.8 0.7 0.8 0.7 0.7 0.6 0.6 0.7 0.6 0.8 0.7 0.7 0.6 0.7 0.5 0.7 0.9 0.6 0.7 0.6 0.8 0.8 0.7 1.0 0.7 0.7 0.7 0.8 0.7 0.6 0.6 0.6 0.8 0.7 0.9 0.9 0.7 0.7 0.8 0.6 0.9 0.8 0.8 0.8 0.7 0.7 0.7 0.8 0.7 1.0 0.8 0.7 0.8 0.7 0.6 0.6 0.6 0.8 0.7 0.9 0.8 0.7 0.6 0.8 0.6 0.8 0.7 0.8 0.8 0.8 0.7 0.8 0.8 0.7 0.8 1.0 Source: Deutsche Bank, CoreLogic Undoubtedly some of the correlation differences can be explained by geographic proximity. Using principal component analysis we can find other commonalities. Factor #1: Affordability The most powerful link between all these markets since 2003, not surprisingly, is affordability—especially affordability facilitated by pre-crisis subprime and Alt-A lending. Figure 26 shows the factor loadings and factor scores for the first principal component. Las Vegas has the largest exposure to the first factor and Dallas has the least exposure. The weightings of markets on this first component correspond roughly to the incidence in the last decade of affordability lending. The factor scores have a correlation of 96% with national Page 42 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly 0.15 1.5% 0.30 0.10 1.0% 0.25 0.05 0.5% 0.20 0.15 0.00 0.0% -0.05 -0.5% -0.10 -1.0% 0.05 -0.15 -1.5% 0.00 -0.20 -2.0% -0.25 -2.5% 0.10 First Factor National Appreciation % (rhs) Monthly HPA 0.35 Factor Score Factor Loadings Figure 26: The first factor explains 75% of the variance of monthly house price appreciation First Factor Source: Deutsche Bank, CoreLogic house price appreciation. This makes sense because the first factor explains 75% of the variance of the 25 largest markets. Where affordability lending entered, boom, bust and delinquency often followed. Figure 27 shows the relationship between the loadings of the first factor and the peak to minimum range of serious delinquencies in each market. The correlation is a high 80%. Figure 27: The first factor loadings are highly correlated to the range of serious delinquencies in each local area 0.40 y = 0.0069x + 0.0964 R² = 0.6379 0.35 Factor Loading 0.30 0.25 0.20 0.15 0.10 0.05 0.00 0 5 10 15 20 25 30 35 40 Serious Deliquency Minimum to Peak Difference Source: Deutsche Bank Factor #2: Seasonality There is a season for everything, but it doesn’t seem to have the same effect everywhere (Figure 28). The second factor, which explains 6% of variance, appears to be a localized seasonal effect countering or amplifying the overall seasonal effect that is already captured by the first factor. The second factor has an absolute correlation of only 18% with national house price appreciation as this factor is explaining how local prices move in different directions. Deutsche Bank AG/London Page 43 10 October 2014 Global Fixed Income Weekly 0.05 0.04 0.03 0.02 0.01 0.00 -0.01 -0.02 -0.03 -0.04 -0.05 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% National Appreciation % (rhs) Second Factor Monthly HPA 0.5 0.4 0.3 0.2 0.1 0.0 -0.1 -0.2 -0.3 -0.4 -0.5 Factor Score Factor Loadings Figure 28: The second factor, which explains 6% of variance, appears to be a localized seasonal effect countering or amplifying the overall seasonal effect that is already in the first factor Second Factor Source: Deutsche Bank, CoreLogic Figure 29: The second factor loadings have a 33% correlation to latitude that affects seasonality 0.5 35 y = -0.0125x + 0.426 R² = 0.1101 0.4 0.3 30 Percent of All Sales Second Factor Loading Figure 30: Distressed sales have been elevated since 2008 0.2 0.1 0 -0.1 -0.2 25 20 15 10 5 -0.3 0 -0.4 -0.5 25 30 35 40 45 50 Latitude of MSA Source: Deutsche Bank REO Sales Short Sales Source: Deutsche Bank Third Factor 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0.00 -0.01 -0.02 -0.03 -0.04 3.0% 2.0% 1.0% 0.0% Monthly HPA 0.5 0.4 0.3 0.2 0.1 0.0 -0.1 -0.2 -0.3 -0.4 -0.5 Factor Score Factor Loadings Figure 31: The third factor explains 4% of the variance of monthly home price appreciation -1.0% -2.0% National Appreciation % (rhs) Third Factor Source: Deutsche Bank, CoreLogic Page 44 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Figure 29 shows the relationship between the loadings of the second factor and the latitude of each market that affects seasonality. The second factor loadings have a weak 33% correlation to the North/South location of each market. But the second factor is also 65% correlated to the peak to minimum range of serious delinquencies in each market. This seasonal effect is particularly evident from 2008 onward corresponding to the period when distressed sales became elevated (Figure 30). Figure 32: The third factor loadings are highly correlated to the East/West location of the MSA 0.5 y = -0.0078x - 0.8071 R² = 0.5362 Third Factor Loading 0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 -0.5 -130 -120 -110 -100 -90 -80 -70 Longitude of MSA Source: Deutsche Bank Factor #3: East-West Figure 32 shows the relationship between the loadings of the third factor and the longitude of each market. The third factor loadings have a 73% correlation to the East/West location of each market. This factor explains only 4% of variance and is not correlated to national house price appreciation. San Jose, San Francisco and Oakland have the largest positive exposures while Chicago, Baltimore and Philadelphia have the largest negative exposures. Deutsche Bank AG/London Page 45 10 October 2014 Global Fixed Income Weekly Europe Rates Gov. Bonds & Swaps Inflation Rates Volatility Abhishek Singhania Strategist (+44) 207 547-4458 [email protected] Euroland Strategy The “whatever it takes” mantra has been replaced with “we will do exactly that”. However, market pressure might have to increase before the ECB coalesce around the next steps. We therefore maintain the EUR 10s30s flattener and also recommend going short EUR 5Y5Y inflation breakevens vs. the US 5Y5Y breakevens The ECB’s analysis of the usage of the TLTRO suggests that it is likely to be used by banks to reduce their funding cost rather than to expand their balance sheet. Further, the flow of loans to the real economy from banks in the periphery suggests that their capacity to borrow at the TLTROs starting from Mar-15 is limited and there is a risk that they may be forced to repay all their TLTRO money by Sep-16, unless the pace of deleveraging slows down post AQR This could increase the pressure to actively manage the size of its balance sheet as mentioned by Draghi at the Brookings Institute. This would also imply that the peak of the ECB balance sheet is likely to happen later than mid-2015 as is currently priced in. We maintain a Jun-15/Jun-16 Eonia flattener as well as an outright received position in Jun-16 Eonia The elevated correlation between the euro fx and the front-end of EUR and EUR-USD rates differentials implies fx returns are likely to dominate fixed income returns given the low level of yields of shorter-dated bonds. In fact, this can already be seen in the recent Yen denominated returns of OATs vs. USTs and consequently in Japanese investor flows The recent decline in the ex-post sharpe ratio of peripheral government bond returns, increased volatility of longer-dated peripheral govt. bonds and the limited YTD buying from domestic banks leads us to prefer the front-end of the periphery. We recommend outright buying of 5Y BTPs “Whatever it takes” to “We will do exactly that” Draghi highlighted the fundamental change in the nature of the ECB’s monetary policy framework from a passive provision of liquidity to a more active management of the ECB’s balance sheet. The tensions inherent in a move from a passive to an active management of the balance sheet is, apparent by the fact that the ECB does not as yet appear to be willing to recognize the increasingly likely failure of the measures announced to achieve the EUR 1trillion balance sheet expansion. In fact, not surprisingly some of the hawkish members of the council have highlighted concerns about the risk being borne by the ECB due to the measures announced so far let alone the prospects of pursuing a government bond QE. Over the last couple of years the ECB has delivered eventually. The “whatever it takes” mantra has been replaced with “we will do exactly that” in reference to lifting inflation from its excessively low levels. However, despite delivering previously the ECB still lacks credibility and the market pressure might have to increase. We therefore maintain the EUR 10s30s flattener and also recommend going short EUR 5Y5Y inflation breakevens vs. the US 5Y5Y breakevens (see Global Inflation Update). Page 46 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly TLTRO Update The October ECB monthly bulletin2 provided some additional information about the September TLTRO take-up. First, in the ECB’s assessment there were probably a number of reasons for banks to defer their use of the first two TLTROs until December and therefore a full assessment of the usage of the TLTROs would be possible only after the December TLTRO. Second, an initial analysis suggests that banks have probably used the TLTRO funds to replace other expensive sources of funding, i.e. the TLTRO usage is likely to be a liability management exercise rather than a way to fund additional assets. This along with recent comments from various ECB speakers indicating that there is no stigma attached to the use of the TLTRO facilities would suggest that the aggregate take up should be reasonably large purely based on economic considerations. The cost of 4Y funding via the TLTROs at 15bp remains attractive given the level of 4Y swap rates (35bp) and iTraxx senior financial spreads (66bp). Third, a large majority of the smaller institutions who used the Sep TLTRO have fully used their allowance which would indicate that a large take-up in aggregate would depend on the behaviour of the larger banks. In addition to the two TLTROs in September and December, the ECB will also conduct 6 more quarterly TLTROs starting in Mar-15. Banks can borrow 3x the amount by which their net lending is above the benchmark level. For banks with positive net lending in the 12M to Apr-14 the benchmark level is zero while for banks with negative net lending in the 12M to Apr-14 the benchmark level is equal to the cumulative net lending over the 12M to Apr-14. The development in the flow of loans to the real economy excluding mortgages as of August-14 is not particularly encouraging as far as banks additional capacity to borrow at the subsequent TLTROs and the ability of banks to retain the TLTRO funding beyond Sep-16 is concerned. For Italy and Spain the deleveraging from May-14 to Aug-14, i.e. over 4 months, has been 40% and 19% of their benchmark level (the data has not been seasonally adjusted and hence the numbers might overstate the pace of deleveraging). This reduces the likelihood that the banks will have any reasonable borrowing capacity at the 6 TLTROs staring in March and more importantly they might be forced to repay their TLTRO funding in Sep-16. By Q1 2015, unless there is a meaningful change in the pace of deleveraging post the AQR, the inability of the ECB to expand the balance sheet via the remaining TLTROs will become increasingly obvious. This will increase the pressure on the ECB to expand the balance sheet via asset purchases. The eventual expansion of the ECB balance sheet which was further stressed on by Draghi in his address and discussion at the Brookings Institute would favour being long June-16 Eonia (see Top Fixed Income Trades for the Autumn). However, the delay in the expansion of the balance sheet should also favour a flattening of the Eonia curve. We maintain our Jun-15/Jun-16 Eonia flattener recommended last week. 2 http://www.ecb.europa.eu/pub/pdf/mobu/mb201410en.pdf Deutsche Bank AG/London Page 47 10 October 2014 Global Fixed Income Weekly Lending to real economy excluding mortgages: Benchmark level for TLTROs and developments from May-14 to Aug-14 Country Flow of loans May-13 to Apr-14 (EUR bn) Benchmark level (EUR bn) Flow of loans May-Aug 14 (EUR bn) France 5.3 0 8.3 Finland 4.6 0 1.4 Belgium 3.8 0 -0.1 Slovakia 2.5 0 1.3 Estonia 0.2 0 0.2 Latvia 0.0 0 0.0 Malta -0.3 -0.3 0.1 Luxembourg -0.4 -0.4 -0.2 Austria -1.6 -1.6 3.2 Cyprus -1.5 -1.5 -0.1 Slovenia -3.4 -3.4 -1.4 Netherlands -6.0 -6.0 -1.3 Ireland -6.7 -6.7 -4.7 Greece -5.9 -5.9 -1.8 Portugal -6.3 -6.3 -2.3 Germany -10.7 -10.7 -1.3 Italy -42.3 -42.3 -17.1 Spain -81.3 -81.3 -15.8 Source: Deutsche Bank, ECB Rally in core rates and euro depreciation a double edged sword The move lower in EUR rates over the past few weeks has been accompanied by the move lower in euro currency. The latest FOMC minutes suggest that the Fed is concerned about the appreciation of the dollar and while it is debatable whether this is material enough to alter the course of the Fed’s normalisation it is worth noting the elevated correlation between the FX and front-end EUR rates outright and EUR - USD rates spread. Given the probability of further declines in excess liquidity until the December TLTRO the very front-end of the EUR curve could be vulnerable to a short-term correction in the FX. This would be consistent with our recommendation of a June-15/ June-16 Eonia flatteners. Correlation between EURUSD and EUR rates Correlation between EURUSD and EUR-USD rates spread 2Y 1.0 5Y 10Y 30Y 2Y 1.0 0.8 0.8 0.6 0.6 5Y 10Y 30Y 0.4 0.4 0.2 0.2 0.0 0.0 -0.2 -0.2 Source: Deutsche Bank, Bloomberg Finance LP Note: We plot the 13 week rolling correlation between weekly changes in FX and rates Page 48 Jul-14 Oct-14 Jan-14 Apr-14 Jul-13 Oct-13 Apr-13 Jan-13 Oct-12 Jul-12 Apr-12 Jan-12 Oct-11 Jul-11 Jan-11 Oct-14 Jul-14 Apr-14 Jan-14 Jul-13 Oct-13 Jan-13 Apr-13 Jul-12 Oct-12 Jan-12 Apr-12 Jul-11 Oct-11 -1.0 Apr-11 -0.8 -0.8 Jan-11 -0.6 -0.6 Apr-11 -0.4 -0.4 Source: Deutsche Bank, Bloomberg Finance LP Note: We plot the 13 week rolling correlation between weekly changes in FX and rate spreads Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Japanese investors shy away from Eurozone govt. debt With core and semi-core Eurozone sovereign bond yields, especially at the very front-end, at levels which do not leave room for a further rally and the prospect that a further rally can only come if accompanied by a decline in the euro means that investors with global mandates could increasingly shift their exposure to other fixed income markets. The total return performance of French govt. bonds and USTs denominated in JPY shows a significant outperformance of USTs largely because of the currency developments in recent weeks. Against this backdrop it is not surprising that the Japanese ministry of finance data shows the first evidence of a move away from core Eurozone sovereigns into UST in recent months. Although this is not representative of all international investors it nevertheless serves to highlight the risk that the inflows into core/semi-core Eurozone might reduce given the low level of yields and the prospect of further depreciation of the euro. Recent underperformance of France vs. UST returns denominated in JPY 30% Reduced inflows into core Eurozone sovereign bonds from Japanese investors (Monthly flow, in 100 mn Yen) 40,000 France 1Y+ index 3M total return (JPY denominated) 25% 20,000 15% 10,000 10% 0 5% -10,000 0% -20,000 -5% -30,000 -10% -40,000 Jul-14 May-14 Mar-14 Jan-14 Nov-13 Sep-13 Source: Deutsche Bank, Bloomberg Finance LP Jul-13 Jan-14 May-13 Jan-13 Mar-13 Jan-12 Jan-13 Jan-11 US 30,000 UST 1Y+ index 3M total return (JPY denominated) 20% -15% Jan-10 Eurozone Source: Deutsche Bank, Ministry of Finance Japan Increased volatility in periphery argues for limiting exposure to the front-end Peripheral government bonds are increasingly coming under pressure due to stretched valuations, weakening economic data and the lack of structural reforms which are increasing debt sustainability concerns over the mediumterm while reluctance from the ECB to announce broad based asset purchase implies that there could be some shakeout of weaker positions. This is reflected in the increased realised volatility of realised returns which has reduced the sharpe ratio of the periphery in recent weeks. Within the periphery, the lower volatility of realised returns on the front-end is likely to make the front-end more attractive especially given that domestic banks’ holdings of government securities have remained broadly unchanged YTD. Sharpe ratio for the periphery has Increased volatility of long-end declined returns 6.0 5.0 Italy 1Y+ index ex-post sharpe ratio (Annualized 6M returns and vol) 4.0 16% 14% 2014 Italy 3Y-5Y annualized 6M returns volatility (LHS) 10% -1.0 -3.0 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Deutsche Bank, Bloomberg Finance LP Deutsche Bank AG/London Jan-13 Jan-14 46 36 22 20 5% 0 0% -20 2% 0% Jan-08 53 39 40 4% -2.0 Spain 60 6% 0.0 94 EUR bn 80 15% 8% 1.0 100 Italy 20% 10% 2.0 25% Italy 7Y-10Y annualized 6M returns volatility (RHS) 12% 3.0 Limited buying by domestic banks in 4 6 10 9 46 32 15 14 6 0 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Source: Deutsche Bank, Bloomberg Finance LP Jan-14 2007 2008 2009 2010 2011 2012 2013 2014 YTD Source: Deutsche Bank, ECB Page 49 10 October 2014 Global Fixed Income Weekly Global Credit Covered Bonds Bernd Volk Strategist (+41) 44 227-3710 [email protected] Covered Bond and Agency Update CIBC issued the tightest ever Canadian covered bond, a EUR 1bn 5Y issue at ms flat, confirming that CBPP3 also supports EUR covered bonds issued by non euro area banks. With 54%, bank buying was strongly supported by the Level 2A LCR status of non-EU covered bonds, confirmed by the publication of Delegated Act by the European Commission this week. ASW spreads of iBoxx Netherlands and iBoxx Norway/Sweden confirm the outperformance of euro area covered bonds. ASW spreads of iBoxx Italy Covered tightened significantly from 71bp on 3 Sep to 42bp on 9 Oct, strongly outperforming sovereign bonds. Due to CBPP3 and the ECB likely being aggressive to source volume, we expect further spread convergence between covered bonds of weaker and stronger peripheral banks. The ECB said that only a volume of EUR 600bn of covered bonds in its database is eligible for CBPP3. We highlight that EUR 1049bn of covered bonds are categorised by the ECB itself as “eligible for own-use” (i.e. CRR compliant). Using the 70%/30% limit per ISIN brings down the volume to around EUR 725bn, i.e. still more than the mentioned EUR 600bn. Separate covered bond ratings could be an issue. For example, covered bonds ISPIM Float Aug 2018 do not have a separate rating but are eligible for ECB repo, likely based on the issuer rating of Baa2/BBB/BBB+. However, given that CBPP3 says “covered bonds must...have a minimum first-best credit assessment of credit quality step 3”, the wording suggests that unrated retained Italian covered bonds would not qualify for CBPP3. Currently, not all Italian covered bonds programmes used for retained issues have a separate rating. Due to using a pass-through structure, the second programme of Banca Carige is rated Baa3 by Moody's, i.e. higher than the programme used for public issuance (Ba1). Retained covered bonds are not accounted for as liability under IFRS. In case the issuer sells the covered bond to the ECB, it has to pay a coupon. In our understanding, the coupon is accounted for as interest cost (e.g. 3M Euriobor+75bp in case of ISPIM Float Aug 2018), leading to a burden for interest income, potentially reducing the incentive to sell retained covered bonds. With EUR 74bn of Italian covered bonds in FRN format in the ECB database, the volume available for CBPP3 (potentially only after structural changes or getting a rating) seems substantial. For example, Monte Dei Paschi has a second EUR 20bn covered bond programme used for retained issuance, with covered bonds under this programme amounting to EUR 8.4bn as of 29 July (backed by EUR 6.7bn residential and EUR 4.48bn commercial loans). The European Commission published the Delegated Act regarding LCR. EU banks need to meet at least 60% on 1 Oct 2015. The Delegated seems is mainly in line with expectations regarding covered bonds, i.e. Level 1 with 7% haircut and 70% cap in case of ECAI 1 and Level 2A with 15% haircut and 40% cap in case of ECAI 2. However, also unrated high quality covered bonds are eligible as Level 2B asset with a 15% cap and a 30% haircut, confirming elevated regulatory support for legal framework based covered bonds in the EU. Page 50 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Figure 1: Outperformance of Dutch covered bonds versus sovereign bonds and Nordic covered bonds 200 Figure 2: Outstanding volume of publicly issued Italian EUR benchmark covered bonds per issuer (as of 1 Oct) iBoxx Euro Norway Covered iBoxx Euro Sweden Covered iBoxx Euro Netherlands Covered iBoxx Euro Finnish Covered iBoxx Euro Germany Sovereign iBoxx Euro Netherlands Sovereign 150 100 Bn EUR 16 14 12 10 8 50 6 0 4 2 -50 0 -100 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Source: Markit Source: Markit Figure 3: Annual public issuance of Italian EUR Figure 4: Outstanding volume of Italian covered bonds benchmark covered bonds based on the ECB collateral database (as of 1 Oct) Bn EUR 45 Bn EUR 18 FIXED FLOATING 40 16 14 35 12 30 10 25 8 20 6 15 4 10 2 5 0 0 2005 2006 2008 2009 Source: Deutsche Bank Deutsche Bank AG/London 2010 2011 2012 2013 2014 ytd Source: ECB, Deutsche Bank Page 51 10 October 2014 Global Fixed Income Weekly United Kingdom Rates Gov. Bonds & Swaps Inflation Rates Volatility Soniya Sadeesh Strategist (+44) 0 207 547 3091 [email protected] UK Strategy Market update: Core rates rallied sharply over the week, as concerns over the global slowdown grow; GBP largely tracked USD rates, and both outperformed EUR rates. The 5Y point was the primary outperformer, as rate hikes were priced out. This was the last week of BoE reinvestment - in part this may have helped drive some of the performance, as the last couple of operations had weak covers. However, more marked was the decline in inflation; 5Y RPI fell 10.5bp, steepening the breakeven curve. The beta between nominals and breakevens has increased of late (on daily changes) suggesting inflation expectations are increasing in relevance for nominal rates. B/E Nominal beta rising 0.4 0.4 0.3 0.3 0.2 0.2 0.1 BoE cover soft in last operations 8.00 10Y RPI v Nominals on changes Rolling Beta 7.00 Cover 6.00 Last Two 5.00 4.00 3.00 2.00 0.1 0.0 1.00 0.00 09 Source: Deutsche Bank 12 Source: Deutsche Bank, BoE The rally post the FOMC minutes pushed the front end even further, now only pricing the first hike by August, and only two hikes in 2015, and 2016 (respectively). While concerns over a global slowdown have been cited by all three major central banks, these risks are now arguably already priced. UK data so far has been relatively resilient, the core of the FOMC still indicate that a mid 2015 hike is on the cards (see Dudley’s latest speech) and President Draghi’s speech highlights the ECB is alert to the risks – action on this or the fiscal front would enable normalization in the UK. We like being short Dec 16 short sterling, which is not inconsistent with the 5Y10Y steepener, which will also benefit from a normalization of inflation expectations, a likely scenario in which rate hikes are repriced. Page 52 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Dec 15 only pricing 2 hikes now Forget gradual 4.50 1.30 1.25 Dec 15 OIS 1.20 Live 4.00 100bp/year 3.50 50bp/year 3.00 Terminal Rate 2.5% Yest 2.50 1.15 2.00 1.10 1.50 1.00 1.05 0.50 07-Oct 05-Oct 03-Oct 01-Oct 29-Sep 27-Sep 25-Sep 23-Sep 21-Sep 19-Sep 17-Sep 15-Sep 13-Sep 11-Sep 09-Sep 07-Sep 05-Sep 03-Sep 01-Sep 1.00 Source: Deutsche Bank 0.00 Source: Deutsche Bank The rally has also steepened the 10Y30Y curve, back to fair levels (when considering a recent sample). Starting to look stretched 10Y30Y steepening back to fair L Z6 Pre Guidance Peak 99 60 50 98.5 40 Aug IR, Fwd guidance expected 30 98 20 97.5 Fitted Residual 10Y30Y 10 Taper Tantrum 0 97 -10 Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank RV: 28s have been richening versus surrounding bonds, with the fly moving 2.8bp in last two weeks (z-score -3 on a 6m horizon) More signs of housing slowing: The latest credit conditions survey revealed a sharp drop in both the supply and demand for mortgages over Q3 (the survey was conducted between 13 Aug and 8 Sept). The fall in credit availability was attributed to be a function of changing risk appetite and views over house prices. The FPC recommendations as well as the MMR implementation was said to contribute. Looking ahead, a rebound in both supply and demand was expected - looking at historical survey responses, lender expectations generally tend to capture the direction of changing conditions, but less so the magnitude of the move. Credit availability tightened Demand also moderating 50 80 40 Past 3M 30 20 40 10 20 0 Next 3M 0 -10 -20 -20 -30 -40 -40 Mortgage Availability Oct-08 Mar-10 Jul-11 Dec-12 Source: Deutsche Bank Deutsche Bank AG/London Mortgage Demand -60 -50 -60 Jun-07 Past 3M 60 Next 3M Apr-14 Sep-15 -80 Jun-07 Oct-08 Mar-10 Jul-11 Dec-12 Apr-14 Sep-15 Source: Deutsche Bank Page 53 10 October 2014 Global Fixed Income Weekly Mortgage approvals have also slowed from Q1 levels, and the latest RICS survey indicates a slowing in momentum – it also indicates that London in particular seems to be softening more than regions. This suggests that the macro prudential policies/valuations/rate hike expectations are having an effect on the housing market, but much like the PMIs, it is a slowing from elevated levels. # Mortgage approvals declining (Thousands) BoE BBA 00_07 Ave 107 69 Q113 53 31 Q213 58 36 Q313 64 40 Q413 70 45 Q114 71 47 Q214 64 42 Q314* 65 42 Latest 64 42 * incomplete, BOE BBA Jul, Aug, CML Jul House prices moderating CML 98 39 51 57 60 49 57 68 68 10% 80 QQ% = Halifax, Nationwide, RICS = pice balance 8% 60 40 6% 20 4% 0 2% -20 0% -40 -2% -60 Halifax -4% -100 RICSrhs -8% 02 Source: Deutsche Bank -80 Nationwide -6% 03 04 05 06 -120 07 08 09 10 11 12 13 14 Source: Deutsche Bank Partly regional convergence? Mortgage rates still lower than 1Y ago 150 2Y Fixed 8.50 London-West Midland price balance rhs 100 7.50 50 6.50 0 5.50 -50 4.50 -100 3.50 Base Tracker SVR 2.50 -150 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 1.50 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 Source: Deutsche Bank Source: Deutsche Bank A shift in sentiment Past 3M Factors Driving Credit Availability Q113 Q213 Econ Outlook 1.9 2.0 Mkt Share 21.6 34.9 Risk Appetite 8.3 13.1 Funding 7.6 3.9 House Price Exp -1.8 0.5 Q313 4.8 29.5 -4.8 0.0 1.7 Q413 5.3 20.1 11.5 0.0 17.1 Q114 7.3 0.3 14.8 0.0 3.1 Q214 1.4 9.5 -2.3 2.3 0.7 Q314 0.0 11.4 -25.5 0.0 -10.1 Source: Deutsche Bank Page 54 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Japan Rates Gov. Bonds & Swaps Makoto Yamashita, CMA Strategist (+81) 3 5156-6622 [email protected] Japan Strategy Overview The BOJ's massive bond-buying operations have perhaps convinced many JGB market participants that ultra-low yields are here to stay, but we expect high volatility to start generating upward pressure if further yen depreciation makes the central bank's +2% inflation scenario look achievable. Non-bank investors have bought up foreign bonds for six straight months since April, continuing to do so even in September as the yen weakened. We therefore see potential for a self-fulfilling prophesy whereby investor expectations of further yen weakness drive the currency even lower. It is still possible that the BOJ will announce further monetary easing measures at the end of October, but some veterans from within the ruling Liberal Democratic Party (LDP) have actually started to suggest that the central bank should be moving closer to an exit from Quantitative and Qualitative Monetary Easing (QQE) as yen depreciation continues to draw ire from regional voters struggling with higher gasoline prices and smaller businesses finding it difficult to pass through higher import costs. We expect to see further opposition to BOJ easing—from both politicians and the broader public—in the event that the yen continues to weaken, which suggests to us that there is perhaps only limited room for JGB yields to decline from their current (already historically low) levels. JPY rates can't stay ultra-low forever The 10y JGB yield has dropped back below 0.5% as declines in short- to medium-term interest rates to almost unfeasibly low levels—with the 2y yield hitting 5bp—generate downward pressure further out the curve. When contemplating the sustainability of such ultra-low interest rates it is necessary to recognize that they reflect (1) a renewed decline in overseas interest rates, (2) concerns over domestic economic weakness and an increasingly gloomy global outlook (particularly in the eurozone), (3) the fact that JGB yields rose only modestly in September even as the yen weakened and equities rallied, and (4) continued tightening of supply/demand as a consequence of the BOJ's massive bond-buying operations. Supply/demand will probably continue to tighten as the BOJ keeps buying up JGBs for at least the time being, but the bond market landscape has started to look quite different since September due to higher volatility in the equities and FX markets. The yen has already weakened quite significantly, but we expect that USD/JPY will keep rising to around 115–120, thereby raising the possibility of Japan's core CPI inflation rate—already above +1% even after subtracting out the consumption tax hike impact—reaching the BOJ's +2% "price stability target" at some point next year. The final quarter of 2014 is liable to be a particularly volatile time for global financial markets as the Fed takes further steps towards its exit from QE3. Deutsche Bank AG/London Page 55 10 October 2014 Global Fixed Income Weekly Continued investment in foreign bonds will keep driving the yen lower Japanese investors were net buyers of foreign bonds (long-term debt securities) to the tune of JPY1.3 trillion in September. Moreover, banks—who tend to invest mostly on an FX-hedged basis—accounted for just JPY371.6 billion of this total, meaning that JPY941.4 billion is likely to have reflected purchases by investors taking on at least some exposure to exchange rate risk. Life insurers bought JPY653.1 billion more that they sold, while "financial instruments firms" were net buyers to the tune of JPY760.3 billion. Non-bank investors have now been net buyers for six straight months since April, with their total net purchases over this period amounting to some JPY7.5 trillion. Some might have expected a selloff in September as USD/JPY surged out of its 101–104 range to around 110, but while investment trusts did indeed sell JPY155.4 billion more than they bought last month, other investors were seemingly prepared to chase the yen even lower rather than taking profits on their existing positions. Figure 1: Banks versus non-bank investors: net purchases of foreign long-term debt securities 4000 (billion yen) Banks Non-bank investors 3000 2000 1000 0 -1000 -2000 -3000 -4000 11 12 13 14 Source: Ministry of Finance, Deutsche Securities Data on the regional breakdown of investment for August indicate that Japanese players became net sellers of French bonds after net purchases of JPY3.1 trillion from April through July, also became modest net sellers of German bonds, and continued to sell off Italian bonds as eurozone interest rates declined even further. The UST market appears to have picked up the slack, attracting some JPY877.5 billion in net purchases. We will not be surprised if September data show a further shift from Europe to the US consistent with a continued rise in the USD/JPY exchange rate. Page 56 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Figure 2: Net purchases of foreign long-term debt securities by region (trillion yen) France Germany US 13 14 4 3 2 1 0 -1 -2 -3 -4 11 12 Source: Bank of Japan, Deutsche Securities Political concerns over inflation liable to hinder additional BOJ easing It is still possible that the BOJ will announce further monetary easing measures at its October 31 board meeting. However, the central bank's October 7 statement merely reiterated that "Japan's economy has continued to recover moderately as a trend", with its overall tone and inflation outlook unchanged despite an acknowledgment that "industrial production has recently been showing some weakness, due in part to inventory adjustments". The September industrial production index (to be published on October 29) will be the only important economic indicator before that time, and with the yen having weakened quite significantly of late, it should come as little surprise if the BOJ sticks to its scenario of +2% inflation despite (perhaps) lowering its economic growth forecasts for the current fiscal year. In other words, we do not expect the BOJ's semiannual Outlook for Economic Activity and Prices report to provide much justification for additional monetary easing at this juncture. Recent concerns over yen weakness expressed by a number of policymakers are also likely to stay the BOJ's hand. The recent rise in USD/JPY has been driven largely by Fed rate hike expectations and will perhaps continue until and unless the BOJ shows signs of shifting into tightening mode. By driving up import prices and raw materials costs, recent yen depreciation has exacted a significant toll on regional voters who are comparatively big users of gasoline and smaller businesses that find it relatively difficult to pass through upstream cost increases. BOJ Tankan results for March did show the business conditions diffusion index (DI) for small nonmanufacturers—collectively Japan's biggest employers—rise above zero for the first time since 1990, but subsequent declines in June and September suggest that the economic recovery might still be limited mostly to large manufacturers. Deutsche Bank AG/London Page 57 10 October 2014 Global Fixed Income Weekly Figure 3: Tankan business conditions DI: large manufacturers vs. small nonmanufacturers (% pt) 60 Large manufacturers Small nonmanufacturers 40 20 0 -20 -40 -60 -80 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 Source: Bank of Japan, Deutsche Securities Politicians are likely to be well aware of this state of affairs. According to Bloomberg, Toshihiro Nikai—chairman of the ruling Liberal Democratic Party's general council—has indicated that the potential need for the BOJ to consider an exit strategy was flagged at the council's meeting on October 7. At this point in time it would appear that a majority of LDP lawmakers are still in favor of the BOJ maintaining the status quo, but that could quite easily change if further yen deprecation keeps driving up import prices. Before BOJ Governor Haruhiko Kuroda took the helm it was common for the government to call for further monetary easing and the central bank to resist, but the tables could soon be turned, with the BOJ finding it difficult to take any additional action unless the global economy slows sufficiently to start driving up the yen once again. We believe that the BOJ will see little option but to stick with its +2% inflation scenario for at least the time being, but it is quite possible that politicians will start questioning the need for that pace of price growth if the yen should continue to weaken. Page 58 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Pacific Australia New Zealand Rates Gov. Bonds & Swaps David Plank Macro strategist (+61) 2 8258-1475 [email protected] Dollar Bloc Strategy Ken Crompton Strategist (+61) 2 8258-1361 Bonds have rallied in virtually a straight line since 19 September. The gains over the past week have come despite the better-than-expected US payrolls report. If wage growth remains low then we expect the bond market will remain resilient even in the face of decent US payrolls. Of course there will be some nervousness of getting behind the curve if the unemployment rate continues to decline. But the evidence so far this year is that the bond market is prepared to wait for signs that wage growth is picking up before it reacts all that much to a declining unemployment rate. This suggests we shouldn’t be in a hurry to enter into a short duration position. We do, however, need to take valuation into consideration. The 10Y ACGB is very close to its low point for the year and now some 40bp below our year-end target. We think this is sufficient to recommend a modest duration underweight. A global rally remains the key risk. The AUD yield curve continues to be highly correlated with the direction of the long-end, steepening on sell-offs and flattening on rallies. Given our outlook for the RBA we see no reason why this won’t continue to be the case. Given that we expect the 10Y yield to finish the year higher we favour the curve to steepen from here. [email protected] 10Y yields close to their lows for 2014, but still some way above 2013 $-bloc 10Y bonds have rallied further this week, continuing the gains seen since the September FOMC statement. 10Y yields are now at or close to their lows for 2014. This is still some way above the lows for 2013, however. $-bloc 10Y bond yields 5.0 10Y NZGB (LHS) 10Y ACGB (LHS) 10Y UST (RHS) 10Y CAN (RHS) 4.8 3.2 3.0 4.6 2.8 4.4 2.6 4.2 4.0 2.4 3.8 2.2 3.6 2.0 3.4 1.8 3.2 3.0 Jan-13 1.6 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Source: Deutsche Bank, Datastream The rally this week has come despite the better-than-expected US employment report. The focus of commentary seeking to explain the US bond market reaction has been on the soft wages component. Average hourly earnings Deutsche Bank AG/London Page 59 10 October 2014 Global Fixed Income Weekly were unchanged for the month and the annual change slowed to 2% from 2.1% in August. Our US fixed income strategists interpret weak wage growth as reflecting low productivity and the ongoing need to protect profits. This is not something they expect to change any time soon. There have also been other factors at play this week. Weak European data, downbeat commentary from the IMF and ECB and news about Ebola have all been cited as contributing to the bond market gains over the course of this week. We think, however, that the soft US wages data has been the main driver. If wage growth remains low then we expect the bond market will remain resilient even in the face of decent US payrolls. Of course there will be some nervousness of getting behind the curve if the unemployment rate continues to decline. But the evidence so far this year is that the bond market is prepared to wait for signs that wage growth is picking up before it reacts all that much to a declining unemployment rate. This suggests we shouldn’t be in a hurry to enter into a short duration position. We do, however, need to take valuation into consideration. The 10Y ACGB is very close to its low point for the year and now some 40bp below our year-end target. We think this is sufficient to recommend a modest duration underweight. ACGB curve continues to be highly correlated with the 10Y UST During the first 19 days of September the 3Y/10Y ACGB futures curve steepened by a little more than 15bp. This was its biggest steepening move in 2014. While the period in question covers a futures roll, in this case the impact of the roll was essentially zero. The curve has retraced more than half of this steepening move over the past few weeks. 3Y/10Y ACGB curve since 2013 130 120 110 100 90 80 70 60 3Y/10Y ACGB futures spread, bp 50 40 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Source: Deutsche Bank, Reuters The steepening of the curve in September lasted for the duration of the bond sell-off. This makes it fairly easy to identify the cause of the recent moves in the curve – the direction of the 10Y UST. While the correlation between the curve and the US long-end is not perfect in 2014, possibly because of the impact of events in Europe, we think it is clear that the AUD curve is being driven by the global long-end (whether that be the 10Y UST or the 10Y Bund) not the AUD front-end. Page 60 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Curve vs 10Y UST in 2014 140 3.1 135 3Y/10Y ACGB futures spread, bp (LHS) 130 3.0 10Y UST (RHS) 125 120 2.9 115 110 2.8 105 100 2.7 95 90 2.6 85 80 2.5 75 70 2.4 65 60 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 2.3 Jul-14 Aug-14 Sep-14 Oct-14 Source: Deutsche Bank, Reuters This has been the case for more than two years. This reflects the fact the AUD front-end has, to all intents and purposes, been stable since mid-2012. This is not to say the front-end has been completely devoid of volatility, but it has lacked a trend powerful enough to have a material impact on the yield curve. Curve vs front-end 1.8 1.6 1.4 0.0 3Y/10Y futures spread (LHS) 1.0 3M rate implied by IR4 - inverted (RHS) 1.2 2.0 1.0 3.0 0.8 4.0 0.6 0.4 5.0 0.2 6.0 0.0 -0.2 7.0 -0.4 8.0 -0.6 9.0 -0.8 -1.0 Jan-98 10.0 Apr-00 Jul-02 Oct-04 Jan-07 Apr-09 Jul-11 Oct-13 Source: Deutsche Bank, Bloomberg Financial LP Our Australian economics team expects the RBA to be on hold for an extended period of time, perhaps into 2016. If this view is correct and the market continues to accept this then the fate of the curve will remain in the hands of the long-end. And while the 10Y ACGB hasn’t been solely driven by the 10Y UST in 2014, it remains the case that the big moves in the long-end rates over the past few years have been driven by the US. We see little reason for this to change. Hence we continue to see the outlook for the curve as highly correlated with the outright direction of the 10Y bond. Given that we expect the 10Y yield to finish the year higher than currently we favour the curve to steepen from here. The biggest risk to this view is a continued rally in the US long-end. David Plank +61 2 8258 1475 Deutsche Bank AG/London Page 61 10 October 2014 Global Fixed Income Weekly Global Economics Rates Gov. Bonds & Swaps Inflation Markus Heider Strategist (+44) 20 754-52167 [email protected] Global Inflation Update Global EUR and GBP breakevens continued to tighten in steepening mode this week, while USD B/Es stabilized after the September FOMC meeting minutes were perceived as dovish. Agricultural and industrial metal prices rose, equity markets showed some signs of stabilization—at least in the US—, but oil prices continued to fall strongly and nominal yields rallied. Economic data were on balance weaker than expected in EUR, but continue to be robust in the US. Labour market trends in particular appear to remain strong, and despite only gradual progress in some metrics such as quits and part-time employment, leading indicators remain consistent with a progressive increase in US wage growth in the coming quarters (chart 1). Cross-market trends have been more consistent with relative data trends, with GBP/USD spreads—which looked too wide a few weeks ago—now back at the tighter end of their three-month relationship. One noteworthy recent trend has been the sharp decline in 5y5y forward TIPS B/Es, which this week reached levels close to historical lows (chart 4). The 5y10y TIPS B/E curve indeed has steepened less in the recent sell-off than could have been expected based on typical directionality (see last week’s update). The 5y10y slope also looks somewhat flat when compared against economic factors such as oil prices, spot CPI or the ISM (chart 3). As a result, 5y5y TIPS B/Es have fallen well below 2.20% (chart 4), which is probably lower when compared to implied central bank inflation targets than 5y5y B/Es in the euro area. While in the euro area the market is concerned about the possibility of a regime shift in inflation, the risk would appear much lower in the US, despite the recent FOMC discussions about a possible start to policy rate normalization; Fed policy has proved quite pro-active in addressing downside risks since 2008. Some of the cheapness in 5y5y TIPS can probably be explained by institutional factors, given the recent widening in the swap-cash basis (chart 2). We see upside for 5y5y TIPS B/Es, for 10y should commodity prices stabilize, as well as for 5y5y USD/EUR B/E spreads. 3. 5y10y TIPS B/Es steepened less than expected 3.5 5.5 z-scores 5.0 2.5 4.5 1.5 4.0 3.5 0.5 3.0 -0.5 2.5 2.0 -1.5 NFIB exp compensation (10m lead) umplyt rate (15m lead) quit rate, priv (10m lead) hourly earnings, % y/y (rhs) -2.5 -3.5 1988 1991 1994 1997 2000 2003 1.5 1.0 0.5 2006 2009 2012 2015 Source: Deutsche Bank 2. USD 5y5y swap-cash basis wider 0.8 5y5y USD BEI: swaps - cash 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 -0.1 -0.2 Jan-10 Sep-10 May-11 Jan-12 Sep-12 May-13 Jan-14 Sep-14 Source: Deutsche Bank 4. 5y5y TIPS B/Es at lows 4.0 0.80 TIPS implied ZC 5y5y BEI 5y10ys 0.70 1. LI point to rising US wage growth last fitted 3.5 0.60 0.50 3.0 0.40 2.5 0.30 0.20 2.0 0.10 0.00 Jan-10 Aug-10 Source: Deutsche Bank Page 62 Mar-11 Oct-11 May-12 Dec-12 Jul-13 Feb-14 Sep-14 1.5 2003 2005 2007 2009 2011 2013 Source: Deutsche Bank Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly EUR EUR B/Es across all maturities continued their slide lower this week (chart 1). Oil prices were down another 3%-5%, with brent falling below USD90. The trend in crude has been putting ongoing downward pressure on near-term HICP expectations, with both October and November forecasts revised lower again this week; headline inflation is now expected at only 0.5% y/y in Q4. Downward revisions to near-term ILB carry projections have pulled 1y B/Es lower. Recent B/E weakness has however gone beyond what could have been expected on the basis of commodity price and spot HICP trends alone (chart 2). Economic data has been a negative as well, with German industrial production in particular pointing to downside risks to Q3 GDP forecasts, even when taking into account monthly volatility. While we are expecting some stabilization in data in the coming months, recent negative momentum raises the downside risks for forecasts of domestic inflation recovering. In that context, and with the exchange rate appreciating somewhat and Spain issuing EUR5bn in a new SPGei19, B/E weakness has been broad-based across maturities (chart 1). 1y swap rates 1y, 2y or 4y ahead were down about 8bp, while 5y5y fell to new lows below 1.9%. The decline in 5y5y is likely to reflect in part the shift lower in the balance of risks to the inflation outlook (chart 3), and with the ECB apparently in ‘wait-and-see’ mode for now, the risks may still be on the downside. 1. EUR B/Es decline… 3.0 5y5y HICPxt swap rates 1y1y 4y1y 2.5 2.0 1.5 1.0 0.5 Jul-12 Dec-12 May-13 Oct-13 Mar-14 Aug-14 Source: Deutsche Bank 2. …more than suggested by spot HICP, commodities alone 2.5 DEMBE5Y 2.3 fitted, f(oil, agriculture, metals, spot HICP) 2.1 Next week will bring the final September HICP. Domestic CPI data released so far on their own do not explain the weak euro area core (and in particular services) flash HICP print, so further domestic core CPI weakness is to be expected, not least from France. With m/m inflation expected negative (around 0.4%) for French CPI and positive (around 0.4%) for EUR HICP, carry trends will be significantly more positive for EUR ILBs than for FRF CPI ILBs through November. We expect inflation to remain relatively subdued in France, and maintain a preference for EUR over FRF inflation. 1.9 1.7 1.5 1.3 1.1 0.9 0.7 Jan-10 Aug-10 Mar-11 Oct-11 May-12 Dec-12 Jul-13 Feb-14 Sep-14 Source: Deutsche Bank In RV, 2018 issues in our view look cheap and 2020 issues slightly rich on both the OATei and DBRei curves. The spread between BTPei and OATei inflation valuations has continued to narrow, while the SPGei24 is trading in line with OATei valuations. DBRei and especially OATei B/Es have cheapened against swaps, with long-end OATei close to the cheapest levels against swaps in one year (chart 4). We would be neutral on swap-bond B/E spreads. 3. Risks to the inflation outlook shifting to the downside SPF, skew: prob of infl. >=2% - <1.5% 5Y ahead 60 5y5y forward HICP swap 4. OATei B/Es have cheapened against swaps 40 2.8 50 2.6 ILB rich (-) / cheap (+) vs CPI swaps spot 30 1y mean 1y max 20 1y min 40 2.4 30 10 0 2.2 20 2.0 10 -10 -20 -30 0 2002 1.8 2004 2006 Source: Deutsche Bank Deutsche Bank AG/London 2008 2010 2012 OATei18 OATei20 OATei22 OATei24 OATei27 OATei32 OATei40 2014 Source: Deutsche Bank Page 63 10 October 2014 Global Fixed Income Weekly GBP In RV, up to 15y we find the UKTi19, -24 and -29 cheap against neighboring issues. At the long-end the new IL58 continues to look cheap on the curve. In forwards, 5y RPI remains richest 15y forward (around 3.9%) and we estimate cash 15y5y forward B/Es are above 4%; the low point in RPI (at the long-end) is 30y5y, at below 3.5%. 2 1w change on 9-Oct, carry adj, bp 0 -2 -4 -6 -8 BEI -10 Real Yld Nom Yld UKTi68 UKTi62 UKTi58 UKTi52 UKTi50 UKTi47 UKTi44 UKTi42 UKTi40 UKTi37 UKTi34 UKTi32 UKTi29 UKTi27 UKTi24 UKTi22 -12 UKTi19 We have been neutral on GBP B/Es given the weak trend in spot RPI, subdued imported inflation and absence of clear signs of a pick-up in domestic inflation. Economic data have remained relatively resilient however, and leading indicators continue to point to rising pay growth in the coming quarters. Moreover, valuations have declined significantly, and in 5y look low against historical averages (1y z-score below -4.5), baseline RPI forecasts, trends in commodities, FX or spot RPI (chart 3) or economic indicators (chart 2). While the near-term RPI risks may remain to the downside—we see headline RPI (as well as core CPI) inflation easing slightly next week—the risk-reward of being long B/Es has risen in our view. We would see upside for 5y B/Es at 2.85% (RPI) and 2.55% (UKTi19). 1. UKTi B/Es lower and steeper again UKTi17 UK breakevens continued to be under heavy pressure this week, with the B/E curve steepening significantly again; real yields rallied (chart 1). The re-pricing of policy rate expectations is a negative for front-end B/Es given lower expectations for the RPI mortgage interest payment component. Across markets, GBP B/Es mostly underperformed, and GBP/USD spreads have mostly moved broadly back in line with our models—in 5y GBP B/Es look even slightly cheap v USD. The B/E curve has however steepened more in GBP than in USD, which means that 5y5y B/E spreads remain relatively wide (chart 4); in 5y5y cash, we would maintain a preference for USD over GBP. Source: Deutsche Bank 2. 5y BEI looks low v economics… 4.0 3.5 GBP BEI 5y fitted, f(cost, demand, spot inflation & risk indicators) 3.0 2.5 2.0 1.5 1.0 0.5 2001 2003 2005 2007 2009 2011 2013 2015 Source: Deutsche Bank 3. …and against commodities, FX and spot RPI 3.6 3.4 4. 5y5y GBP/USD B/E spread still wide 1.2 GBPBE5Y 5y5y BEI: TIPS v UKTi fitted, f(FX, commodities, spot RPI, formula effect dummy) 1.1 3.2 1.0 3.0 0.9 2.8 0.8 2.6 0.7 2.4 0.6 2.2 0.5 2.0 Jan-10 Aug-10 Mar-11 Source: Deutsche Bank Page 64 Oct-11 May-12 Dec-12 Jul-13 Feb-14 Sep-14 0.4 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Source: Deutsche Bank Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Rates Gov. Bonds & Swaps Inflation Rates Volatility United States Alex Li Research Analyst (+1) 212 250-5483 [email protected] Inflation-Linked Inflation markets remained volatile this week, as investors digested the September FOMC minutes. The minutes were more dovish than expected, and provided some support to TIPS breakevens. We like the front end and the long end inflation markets. Our updated NSA CPI forecast favor the January 2016 TIPS. The 30yr TIPS auction later this month presents an opportunity to be long 30-year breakevens. We expect the Treasury to announce a $7 billion reopening of the 2/2044 TIPS on Thursday, October 16. Dovish minutes support breakevens Inflation markets remained volatile this week, as investors digested the September FOMC minutes. The minutes were more dovish than expected, and provided some support to TIPS breakevens. The minutes stated: “The Committee again anticipated that it likely would be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continued to run below the Committee's 2 percent longer-run goal, and provided that longerterm inflation expectations remained well anchored.” In Deutsche Bank’s updated NSA CPI forecast (based on the term structure of gasoline futures prices), the headline CPI is likely to drop towards 1% by March 2015, which would be a trough before a recovery in the second half of 2015 towards 2%. The core CPI will probably range between 1.7% and 1.8% for most of the first half of 2015, before rising towards 2% by 2015 yearend. DB NSA CPI forecast 6 5 4 3 2 1 0 -1 Headline CPI yoy -2 -3 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Source: BLS and Deutsche Bank We like the front end and the long end inflation markets. Our updated NSA CPI forecast favor the January 2016 TIPS. Deutsche Bank AG/London Page 65 10 October 2014 Global Fixed Income Weekly Rich/cheap issues in the front end TIPS market Price date: 10/09/14 BE Inflation Implied CPI DB forecast CPI Rich/ Cheap TII 1.625% 1/15/2015 TIPS -1.62% 237.12 236.95 Ri ch: 2 ti cks (-27bp) TII 0.500% 4/15/2015 -0.37% 237.69 237.23 Ri ch: 6 ti cks (-37bp) TII 1.875% 7/15/2015 1.00% 239.98 240.19 Cheap: 3 ti cks (11bp) TII 2.000% 1/15/2016 0.93% 240.97 241.55 Cheap: 8 ti cks (19bp) Source: Deutsche Bank The 30-year TIPS auction later this month presents an opportunity to be long 30-year breakevens. We expect the Treasury to announce a $7 billion reopening of the 2/2044 TIPS on Thursday, October 16. The auction will be a week later. The 30-year TIPS breakevens are near multi-year lows. Long end real yields in the US still look attractive relative to those in Europe. 30yr TIPS breakevens near multi-year lows Source: Bloomberg Long end real yields in the US still look attractive relative to those in Europe 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 3/1/11 US TIPS 2041 real yield minus French 2040 real yield 3/1/12 3/1/13 3/1/14 Source: Bloomberg and Deutsche Bank Page 66 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Contacts Name Title Telephone Email Head of European Rates Research 44 20 7545 4017 [email protected] EUROPE Francis Yared Alexander Düring Euroland & Japan RV 44 207 545 5568 [email protected] Global Inflation Strategy 44 20 754 52167 [email protected] Covered Bonds/SSA 41 44 227 3710 [email protected] Global RV & Rates Vol 33 1 44 95 64 08 [email protected] Euroland Strategy/ EUR Govt. bonds 44 20 754 74458 [email protected] UK Strategy & Money Markets 44 20 7547 3091 [email protected] Nick Burns Credit Strategy 44 20 7547 1970 [email protected] Stephen Stakhiv Credit Strategy 44 20 7545 2063 [email protected] Sebastian Barker Credit Strategy 44 20 754 71344 [email protected] Conon O’Toole ABS Strategy 44 20 7545 9652 [email protected] Paul Heaton ABS Strategy 44 20 7547 0119 [email protected] Rachit Prasad ABS Strategy 44 20 7547 0328 [email protected] Markus Heider Bernd Volk Jerome Saragoussi Abhishek Singhania Soniya Sadeesh US Dominic Konstam Global Head of Rates Research 1 212 250 9753 [email protected] Steven Abrahams Head of MBS & Securitization Research 1-212-250-3125 [email protected] Aleksandar Kocic US Rates & Credit Strategy 1 212 250 0376 [email protected] Alex Li US Rates & Credit Strategy 1 212 250 5483 [email protected] Richard Salditt US Rates & Credit Strategy 1 212 250 3950 [email protected] Stuart Sparks US Rates & Credit Strategy 1 212 250 0332 [email protected] Daniel Sorid US Rates & Credit Strategy 1 212 250 1407 [email protected] Steven Zeng US Rates & Credit Strategy 1 212 250 9373 [email protected] ASIA PACIFIC David Plank Head of APAC Rates Research 61 2 8258 1475 [email protected] Makoto Yamashita Japan Strategy 81 3 5156 6622 [email protected] Kenneth Crompton $ bloc RV 61 2 8258 1361 [email protected] [email protected] Sameer Goel Head of Asia Rates & FX Research 65 6423 6973 Linan Liu Asia Strategy 852 2203 8709 [email protected] Arjun Shetty Asia Strategy 65 6423 5925 [email protected] Kiyong Seong Asia Strategy 852 2203 5932 [email protected] Head of European FX and cross markets strategy 44 20 754 79118 [email protected] CROSS-MARKETS George Saravelos Source: Deutsche Bank Deutsche Bank AG/London Page 67 10 October 2014 Global Fixed Income Weekly Appendix 1 Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Francis Yared/Dominic Konstam Page 68 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly (a) Regulatory Disclosures (b) 1. Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. (c) 2. Short-Term Trade Ideas Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com. (d) 3. Country-Specific Disclosures Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan, Japan Investment Advisers Association. This report is not meant to solicit the purchase of specific financial instruments or related services. We may charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless "Japan" or "Nippon" is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may engage in transactions in a manner inconsistent with the views discussed herein. Qatar: Deutsche Bank AG in the Qatar Financial Centre (registered no. 00032) is regulated by the Qatar Financial Centre Regulatory Authority. Deutsche Bank AG - QFC Branch may only undertake the financial services activities that fall within the scope of its existing QFCRA license. Principal place of business in the QFC: Qatar Financial Centre, Tower, West Bay, Level 5, PO Box 14928, Doha, Qatar. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Business Customers, as defined by the Qatar Financial Centre Regulatory Authority. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation. Kingdom of Saudi Arabia: Deutsche Securities Saudi Arabia LLC Company, (registered no. 07073-37) is regulated by the Capital Market Authority. Deutsche Securities Saudi Arabia may only undertake the financial services activities that fall within the scope of its existing CMA license. Principal place of business in Saudi Arabia: King Fahad Road, Al Olaya District, P.O. Box 301809, Faisaliah Tower - 17th Floor, 11372 Riyadh, Saudi Arabia. United Arab Emirates: Deutsche Bank AG in the Dubai International Financial Centre (registered no. 00045) is regulated by the Dubai Financial Services Authority. Deutsche Bank AG - DIFC Branch may only undertake the financial services activities that fall within the scope of its existing DFSA license. Principal place of business in the DIFC: Dubai International Financial Centre, The Gate Village, Building 5, PO Box 504902, Dubai, U.A.E. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Professional Clients, as defined by the Dubai Financial Services Authority. (e) Risks to Fixed Income Positions Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a Deutsche Bank AG/London Page 69 10 October 2014 Global Fixed Income Weekly loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements. Page 70 Deutsche Bank AG/London 10 October 2014 Global Fixed Income Weekly Deutsche Bank AG/London Page 71 David Folkerts-Landau Group Chief Economist Member of the Group Executive Committee Guy Ashton Global Chief Operating Officer Research Michael Spencer Regional Head Asia Pacific Research Marcel Cassard Global Head FICC Research & Global Macro Economics Ralf Hoffmann Regional Head Deutsche Bank Research, Germany Richard Smith and Steve Pollard Co-Global Heads Equity Research Andreas Neubauer Regional Head Equity Research, Germany Steve Pollard Regional Head Americas Research International Locations Deutsche Bank AG Deutsche Bank Place Level 16 Corner of Hunter & Phillip Streets Sydney, NSW 2000 Australia Tel: (61) 2 8258 1234 Deutsche Bank AG Große Gallusstraße 10-14 60272 Frankfurt am Main Germany Tel: (49) 69 910 00 Deutsche Bank AG London 1 Great Winchester Street London EC2N 2EQ United Kingdom Tel: (44) 20 7545 8000 Deutsche Bank Securities Inc. 60 Wall Street New York, NY 10005 United States of America Tel: (1) 212 250 2500 Deutsche Bank AG Filiale Hongkong International Commerce Centre, 1 Austin Road West,Kowloon, Hong Kong Tel: (852) 2203 8888 Deutsche Securities Inc. 2-11-1 Nagatacho Sanno Park Tower Chiyoda-ku, Tokyo 100-6171 Japan Tel: (81) 3 5156 6770 Global Disclaimer The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information. Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report. Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Prices and availability of financial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an offer or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fluctuations and other factors. If a financial instrument is denominated in a currency other than an investor's currency, a change in exchange rates may adversely affect the investment. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis. Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors' own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the "Characteristics and Risks of Standardized Options," at http://www.theocc.com/components/docs/riskstoc.pdf . If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document. The risk of loss in futures trading and options, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures and options trading losses may be incurred that are greater than the amount of funds initially deposited. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor's home jurisdiction. In the U.S. this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorized by the BaFin. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and authorized by the BaFin. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. This report is distributed in Singapore by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch (One Raffles Quay #18-00 South Tower Singapore 048583, +65 6423 8001), and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/or distributed by Deut sche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank's prior written consent. Please cite source when quoting. Copyright © 2014 Deutsche Bank AG GRCM2014PROD032979
© Copyright 2024